Regulation Can’t Keep A2 Milk Down

Earlier this year, China sought to impose an e-commerce tax on foreign bought goods. Consumer products like baby formula and vitamins were going to be taxed as high as 11.9%. However, this policy must be taken with a grain of salt. Not all goods are tariffed.

There is what’s called a ‘positive list’. This list is a collection of approved foodstuffs for online sale in China. Some of the approved foodstuffs include wine and pet food. But the ‘positive list’ has caused some confusion among investors.

They are unsure whether some foodstuffs are on the ‘positive list’ or not. To be safe, investors sold out of many Australian consumer goods to limit their potential losses. Shares of Bellamy’s Australia [ASX:BAL] dropped as much as 11.5%, and Blackmores [ASX:BKL] fell 19.1%.

Instead of being fearful when others are, investors should be greedy. Sure, you could end up being wrong. But the way you decrease your chances of being wrong is by doing your homework. If you believe the tax won’t disrupt Aussie consumer products, then don’t run with the masses. Instead, based on your opinion, you can pick up companies like Bellamy’s and A2 Milk [ASX:A2M] for cheap.

I have a feeling that a lot of investors will be running back into A2 Milk this morning.

A2 Milk raises their outlook

This morning, A2 Milk announced that they expected earnings to beat original expectations yet again. This is the third time in the past six months that A2 Milk has increased their expected earnings. Even with the negative spin of the e-commerce tax, and the woes of the dairy industry in general, A2 Milk is still coming out on top.

They expect full-year revenue to be in the range of $350–360 million. And full-year operating earnings are expected in the range of $52–54 million. In addition, the balance sheet positive is forecasted to remain strong. This will reflect improved operating cash flow in the second half. Cash on hand is likely to exceed $50 million.

But what was it that made A2 Milk raise their earnings expectations?

Continuing to perform strongly

A2 Milk acknowledged a number of changes had taken place within the baby formula industry. The regulations have become extremely negative — at least in the eyes of investors. China’s e-commerce tax is still a burden on the outlook for baby formula.

However, the optimism of the ‘positive list’ is helping to soften fears. This is also coupled with the more recent Infant Formula Registration Rule. The rule extends to both domestic and imported baby formula products into China.

And ‘[While] the overall volume of infant formula exports is unlikely to change, there are likely to be fewer brands sold,’ according to Jan Carey, the chief executive of The Infant Nutrition Council.

So it was strong continued demand from China that spurred A2 Milk’s positive expectations. Yet there is always room for improvement. ‘The company continues to adjust and evolve its manufacturing and distribution model in response to such changes,’ the group said.

Some basic calculations

Before we start, I’d like to note this is a super simple example of how to use earnings expectations to determine things like earnings per share (EPS) and price-to-earnings (P/E) ratios.

OK, first we can find out EPS using the following: divide earnings by the outstanding number of shares. If we want to be technical, then we use:

Net income dividends

Source: Investopedia

But let’s keep things simple. Let’s also use the lower range of A2 Milk’s earnings expectations to be conservative. The number of outstanding shares is around 723 million.

Therefore, if we divide 52 million by 723 million, we get 0.07189. The idea is to achieve a really high EPS. As a point of comparison, a competitor like Bellamy’s has an EPS of 0.20.

But let’s now calculate P/E ratios to see how they stack up.

Using EPS, we can obtain P/E by dividing current share prices by EPS. As of close on Tuesday, A2 Milk’s share price was $1.50 per share. Now, just by plugging in the numbers, A2 Milk has a P/E ratio of 20.8.

If we put this figure into words, investors are willing to pay $20 for every $1.00 of current earnings. Comparing this to Bellamy’s P/E ratio of 52.5, A2 Milk is definitely the cheaper option. However, there could be an expectation that Bellamy’s might have much more potential than A2 Milk.

Again, keep in mind these are simplistic calculations to show you how you might do this with earnings expectations. If you wanted to do this properly, then averages and multiple variables need to be taken into account.

But hopefully this example might help you in your own further research into A2 Milk, or any other stock for that matter.

Härje Ronngard,

Junior Analyst, Money Morning

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Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

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