Insights

The A2 Milk Company (ASX:A2M) has concluded FY18 with a robust performance, surpassing recent guidance and consensus expectations. Notably, underlying NPAT soared by 116% to NZ$195.7 million, while underlying EBITDA witnessed a remarkable 101% increase to NZ$283.0 million. This impressive growth was propelled by a significant surge in revenue (+68%), primarily driven by the stellar performance of infant formula, constituting 79% of group sales.

Strong Market Presence

Australia/New Zealand

The region witnessed a remarkable 69% EBITDA growth, with a2 Platinum commanding a market share of 32% in Australian supermarkets, marking a notable increase from previous periods.

China and Other Asia

Similarly, China and other Asian markets reported robust results, with EBITDA soaring by 148%. Notably, a2 Platinum's market share by value in China witnessed a rapid ascent, reaching 5.1% over the year and 5.4% by 4Q18.

Financial Strength and Outlook

Cashflow Performance

Operating cashflow surged by 131% to NZ$231.1 million, significantly surpassing expectations. This strong cash generation has bolstered A2M's balance sheet, culminating in a net cash position of NZ$340.5 million, or 47 cents per share.

Growth Prospects

While A2M refrained from providing formal FY19 earnings guidance, its outlook commentary remained optimistic. Forecasts anticipate robust NPAT growth of 37.0% in FY19 and 29.4% in FY20, driven by further market share gains, recent price adjustments, and expansion into new products and markets, particularly in China.

Investment Perspective

Strategic Investments

A2M continues to invest in long-term profitability through heightened marketing efforts to enhance brand awareness, expansion into new territories such as the UK and USA, and innovation in product development. While these endeavors may temporarily impact profitability, the company's strong balance sheet augments its ability to drive additional earnings growth over the long term.

Investment Insights

Trading at a PEG ratio of 0.9x in FY19 and FY20, A2M maintains an Add recommendation, reflecting its robust performance and promising growth prospects. Additionally, the share price target has been revised upwards, signaling confidence in the company's trajectory.

In summary, The A2 Milk Company's stellar performance in FY18 underscores its resilience and market leadership. With a solid foundation and strategic initiatives in place, A2M is well-positioned for sustained growth and value creation in the evolving dairy industry landscape.

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Reporting season playbook

Investors are waiting for a circuit-breaker. Stretched valuations limit upside potential for a further re-rating of the market multiple (15.8x 12month forward PE, Industrials ex-Financials at 21.8x) and without clear earnings momentum in either direction the market is likely to remain rangebound.

We prefer to err on the side of caution and take profits where prices have run ahead of fundamentals (CSL, DMP, BKL, BAL and CGC) and think rotation within the market rather than a clear breakout will define FY18 reporting season. We stick by our conviction calls and supplement them with higher-than-average cash levels. This will give investors capacity to deploy capital into the inevitable bouts of volatility.

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Three additions to our list this month

We add OZ Minerals (OZL), Atlas Arteria (ALX) and Volpara Health Technologies (VHT) to our list in August 2018.

OZ Minerals (OZL) enjoys robust cashflows from an established production base in copper, which has among the best outlooks in the commodities suite, driven by electrification of the developing world. OZL's counter-cyclical growth strategy will be rewarded as the Carrapateena development project is gradually de-risked in the coming 1-2 years, and could justify valuations closer to $12.50 per share upon successful commissioning.

Atlas Arteria (ALX) offers valuation support and strong potential distribution growth over coming years. French tollroad APRR is ALX's key asset. Cashflows are driven by growing toll revenues, cost containment, substantial decline in debt service and legislated corporate tax rate cuts.

Volpara Health Technologies (VHT) is a leading IT healthcare provider aiming to improve early detection of breast cancer. Volpara's SaaS model is linked to a growing medical need. Volpara's market share of breast screening in the US is currently 3.7% with a pathway to grow to 9% in FY19. VHT have a business model leveraged to growing and reoccurring revenue (FY19 guidance of NZ$9.0m) with the ability to pass on improved pricing over time.

Eight high conviction stocks in August

Our high conviction stocks are those that we think offer the highest risk-adjusted returns over a 12-month timeframe, supported by a higher-than-average level of confidence. They are typically our preferred sector exposures.

Here are our eight high conviction stock picks this month:

1. Westpac Bank (WBC)
2. Suncorp (SUN)
3. OZ Minerals (OZL)
4. Atlas Arteria (ALX)
5. Volpara Health Technologies (VHT)
6. Kina Securities (KSL)
7. CML Group (CGR)
8. PWR Holdings (PWH)

Morgans clients receive access to detailed market analysis and insights, provided by our award-winning research team. Begin your journey with Morgans today to view the exclusive coverage.

Disclosure of interest: Morgans may from time to time hold an interest in any security referred to in this report and may, as principal or agent, sell such interests. Morgans may previously have acted as manager or co-manager of a public offering of any such securities. Morgans affiliates may provide or have provided banking services or corporate finance to the companies referred to in the report. The knowledge of affiliates concerning such services may not be reflected in this report. Morgans advises that it may earn brokerage, commissions, fees or other benefits and advantages, direct or indirect, in connection with the making of a recommendation or a dealing by a client in these securities. Some or all of Morgans Authorised Representatives may be remunerated wholly or partly by way of commission.

Stock investors have enjoyed an extended bull market since March 2009. It was particularly enjoyable during 2017, when the ASX 200 Accumulation Index rose by 11.8% over the year. Such an impressive return is quite extraordinary for an aging bull market going on nine years in 2018. The music seemed to stop abruptly when the S&P 500 plunged 10.2% over 13 days from late January through early February. Our market fared much better given we had missed most of the US January rally.

Although equities have recovered somewhat since, the episode is a reminder that expensive equity, bond and bond-proxy prices are at risk from the end of ultra-low cash and bond yields. The bout of volatility does present some opportunities and we added some names that we think will outperform on a risk-adjusted basis over the year.

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Four changes to our list this month

We add Suncorp Group (SUN), Cleanaway Waste Management (CWY) and CML Group (CGR) to our list in April.

This month we remove ResMed (RMD) following a strong 52% return since inclusion. While we maintain a positive view of the company's strategy, RMD has exceeded our price target and think it prudent to book in profit ahead of a typically volatile quarter for the company (RMD reports Q3 results on April 27).

Nine high conviction stocks in April

Our high conviction stocks are those that we think offer the highest risk-adjusted returns over a 12-month timeframe, supported by a higher-than-average level of confidence. They are typically our preferred sector exposures.

Here are our nine high conviction stock picks this month:

Suncorp Group (SUN)

Suncorp is a financial services conglomerate offering banking, general insurance, life insurance, super and investment products.

We think SUN can comfortably get back to its long run target of 12% underlying insurance margin in FY19. This is driven by non-recurrence of some costs in FY19, benefits of SUN's business improvement program (+ approximately A$130m in FY19) and roll through of recent rate increases.

Cleanaway Waste Management (CWY)

Cleanaway is a provider of waste management services in Australia, with operations in both solid and liquid waste.

With the growing importance of sustainability in household, business and government decision-making, we expect waste management to become an increasingly valuable sector with CWY the Australian leader.

Oil Search (OSH)

Oil Search is a major oil and gas developer/producer. OSH's key asset is its 29% interest in the world-class PNG LNG Project/Development, operated by ExxonMobil.

We still hold the view that OSH is ideally placed to benefit from a global-scale organic growth profile, which could be further enhanced by additional exploration and appraisal.

Westpac Bank (WBC)

Westpac is Australia's oldest banking and financial services group, with operations throughout Australia and New Zealand.

We expect WBC to comfortably meet APRA's 'unquestionably strong' capital benchmark through undiscounted dividend reinvestment plans.

Link Administration (LNK)

Link is the largest provider of superannuation fund administration services to funds in the Australian super system and a leading provider of shareholder management and analytics and share registry services.

We believe the market's view on LNK's core Fund Administration business being ex-growth is too bearish. We think it will at least grow at inflation levels from here. Moreover, the synergy target from the CAS acquisition of £25m would appear to be conservative.

BHP Billiton (BHP)

BHP is the world's largest diversified resources company, with a large portfolio of diversified mining and energy interests.

BHP asserts itself as an attractive sector exposure, with group EBITDA margin stable at an impressive 52%, balance sheet gearing down below 20%, and the prospect for excess cash flow being returned to shareholders.

Senex Energy (SXY)

Senex is an oil and gas company focused on operating and developing energy sources in Australia's Cooper, Eromanga and Surat Basins.

SXY is ideally positioned to make a material impact on the east coast gas market with two gas projects expected to transform earnings over the next few years.

PWR Holdings (PWH)

PWR designs and produces cooling solutions for the high performance automotive industry and has an established track record in servicing motorsports, including Formula One, NASCAR and V8 Supercars.

Key growth opportunities include: 1) capturing a greater share of customer spend on cooling solutions; 2) partnering with OEMs on high performance/low production run vehicles; 3) increased presence and entry into adjacent markets; 4) increased penetration in the US automotive aftermarket segment; and 5) opportunities in emerging technologies (Tesla, Google etc).

CML Group (CGR)

CGR provides small business financing solutions, primarily debtor finance (invoice factoring) and equipment finance to small-medium enterprises (SME) in Australia.

In our view, CGR has the potential to outperform earnings expectations over the next two years, in part via executing on its recent acquisition (meaningful potential cost synergies). This is coupled with a relatively undemanding valuation of approximately 10x FY19 PE.

Morgans clients receive access to detailed market analysis and insights, provided by our award-winning research team. Begin your journey with Morgans today to view the exclusive coverage.

There was a lot to like about the February reporting season. By our estimates, over 30% of large caps beat the market's expectations, while downgrades and significant misses among large caps were largely a non-event. However, the valuations investors are paying for earnings remain elevated by historical standards, and we caution investors who are expecting higher-than-average returns.

Current earnings growth sits well below the long-term average (approximately 9-10%), reflecting below-trend economic growth, while valuations (XJI on approximately 16x forward) appear to be pricing in earnings acceleration that is yet to be delivered. The market has been prone to overshoot the actual earnings trajectory in recent years and we think investors should stand ready to buy the dips when the inevitable bouts of market volatility hit, rather than chase expensive stocks higher.

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Two changes to our list this month

We add BHP Billiton (BHP) back to the list in March. Higher commodity prices, robust profitability, further valuation upside potential and rising shareholder returns all support our High Conviction call on BHP. The company also recently outlined that data rooms for all of its US onshore oil & gas assets would be open by the end of March, with the bids expected in the June quarter and assessed in the September quarter. We see this as the strongest positive catalyst for BHP in 2018. We also believe strong leverage to cyclical growth positions BHP well into a multi-year recovery for commodities.

This month we remove Corporate Travel Management (CTD) from our list. While we believe CTD can continue to deliver strong double digit EPS growth over coming years, the stock has put on 27% following its recent result, and has now exceeded our 12-month price target. Beyond the strong result, share price catalysts include further accretive acquisitions with opportunities currently being evaluated in both North America and Europe.

Seven high conviction stocks in March

Our high conviction stocks are those that we think offer the highest risk-adjusted returns over a 12-month timeframe, supported by a higher-than-average level of confidence. They are typically our preferred sector exposures.

Here are our seven high conviction stock picks this month:

1. Oil Search (OSH)
2. ResMed (RMD)
3. Westpac Bank (WBC)
4. Link Administration (LNK)
5. BHP Billiton (BHP)
6. Senex Energy (SXY)
7. PWR Holdings (PWH)

Morgans clients receive access to detailed market analysis and insights, provided by our award-winning research team. Begin your journey with Morgans today to view the exclusive coverage.

Disclosure of interest: Morgans may from time to time hold an interest in any security referred to in this report and may, as principal or agent, sell such interests. Morgans may previously have acted as manager or co-manager of a public offering of any such securities. Morgans affiliates may provide or have provided banking services or corporate finance to the companies referred to in the report. The knowledge of affiliates concerning such services may not be reflected in this report. Morgans advises that it may earn brokerage, commissions, fees or other benefits and advantages, direct or indirect, in connection with the making of a recommendation or a dealing by a client in these securities. Some or all of Morgans Authorised Representatives may be remunerated wholly or partly by way of commission.

If you have a large stockmarket shock as we have had in the last couple of days, the market will vary in a broad range in order to discover the prices that people want to buy at and sell at.

Market clearing is important. If markets always went up, no one would ever sell. There would be no supply of stock and the market would never clear itself. That's why corrections are really important.

When we go into periods of big volatility like this, it is the amount of liquidity in the US wholesale system that decides how long that period of volatility will last.

I think this period will last weeks rather than days. I think by the time we get to the end of March and into April, the amount of volatility will be absorbed and the market will be returning to its normal buoyant self.

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We are in a period like 2006 where there is a very large amount of US corporate liquidity. We can tell that because the spreads between US corporate debt in the US wholesale market and sovereign debt have fallen to the lowest levels since 2006. So there is a vast amount of liquidity and that is providing a lot of money to the stock markets.

If I value the Australian stock market in terms of earnings per share and bond yield right now I get a value of around 5700 points. But if I include the additional supply of US corporate debt in the US wholesale market to a model, I get a fair value of 6300 points. I think that estimate is what is appropriate right now. I think that our market right now is hundreds of points too cheap.

When we came into this correction, the US market was about 9% too high including all of the factors I've just spoken about and the Australian market was about 4% too low.

That is because the US market is extending a run towards the end of its cycle whereas we are starting a new cycle based on the improvement of commodity prices.

We are going through a period of high volatility. Because of the size of that volatility I think it will take weeks to clear and not days. By the end of March we will be out of this period.

When we come out of this period we should realise we are in a period of a huge amount of US corporate wholesale liquidity which will continue to bid up markets. My fair value of the Australian stock market including that liquidity is 6300 points. This means that when this volatility eases we will be in a market which is hundreds of points too cheap.

Morgans clients receive access to detailed market analysis and insights, provided by our award-winning research team. Begin your journey with Morgans today to view the exclusive coverage.

On track for a solid season

The first half reporting season kicks off later this week, and according to the latest Thomson Reuters earnings estimates, EPS for the S&P/ASX200 is forecast to grow by 7.0% in FY18, down from the 11.3% in FY17.

This pace of growth is forecast to continue over the following two years (FY19: 5.9%, FY20: 5.2%) providing a platform for steady equity returns, with stronger global growth and improving business conditions offering the upside.

In our view the sectors best placed for upside surprise this reporting season include Resources, Offshore Earners and Retailers.

Key points

• Positive business and consumer sentiment sets the tone for the February reporting season and investors have responded by putting capital to work.
• Since August results, already extended growth stocks have further re-rated against a backdrop of US tax cuts, low inflation and low volatility. This cannot occur indefinitely and company results typically provide the reality check that investors need to recalibrate their expectations. We think growth stocks risk underperforming in February.
• The European resurgence and the Trump-led economic reforms in the US are poised to continue to buoy ASX offshore earners (Corporate Travel Limited, Reliance Worldwide, Apollo Tourism). While Australian economic growth is improving, offshore markets continue to set the pace for an economic rebound. We expect to see companies further clarify the extent of the US tax reform benefits via their results.

Valuations set a high bar for market darlings and growth stocks

Elevated valuations will again set a high bar for growth stocks and unless earnings upgrades are likely, we prefer to err on the side of caution and take profits where we think prices have run ahead of fundamentals.

We look for evidence that improving business and consumer sentiment is beginning to translate into meaningful earnings tailwinds for businesses.

What concerns us is the magnitude of the divergence between high PE and low PE industrial stocks. The spread is the widest it's been in five years, and we think February will be the reality check the market needs to bring valuations back into line.

We prefer industrial stocks where we identify upside risk to earnings and guidance (Corporate Travel Limited, Reliance Worldwide, JB Hi-Fi).

Counting on a capex turnaround

The Australian corporate environment is witnessing evidence of some positive earnings trends driven by the rebound in commodity prices and better operating conditions. Until recently capital spending had been conspicuously absent from the rebound.

That has changed, and with the improving earnings environment and high levels of business confidence, we believe capital expenditure could continue to grow, which could strengthen the earnings expansion and help reverse declining growth in productivity.

Commodities recovery doing the heavy lifting

The Resources segment is enjoying EPS growth of 15-20% while Industrials growth is tepid at 6-7%. Arguably the Industrials side of the market, which is trading on elevated valuations, is in part trying to pre-empt the flow through of higher Resources earnings into the economy.

Higher dividends are a certainty in February (in line with dividend policies) with dividend upside risk driven by the fact that key commodity prices (oil, iron ore, coal) have traded well above consensus expectations through late 2017.

In our view, the bulk commodity miners (BHP, Rio Tinto, Fortescue Metals, Whitehaven Coal) offer best upside capital management potential.

Morgans clients receive access to detailed market analysis and insights, provided by our award-winning research team. Begin your journey with Morgans today to view the exclusive coverage.