Prospective Analysis On A2 Milk Financial Performance

Question

Task: Create a report on the prospective analysis of the A2 milk. Forecast the future A2 milk financial performance for the next five years and beyond.

Answer

1: EXECUTIVE SUMMARY:
This report forecasts the A2 milk financial performance for the future years. This has been done using the valuation models i.e. Dividend Discount Model, Cash Flow Model and Residual Income Model. A sensitivity analysis has been presented to ascertain the impact of various assumed factors on the financials which shall help the management in impoverishing the possible threats and identifying business opportunities. Suggestions have been made to the management with remedies to the identified challenges. This study on A2 milk financial performance shall help the management of the company in planning its future operations accordingly.

2: FORECASTS
Financial Forecasts refers to estimating the future profits and losses for an entity over a period of time. Generally, projections of the elements of Profit and Loss Account like Sales, Expenses etc. are made. Accordingly, the Balance Sheet and Cash flow projections are made. It is a vital part of operating a healthy business structure. With correct and accurate A2 milk financial performance and planning, entities can look forward to expansion opportunities by planning their allocation of funds in the right way. Any future A2 milk financial performance requirements can be ascertained which shall help the management in making sound decisions on the sources of funds. The management can start preparing for the same at the right time. Any future roadblocks can be predicted and the management can prepare for the same so that the core functions of the business operations are not impacted (Acharya, Eufinger and Hirsch 2018). With correct management decisions, the firm can achieve overall success. With effective sales forecasts, the productions and procurements can be managed effectively. There is control over the cash flows of a company and thus overall satisfaction of all stakeholders.

A2 milk financial performance forecasts are therefore done in order to:

• Determine the requirements of any additional external funding in the plan.
• Determine the availability of surplus cash resources in the future to distribute to investors as dividends from the plans.
• To ascertain if the plans prepared are feasible. If the forecasts show poor results of the company in the future due to certain factors, the management can make amendments to the plans in an endeavor to produce better outcomes.

2.1: Steps to create A2 milk financial performance forecasts:
Financial plans are created to outline the growth of the company. It forms a primary component of a business plan. Financial plan is not just about the numbers, it is also about how various components of the financial forecasts are clubbed together to create an overall financial plan suitable to the business. Sales forecast, expense budget and cash flow statement form the most important components of financial forecasts. An overall business plan which also contains marketing plan and strategies have no meaning unless they are backed by a financial plan which contains the numbers based on which other plans have been derived. A good financial plan can help to win investors in a business model. Investors see future prospects of the company and invest in it. They see the return expectations, the market price fluctuations, free cash flows and various other parameters before making a decision to invest. Investors check if a particular share is currently over-priced or underpriced to determine its purchase viability. Dividend payout ratio is another key parameter impacting investor decisions.

The second important purpose of A2 milk financial performance forecasts or plans are to obtain bank loan. In order to obtain a bank loan, the client company is required to submit the future prospects by way of a project feasibility report. This report contains the previous year data as well the future forecasts with underlying assumptions. The credit rating of the company is done and based on that the bank grants the client company the required loan with the interest rate dependent on various factors like the credit rating, equated monthly instalments, tenure of loan, amount of loan, business industry of the client company etc. Hence, the financial statements play a very important role. The steps to build A2 milk financial performance forecasts are:

• Estimate sales figure of current goods and services based on previous year trends. Usually an average of regular sales is calculated. A markup of growth is added to the average figure. Any new products or services aimed to be sold or serviced are determined. The revenue from the sale of new goods and services is determined based on demand and market study. This is added to the figure or original goods and services initially calculated to arrive at the forecasted sales numbers. Any change expected due to other socio economic, environmental or political factors are factored in.
• Cost of sales: To estimate the cost of sales while evaluating A2 milk financial performance, the purchase forecast is prepared. This is done by preparing a list of suppliers and analyzing the purchases made during the previous year. Obsolete or outdated stocks which are not required to be purchased in the years going forward are excluded. The purchases are done in a manner that the sales targets are achieved and the minimum required inventory is always lying in the inventories. Cost of sales in then determined based on the opening inventory, added to the purchases and deducting the amount of closing inventory required.
• Other income and expenditures (operating): All other operating incomes and expenditures too are arrived by computing the previous year numbers as a percentage of sales.
• Plant and Machinery: With increase in sales volumes, the requirement of additional plant and machinery also increases. New machines are required to cater enhanced supplies if the full capacity of the existing machine is exhausted. A company needs to make investments in its fixed assets as and when required. These are big investments and required years of retaining of funds to be used. A2 milk financial performance forecast need to prepare in a manner that there are surplus funds available to invest. Depreciation and other repair expenditures need to be factored in the forecasts.
• Current Assets and Liabilities: These are usually derived as a percentage of sales and purchases based on past year trends. As per the A2 milk financial performance, the previous year trends of Accounts receivable turnover, accounts payable turnover, current ratios, quick ratio etc. are analyzed and used in preparation of future year forecasts. Any abnormal change in past years needs to be eliminated in the budgets.
• Long term investments: If there is surplus cash arising out of earnings, the same needs to be invested in interest bearing assets. A high level of liquid funds is not ideal for any company. A proper planning of long term investments and their maturities is therefore very important.
• Long term borrowings: Any acute possible cash shortage should be immediately identified and plans should be made in advance to procure funds from external sources. Any growth in business or diversification would require a huge amount of investment which can be procured through debt instruments. The A2 milk financial performance should therefore identify such possibilities and apply for loan in time because the process takes a long time.

The A2 milk financial performance forecast for the next ten years has been presented in the Appendix.

2.1: What are the assumptions in A2 milk financial performance Forecasts:

• Sales: Sales Forecast is the basis for all financial forecast in any company. The management team in-charge of preparing forecasts start with the sales forecasts. The most recent year’s balance sheet values are considered to be the baseline for the budgetary numbers. As per the A2 milk financial performance, the sales of the company have grown at a rate of more than 50% in each year over the last five years before 2019. In 2019, the sales grew at a rate of 41%. However, considering Global Recession and entrance of competitors in the field of dairy product supplies off late, a sales growth of 30% has been assumed for the first five years and a growth rate of 20% for the years thereafter. This growth accommodates both volume increase and price increase in the case of protein free milk provided by the company.

• Cost of Sales: The cost of sales as a percentage of total sales of A2 Milk has been reducing since the past years except for 2018. Only in 2018, the cost of sales rose by 60%. The A2 milk financial performance in 2019 signifies that the cost of sales was 45% of total sales. A similar assumption has been made on the A2 milk financial performance to forecast the cost of sales for future years. The percentage increase in cost of sales has been taken to be 50% of sales figure which is at par with the average of last five years. (Anderson et al., 2018).

• Other Revenue: The study of A2 milk financial performance signifies that this is an insignificant amount in the company’s income statement. It forms only 0.01% or less of the sales. It has therefore been assumed at a constant of $ 200 for the rest of the years of forecast. A slight upside or downside may be possible for the figures. No correlation of the other revenue figure could be established with sales. This is the reason why a fixed amount assumption has been taken for future years rather than presuming the other revenue total to be a certain percentage of sales.
• Operating Expenses: This includes the distribution, administrative, marketing, occupancy and other expenditures. These have been derived as a percentage of sales for the future forecasts. The basis for deriving the percentage applicable is the actuals of the last year ended 2019. Sales related operating expenses associated with the A2 milk financial performance like distribution expenses, administrative expenses and marketing expenses have been assumed as a percentage of sales same as last year i.e. 2019. Only a slight increase in distribution expense is assumed. Other expenses has been considered at a higher rate in the forecasts since with the addition of new plant, machinery etc. and degradation of existing machinery and equipment’s, the overall expenses like depreciation, repairs, reconstruction etc. shall increase. Thus, while evaluating A2 milk financial performance other expenditures have been assumed to be 15% of sales. This also includes a dividend payout growth of 5%.

• Interest Income: This component is also related to the A2 milk financial performance that has been derived as a percentage of Cash and Short term Investments where money held in the form of deposits in banks and other short term investments earn interest. All interest bearing investments are expected to earn 1%. The interest income is therefore calculated to be 1% of the total of cash and other short term investments.
• Finance Cost: This is also an insignificant amount and assumed at a constant rate of $200 for 2020 and $300 for the remaining period. A2 Milk does not have any financing from debt. It is a debt-free company. The only source of funds is equity. This shows that the A2 milk financial performance would be lower since there is no reliability on debt. In future too, there is no possibility of debt unless A2 Milk plans to expand its existing business or enter into newer lines of business.
• Income Tax Expenditure: This expense comes under the A2 milk financial performance shall be based on the Profits earned during the year under review. There are tax slabs to ascertain the income tax expenditure of an entity. For the analysis we have assumed a flat rate of 35% income tax. The average range may however vary from 30 to 40% depending upon the net taxable income arrived after claiming all deductions.

For Balance sheet items too, the A2 milk financial performance forecasting is done as a percentage of sales. Their relationship with Sales is derived and accordingly accommodated in the forecast numbers.

• Trade Receivables: Trade Receivables have been assumed to be 4% of sales. In a dairy business, the majority of transactions are carried out on a cash basis. However, there are some regular clients who follow the credit system of payments. Referring to the actual figures of previous years, this percentage has been arrived to compute the average trade receivables balance expected in future years.
• Prepayments: Similar to Trade Receivables, this balance too has been calculated as a percentage of Net Sales and contributes to the A2 milk financial performance. This balance is 3.8% of Sales.
• Inventories: Inventories are assumed to be 8% of Net Sales. To carry out regular business in smooth manner, entities are required to maintain certain inventory all the time. Since Dairy products have a shorter life span the inventory requirement at any time during the year is comparatively lower than other lines of business.
• Plant and Machinery: Investment in Plant and Machinery or any other fixed assets depends solely upon management and eventually boosts up the A2 milk financial performance. Investment is done based on requirement to expand the business, enter new lines of business or technology improvement. A 10% year-on-year increase has been assumed for each with some amount of lump sum investments every 2-3 years (Bernstein, Colonnelli and Iverson, 2019).
• Financial Assets: The long term financial assets have been assumed to rise at a certain percentage every year with certain lump sum investments every 2-3 years.
• Trade Payables: Trade Receivables have been assumed to be 27% of Cost of sales. Referring to the actual figures of previous years, this percentage has been arrived to compute the average trade payables balance expected in future years. Credit helps the business to invest cash in other areas.
• Other liabilities: Other liabilities include Income tax Payable and other payables. These have been assumed based on the previous year trends.

With changes in Income Statement and Balance Sheet other factors impacting A2 milk financial performance forecasts are:

• Growth margin: The growth margin in sales is assumed to be 50% of sales which is in line with the previous 5 years average trend. The average profit after tax for the last five years is 18% of sales. For 2019, the PAT is 22% of sales. With our forecast assumptions mentioned above, the profit after tax rises at a rate of 16% for the first two years and 14% thereafter. This is arrived after considering increase in distribution costs after volume rise and factoring of dividend distribution in other expenses.
• Asset Turnover: The asset turnover ratio is defined as Total Revenue divided by Average Total Assets. The average asset turnover ratio for the last five years is 140%. For 2019, the ratio stands at 131%. In our forecasts, the asset turnover after considering accumulated earnings, Depreciation, etc. ranges between 110% to 132%.
• Dividend Payout ratio: As per the calculations on A2 milk financial performance, the company currently does not pay any dividend. Its dividend payout for the last five years is zero. However, for future years, the forecasts consider a dividend payout of $0.15 per share with an annual increase of 5%. The dividend payout ratio stands at 41% for 2020 forecast. It keeps declining as the firm needs to retain earnings to work out its expansion plans.

3. Valuation Techniques:
There are primarily three defined valuation techniques which are used both in relative and absolute categories. The Investment models are Dividend Discount Model, Discounted Cash Flow Method and the Residual Income Approach. Each method has its own pros and cons. amongst these, the Dividend Discount Model is the simplest (Cull, Demirgüç-Kunt and Morduch, 2018). Each of the valuation methods have been discussed with reference to A2 milk financial performance.

3.1: Dividend Discount Model:
Dividend Discount Model is a method of valuation of a company’s share price by discounting its future dividend payments back to their present value. In simpler terms, it is the net present value of all future dividends. It is presumed that the present day price is the sum of all its future dividends discounted back to present value.

In case of A2 milk financial performance, the company has not paid any dividends since its listing on the Australian Securities Exchange. Despite earning a very high return on its Equity, the company fails to meet investor expectations of dividend payout (Das, 2018). A company earns profits from its business processes and makes dividend payments to shareholders from its profits. However, in our forecasts the company may be assumed to have a dividend growth rate of 5% each year since the company is currently in a stable position to pay the investors. The current market rate or cost of capital is assumed to be 7% which is the prevailing rate of interest in the market. The first year dividend in the assumption is taken to be $ 0.150. Dividend has been factored in other expenses forecast of all future years.

Value of Share = Expected Dividend per share / (Cost of capital equity – dividend growth rate)

In case of A2 Milk Company, value of share can be derived using the DDM technique as below –

Value of Share = 0.15 / (0.07-0.05)

= 0.15 / 0.02

= $ 7.5

Therefore, as per Dividend Discount Method, the value of equity of A2 Milk Company is $7.5 per share.

This can be multiplied with the number of outstanding shares to arrive at the value of the company.

Value of the company as per Dividend Discount method = 7.5 * 730,039 (in thousands)

= $ 5.5 billion.

Dividend Discount Model has many variations. Each of these differs in complexity. The simplest model assumes zero growth in the dividend. Another model is the Gordon’s growth model which assumes a constant dividend growth rate. In the above calculation, the Gordon’s growth model has been assumed. The third variant called the Supernormal dividend growth model used within this study of A2 milk financial performance where dividends for initial years are on a high and then the dividend policy assumes a constant growth. In such scenario, each year amount is discounted and added to arrive at the stock price (Lament, 2018).

In case of A2 milk financial performance, the DDM method is valuation is not recommended since the company does not have any past record of dividend payments. The future dividend payout of the company too depends upon various factors which include Management decisions; amount invested in fixed assets, capital buyback decisions etc. In such scenario, it is advisable to rely on other methods of investment valuation to value the company’s stock price.

3.2: Residual Income Method:
Residual Income method of valuation is a valuation method where the company is valued on the basis of present value of future residual incomes that are discounted at the most appropriate cost of equity. The RIM method of investment valuation is expressed as:

Value of Equity = Current Book Value + summation of [Residual Income of each future year / (1+required return on equity)]

Where,

Residual Income = (ROE – r) * B _t-1

This method thus measures the value created by a company through its business model and contributes to the A2 milk financial performance.

In case of A2 Milk Company, the current book value of each share is $1.08 for the year ended June 2019. The expected required return on equity is assumed to be 7% as assumed in case of DDM Model. Residual Income of each year has been calculated below: (calculated for 10 years starting 2020)

Value of Equity = 1.08 + 5.60

= $ 6.68.1

Therefore, as per Residual Income Method, the value of equity of equity of A2 Milk Company is $ 6.68 per share.

This can be multiplied with the number of outstanding shares to arrive at the value of the company.

Value of the company as per Residual Income method = 6.68 * 730,039 (in thousands)

= $ 4.9 billion.

This is the best method of equity valuation of firms which do not pay any dividends and have irregular cash flows. This method is thus most suited for the company’s valuation since the available A2 milk financial performance data is used for arriving at the value of the share. This method looks at the economic profitability of the firm and not just its accounting profitability. However, the drawback is that the method relies solely on future forecasts. This leads the valuations to be vulnerable of biases and misrepresentation.

3.3: Discounted Cash Flow Method for the A2 milk financial performance:
This method evaluates the value of a firm using its free cash flows. The future estimated free cash flows are discounted to arrive at the current year value by discounting them using the rate of expected cost of equity.

The study on A2 milk financial performance illustrates that the evaluations are based on how much money a particular company shall generate in the future. In case of DCF method, if the value calculated is greater than the current investment cost, investors consider it as an opportunity to invest in the company since they expect higher returns in the future (Lin, Schmid and Xuan, 2018).

The discount rate is assumed to be the expected cost of equity i.e. 7%, similar to the assumptions in the previously discussed model. The free cash flows and the present value of each using a 7% discount rate has been presented in the table below:

Present Value of A2 Milk Company as per Discounted Cash flow method (calculated taking free cash flows of 10 years) = $ 2 billion.

Value per share = Value of Firm / no. of shares outstanding

= 2 billion / 730 million

= $ 3 per share (rounded off)

In the calculation of discounted cash flows, the weighted average cost of capital is used to derive the discount rate. In this case, the prevailing market rate of return has been presumed to be the cost of equity. The company is a debt free company.

The risks associated with this method are that the risk free rates keep changing over time. This method can be used for small businesses but is not recommended for big firms with complex projects because there are several assumptions inculcated in the calculations. This method may be used for evaluating the valuation of A2 milk financial performance but is not the most recommended methodology.

3.4: Comparison of share prices obtained with actual share price:

On comparing the value of shares of A2 milk financial performance under different valuation methods, it is observed that currently the market price of A2 Milk Company is overvalued. It is not ideal for investors to make any investments in such highly inflated markets. The valuation arrived as per all the three models are lower than the current market price.

4: Sensitivity Analysis:
Sensitivity Analysis is the measurement of how uncertain the output is to with respect to changes in the input data. In case of A2 milk financial performance, the analysis has been done on the Residual Income approach as per the requirements of the assignment. The sensitivity of share valuation to Sales, Profit Margin, Asset Turnover and Cost of Equity has been ascertained. The company is a debt free company and pays no dividend. These factors have therefore been ignored in performing the sensitivity analysis.

4.1: Sensitivity to Sales and Operating Profit:
With change in sales forecasts, the profit forecasts of the company also changes. This leads to a change in the free cash flows available and ultimately impacts the valuation of the company. In the table below, the analysis has been done on the A2 milk financial performance wherein the change in valuation is determined with respect to the change in sales and operating profit.

The table is based on the A2 milk financial performance and shows the sensitivity of valuation of share to the company’s sales and operating profits. The value of share is highly sensitive to change in sales. For 10% change in sales, the share value changes by 78%. A similar sensitivity shall be observed in case of operating profit too as change in sales and change in operating profit both directly impact the PAT and Equity. This shows that to lure investors to invest in the company, the company can target higher sales in the future and present it in its A2 milk financial performance forecasts. This will lead to increase in valuation of its shares and impact the market price of the share. A higher market capitalization would show that the company is doing really well.

4.2: Sensitivity to ROA:
With change in ROA, the value of share will be impacted similarly as in the case of change in sales. ROA is calculated as sales divided by net assets. Any change in ROA shall lead to change in both ROE as well as book value (Wright and Zhu, 2018). However, the study of A2 milk financial performance clarifies that the net impact shall be higher change in Share value.

The value of share is highly sensitive to change in ROA. For 10% change in ROA, the share value reduces by 65%. As per the study on A2 milk financial performance, the value of equity is therefore highly inversely proportional to change in ROA.

4.3: Sensitivity to Cost of Equity:
Cost of Equity is the return an entity is expected to pay to its equity shareholders or investors to compensate them for the risk they have taken by investing their funds in the entity’s business. A large business model needs funds to grow and the same is obtained by obtaining finance from others. The operations are carried out by financing from two major sources i.e. equity and debt. Each of these sources has their own pros and cons and separate costs and benefits associated with them. The cost of debt is usually cheaper for a company, but comes along with high risks. In the table below, the sensitivity of share value towards change in the cost of equity has been ascertained.

It is observed here in the context of A2 milk financial performance that the share price calculated as per Residual Income Approach is inversely sensitive to change in ROE. With a 10% increase in Return on equity, the calculated share price reduced by 5%. The sensitivity however is very low as compared to Sales and ROA.

This indicates that cost of equity is not a major criteria impacting share price volatility. Investors are unaffected by the short term return on equity and are more concerned about their long term earnings.

4.4: Sensitivity to Cost of Debt:
As per the A2 milk financial performance analysis, the company currently does not have any debt or long term obligations. However, if we assume a debt of any amount across all the forecasted years and a cost of debt of 10% as compared to 0% currently, the return on equity shall drop down.

Assuming the revised capital structure to be 40% debt and 60% equity.

The above table is based on the A2 milk financial performance and shows how the figures of equity, debt, profits, book value of shares etc. change with change in the capital structure of A2 Milk. Since cost of debt is cheaper than equity, the value of equity is improved with induction of debt.

Now comparing the sensitivity of Share value to cost of debt, the capital structure is assumed to be same as above i.e. 40% debt and 60% equity and the cost of debt is increased by 10%.

This shall lead to change in PAT and revised residual incomes. The revised share price is calculated as:

The sensitivity of share value calculated as per residual income method is seen to be highly sensitive to the cost of debt. With a 10% increase in the cost of debt, the share value dropped down by 152%. With debt becoming more expensive, a higher amount shall be paid to the lenders leaving the equity holders with little or no earnings. This shall lead to disappointment of investors and they would not be willing to invest in the company leading to a steep fall in the value of shares.

4.5: Sensitivity Summary:
Forecasting assumptions are thus chosen based on their sensitivity to various factors both qualitative and quantitative. External factors like political, social, environmental etc. impact the firm’s growth potential. Since the company is a dairy company with its main product being the A2 milk, any change in the environmental factors shall lead to a great change in the sales of A2 Milk. Similarly competition from other dairy product suppliers also impacts A2 milk financial performance. Internal factors include the company’s employees, machineries, quality checks etc. These factors directly impact the demand and supply and thus the market valuation of the company. Any optimistic outcome like increase in demand increases the share price. Similarly, any pessimistic outcome like constraints in labor supply reduces production and leads to underutilization of resources which in turn reduces the market price of the shares. The company should thus forecast its operations keeping in mind the optimistic and pessimistic factors impacting its valuations.

5: Management Consulting Advice:
A2 milk financial performance status is quite well in the market. Its share price is quite high when compared to the valuations arrived using the three given approaches. This shows that there are qualitative factors impacting the status of the company which has led to a higher market capitalization. The company is debt free and the major source of funding is only equity. The sales and profits have risen drastically over the past five years owing to the high demand of protein free milk. The milk is suitable for consumption for people with stomach complaints. The company can thus foresee a rising demand of its products across Australia, New Zealand and all other countries where it has its chains.

The key factors impacting share valuation are:

• Cost of Equity: This is the prevailing market rate of interest which is assumed to be the expected cost of equity. Investors expect a minimum return of cost of equity so as to not divert their invested amount to other areas.
• Free Cash Flow: The free cash flow available with a firm at its disposal anytime is an important factor impacting share valuation. It ascertains how much a company can invest to buy back its shares from the open market or pay of its dues.
• Dividend Payout: This is yet another factor impacting share valuation. A good dividend paying company is valued higher than a non-dividend company. This is because when investor expectations are met, they tend to invest in the share causing a price rise of the particular share.
• Appropriate capital structure: A2 Milk needs to maintain an appropriate capital structure to enhance its market value to the maximum. A cheap source of funds such as debt would be ideal but only to a limit. The management needs to make strong decisions in maintaining an adequate capital structure or gearing ratio.

To improve A2 milk financial performance and current profitability, the company can look forward to Global expansion. It needs to identify potential markets where such protein free milk is in demand. It can open up production centres in countries having demand of milk. The company should also target to reduce its cost of sales. For A2 milk financial performance, the company can improve its distribution network by opening smaller collection and distribution centres to streamline supplies. This will bring down the cost drastically. As seen in the forecasts, the company shall have a lot of surplus funds available. The management can think of expanding and investing the amount into right assets to yield better returns.

There are potential threats as well which may lead to a fall in revenues. This includes factors like competitors gaining market share or quality standards not being met by the company, lawful restrictions etc (Zolfani et al., 2018). The management needs to identify these in advance and work towards diminishing the potential threats.

A2 milk financial performance can improve value by paying out dividends to its investors. Appropriation of cash flows in the right place shall lead to higher valuation. Increase in market demand is another factor that shall contribute to price rise of shares. The management should thus look forward to expansion opportunities to ensure better market valuation to enhance the A2 milk financial performance. The sensitivity analysis of various factors to the valuation of the company can help management to ascertain and drive growth prospects.

References
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Lin, C., Schmid, T. and Xuan, Y., 2018. Employee representation and financial leverage. Journal of Financial Economics, vol.127, no.2, pp.303-324.

Wright, J. and Zhu, B., 2018. Monopoly rents and foreign direct investment in fixed assets. International Studies Quarterly, vol.62, no.2, pp.341-356.

Zolfani, S.H., Yazdani, M. and Zavadskas, E.K., 2018. An extended stepwise weight assessment ratio analysis (SWARA) method for improving criteria prioritization process. A2 milk financial performance Soft Computing, vol.22, no.22, pp.7399-7405.

Appendix:
Statement of Comprehensive Income:

Statement of Assets and Liabilities: