Brian Gaynor: Focused a2 shows how it's done, who's next?

The always understated Geoff Babidge, managing director and CEO of a2 Milk, addresses shareholders at this week's AGM. Photo / File

The rise and rise of a2 Milk has been one of the NZX's most exciting stories.

The milk and infant formula company has a sharemarket value of $6.1 billion, making it the fifth largest NZX company behind Meridian Energy ($7.6b), Auckland International Airport ($7.6b), Fisher & Paykel Healthcare ($7.3b) and Spark ($6.7b).

Just seven years ago, a2 attracted almost no investor interest. For example, on November 25, 2010, only 12,865 shares were traded, at 9 cents each, giving the company a sharemarket value of just $46 million at the close of trading.

So how did the company's market value soar and does a2 offer lessons for other ambitious New Zealand companies?

The a2 story essentially begins with Dr Corrie McLachlan, who came from a Wairarapa farming background. He gained a first class honours degree in chemical engineering at Canterbury University and completed a PhD thesis on the reactions of carbon dioxide to alkaline solutions at Cambridge University.

After returning to New Zealand in 1970, McLachlan had numerous research positions before joining the commercial sector in 1985 when he was appointed General Manager, New Investments at the high-flying NZX-listed Kupe Group.

Kupe, now CDL Investments, was a hotbed of new investment ideas but it didn't survive the '87 sharemarket crash in that form.

After leaving Kupe, McLachlan began researching A1 beta casein's link with heart disease and type 1 diabetes. McLachlan concluded there was a strong connection, but this wasn't widely accepted by scientists.

At the same time, professor Bob Elliott of Auckland University, who is a director of Living Cell Technologies, was looking at the incidence of type 1 diabetes in Samoan children.

The two scientists came together when the New Zealand Child Health Research Foundation asked McLachlan to review Elliott's work programme.

McLachlan made the transformation from research to commercialisation when he teamed up with Dunedin entrepreneur Howard Paterson to establish a2 in February 2000. Its original directors were McLachlan, Paterson, Wayne Burt and Jim Guthrie, while Metlifecare founder Cliff Cook was the largest shareholder.

The company issued a prospectus on April 19, 2004 for a renounceable rights issue of 1 share for every 2 shares at 5c each and listed on the NZX's alternative market, the NZAX, the following day.

The company had a post-rights sharemarket value of just $9m based on the 5c a share rights issue price.

Chairman Guthrie wrote in the 2004 prospectus: "The past six months have been a time of significant achievement and change for A2 Corporation after the tragic deaths last year of co-founders Dr Corrie McLachlan and Howard Paterson. The company will use the proceeds of the rights issue [$3.0m] to aggressively pursue new licensing and business opportunities in Europe and Asia and to continue day-to-day operations until it begins receiving a steady flow of royalties under its exclusive licence agreements for North America and Australia".

It went on to note that the rights issue proceeds would be partially used to repay a $1.4m loan to BNZ which had been guaranteed by Cliff Cook and Paterson's estate.

The prospectus gave a clear indication of the company's strategy when it noted: "The ability of a2 to generate revenue via licensing is dependent to a large extent on its patents and trademarks. The company will therefore continue to devote significant resources towards maintaining and further developing its patent and trademark portfolios, while at the same time enforcing its intellectual property rights against infringers, if appropriate".

The 2004 to 2010 period was relatively unexciting as far as a2's sharemarket performance was concerned, except for a brief flurry in 2007 when $2.7m worth of shares were traded over the full 12 months.

However, share turnover dropped away to only $1.1m the following year and a minuscule $0.5m in the 12 months to December 2010.

A2 seemed to be going nowhere and the company was attracting minimal investor interest.

However, two major appointments were made during this period. Cliff Cook was appointed chairman and Geoff Babidge started as managing director in September 2010.

The stock exchange announcement of Babidge's appointment was brief and contained little information on his previous achievements. This is consistent with a2's style: no flashy rhetoric and promises, just a clear focus on effective execution.

Successful companies are all about strategy and execution and a2 has excelled at these.

Geoff Babidge is quiet and understated but has earned an A+ for his execution. He has been assisted by a strong board with a clear focus on growth and a strong drive to increase shareholder value.

The next big move, as far as the company's share price was concerned, was the listing on the ASX on March 31, 2015.

The previous day a2 shares were trading at 50c on the NZX.

Since then, trading in a2 shares by volume has gone from 100 per cent on the NZX in 2014 to 47 per cent in 2015, 27 per cent in 2016 and 25 per cent this year.

The NZX's share of Australasian volume has declined to 21 per cent in the latest quarter.

This year, $2.5b worth of a2 shares have been traded on the NZX and A$7.1b ($7.8m) on the ASX, compared with just $0.5m in 2010.

The total number of a2 shareholders rose sharply after the company listed on the ASX in 2015.

But a2's success has been due to its effective business model, which was clearly outlined at this week's annual meeting.

This has included:

• Developing its science and intellectual property in the 2000 to 2006 period.
• Transitioning from an IP licensing to an operating business model in the 2007 to 2017 period.
• Having a clear growth strategy.
• Having a strong presence in the Australian milk market.
• Diversifying into infant formula when opportunities arose and launching the a2 Platinum brand.
• Identifying growth opportunities in China, the UK and US.
• Employing highly motivated and capable executives.

It goes without saying that Babidge is one of the main reasons for the success of a2, as he has initiated a clear growth strategy for the company and has ensured that his management team fully executes on this plan.

A2 made its big breakthrough in the 2015/16 financial year when "brand awareness and consumer demand for a2 Platinum infant formula in both Australia and China has grown exponentially" and in 2017 "with outstanding performance in infant formula, and continued growth in liquid milk in each of [the company's] core markets".

Babidge announced at this week's annual meeting that group revenue for the first four months of the June 2018 year was $262.2m, 69 per cent above the same period for the previous year, and that net profit after tax was $52.3m, 138 per cent above the July to October 2016 period.

His address was formal and understated, as it always is, with a strong emphasis on the opportunities facing the company rather than a promise that these opportunities will be realised.

A2's success has been built on its IP, clear growth strategy, employing top-rate executives and executing on its plans. However, the company's share price has run a long way and there is no guarantee that its stellar performance will continue.

Most analysts believe the stock is either fully valued or overvalued and Babidge sold $6.5m worth of shares in the June 2017 year.

But the a2 story shows that investors could generate massive returns if they identify the next a2.

Brian Gaynor is an executive director of Milford Asset Management which holds shares in a2 Milk on behalf of clients.