EUR 850.00 For Business Accounts Only

Morningstar | New Government Regulations Don’t Derail A2 Milk’s Growth Opportunity; Shares Fairly Valued

We don’t expect China’s proposed regulations to support its domestic infant formula market will damage the market-share opportunities we see for narrow-moat a2 Milk, and we maintain our NZD 14.50 (AUD 13.60) fair value estimate. However, the stock appears fully valued, and doesn’t offer a margin of safety to account for the potential risk of further government regulation or change in competitive dynamics.

China’s National Development and Reform Commission, or NDRC, has outlined several planned measures to improve the quality and consumer confidence of domestically produced formula, with an aim to increase local manufacturers’ market share to more than 60% from the current 47% level. These include greater quality monitoring, increased e-commerce regulation, opportunities for domestic manufacturers to source overseas ingredients, and support for industry consolidation. At first blush, we think these measures could stem the tide of domestic players’ market share losses, which have struggled following 2008 health scandals, and could therefore impact the growth opportunity for foreign brands such as a2.

But we don’t expect the impact will be equally felt. We see a greater risk to smaller companies with significant Chinese exposure such as Bellamy’s, given their ongoing regulatory challenges and more limited brand awareness in China. We currently assume that Chinese domestic manufacturers and smaller foreign manufacturers will cede about 15 points of market share over the next 10 years, as larger companies--Nestle, Danone, and Reckitt Benckiser--and a2 enjoy faster growth given their competitive advantages in the region. The NDRC’s plans don’t necessarily change this outlook, but could shift it toward greater losses among the less-advantaged foreign players. Conversely, a2 has proven capable in managing a twisting web of regulatory changes in recent years, and we expect the firm’s strong brand positioning and distribution expansion will continue to prove successful.

There is downside valuation risk, however. We forecast a2 picking up about a point of market share annually, leading to a roughly 15% capture rate by fiscal 2028 versus about 5% in fiscal 2018. But for every percentage point degradation in this assumption, we estimate a 4% to 5% hit to our fair value estimate; for instance, a2 achieving only 10% market share in 10 years would reduce our valuation 23% to NZD 11.20 (AUD 10.50), all else equal.