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Morningstar | The Chinese Infant Formula Market Remains a High Growth Opportunity for a2, Despite Near-Term Risks

Concerns over increasing infant formula competition and upcoming e-commerce law changes in China have driven down narrow-moat a2 Milk's share price nearly 20% over the past three months. While we see potential short-term volatility from these factors, we remain confident in the long-run growth potential in Chinese infant formula, highlighted by strong results in the first four months of fiscal year 2019. Although we’ve lowered our fair value estimate to NZD 13.70 (AUD 12.90) from NZD 14.60 (AUD 13.30) given a lower mix shift impact we see in in China, we view shares as undervalued at present.

The Chinese infant formula market is critical for a2. Despite the company reporting only 23% of revenue from the geography, we estimate that adding indirect sales leads to more than 70% of revenue and nearly 80% of underlying EBITDA stemming from the country. With our forecast for high-single-digit end-market growth and substantial market share gains, we expect a2’s earnings per share to grow at a 25% CAGR through fiscal 2023, justifying lofty 41.5 forward price/earnings ratio implied by our fair value estimate.

While China’s infant formula volumes look to decline at a 2% annual rate over the next 10 years, we expect positive pricing and mix shift to help the total value in the market grow at about 6.5% per year. This outlook is lower than our prior 8% forecast, owing to more-muted mix shift, but we continue to believe a2’s brand intangible assets will propel the company’s market share to about 15% in fiscal 2028 from 5% in 2018, driving 18.5% annual top-line growth. The company remains on this trajectory in early fiscal 2019, with first-quarter share at 5.6%. Moreover, a2 Platinum is among a2 Milk’s highest margin offerings, owing to the high degree of safety scrutiny which creates barriers to entry around trusted brands and substantial pricing power.

For more details, please see our special report, “The Market’s Souring on a2 Milk Offers a Sweet Deal for Investors”.

A2’s results so far this fiscal year highlight its continued success. The company noted that consolidated revenue climbed 41% in the first four months of fiscal 2019 versus previous comparable period, or pcp, while EBITDA margins leapt to 33.7% compared with 29.9%. We expect some of the margin improvement to retreat as a2 ramps up its marketing spending over the remainder of the fiscal year, but nonetheless project the company comfortably reaching our updated 30.2% forecast, roughly in line with fiscal 2018 results. Similarly, we forecast full-year revenue growth of about 26%, suggesting some softening in the second half of the year as a2 laps difficult comparisons.

However, one of the key risks recently highlighted in the press is upcoming Jan. 1, 2019 changes to Chinese e-commerce regulations, which aim to further protect consumers by better regulating and holding responsible product sellers for the authenticity of their goods, while also potentially cracking down on the lack of consistent tax collection for personal shoppers importing formula into the country.

As a result, we see the primary risk to a2’s daigou-related, individual-shopping and import business, which represents about 65% of the company’s revenue in China, per our estimates. We don’t expect the new regulations to impact a2’s Chinese-language-labelled products, which have already gone through a separate licensing approval process with China’s State Administration for Market Regulation, or SAMR (formerly China Food and Drug Administration, or CFDA), in late 2017. These products are sold through a local distributor into mother and baby retail stores. Similarly, we expect minimal impact to the firm’s cross-border sales it ships directly to China, based on supplier Synlait’s past work in successfully navigating these new laws.

Nonetheless, our overall takeaway is that a2 and other overseas participants could see short-term disruption, but the alterations are unlikely to sway our longer-term forecasts. Our conversations with a2 suggest the company is working increasingly with large, corporate import partners rather than personal travellers, and we believe these larger importers are much more likely to successfully manage any disruption from the transition.

We also note that the regulations are part of a fluid, moving situation. On Nov. 21, 2018, for instance, the Chinese government provided further clarity, noting that many individual daigou will still be seen as transporting product for “personal individual use”, which should prevent complex and expensive tax considerations for products on the retail imports list, including infant formula. And at the company’s annual general meeting, a2’s management reiterated its view that it has managed its daigou network effectively to prepare for these changes.

In all, if our assumptions on this matter hold, we see limited long-term impact for a2's brand or growth prospects. Should new regulations create short-term volatility, we expect a2 is well-prepared to navigate through the noise, and potentially even capture greater market share should the market consolidate further.