A2 Milk Company (A2M) has had a wild ride on the stock market since listing in 2015, becoming a market darling rising over 3,500% in just over 5 years, before inventory issues, increased competition, and lower birth rates in China saw earnings fall considerably. The share price fell >75% peak to trough. The share price has been treading water with a new CEO announced in February 2021 overseeing a turnaround strategy, which we believe is beginning to come to fruition, albeit with a long road ahead of it.
Market share gains. A2M has continued to gain market share in certain channels, however, has lost in others, leading to mixed fortunes. With new management, A2M is already showing signs of returning to growth despite increased competition.
Return of Daigou channel. Lockdowns halted travel to and from China, impacting the reseller and exporter markets. As the world re-opens, A2M should be able to regain growth through the channel.
USA infant formula market entry. The US shortage provided an opportunity for foreign brands to encroach on the market. The market is dominated by 4 key brands, although A2M has a launch platform through its already established liquid milk presence.
Population growth and birth rates. China’s population has begun to slow, which has shrunk the addressable opportunity. We see continued slowing population growth and birth rates as a continued risk to the growth of the overall market.
FY26 ambitions achievable, but priced in. The new management team set ambitious FY26 targets to turn around the company. We believe these are achievable, if not conservative, although with risks attached and a valuation suggesting some is already priced in.
What does the science say? The jury is out as to whether the benefits of A2 scientifically exist. More evidence amounting to either argument could swing consumers’ preferences.
Investment View
A2M continues to face structural headwinds from lower birth rates, increased competition and shifts in China’s consumer preferences. The turnaround strategy however is on, with green shoots emerging from an entry into the US IMF market, a return of the Daigou channel, increased brand awareness and overall market demand of formula.
We rate A2M a buy predicated on a successful execution of strategy and a renewed earnings upgrade cycle as it ramps up its growth trajectory and returns to strong profitability and cash generation, with potential for capital management.
Business Overview
The A2 Milk Company (A2M) is a New Zealand-based company engaged in the sale of products made with milk from cows that produce milk naturally containing only the A2 protein type. The Company was founded in 2000 in New Zealand by scientist Dr Corran (Corrie) McLachlan and his business partner, Howard Paterson, who recognised that not all milk is the same. Other doctors who had earlier discovered that proteins in milk affect people differently also joined to pioneer research to understand these differences better.
The Company operates through four segments: Australia and New Zealand, China and Other Asia, USA and Mataura Valley Milk. The Australia and New Zealand segment includes the sale of infant milk formula (IMF), liquid milk and other dairy products, along with royalty, license fee and rental income. The Mataura Valley Milk (MVM) segment was acquired in August 2021 which manufactures and sells dairy nutritional and commodity products. IMF is typically sold over 4 Stages of the infant’s life, Stage 1 being 0-6 months, Stage 2 being 6-12 months, Stage 3 being 12-36 months, and Stage 4 being beyond 36 months. Revenue splits can be seen in the charts below:
Figure 1: FY22 Geographic revenue split
Figure 2: FY22 Segmental revenue split
Supply chain. A2M purchases its products predominantly from Synlait Milk (SM1.AX not covered). It then distributes these through its various channels to supply Australia and New Zealand, China, other parts of Asia and the USA. It’s important to note that A2M does not own its own manufacturing facilities (apart from Matura Valley assets) and relies on these relationships with SM1. To maintain this, A2M owns 19.8% of SM1 and accounts for a large portion of its output and has maintained this relationship since 2013.
Key staff. David Bortolussi was appointed the CEO in February 2021 to oversee the turnaround strategy, after Jane Hrdlicka (now Virgin CEO) struggled to continue the firm’s growth trajectory, instead burying it in consulting fees. Bortolussi was the former group president of HanesBrands (Bonds, Sherdian etc) having extensive experience in retail strategy. David Muscat replaced Race Strauss as the CFO in October 2022, having previously worked with Bortolussi at HanesBrands. The chair David Hearn has been in the position since 2015 and has extensive experience in the FMCG international markets. We regard the new management team as capable and experienced in the sector, although they have only recently joined and have yet to demonstrate a strong track record. We remain confident that they can reset the strategic direction and return the company to growth.
The science. Originally all cows’ milk contained only the A2 protein type. The A1 protein arose through a genetic mutation over many years. Today, most regular milk contains a mixture of A1 and A2 proteins. Results of several published peer-reviewed human clinical trials have shown that A1 protein can cause digestion issues for some people who have difficulty drinking milk. A scientific and proprietary way to identify cows that naturally produce milk which contains only the A2 protein and no A1, was also discovered. A2M continues to pioneer this science and research, bringing milk that naturally contains only the A2 protein and no A1, to the world.
Clearly funding scientific papers to further the case that A2 is better than A1 is in the best interest of the company. There is mixed scientific evidence on the actual benefits, however it is widely anecdotally accepted that A2 is easier to digest. We will let you draw your own conclusions however note this as a key risk that the A2 story could unravel if enough evidence is found against the benefits.
Key Earnings Considerations
Return of retail Daigou channel. Whilst not specifically quantified, the retail Daigou channel has historically been an important source of growth for A2M. With Covid lockdowns this channel largely disappeared. The return of international travel to Australia could see retail Daigou sales return, providing an important revenue stream for the company. We however do not expect this channel to return to its former glory, with the company preferring to expand through other channels which are more traceable.
China market share. A2M’s market share growth in China has continued to grow in mother baby stores, and recently recovered in the CBEC channel. Material market share gains from China’s domestic competitors have impacted the growth trajectory, albeit currently largely at the expense of other multinational brands, rather than A2M. Positive developments on continued share gains or stagnation from competitors would justify a valuation rerate. Continued brand awareness and marketing campaigns should increase market share opportunity.
USA growth. A2M had previously targeted the UK market before pulling out as it could not gain traction. A2M has sunk significant capital into the USA market, which so far seems to be generating significant sales growth. The FDA has recently approved A2M’s infant formula to be sold, providing a potential meaningful growth avenue. There is a significant marketing and brand awareness spend ahead of A2M for this to take off, potentially diluting returns on invested capital. The company’s focus is for profitability by FY25/26, which may be at risk of being pushed out as it reinvests.
FY26 ambitions. The new CEO has set a refreshed strategy and ambition to grow sales to NZ$2.0bn by FY26, with an EBITDA target margin in the ‘teens’ although possibly in the ‘low-to-mid 20s’. Key accretion drivers are operational leverage and market share gains. We outline the steps A2M have shown in the chart below:
Figure 3: FY21-FY26 target bridge for NZ$2.0bn revenue (note FY22 revenue NZ$1.4bn)
The China Market Opportunity
China has been a key market for A2M and a major driver of growth. The global IMF market is significant and is expected to reach around ~US$110bn by 2026. China remains the largest consumer of IMF in the world, accounting for ~40% of the market. It is estimated that ~60% of Chinese babies are using formula. A2M is currently estimated to have a total market share of ~5%, providing a long runway of growth potential in a largely fragmented market where the top 10 brands make up ~70% of the market. A2M has also begun expanding into other parts of Asia such as South Korea and Vietnam.
The key considerations for the China opportunity lie with the lower birth rates being a structural headwind towards overall market growth, albeit offset by an increasingly positive attitude towards formula. Further, the opportunity for both EL and CL products to continue to grow through e-commerce and Daigou channels, as well as the domestic MBS and online channels. The rise of nationalism and improved perceptions of domestic products over foreign have also impacted recent market growth. We break down these factors in more detail below.
Birth rates. The number of births decreased by 12% in 2021 to 10.6mn, and a further -10% in 2022 to 9.6mn and the overall market volume decreased by 11.0% (12.5% by value) in 1H23 as several years of declining newborns had a cumulative impact on Stages 2 and 3, partially offset by increasing penetration in Stage 4. The overall population in China fell for the first time in 60 years in 2022 and the birth rate also at a record low of 10.9 births per 1,000 people. Even after scrapping the one-child policy seven years ago, China has entered a potential era of negative population growth. The government has offered tax breaks and better maternal healthcare among other incentives to attempt to slow the falling birth rate, however this has not resulted in a sustained increase due to no accompanied efforts to ease the burden of childcare or access to education.
Figure 4: China births per 1,000 population has steadily declined since the 1950’s
Figure 5: Newborns in China by year (millions)
Daigou. The opportunity for the company is unique in that A2M sells two versions of its products, an English Label (EL) and a China Label (CL). The 2008 Chinese milk scandal (where some domestic producers were adding chemicals (melamine) to give an appearance of higher protein) saw a significant shift of Chinese consumers away from domestic products and to seek foreign products, which were perceived to be of a higher standard and quality. This allowed multinational brands to establish a presence as a quality product.
The EL products are sought after, which are often bought in Australia and New Zealand and then shipped back to a purchaser or to be resold in China. This is known as the Daigou channel (which also incorporates many other luxury goods) and can be through individuals or through a syndicated group of exporters. This channel has historically been a key source of growth for A2M, although was negatively impacted during the lockdowns, as it relies on travel between the countries. We expect this channel to improve with the return of international travel, however not to the same extent it once was. A2M has announced its intention to ramp up marketing content and sales in efforts to regain market share.
Cross Border E-Commerce (CBEC). China’s CBEC market has achieved massive growth, with over 150m users, providing a valuable option for A2M product listings. The largest CBEC platforms are Tmall Global, Kaola, JD Global, Vipshop Global and Amazon. Pre-Covid, A2M had been steadily growing its market share of its EL product to a peak of 22.2% in December 2020. The market share has dropped to 19.5% in 2022, however A2M has increased its focus on stabilising and regrowing this share, with significant growth achieved in 1H23.
Figure 6: CBEC market value share
Figure 7: Daigou market value share
In terms on actual sales, the loss of the Daigou channel impacted the ANZ sales. CBEC has since recovered and is growing strongly, however the Daigou channel still remains challenged evidenced by a 39.2% fall in value in 1H23. The mix shift of the EL product has dramatically shifted towards CBEC, which is an intentional move by management, given the channel sales are much more transparent and traceable.
Figure 8: CBEC EL IMF Net Sales Revenue (NZ$mn)
Figure 9: ANZ EL IMF Net Sales Revenue (NZ$mn)
Mother Baby Stores (MBS) and China Label (CL). The MBS and CL products are key channels to drive growth for the company and continue to establish a presence in the country. China has specific stores focussed on mothers and babies (think baby bunting) where companies can promote and educate mothers on their products. A2M has grown its store distribution count from ~10,000 stores in 2018 to over ~26,800 in 2022 and grown market share from 1.4% to 3.2% over the same period in the MBS category. A2M is also focussing on the Domestic Online (DOL) channel and has grown market share to 3.0%, another key avenue to cement domestic brand awareness.
Figure 10: CL Net Sales Revenue (NZ$m)
Figure 11: MBS Market share
Competitive landscape. In the MBS channel, the top 10 brands accounted for ~75% of the market, up from 67% in FY20. Local brands such as China Feihe and Yili (which opened the world’s largest infant formula production base in July 2022) have been steadily gaining market share at the expense of foreign incumbents such as Danone and Reckitt Benckiser. Throughout the pandemic, there has been a marked shift away from purchasing foreign brands and focussing on domestic brands with the rise of Chinese nationalism at the forefront of this shift in consumer preferences. This was exacerbated by the lack of cheaper Daigou channel options and the supply chain difficulties that international shippers faced getting stock into the physical stores. We would expect a partial unwind of these domestic market share gains as Daigou returns and the supply chain issues ease, however remain wary that domestic market share gains could be more permanent.
Born In The USA
Whilst the USA has a very large premium milk market, it is highly competitive and there are several scaled and well-established brands. Speciality milk continues to grow as a category with consumers looking to explore alternative options. A2M launched its USA business in 2015 and is now stocked in over ~29,000 stores, across every major grocery chain. The premium milk market is an estimated ~NZ$4.3bn opportunity.
Liquid milk. A2M has invested heavily in distribution and marketing to establish its brand, which is beginning to come to fruition. A2M expect to reach profitability by FY25/26, although note that there are significant risks in over/under investing, and A2M has had mixed experience with establishing a presence in other markets (A2M had previously attempted to enter the UK market before pulling operations in 2019). We expect A2M to continue to grow, however we are cautious on the path to profitability. Revenue growth has also been mixed over the Covid period, although pleasingly has returned to growth in the last half. A2M has captured ~0.8% of the US retail milk market.
Figure 12: USA Revenue and EBITDA ($NZm)
Figure 13: Distribution store count over time (‘000)
IMF opportunity. Not all markets are created equal, with the US IMF market being a highly concentrated market with the top three brands and private label representing >95% of the market. The market however is the second largest in the world and the IMF shortages over 2022 provided several foreign brands an opportunity to take some share. An entry into the US provides further earnings diversification, however we don’t view future contributions as particularly meaningful to the overall group, with there being limited sales attributed to this opportunity in consensus numbers.
A2M is likely to leverage its existing liquid milk presence in ~29k stores to secure distribution for its IMF products in key retailers. This provides a key advantage over other foreign brands trying to establish a presence during the shortage (including key competitor Bubs). Much like the China market, the US birth rate has been progressively slowing as well to currently just 12.0 births per 1,000 people. Given the structure of the market, it is unlikely A2M’s market share will grow materially over ~1%, representing ~NZ$60-70m revenue.
Land Down Under and Across the Ditch
The ANZ liquid milk business continues to deliver, however growth has begun to slow indicating a potential peaking of market share at ~12%. Brand awareness continues to increase however milk alternatives are continuing to become more prevalent. Further, A2M was forced to put through price increases from higher input and other logistics costs, where it is already amongst the most expensive milk on the market. A2M has also just launched a lactose free product which we expect to gain traction in a ~NZ$130m market. The segment continues to remain important to the group, delivering ~NZ$172m sales in FY22. We expect overall growth in market share to moderate however expect sales to be resilient.
Figure 14: Australia Milk Net Sales Revenue (NZ$mn)
Figure 15: Australian milk market value share over time
Valuation Considerations
Gross margins have fallen since peaking in FY20 at ~56% to ~46% in FY22 as it went through stock and inventory write downs as well as increased COGS. We don’t expect A2M to fully recover this given stronger competition impacting pricing premiums and inflationary pressures on costs. Consensus is not forecasting any material margin recovery, instead maintaining ~46% through to FY25, which we believe is too conservative given unwinding freight costs and other input costs such as packaging, which should improve with scale. A2M have guided to FY23 gross margin to be ‘slightly higher than FY22’ with cost pressures offset by price increases, mix benefits and cost mitigation activities.
Figure 16: Gross margins impacted throughout the Covid period, although starting to show recovery ($NZm)
EBITDA margins had historically been closer to ~30% up until FY20. Margins fell to ~13.5% in FY22 on higher operating costs and lower revenues. A2M’s high margin moat as indicated above has likely eroded, and A2M will need to continue to invest in marketing to improve brand loyalty. Marketing is the largest component of operating expenditure and has been growing consistently, however spending is likely to be more targeted moving forward, which if successful will provide higher returns on capital. We would expect EBITDA margins to recover to ~18-20% by FY26, above A2M’s ambitions of ‘in the teens’ driven by improving operating performance and a more focussed effort on channel marketing spend. A2M have guided for FY23 EBITDA growth with margin ‘similar to FY22’. Consensus are forecasting a relatively flat margin, providing potential upside for the result.
Figure 17: EBITDA recovering ($NZ mn)
Figure 18: Marketing expenses rising
Capital management. A2M generates significant levels of cash given its capital light business model and was purely cash operated (up until the MVM acquisition, which acquired some debt). As of 31 December 2022, A2M a net cash position of NZ$707.2m (roughly equates to A$0.88-90 per share) and is ~60% through the NZ$150m on-market share buyback. With higher interest rates, we expect the large cash balance to generate higher levels of interest income for the company. With such a strong balance sheet and high cash generation, we would expect continued capital management programs or even a dividend to be announced in the coming results. This would indicate increased confidence from the company in its outlook, as well as a welcome return of capital to shareholders.
Peers. A2M’s closest listed competitor in Australia is Bub’s (BUB.AX) which sells formula in similar markets, however is only just reaching profitability so its earnings are volatile. The largest global competitors are Nestle, Danone, Abbott and Reckitt Benckiser, as well as Asia based companies Yili, Feihe, Ausnutria and H&H. Comparisons are difficult as the larger companies also have a significant product suite with varying margins and end market consumers. A2M’s margins are recovering towards high teens, and its earnings growth rate is far above competitors (note BUB’s is off a low base). If A2M can improve margins, then a higher rating is more than justified. Looking at EV/EBITDA,
Figure 19: Peer comparisons are difficult, but provide some context for growth figures
Valuation. On a PER basis, A2M trades just below its 5-year history. We however anticipate that the market is underestimating the potential execution of the turnaround strategy, and the tailwinds re-emerging from international travel. We expect earnings and margins to improve over the coming years, although note that A2M’s FY26 targets are partly in-line with consensus numbers (albeit only a small cohort have released numbers for FY26). If A2M can achieve above its targets as we expect, there are material upgrades for the stock, which then should re-rate. Note that adjusting for the net cash balance sheet, A2M trades on an FY24 PER of just ~23x. On an EV/EBITDA basis, which more accurately reflects underlying business performance (given a net cash balance sheet), A2M trades in-line with key multinational peers (Nestle and Abbott).
Figure 20: Trading just below its own 5-year historical PER
Figure 21: A2M trades in-line with multinational peers on an EV/EBITDA basis
Investment Thesis
A2M has had a roller coaster 3 years, initially being a key beneficiary from the early lockdown hoarding activity, before a collapse of the key Daigou channel, excess inventory and slowing China birth rate saw a significant fall in growth. The company now has a new CEO in place with global experience and we expect will execute on the strategic direction to return the company to its former glory.
The resumption of international travel should see the Daigou channel return, albeit unlikely to the same extent, however, will provide an important revenue stream for the company. Further the USA opportunity is still nascent and could potentially be lucrative.
We believe that the downgrade cycle is largely complete, with market share gains likely to provide strong tailwinds for growth and margins should improve as cost headwinds subside and from cycling inventory write downs and a more targeted marketing spend, delivering higher returns on capital. Net cash of NZ$707m equates to~A$0.88-0.90 of the valuation, improving with the continuation of the NZ$150m buyback program. We initiate with a Buy recommendation.
Risks to Investment View
