A2 Milk At A Crossroad In China?

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Opinion differs as to whether a2 Milk will be impacted by sharply declining volumes of infant formula sales in China or emerge from the pandemic with its market share protected by a strong brand

-Slowing birth rate may impact infant formula sales soon
-Is a2 Milk reflecting a recovery in sales from the pandemic?
-Consumer distrust of China's domestic brands has moderated
 

By Eva Brocklehurst

Can a2 Milk ((A2M)) grow its sales of infant formula and market share in China and defy a declining birth trend? The infant formula market is working through an oversupply issue at present and prices have fallen, with excess inventory at all levels.

Moreover, China's largest domestic producer of infant formula, Feihe, has recently downgraded projections for demand by -45%. Credit Suisse asserts the trend in China of declining birth rates will eventually affect infant formula sales and the industry could soon confront its first contraction.

This could be sharp, as the aggregate number of babies of infant formula age will, if the trend persists, be -30% lower in 2025 compared with 2018. Credit Suisse suspects this trend will undermine the growth and increased use of premium formula.

The broker expects net profit in FY25 may approach, but not surpass, the FY20 peak and, as a result, has an Underperform rating on the stock.

On the other hand, Bell Potter upgraded a2 Milk to Buy from Hold recently, believing the downgrade cycle is reversing and highlights the emergence of stronger Australian exports of finished infant formula to China as a positive sign.

Credit Suisse cites an ageing Chinese female population and flat to declining fertility rates. Investors have been dimly aware of the slowing birth rate in China for some time but the broker believes it will become more evident, as 2020 was a turning point.

UBS points out competitor Danone has indicated that recent Chinese infant formula retail value growth is positive, despite lower birth rates and, in a contrary view, expects a meaningful recovery in indirect infant formula sales over the next two years.

Furthermore, there could be substantial market share gains for a2 Milk in China through the roll-out of in-store product and expansion of the free trade zone.

The broker believes the stock is not reflecting the recovery, although acknowledges short-term earnings risk amid reduced visibility in daigou (stock bought in Australia for sale in China) sales and conflicting messages from peers in the March quarter.

Danone experienced a steep decline in the quarter in its infant formula sales into China with a -45% drop in the cross-border channel. UBS interprets this as a rebound from the front loading of pantries during 2020 amid the pandemic. The broker assesses cross-border infant formula sales of Danone have bottomed while the headwinds from the pandemic have peaked.

Competition

Credit Suisse is positive regarding the potential for a2 Milk to gain some share of a smaller market. The broker models volume share at 4.3% in 2025, from 2.6% in 2021. Premium brands now account for more than 55% of the market and this should underpin a2 Milk.

While consumers remain distrustful of domestic brands this has moderated in the 2020s from the height of distrust in the 2010s and local brands are gaining share. Credit Suisse is impressed with the rise of Feihe as its infant formula sales rose 41% in 2020 in a flat market.

Along with China's success in containing coronavirus and improving domestic quality, the broker notes Feihe gained share in 2020, although it is unclear whether all domestic operators benefitted. While milk formula is expanding to both toddlers and adults, the broker suggests downgrades to infant formula volumes would overwhelm these much smaller segments.

Feihe has caught Citi's attention too, with its revenue growth targets and expansion plans. The broker agrees competition is building for foreign infant formula operators, noting Feihe expects to grow its sales at a 3-year compound rate of 23% to 2023 and then 15% to 2028.

As foreign formula providers such as a2 Milk and Bubs Australia ((BUB)) are already facing headwinds from daigou disruption, Feihe's plan to launch a “super premium” product in August and a goat milk formula in January 2022 is of concern to Citi, particularly in the case of Bubs with the latter product.

Inventory

The company has previously indicated an excess of stock and to combat this scaled back its Australian deliveries. Yet inventory infill appears to have materially contracted and Bell Potter notes two sequential monthly gains for exports to China since the December lows.

This has occurred at a time when it would not typically be expected. When viewed in conjunction with reduced infill this could imply inventory levels are beginning to subside. Looking at similar de-stocking events from the past the broker assesses the company is around 6-9 months into a 9-12 month de-stocking event.

Bell Potter, not one of the seven stockbrokers monitored daily on the FNArena database, has a $9.50 target and the database has two Buy ratings, one Hold (Macquarie) and three Sell. The consensus target is $8.43, suggesting 9.5% in upside to the last share price. Targets range from $7.15 (Credit Suisse, Citi) to $10.40 (Morgans).

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