A2 Milking It

This story features A2 MILK COMPANY LIMITED. For more info SHARE ANALYSIS: A2M

a2 Milk surprised analysts with outperformance in a difficult Chinese infant formula market. But has the share price run too far?

-a2 Milk H1 performance beats consensus
-Execution in a difficult market applauded
-Upside drivers remain in place
-Valuation is of concern

By Greg Peel

It’s been a rollercoaster ride for New Zealand-based a2 Milk Co ((A2M)) over past years. Infant formula is not the only product the company sells, but it represents the bulk of earnings, and the bulk of those earnings are generated in China.

Back in 2015, China's food safety watchdog asked three domestic milk producers in Shaanxi province to recall infant formula powder after excessive nitrate levels were detected in some samples. Beijing had become more sensitive to issues with infant formula after at least six children died and some 300,000 fell ill after consuming domestic milk products contaminated by melamine back in 2008.

Domestic issues proved a boost to foreign formula producers such as a2 Milk. They also boosted the “diagou” market, in which Chinese nationals flew to Australia, for example, cleaned the shelves of formula and flew back to sell in China for a profit. Covid eventually brought an end, and today the diagou market is not quite what it used to be.

Having traded over [AUD] $19 back in mid-2020, a2 Milk shares hit a 52-week low late last year of $3.70. Prior to Monday’s earnings result release, they were trading just over $5.

Beijing’s aforementioned concerns stretched to foreign formula brands as well, and led to ever stricter regulations surrounding their sale. Recently Chinese language-labelled brands have seen new and more onerous regulations applied, while oddly enough regulations around English-labelled brands are not quite as strict.

Ord Minnett notes some 20% of (mostly smaller) brands have dropped out of the market due to the new restrictions, while the remainder have been selling old inventory at a discount, dragging down earnings potential for all. The first half FY24 saw double-digit declines in both value and volumes in the broader Chinese market.

But not for a2 Milk. Its formula sales rose 2% in the period. And while everyone around was discounting, this company actually raised its prices.

Hats Off to Execution

This praise, from Morgans, sums up the way all brokers saw this week's first half result. Having posted a significant beat on consensus earnings forecasts, reflecting a sterling effort in a challenging market, a2 Milk shares jumped 12.5% on release.

Chinese label formula is a2 Milk’s key strength. While the overall market value for Chinese label declined by -15% in the half, a2 Milk sales rose 10%, partially offset by a -7% decline in English label.

But the English label business is stabilising near 2021 levels, Ord Minnett notes, with a2 Milk’s market share rising to 21% from 18% a year earlier.

The company's transition to the new standards for Chinese label has gone materially better, suggests Morgans, than most could have imagined 12 months ago. Morgans also notes the interest income tailwinds for the company’s large cash balance will lead to material consensus earnings upgrades alone.

A major issue for the market in general is China’s falling birth rate. But recent 2023 birth rate data showed a “less bad” outcome than was expected, Macquarie notes, and the company remains confident of a lift in 2024.

Citi sees potential for English label outperformance to continue, noting innovation is easier with English label as it is not covered by the more stringent regulations that apply to Chinese label. The company has an English label market share target of 25%, up from around 20% currently, although Citi is conscious a shift to English label might adversely impact earnings due to a lower price point.

Macquarie notes a2 Milk also is launching fortified milk powder tubs targeting the adult and senior segments. These will help meet the company’s $2bn revenue target, albeit this is now expected to be achieved in FY27 or later, rather than FY26 or later, reflecting cumulative birth rate impacts.

Valuation

a2 Milk shares were up 34% year to date following the result release, including 12.5% on the day.

Macquarie suggest while stock momentum remains and downside catalysts are limited, earnings upgrades from here are also limited. Macquarie retains Neutral.

Bell Potter points out the re-rate has the shares trading at the upper end of Fast-Moving Consumer Goods & Dairy entities on an FY24 enterprise value to earnings basis, which suggests “neither unreasonable nor compelling value”. Bell Potter retains Hold.

Wilsons believes the most significant challenges and uncertainty may well remain ahead for the company, with the need for supply chain transformation and new product development (in addition to ongoing market share gains) to improve the resilience of the business model and achieve medium-term financial targets. This broker now views the risk/reward equation as more balanced and downgrades to Market Weight.

The company’s revenue target is reliant on China label innovation that can only occur if or when a2 Milk obtains more China label regulated slots, Citi suggests, a process which is taking longer than expected. Considering these factors, along with the recent strong share price performance, this broker downgrades to Neutral.

Morgans remains attracted to the top five position in the world's largest infant formula market, brand strength, management team and balance sheet. Over the medium term, this broker believes the company is well positioned and should take further market share, and be an even stronger brand in China given the market has been severely rationalised through regulation. However, after strong recent share price appreciation, Morgans downgrades to Hold on valuation.

On the other hand, UBS suggests the first half result should give investors sufficient confidence that better times lay ahead. UBS retains Buy.

Despite the re-rating, Ord Minnett believes the stock remains undervalued, suggesting the market is overly pessimistic on the pricing and volume outlook for Chinese formula and under-appreciates the strength of the a2 Milk brand in China. Ord Minnett retains an Accumulate rating.

Among the brokers monitored daily by FNArena there are now two Buy or equivalent and four Hold ratings. The consensus target price has risen to $6.08 from $5.39.

Outside those brokers, Wilsons’ target has risen to $5.85 from $5.47, while Kiwi broker Jarden has increased by 26% to NZ$6.50, and retains an Overweight rating.

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