Company Reports

A2 Milk has built a brand that we expect to protect economic profits for years to come. China is the key battleground. A2's future growth relies heavily on further successful penetration of the Chinese infant formula market, which we estimate makes up the vast majority of earnings.

A2 Milk is outperforming in a declining market. A2 Milk’s total infant formula sales lifted about 2%, despite double-digit declines in both value and volume in the broader Chinese market. The new registration process is proving highly disruptive, and births continue to decline. But we forecast fiscal 2024 revenue growth of about 5% for A2 Milk and expect the company to capture more share as increasing premiumization partially offsets falling births in China. Underlying EBITDA for first half fiscal 2024 rose 5% on the previous corresponding period, or PCP, to NZD 113 million. We maintain our full-year forecast of NZD 231 million EBITDA—about 5% higher than fiscal 2023.

We maintain our NZD 8.00 (AUD 7.20) fair value estimate for a2Milk. China is its key battleground. And there are hurdles leaving shares in a2 Milk materially undervalued. The new registration process is weighing on the near term, and demographics and consumer trends are weighing on the longer term. Nevertheless, we expect a2 Milk to continue capturing share in a declining market as increasing premiumization partially offsets falling births in China.

The precipitous slide in a2 Milk shares following the release of fiscal 2023 earnings belies the company's solid and improving position in Chinese infant formula. We think the market is preoccupied by the troubled near-term outlook. The new registration process is proving highly disruptive, and births remain below trend. Fiscal 2023 EBITDA rose 12% to NZD 219 million, about 6% below our forecast. While we make some reductions to our near-term earnings estimates, our long-term thesis for a2 Milk is intact. We expect a2 Milk to continue to capture share in a declining market as increasing premiumisation partially offsets falling births in China. Reductions to our near-term forecasts are broadly offset by time value of money, and we make no changes to our NZD 8/AUD 7.20 fair value estimate.

A2 Milk has been handed its best shot yet to break into the U.S. infant formula market with temporary access to the market granted by the U.S. Food and Drug Administration. Despite receiving notification from the FDA on Aug. 10 that its application to plug the ongoing infant formula shortage is on ice, a2 continued to meet the FDA requirements and has now been approved to sell stage 1 and 2 infant formula through Jan. 6, 2023. Under certain conditions, this could be extended to Oct. 18, 2025.

A2 Milk's door to the lucrative U.S. infant formula market is shut following notification from the U.S. Food and Drug Administration, or FDA. The 8% fall in a2's share price suggests the market had become overly optimistic on the U.S. opportunity amid upbeat media speculation in recent weeks. This is despite persistently cautious management commentary when referring to the U.S. infant formula opportunity. We make no changes to our forecasts (as we had not assumed any U.S. infant formula sales), and our NZD 8.00 (AUD 7.20) fair value estimate remains intact.

The Chinese infant formula market remains the key driver of our unchanged NZD 8.00 fair value estimate for shares in a2 Milk Company. We reduce our fair value estimate for the ASX-listed securities to AUD 7.20, from AUD 7.60 previously, on currency-exchange fluctuations. We anticipate increasing premiumisation to offset the falling number of births in China, and expect a2 Milk can capture market share amid a declining market, supported by the strength of the a2 brand, which underpins the firm's narrow moat.

A2 Milk's latest downgrade indicates our prior expectation--for the firm's share of the Chinese infant formula market to continue its rapid ascent--was too optimistic, particularly in English-label. Persistently high inventory through the sales channel has stifled reordering from key corporate daigou partners, weighed on market pricing, and led to ageing of available product. While we continue to expect continued growth in Chinese-label baby formula and some recovery in the daigou channel, we now anticipate market share growth will prove more gradual as continued expansion of Chinese-label products begin to cannibalise English-label daigou sales and domestic Chinese players increase traction. We lower our fair value estimate for a2 Milk by 34% to NZD 10 per share.

In what has become a dreadful recurring theme for narrow-moat a2 Milk, management again significantly reduced its near-term guidance--the fourth time since September 2020. The expected rebound in English-label formula is proving much slower than we or the firm had previously anticipated, which will likely impact not only fiscal 2021 results but also our forecast for fiscal 2022 and beyond. While there was some (though limited) room for optimism in the fiscal third quarter, including Chinese-language labelled infant formula seeing continued growth versus the prior comparable period despite COVID-19 pantry-stocking a year ago, we put our coverage under review as we examine the medium- and long-term implications for a2's excess channel inventory, lack of traction in reigniting daigou growth, and transfer of coverage to a new analyst. We anticipate lowering our fair value estimate to account for these concerns.

Narrow-moat a2 Milk continues to face COVID challenges that have disrupted customers and distributors. Although revenue of NZD 676.5 million in the first half of fiscal 2021 outpaced guidance of NZD 670 million offered in December, this still fell 16% from the pcp given infant-formula pressures in the corporate daigou channel. In addition, these customers restocked less than expected, leading a2 to write off NZD 23 million worth of inventory. Along with negative foreign exchange movements and one-time costs related to the planned Mataura Valley Milk acquisition, EBITDA margins fell to 26.4% from 32.6% a year ago.

The A2 Milk Company has built a brand that we expect will protect economic profits for years to come. While best known in Australia for its fresh milk, A2’s future growth hinges more upon further successful penetration of the Chinese infant formula market, which we estimate made up nearly 85% of the firm’s EBITDA in fiscal 2020.

Narrow-moat A2 Milk has agreed on terms to acquire 75% of Mataura Valley Milk for NZD 279 million on May 31, 2021, pending regulatory approval. We view this as strategically sound as it will enable a2 to complement existing supply relationships with Synlait Milk and Fonterra, while also capturing manufacturing margin for nutritional products through the new facility. However, the company expects Mataura to continue to operate at approximately EBITDA breakeven as a manufacturer of commodity powders until fiscal 2024, as the facility still requires a blending and canning facility and an A1 protein free milk pool to produce its desired consumer packaged nutritional products.

The A2 Milk Company has built a brand that we expect will protect economic profits for years to come. While best known in Australia for its fresh milk, A2’s future growth hinges more upon further successful penetration of the Chinese infant formula market, which we estimate made up nearly 85% of the firm’s EBITDA in fiscal 2020.

A2 Milk’s COVID-19-related disruption has worsened, but shares in the narrow-moat name now screen as undervalued. A slower rebound in both daigou and online channels has led management to reduce near-term guidance to below our expectations. A2 now forecasts fiscal 2021 revenue of NZD 1.4 to NZD 1.55 billion, down from NZD 1.8 to NZD 1.9 billion, with EBITDA margins between 26% and 29%, versus 31%. We’ve reduced our revenue forecast to about NZD 1.5 billion, with EBITDA margins of 27%. This suggests a top-line fall of 14% versus fiscal 2020, and EBITDA declining a sharper 26%.

The A2 Milk Company has built a brand that we expect will protect economic profits for years to come. While best known in Australia for its fresh milk, A2’s future growth hinges more upon further successful penetration of the Chinese infant formula market, which we estimate made up nearly 85% of the firm’s EBITDA in fiscal 2020.

Narrow-moat a2 Milk remains on track to match our near-term forecasts, and we maintain our NZD 16.30 (AUD 15.20) fair value estimate. At the company’s annual general meeting, management reiterated its full-year 2021 outlook for revenue of NZD 1.8 billion to NZD 1.9 billion and EBITDA margin of about 31%, tracking our estimates. This suggests top-line growth slowing to about 5% to 10% versus 33% in fiscal 2020, owing to pantry destocking after the strong pulled-forward demand in the early part of the COVID-19 pandemic, and disruption to the corporate daigou channel during recent lockdowns in Melbourne, Australia, which has driven down orders for infant formula that otherwise would have gone to China. Management noted some uncertainty to this forecast due to COVID-19 volatility, but as we outlined in our note “A2 Milk Not Immune to Coronavirus, but Long-Term Health Remains; NZD 16.30 FVE Maintained” from Sept. 28, 2020, we view these issues as temporary. We anticipate revenue growth rebounding to double-digit annual gains in the four years from fiscal 2022 through 2025, alongside EBITDA margins increasing to about 32%.

Although narrow-moat A2 Milk initially benefited from pulled-forward consumer demand during coronavirus lockdowns in the second half of fiscal 2020, management’s reduced fiscal 2021 revenue expectations show that few companies are ultimately immune to the virus’ effects. As discussed in our note on Aug. 19, 2020, we had expected sales growth to slow in fiscal 2021, owing to pantry destocking after the strong pulled-forward demand in late fiscal 2020. But the company is now seeing disruption to sales partners in the corporate daigou channel given recent renewed lockdowns in Melbourne, Australia, which has driven down orders for infant formula that otherwise would have gone to China. While alternative channels, like retail stores and e-commerce, have continued to perform strongly in China, the daigou challenges look to constrain first-half fiscal 2021 revenue at about NZD 750 million, roughly 7% below the previous corresponding period, or pcp. The magnitude of this impact is greater than we thought, with full-year revenue guidance of NZD 1.8 billion to NZD 1.9 billion about 8% to 12% below our prior forecast.

The A2 Milk Company has built a brand that we expect will protect economic profits for years to come. While best known in Australia for its fresh milk, A2’s future growth hinges more upon further successful penetration of the Chinese infant formula market, which we estimate made up nearly 85% of the firm’s EBITDA in fiscal 2020.

Narrow-moat The a2 Milk Company has navigated the coronavirus pandemic successfully, but growth will likely slow in fiscal 2021. As expected, fiscal 2020 revenue leapt 33% to NZD 1.7 billion, while EBITDA grew 31% to NZD 552 million, with a margin of 31.9%. Strong 34% growth in infant formula (82% of revenue) was the core driver, with solid execution in China helping a2 gain further market share during the country’s lockdown. We lift our fair value estimate to NZD 16.30 (AUD 14.80) per share given the time value of money, but shares continue to screen as overvalued.

A2 Milk’s newly announced CEO David Bortolussi brings a strong track record to the organisation. Bortolussi has led HanesBrands’ Australasian and international innerwear business since 2016, following the company’s takeover of clothing retailer Pacific Brands (where he was CEO). He was also previously an executive at beverage firm Foster’s before the business was acquired. We’re encouraged that Chairman David Hearn expects a2’s financial framework and strategy will remain relatively similar under Bortolussi’s leadership when he starts in early calendar 2021; the company’s outlook for medium-term EBITDA margins of 30% to 31% matches our own. We make no changes to forecasts or our NZD 16.00 (AUD 15.20) per share fair value estimate.