Can the A2 Milk Company recover from COVID travel bans?

Who would have ever thought that a milk producer could be a growth company? Is there any product more generic? So how did The A2 Milk Company grow from a market capitalisation of about $200 million to $20 billion in the space of five years?

Food products are not typically high growth. People do not start eating a lot more than they used to just because a new product comes out. Aside from a small amount of change due to population growth and the trend to eat more protein as wealth increases, the success of one food product normally comes at the expense of another. If you decide to drink A2 milk you substitute it for another brand of milk. You do not double your milk consumption.

Consequently, the success of A2 milk was largely due to great marketing. They were able to exploit a competitive advantage based on the perceived health benefits of the type of milk. All milk actually contains the A2 beta-casein protein, however regular milk also contains the A1 protein. A2 milk is marketed as potentially being gentler on the stomach due to the absence of A1 protein.

Lion Group decided to challenge this marketing competitive advantage. In 2016 they started labelling their milk with the phrase "contains A2 protein". (At the time they owned Dairy Farmers and Pura fresh milk products.) Whilst this was technically true, the A2 milk company sued Lion for misleading conduct, as the marketing implied this was a point of difference whereas in fact all milk contains the A2 protein.  Lion countersued claiming that there was insufficient evidence for the claimed health benefits. In the end the parties settled so the claims were never tested in court.

A2 have been gradually building up a body of evidence to support their health claims, including a recent clinical trial in the US where participants who suffer stomach discomfort after drinking regular milk showed significantly reduced symptoms when they drank milk only containing the A2 beta-casein protein.

A2 drinking milk consumption has grown strongly in Australia, and now accounts for 11.3% of all milk sold. However, it is the baby formula that has really turbo charged returns, and in particular its appeal to Chinese mothers. By 2020, sales of infant nutrition products accounted for $1.4 billion out of a total $1.7 billion in revenue.

And then the wheels fell off.

A2 baby formula reached Chinese mothers through a variety of channels. A significant one was the diagou channel. This is typically a personal shopper who picks up the product in an Australian store and then on-sells it to contacts in China. These were often Chinese students studying in Australia, as well as tourists. The COVID travel bans all but destroyed that sales channel. Cross-border E-commerce also suffered. The end result was sales falling 16% in the half year to December and net profit falling 35%. The share price has retreated 55% from its highs in July.

Value and contrarian investors may be starting to get interested at this point, wondering if the sell down has been overdone. Has all the bad news been absorbed and is the stock primed for a rebound?

There are still a lot of areas for concern. Sales to Chinese consumers may continue to suffer even after COVID restrictions are lifted. Negative sentiment towards Australia from China has been well documented and at the same time, domestic competition in China is heating up in the baby milk powder market. One brand, China Feihe is aiming to supply domestic infant milk powder market by 2023, capitalising on the growing nationalism trend.

On the plus side A2 have very good products. The market for liquid milk has been growing strongly in Australia, the US and in China, albeit from a small base. There is potential for continued growth in these three markets as well as new markets such as Canada. The store footprint in the US has been growing strongly but they have also started offering the product at cheaper prices due to the pressures from the pandemic.

There is no debt on the balance sheet and a healthy cash balance.

It is likely that the business still has a profitable future, however the growth rates witnessed over the last five years are unlikely to be repeated. Market analysts are forecasting a rebound, but a slow one. Consensus forecasts do not see earnings per share returning to 2020 levels until at least 2024.

Given that the forward PE ratio for financial year 2021 is still over 30, the market is factoring in a more optimistic view. If growth rebounds strongly and picks up where it left off pre-COVID, then the current price represents good value, but those who believe the turnaround could take a lot longer will want to wait for the price to fall further before considering A2 Milk to be a bargain hunters delight.

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