ACOPF - The a2 Milk Company: A Mixed Outlook

2023-12-20 08:40:32 ET

Summary

• The company's share price has dropped by more than -40% year-to-date, and its current valuations are below historical averages.
• But the outlook for a2 Milk and China's infant milk formula market is mixed, considering various positive and negative factors.
• A Hold rating for a2 Milk is warranted after reviewing its outlook and valuations.

Elevator Pitch

My investment rating for The a2 Milk Company Limited (ACOPF) [A2M:AU] stays as a Hold.

I outlined key takeaways from a2 Milk's 2021 Investor Day in my earlier write-up for the company published on November 8, 2021. In the current update, I draw attention to a2 Milk's share price underperformance and the outlook for the company's business.

The company's poor stock price performance is justified by its mixed outlook. On the negative side of things, the birth rate in China is coming down and there is pricing pressure in the Chinese IMF (Infant Milk Formula) market. On the positive side of things, there are still some growth drivers in the form of an expanding adult milk powder market and industry consolidation opportunities, and a2 Milk has enjoyed market share gains due to its positioning in the premium segment. Considering all these factors, I think that a2 Milk deserves a Hold rating.

Readers should pay attention to the fact that a2 Milk's shares can be traded in Australia and on the OTC market. Its OTC shares' three-month mean daily trading value was roughly $10,000 (source: S&P Capital IQ ), while the Australia-listed shares have a higher three-month average daily trading value of $7 million. It is worthy of note that US brokers such as Interactive Brokers allow clients to deal in a2 Milk's relatively more liquid Australian shares.

Stock Price Underperformance In 2023 Thus Far

Year-to-date, a2 Milk's OTC shares fell by -44.6% , while the company's Australia-listed shares also dropped by -41.6% as per S&P Capital IQ data. The company's shares traded on the OTC market and the Australian Securities Exchange are now trading at +12.7% and +9.5% above their respective 52-week lows. It will be an understatement to claim that the stock has done poorly this year.

As a2 Milk's Australia-listed shares are more liquid than its OTC shares, I will assess the stock's valuations based on the company's Australian shares with the A2M:AU ticker. According to valuation data obtained from S&P Capital IQ , a2 Milk is now trading at consensus forward next twelve months' normalized P/E and EV/EBIT multiples of 20.5 times and 11.9 times, respectively. As a comparison, the stock's five-year mean P/E and EV/EBIT metrics were much higher at 30.3 times and 18.9 times, respectively. In other words, a2 Milk's valuations have de-rated significantly as compared to their historical averages.

At the company's 2023 AGM or Annual General Meeting (transcript sourced from S&P Capital IQ ) that was organized in the middle of last month, a2 Milk highlighted that "the key challenge for us and our competitors is that the IMF (Infant Milk Formula) market in China has declined significantly, being down double digits in FY '23." This helps to provide an explanation for a2 Milk's share price correction and valuation compression in the current year.

In the subsequent two sections of the article, I detail the positives and negatives associated with the outlook for the Mainland Chinese IMF market and a2 Milk.

Key Negatives

The two major challenges for China's IMF industry is that the market is shrinking due to a decrease in the number of newborns in the country and pricing pressures.

The number of newborns in China is falling, and this will naturally hurt IMF demand in this market. South China Morning Post recently published an article on December 12, 2023, which cited data from the "China Population and Development Research Centre" which indicated that the country's fertility rate decreased from 1.3 three years ago to 1.09 last year. Earlier, a November 20, 2023 Nikkei Asia commentary piece mentioned that there are researchers estimating at least a -10% contraction in the number of newborns for the Chinese market to under 9 million this year.

IMF Market Prices In China Have Been On The Decline

An earlier June 6, 2023, news article published in Australian media publication The Sydney Morning Herald mentioned that "infant formula sold in China underwent a regulatory process to meet the country's more stringent food safety rules, known as GB standards" this year. ACOPF shared at the company's 2023 AGM that many IMF "brands started to increase their promotional activity and discounting to clear old inventory" in the Chinese market, which led to a decrease in IMF prices (as detailed in the chart above). It is possible that weaker IMF demand resulting from a fewer number of newborns in China will translate into more intense price competition and lower IMF market prices in China going forward.

I touch on the positives associated with the Chinese IMF market and a2 Milk in the next section.

Key Positives

There are two key positives for ACOPF and China's IMF industry.

Firstly, there are still growth opportunities relating to industry consolidation driven by tightening regulatory requirements (known as GB standards) and the growing adult milk powder market.

It is reasonable to assume that certain sub-scale players in the Chinese IMF market won't have the financial resources to meet the new GB standards (as highlighted in the previous section). The sale of existing inventories at discounted prices will have already driven some of these smaller IMF companies operating in China into realizing substantial losses. This means that foreign and more well-established IMF players have the potential to generate higher sales by capitalizing on the vacuum left by these companies which have exited the market.

Separately, the adult milk powder market might be a new source of growth for IMF businesses. The IMF market in China is shrinking as highlighted in the prior section of this market. On the flip market, China's adult milk powder segment has a favorable growth outlook. According to Euromonitor research (paid report not publicly available) for the Chinese dairy market, the size of China's adult milk powder market is projected to grow from RMB24 billion in 2022 to RMB29 billion for 2027.

Secondly, the pie might be getting smaller, but certain players including a2 Milk are grabbing a larger slice of the pie.

ACOPF's Market Share Expansion In The Chinese IMF Market

As per the chart presented above, a2 Milk has been gaining share in China's IMF market. In the preceding section, I wrote about the decrease in China's newborns. As a growing number of Chinese have fewer children, they will naturally want the best for their loved ones. This means that a2 Milk, which is focused on the premium segment of the Chinese IMF market, is well-positioned to increase its market share.

Concluding Thoughts

A Hold rating for a2 Milk is justified, taking into account the mixed prospects for the company and the industry. The stock's current valuations might be below historical averages, but a mixed outlook implies that meaningful capital appreciation for the company's shares is unlikely in the short term.

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