Just when it appeared time to buy A2 Milk (ASX:A2M) again, investors have fresh concerns

A2 Milk shares have been listed on the ASX for over 9 years, listing in late March 2015 at $2.30 per share. After hitting an all-time high of $20.05 per share, it was downhill for a couple of years, then a period of uncertainty as to where the company was going next.

While off its all time highs, the company gained 60% in the first eight and a half months of CY24…until its recent results sent some investors running for the exits.

 

 

In this article, we ask why did A2 Milk shares surge so high in the first place, why did shares go so low and what does the future hold?

 

How did A2 Milk shares go so high?

A2 Milk rose in the first place because it had significant success in selling its dairy products (milk and infant formula), particularly in China. China was not just an opportunity because of the population size and its consumption of dairy products (roughly 30 kilograms per year), but because consumers preferred foreign brands. There are local brands, but they have been tainted since a contamination scandal in the 2000s.

In the 12 months to June 2019 (FY19), it recorded NZ$1.3bn in revenue. Although China and the rest of Asia was by no means its largest market (accounting for roughly 31% of revenues), it was growing fast. The company’s sales in Australia and New Zealand only grew by 28% but sales in China and the Asia-Pacific grew by over 74%.

During the Corona Crash, when the ASX 200 fell by >30%, A2 Milk shares actually gained 4% and ultimately reached its all time high in July of 2020. We think there were 4 reasons. First, because it provided essential products so its operations (and therefore revenues) were unaffected by lockdowns. Second, ‘panic buying’ by consumers in all markets. Third, a depreciation of the NZD against the USD which artificially inflated revenues.

 

 

Why did A2 Milk shares fall after mid-2020?

As of May 2024, A2 Milk shares have failed to reached their mid-2020 levels in the nearly four years since they peaked.

Issues bubbling under the service during the early days of the pandemic started to bite the company including supply chain disruptions, diplomatic spats between China and the West and the drying up of the daigou trade (which was a major source of revenue). Daigous are exporters who buy in Australia or New Zealand on order from contracts in China and despatch the goods back to China themselves. Some investors were also concerned about the company’s high marketing budget and perceived low return on it.

Ultimately, the China opportunity was shrinking but there was one factor more important than any other. Namely: China’s falling birth rate. The abolishment of China’s one child policy had done little to encourage couples to have more children. And women were delaying their pregnancies to get vaccinated against COVID-19.

In FY21, the company’s revenue fell 30% to NZ$1.2bn and its net profit fell 79% to NZ$80.7m. This after four guidance downgrades in the preceding 4 months. Ouch for A2 Milk shareholders. This led to shareholder launching multiple class actions against the company.

 

 

What about the USA?

Prior to COVID-19, A2 Milk had a presence in the US market but it was just 2.6% of sales in FY19. Obviously, the US has a high population and a big market (at US$4.3bn) but it is a competitive market with local brands dominating. However, a severe shortage in April 2022 led to the Biden administration launching ‘Operation Fly Formula’ – flying infant formula into the country from overseas.

A2 Milk was a little late to the party compared to its peers, thanks to the FDA taking its time to review its application. It first applied in May and heard nothing until August, only hearing then that the FDA was deferring a further review. And keep in mind that there were 160 companies around the world trying to crack this market too, some of which were getting approval faster.

Eventually, A2 received market access in November 2022. But this was only on a temporary basis and gross margins were lower due to higher air freight and rework costs. In 1HY24, it only made NZ$56.8m in the US, not even 10% of the company’s total NZ$812.1m in that period. The company is still pushing for long-term regulatory approval, aspiring for this to happen in FY26.

 

Big growth in China in FY23 and FY24

In FY23, the company made NZ$1.6bn in revenue and a $155.6m profit, up 10% and 27%. $1.0bn of its revenue came from China and this rose 38% from FY22. Pleasingly, this occurred despite a decline in the overall IFM market (which includes the daigou trade) and in births. The takeaway from this results was that cost inflation had peaked, and even if the Chinese market stagnates, the company can grow (and is doing so) by taking market share from competitors. Still, the company told investors it expects the number of newborns to grow in CY24 overall.

In FY24, the company delivered $1.68bn revenue and a $167.9m profit, up 5% and 8% respectively. Investors were told to expect revenue growth of ‘mid-single digit percentage’. This did not stop shares declining on the day the company released its results. Why? We think it was because the company admitted conditions were challenging impacted by the decline in newborns, intense industry competition and tough macroeconomic conditions.

However, the company hung its hat on several facts including that its own market share and that of English-label brands are continuing to grow, with a 3.3% and 17.2% market share respectively. It is now a top 5 brand by market share and the second biggest among English label brands (only trailing Aptamil).

 

 

With the daigou trade in Australia all but dead, and even shrinking within China, more than half of A2 Milk’s sales occur through Cross Border E-Commerce (CBEC). It is promoting on platforms including Baidu, TikTok, WeChat and JD and claims these campaigns are bearing fruit. It is entering other Asian markets like Vietnam and Singapore as well. But sales from these markets will pale in comparison to China.

 

So will the years ahead be better for A2 Milk?

A2 Milk is aspiring for ~$2bn in revenue by FY26. So FY25 will have to be a big year for the company to meet this goal. A2 Milk’s management has admitted this goal might not be achieved until FY27, without formally withdrawing its initial FY26 target.

Analysts covering the stock expect the company to only surpass $2bn in revenue in FY28, although it will fall just short in FY27. Their mean target price is $6.07, a near 10% discount to the current share price. Nonetheless, analysts do expect profit growth from FY25 onwards after a flat FY24. Specifically, $173.5m in FY25, $202.4m in FY26 and $267.5m in FY27.

On the basis of these estimates, A2 Milk is trading at 27.2x P/E and 2.3x PEG for FY25, not cheap in our view. The first of these figures is well ahead of the ASX 200, and the second is well ahead of the 1x threshold over which a stock is considered overvalued relative to its growth. The mean target price on the stock is $6.31, up 9% from the current share price.

 

So, is it time to buy A2 Milk shares?

We think it could be, but it may take until CY25 for investors to make any material gains for the company. On one hand, the situation in Chinese market opportunity is improving from what it was a couple of years ago. The other, investors need to realise that the company is different to what it was in 2019 and never will be again.

But this is a solid company that is adjusting to the ‘new normal’ and appears to be successfully doing so right now. The risk is that, with the bar set high, any setbacks could kill investor confidence in the company for good.

 

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