Is it time to buy A2 Milk shares again now that China is back in vogue?

A2 Milk shares have been listed on the ASX for roughly 8 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.

 

 

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?

To answer the latter question, that will come down to whether or not it can A2 can regain the foothold in China it once had and whether or not it could gain a foothold in any other market enough to make up for the loss of China?

 

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.

 

Big growth in China in FY23

In FY23, the company made $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. We noted above that 1HY24 revenue came in at $812.1m, but its net profit was $85.3m, up 16%.

The takeaway from these are that cost inflation has 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.

 

So will the years ahead be better for A2 Milk?

It is aspiring for ~$2bn in revenue by FY26 and to have low to mid single digit growth in FY24. 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.

 

So, is it time to buy A2 Milk shares?

We don’t think so at the moment. On one hand, its multiple are more reasonable than a few years ago, and the Chinese market opportunity is not completely gone. The other, investors need to realise that the company is different to what it was in 2019 and never will be again.

We think investors should wait until the company’s FY24 results (due in August 2024) where it will provide an update on its US endeavours and China sales.

 

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