Australia | Jun 05 2019
Will China's self-sufficiency action plan for infant milk formula have a detrimental impact on imports?
-Lack of clarity on achieving the goals, given no timeframe
-Action plan has weighed on sentiment but local brands still struggle
-A2 Milk may be well positioned, with flexible distribution channels
By Eva Brocklehurst
China has announced a plan to improve confidence in domestic infant milk formula. The intention of the National Development and Reform Commission (NDRC) is to obtain a higher market share for domestic brands and a 60%-plus self-sufficiency rate.
The plan envisages support for domestic dairy processors to acquire, or set up, bases overseas for milk supply and to encourage foreign dairy firms to invest in China. No new regulation or changes to existing regulations are proposed.
While the policy appears favourable to domestic players, Morgan Stanley notes a lack of clarity on how the government intends to achieve its goals, given no time frame. For a2 Milk ((A2M)) and Bellamy's Australia ((BAL)), the broker believes there are risks that the addressable market may shrink and a focus on traceability could lead to a crackdown on the daigou, suppliers that are based outside China, to which a2 Milk is heavily exposed.
Changing consumer perceptions of domestic products is the key challenge for the government, Macquarie asserts, as local brands have been selling foreign-manufactured goods in China for some time but have struggled to build share. A preference for imports was triggered by the 2008 contamination, where melamine was found in domestic formula, while the number of brands operating in China has been reduced significantly since 2018.
Hence, Macquarie assesses manufacturing and providence do not seem to be the limiting factors in consumer acceptance. The broker considers it unlikely the government will reduce access to imported formula, given consumer sensitivity.
UBS assesses domestic brands make up less than 60% of the aggregate share, which means some market share risk for international brands in the longer term. The broker also notes China's government has previously sought to promote domestic brands, the last time in 2013.
Three-year targets have also been set for establishing a research database, safety monitoring system and a new round of inspections on production facilities. The broker does not believe there is a significant issue for international companies as these often have greater flexibility, in that they can produce locally or import.
Infant Formula Stocks
Macquarie considers this a buying opportunity for a2 Milk, as the action plan as it stands has limited near-term impact. The company continues to have a partnership with China State Farms and a flexible multi-channel distribution structure.
Bell Potter is not so sure, as a2 Milk is still largely dependent on cross-border e-commerce entities and the daigou trade, and any disruption through a tightening of e-commerce regulations may disrupt revenues in FY20-21.
The broker, not one of the eight monitored daily on the FNArena database, retains a Sell rating on a2 Milk with an $11.50 target. The database has two Buy ratings, four Hold and one Sell (Morgan Stanley) for a2 Milk. The consensus target is $14.40, signalling 7.1% upside to the last share price.
Nevertheless, Macquarie asserts, while a2 Milk is a fast-growing and trusted consumer brand in China, increased support for domestic players could mean competition intensifies and requires additional investment in sales and marketing.
Bell Potter also continues to envisage a risk from the transition in the sales mix to lower-margin China direct sales at a time when ingredient costs are rising and sector-wide demand in China is slowing.
Synlait Milk ((SM1)), meanwhile, has come under pressure because of the uncertainty around its Pokeno site and Munchkin putting its US FDA application on hold, the latter which entails a gap in filling capacity. At present a2 Milk makes up almost all Synlait Milk's infant formula production. Therefore, should China's latest announcement affect volumes for a2 Milk it would have a corresponding impact on Synlait Milk.
Macquarie has an Underperform rating for the stock, reflecting a view on the medium to longer term margin sustainability as well as the uncertainties referred to above. On balance, Bell Potter finds China's announcement underscores the strategic value of Synlait Milk's manufacturing footprint, a positive, and retains a $12.50 target with a Buy rating.
Fonterra Shareholders Fund ((FSF)) has a small exposure to infant formula in China and the main impact, Macquarie suggests, would be further strength in Beingmate's share price (Fonterra has a 19% stake) relative to this action plan. Macquarie notes the company is looking to potentially divest its stake in Beingmate as well as two farming hubs in China.
Bell Potter flags the dependence of Bellamy's Australia on e-commerce sales in China, and suggests any more rigid enforcement of e-commerce laws, may have a detrimental effect. Given delays, the broker has removed China-direct organic label sales from its forecasts, as this remains subject to China's market regulator approval.
The broker also reduces the probability of the company achieving its $500m revenue target. Bell Potter's Hold rating is maintained with an $8.05 target. On the database, there are three Hold ratings for Bellamy's Australia and the consensus target is $9.78, signalling 22.0% upside to the last share price.
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