Treasure Chest | Sep 10 2020
This story features THE A2 MILK COMPANY LIMITED, and other companies. For more info SHARE ANALYSIS: A2M
FNArena's Treasure Chest reports on money making ideas from stockbrokers and other experts. Elevated inventory accrued during the height of the pandemic has led to de-stocking of infant milk formula product in China. Is a2 Milk in danger of more permanent disruptions?
-a2 Milk adversely affected by resurgence in China's domestic brands
-MVM acquisition tying a2 Milk more closely to Chinese partners
-Significant insider selling recently in the stock
By Eva Brocklehurst
Is a2 Milk ((A2M)) in danger of more permanent disruptions to the daigou channel, where exporters outside of China purchase commodities for customers inside China?
While enjoying extremely high rates of revenue growth in recent years, current observations suggest a2 Milk's growth is slowing and, as Ord Minnett points out, this is consistent with concerns regarding elevated inventory levels and pantry de-stocking.
Management has repeated expectations that revenue growth will be supported by investment in marketing and production capabilities and reiterated margins of 30-31% for operating earnings. Capital expenditure intentions of around NZ$50m are targeted at investment in systems and Australian fresh milk processing.
Stockpiling which occurred during the height of the pandemic is still unwinding, although Citi is surprised it has continued for such a long period. This is based on a previous survey that showed only four weeks of excess supply among Chinese consumers had been purchased.
The broker is concerned that a2 Milk is being adversely affected by a resurgence of China's domestic brands and increased competition. The company has indicated the entire daigou channel has been disrupted in the midst of stage 4 lockdowns in Victoria.
Warehousing and logistics may be considered essential services but operating efficiency is being affected by the lockdowns. This adds to weakness experienced in the small end of the daigou channel from lower levels of inbound Chinese tourism and lower international student numbers.
This situation is unlikely to recover any time soon. Citi calculates the corporate daigou channel accounted for 29% of a2 Milk's infant milk formula (IMF) sales in FY20 and Australian retail, predominantly pick & pack daigou, accounted for 23%. Weakness in both these channels could impact on the company's ability to acquire new customers, to the extent this is not offset by other marketing or promotional activities elsewhere.
Yet while there have been discussions recently about the political tensions between Australia and China and the risks to a2 Milk, Macquarie suspects IMF is largely immune, given the essential nature of the product and sensitive consumer base. A lack of IMF self-sufficiency in China is, to some extent, preventing large producers and brands being caught up in political tensions.
While acknowledging the pandemic has disrupted the supply/demand balance and tilted consumption towards China's labelled product CLSA considers this temporary. The broker, not one of the seven monitored daily on the FNArena database, retains a Buy rating and $22.60 target.
Mataura Valley Milk
Moreover, under the proposed acquisition of 75.1% of New Zealand's Mataura Valley Milk, the remaining 24.9%, will be owned by China Animal Husbandry, a subsidiary of China National Agricultural Development, which is also the parent of a2 Milk's strategic partner in China.
The main curiosity for Macquarie, therefore, in terms of China's domestic policy on infant formula, is at what point in the value chain the product is classified as domestic.
Noting a2 Milk's reliance on its primary manufacturer Synlait Milk ((SM1)), Citi considers the acquisition will boost bargaining power but also increase capital intensity. The broker would have preferred the company built its manufacturing capability in China with a local partner, as this would provide easier access to the market.
The broker believes there is still substantial upside in China for a2 Milk although a Sell rating is retained, as the outlook is increasingly risky while the regulatory landscape evolves and geopolitical risks mount.
a2 Milk has made a non-binding indicative offer to acquire the Mataura stake for NZ$270m, which Macquarie points out will not even "scrape the sides" of the current cash balance.
The broker assesses the investment is consistent with the strategy of more close participation in manufacturing and believes this only strengthens the relationship with China. A2 Milk has not ruled out launching new infant formula products, including a potential second label for China.
Over the longer term, UBS believes Mataura provides manufacturing diversity and protection against any potential regulatory shift in China that requires integrated manufacturing and a deeper relationship with a Chinese state entity.
The broker also points out, for Mataura to be capable of producing finished IMF, it will need to add a blending and canning line. For Chinese labelling, it would need to obtain factory registration and brand registration in China, a process that could take five years.
There has been significant insider selling recently in a2 Milk, as these investors have enjoyed high-value equity holdings and options on issue. The size and value of these sales as well as breadth of selling across management has created some concern among brokers, including Ord Minnett.
While the due diligence on Mataura may have been a catalyst for the sales, concerns in this regard linger and Ord Minnett retains a Lighten rating. FNArena's database has three Buy ratings, one Hold and two Sell. The consensus target is $18.08, signalling 9.1% upside to the last share price.
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