Ann: FY24 Results commentary and outlook, page-97

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A2 Milk Company's Moat Is Underpinned by Its Infant Formula Brand in China

Angus Hewitt

Aug 19, 2024

Business Strategy and Outlook

A2 Milk has built a brand that we expect to protect economic profits for years to come. China is the key battleground. A2's future growth relies heavily on further successful penetration of the Chinese infant formula market, which we estimate makes up the vast majority of earnings.

A2 is a licensor and marketer of fresh milk, infant formula, and other dairy products that lack the A1 beta-casein protein. Dairy cows naturally produce two beta-casein proteins in their milk: A1 and A2, which differ by one amino acid. A2 milk is produced by cows that naturally produce milk only containing the A2 protein; genetic testing is done to build herds of supply. Some studies have suggested the A1 protein may be associated with serious health issues, although a2 Milk only asserts that milk with only the A2 protein may positively affect digestive function.

Consumers have flocked to a2 Milk as a result of these perceived health benefits, helping to expand market share in Australian fresh milk, as well as infant formula in Australia and China following the launch of a2 Platinum in 2013. These gains have occurred alongside premium price points. In Australia, a2 Milk is typically more than double the price of private-label offerings, while a2 Platinum has higher pricing in Australia and China versus other leading brands.

Continued success in the Chinese-label business is crucial for a2. While the English-label business continues to recover, we think the Chinese-label business will more durably drive market share growth without the same reliance on resellers. Indeed, a2's marketing and distribution investment has shifted to focus on the Chinese label business. This appears to be reaping rewards with brand awareness and loyalty improving across the board, boding well for the long-term health of the a2 brand in China, which underpins the firm's narrow economic moat.

Bulls Say, Bears Say

Bulls

China remains a major long-term growth opportunity for a2 and should help to drive continued margin improvement.

While the science is currently uncertain, further studies on the benefits of A1-protein-free dairy products could support positive health claims for a2 Milk.

A2 generates solid free cash flow, which could be used to make accretive acquisitions or vertically integrate, or returned to shareholders.

Bears

A2 relies heavily on only two major suppliers, which risks price hikes, supply challenges, or future competition.

The company fights against strong competition in China and elsewhere. In the longer term, a2 may be undercapitalized to take on the marketing arms of dairy behemoths such as Nestle and Danone.

China could further alter the regulatory environment for infant formula, which may lead to supply disruptions for a2 or a greater ability for local manufacturers to compete.

Financial Strength

A2 is in solid financial shape. Apart from the NZD 38 million in debt as part of the 75% ownership in Mataura Valley Milk, a2 holds no debt and only minimal operating lease obligations on its balance sheet, and runs its business without need for major capital expenditures. With a net cash position of nearly NZD 1 billion (including Mataura Valley debt) at June 30, 2024 and limited working capital requirements, a2 can easily fund increased brand investment in China, capability buildout at Mataura Valley, and potential inorganic opportunities. Thus far, a2 has opted to not pay a dividend, but has indicated this as a potential future use of profits. We assume such a payment starting in fiscal 2027, at a 50% payout ratio of net profit after tax.

Economic Moat

With strong returns on invested capital, stemming from premium pricing and a capital-light business model, we assign a2 Milk a narrow economic moat based on its strong brand intangible assets.

A2 Milk enjoys solid brand positioning, particularly in the Chinese infant formula market and Australian fresh milk arena, which has led to premium pricing versus local and private-label alternatives. The company's products have become synonymous with the A1-protein-free dairy category, and have gained market share as the perceived health benefits of the offering have increased among its target consumer base. Infant formula market share in China increased to 3.4% in fiscal 2023 at retail, and around 21% through reseller channels, following the initial product launch in 2015. Similarly, A2 fresh milk has seen its share of the Australian market increase to more than 11%, from about 7% in fiscal 2013, suggesting low-double-digit compound annual growth in a market that has otherwise grown at about 3% per year, per GlobalData.

These gains have come despite a2's generally premium pricing, suggesting consumers are willing to pay up for the brand. In Australian fresh milk, a2 Milk is available for roughly double the price of the store-brand equivalent. This higher pricing extends to infant formula, as well. A2 Platinum generally runs about 50% higher in Australia versus other major players such as Nestle, Karicare, and Bellamy's. And in China, a2 is part of a growing consumer preference for premium, international brands instead of locally manufactured product, although the pricing premium is less pronounced versus major peers. A2 Platinum is priced near CNY 200 per tin (roughly AUD 39), in line with Danone's Aptamil, but trailing Nestle's Wyeth and Mead Johnson's (a unit of Reckitt Benckiser) Enfamil. Nonetheless, these market-leading formula products are all priced substantially higher than mainstream products such as Hero Baby (a Swiss company) and leading local manufacturers such as Yili.

A2 has continued to price at a premium even when entering new markets. This strategy extends to the US, where the company has recently expanded to about 22,300 stores nationwide, including Whole Foods, Sprouts, and Wegmans, and regionally with Costco and Walmart. While the company hasn't achieved break-even profitability yet—we estimate positive EBITDA by fiscal 2023—the product has seen share gains despite a solidly premium price point. A2 Milk is available at Wegmans for nearly 4 times the price of store-brand milk, more than double Dean Foods' branded product, substantially above private-label organic milk, and slightly higher than Coca-Cola's lactose-free and protein-rich Fairlife milk.

Outside of premium pricing, other intangible assets include a2's exclusive rights to market the perceived benefits of A1-protein-free milk until 2023 under patent, along with several other pieces of intellectual property, and license approval to import its products into China under regulations put in place starting January 2018—an accomplishment that Australian organic-milk competitor Bellamy's has struggled to achieve. In all, the firm's operating margins have skyrocketed to north of 30% from less than 1% in fiscal 2015, compared with midteens at Nestle, Danone, and Bellamy's; 25% for infant-formula focused Mead Johnson (in 2016, prior to being acquired by Reckitt Benckiser); and just 2% for commodity-milk-focused Dean Foods.

A2 Milk's business strategy supports sky-high returns on invested capital. The company does not produce its own milk, but instead contracts with local dairy farmers or third-party producers to produce milk from genetically tested cows that do not produce the A1 protein. This milk is processed at a2-owned sites for fresh milk in Australia, but is otherwise sourced and produced by New Zealand company Synlait (of which a2 also owns a 19.8% share) for infant formula in Australia, New Zealand, and China; by Fonterra—under a recently signed agreement—for dairy in potential growth markets; and by local third-party partners in the US With this capital-light business model, a2's ROICs have leapt to more than 100%, including goodwill, in fiscal 2020, from low single digits in fiscal 2015. We expect further strong growth, solid long-run margins, and a lack of sizable capital requirements leading to returns averaging 30% through fiscal 2026. Even if we were to capitalize 15% of the company's cost of goods sold, which represents the gross margin captured by publicly traded Synlait, ROICs would still average comfortably above our estimate weighted average cost of capital over the next 10 years.

In all, we expect the company's pricing premium and market share gains to continue. However, there are risks on the horizon for a2 that prevent a wide moat rating, despite incredibly strong profitability. The company faces formidable competition in the Chinese infant formula market from large international dairy conglomerates, and while we forecast continuing share gains over the coming decade as consumers continue to flock to international brands following food-safety scares in recent years, the marketing and promotional arms of Nestle, Danone, and Reckitt Benckiser could prove to be sizable impediments to A2 participating in this uplift. As evidence, alongside key genetic-testing patents expiring in recent years, Nestle launched Atwo, its own A1-protein-free infant formula product, in early 2018, and Danone launched an A2 rival under its Cow & Gate brand in Hong Kong. A2 Milk believes these developments will help to expand the overall A2 category, with the products taking share from traditional offerings, and Atwo in particular is priced at a significant premium to a2 Platinum. But a situation in which these products become substitutes for a2 Platinum could drive down a2 Milk's market share and reduce ROICs, including capitalized cost of goods, to 24% by the end of the next 10 years versus nearly 40% in our base case. Nonetheless, even in this bear case, ROICs remain well above our estimated 10% WACC.

We also see risk from future scientific developments and potential regulatory responses, but believe the a2 brand is strong enough to withstand most challenges. The science behind the benefits of drinking milk that excludes the A1 protein is inconclusive, with many original a2 Milk claims that A1 protein consumption has serious negative side effects not substantiated in follow-up research by independent investigations or government bodies. Subsequently, a2 Milk has relied on messaging that suggests A2-only dairy products prevent stomach discomfort for those with lactose sensitivity, although again, the studies supporting this claim have been small and inconclusive. Still, these facts haven't stopped sizable market share gains, and we believe anecdotal consumer experience and strong brand positioning will protect a2's premium pricing even if government bodies limit the company's ability to make similar health claims in the future.

We don't believe a2 has carved a durable cost advantage. The A1-protein-free milk production process is identical to traditional milk production; the difference stems from determining—by genetic testing—which cows in the herd will produce milk with only the A2 protein. But despite this, a2 and its supply partners have agreed to pay farmers a premium over the farmgate milk price, to lock in supply and incentivize further A1-protein-free production. Moreover, both Fonterra and Synlait operate with slimmer margins and economic profits. Synlait, which produces all of A2 Milk's infant formula at present, posted EBITDA margins of about 13% in fiscal 2020, along with ROICs in the low teens, while Fonterra generated a lower 7% margin. A2 Milk has signed medium-term contracts with these suppliers, with the Fonterra agreement set up on a rolling three-year basis, and the Synlait deal set to run through fiscal 2025 after an extension signed in 2019.

Fair Value and Profit Drivers

Our fair value estimate for a2 Milk is NZD 8.00 per share. We forecast double-digit annual earnings growth over the next five years, justifying the lofty 32 price/forward earnings multiple our valuation implies.

We forecast revenue growing at an 8% yearly clip through fiscal 2029. Infant formula is the most substantial driver of our outlook. This product makes up the vast majority sales, and we project 6% annual top-line gains for the next decade. We expect China will remain the lion's share of a2's infant formula sales. We estimate that the country, either through direct sales or indirect consumption via Australian third parties, makes up more than 90% of a2's infant formula demand. We forecast a2 enjoying high-single-digit annual revenue growth in this geography, ahead of mid-single-digit market growth, owing to volume share gains and continued solid pricing power.

Outside of infant formula, we expect a 5% 10-year revenue CAGR for fresh milk, which made up about 18% of fiscal 2024 sales, and 5% annual gains for other products. These assumptions are ahead of industry growth rates, driven by market share gains, geographic expansion, and launches of other dairy products.

We expect strong margin performance to somewhat reverse from negative mix shifts and increased marketing and distribution costs to support the Chinese label business. Infant formula generates higher profit margins than a2's other offerings, which has helped to drive EBIT margin to 32% in fiscal 2020 from 1% in fiscal 2014, but we expect the lower-margin Chinese-label business to outgrow English label, placing some mix shift within the business. We forecast that rising contribution from this product, along with leverage of employee and other administrative costs, will maintain lofty margins. But with infant formula already a large piece of a2's business, and our expectation that marketing expense will outpace revenue gains in the near term, we see EBIT margins constrained at around 22% by fiscal 2029.

A2 has limited capital reinvestment needs, given that it outsources most milk sourcing and processing, and we see a solid near-100% of net income converted to free cash most years. We use a 10% weighted average cost of capital to discount a2's cash flow, consisting of a 9% cost of equity, and a 1% country risk premium to account for the company's heavy exposure to China.

Risk and Uncertainty

We assign a a2 Milk a Morningstar Uncertainty Rating of High. Although the firm offers fresh milk, infant formula, and other dairy products, we view a2 as essentially a single-product company, as its outlook hinges upon the continued demand for A1-protein-free dairy. Past scientific studies are inconclusive as to the health benefits of consuming A2-only milk versus traditional dairy, but some consumers anecdotally suggest improved digestion. Follow-up scrutiny could uncover underlying proof of such claims or dispute them entirely, which could drive an outcome that differs significantly from our base-case expectations.

A2 also operates in a competitive field. The company holds only a roughly mid-single-digit share of the fragmented Chinese infant formula market, with international dairy majors such as Danone, and local players such as Feihe commanding much larger positions. The loftier market budgets of bigger competitors could stifle a2's market share gains.

Supplier concentration is another risk. A2's infant formula has been exclusively manufactured by New Zealand's Synlait, of which a2 owns a minority stake. Synlait has proven capable to date, keeping up with massive growth in the product since 2014, and gaining Chinese Food and Drug Administration approval for imported product in 2017. However, risk remains that Synlait's future supply of A1-protein-free milk could become constrained, or that the firm could lift prices at a faster clip. To diversify, a2 has signed an agreement with fellow New Zealand milk producer Fonterra, for fresh milk in New Zealand as well as infant formula and other dairy products in future geographies. But there's also a risk that volume growth may prove lower than anticipated, which could lead to oversupply, price discounting by distributors, and pressure from suppliers.

Capital Allocation

We assign a2 Milk a Standard Morningstar Capital Allocation Rating based on our assessment of balance sheet risk, investment efficacy, and shareholder distributions.

A2's balance sheet is in sound condition. Apart from the NZD 38 million in debt as part of the 75% ownership in Mataura Valley Milk, a2 holds no debt and only minimal operating lease obligations on its balance sheet, and runs its business without need for major capital expenditures. With a net cash position of about AUD 1 billion (including Mataura Valley debt) at June 30, 2024, and limited working capital requirements, the company should generate robust free cash flow, typically converting nearly 100% of net profit after tax to free cash.

Investment efficacy is fair. The firm has expanded its infant formula business from essentially nothing five years ago to the vast majority of earnings now, which has supported a major expansion in profitability and return on invested capital. However, the company is now entering a phase of substantial marketing and personnel investment, which will require heightened diligence in managing returns and allocating capital. However, in 2021 persistently high inventory through the sales channel stifled reordering from key corporate daigou partners, weighed on market pricing, and led to ageing of available product—leading to significant write-downs and a slowdown of reordering.

Shareholder distributions are appropriate. The company's balance sheet comfortably managed the NZD 150 million on-market buyback flagged in August 2022. With a2 shares at a discount to our fair value estimate, the buyback is marginally accretive to our fair value estimate. A2 has opted to not pay a dividend, but has indicated this as a potential future use of profits. This is prudent given the significant growth available to the company through market share gains, and management outlining the potential to invest with partners in product manufacturing to reduce supplier concentration risk. We assume dividends starting in fiscal 2027, at a 50% payout ratio of net profit after tax.