A2M: Can a milk producer be a growth stock?

From 2015 to 2020, A2 Milk (ASX:A2M) grew its market capitalisation from about $200 million to $20 billion. They produce milk. And milk products. Not AI or other high tech wizardry. Just the most generic of products, milk.

Food products are not typically high growth. People do not start eating a lot more than they used to just because a new product comes out. Aside from a small amount of change due to population growth and the trend to eat more protein as wealth increases, the success of one food product normally comes at the expense of another. If you decide to drink A2 milk you substitute it for another brand of milk. You do not double your milk consumption.

Consequently, the success of A2 milk was largely due to great marketing. They were able to exploit a competitive advantage based on the perceived health benefits of the type of milk. All milk actually contains the A2 beta-casein protein, however regular milk also contains the A1 protein. A2 milk is marketed as potentially being gentler on the stomach due to the absence of A1 protein.

Lion Group decided to challenge this marketing competitive advantage. In 2016 they started labelling their milk with the phrase “contains A2 protein”. (At the time they owned Dairy Farmers and Pura fresh milk products.) Whilst this was technically true, the A2 milk company sued Lion for misleading conduct, as the marketing implied this was a point of difference whereas in fact all milk contains the A2 protein. Lion countersued claiming that there was insufficient evidence for the claimed health benefits. In the end the parties settled so the claims were never tested in court.

A2 drinking milk consumption has grown strongly in Australia, and now accounts for 11.5% of all milk sold. However, to understand A2 Milk’s success, you need to understand the demand for baby formula and in particular its appeal to Chinese mothers. Sales to China and other Asia now account for 68% of all revenue, and most of that is to China. 93% of sales to the China and Asia segment are for infant milk formula (IMF).

A2 Milk’s success or otherwise, is largely driven by its ability to sell into China. Overall that has been successful but it has not been without its hiccups. Over the last 4 years the birth rate in China has fallen by a total of 39%. In the most recent year, the China IMF market declined 8.6% in volume and 10.7% in value. Despite that, A2M achieved 14% revenue growth in China during the year. A2M has increased its share of the total China IMF market from 4.9% in 2021 to 7.3%, becoming one of the most successful formula brands in China and is now one of the top 5, ahead of firms like Nestle.

Source: A2 Milk, Full year results presentation, 19 Aug 24

Aside from China, 19% of revenue comes from Australia and New Zealand and 7% from the USA. Liquid milk makes up the majority of sales in ANZ and almost all sales in the USA. As well as liquid milk and IMF sales they also sell ‘other nutritionals’ which are powdered and liquid milk products.

Another milk producer listed on the ASX and NZX is Synlait Milk (ASX:SM1). A2M owns 20% of Synlait. Synlait has had the exclusive right to manufacture all of the infant formula marketed under the A2 brand. This has been a source of contention and dispute between the two firms.

In mid August, Synlait agreed to end the exclusivity in exchange for a NZ$25m payment. A2 will now be able to produce some of their formula at their Mataura Valley processing plant in NZ which should lead to higher margins and therefore better returns for investors. This should help the Mataura Valley plant to move from losses to break-even. This change will also give A2 more control over its supply chain as well as the opportunity to bring new products to market.

A2 Milk’s revenue peaked in 2020 with sales of infant nutrition products accounting for NZ$1.4 billion out of a total NZ$1.7 billion in revenue. It then plummeted in 2021. A2 baby formula reaches Chinese mothers through a variety of channels. A significant one was the diagou channel. This is typically a personal shopper who picks up the product in an Australian store and then on-sells it to contacts in China. These were often Chinese students studying in Australia, as well as tourists. The COVID travel bans all but destroyed that sales channel. Cross-border E-commerce also suffered. The end result was revenue fell by 30% and net profit fell 79%. The share price retreated from highs around A$20 to about A$5.

Since 2021 the business has been steadily rebuilding. It has still not regained the 2020 level of NZ$1.73 billion but current forecasts are that it will pass that level in 2025 and reach NZ$2b by 2027.

The full year results released in August were generally positive. Some of the key points were:

• Sales grew 5.2%.

• Sales for China grew 14% despite the demographic challenges.

• USA sales were up 8%

• ANZ sales were down

• IMF sales up 4.6%. China label up 9.5% and English label up 0.3%.

• Liquid milk sales up 4.8%

• Net profit up 7.7%

• EPS up 9.2%

Despite this solid result, the share price fell 18% on the day of the announcement and has drifted slightly lower since. The reason for this was that the forward guidance provided by management fell well short of expectations. They also pushed out the target of NZ$2b in revenue from 2026 to 2027. This forecast of mid-single digit revenue growth for FY25 was a disappointment, given the stock had been trading at prices that assumed a stronger growth profile.

In its early days, A2 Milk was a strong growth company with revenue going from NZ$155 million in 2015 to NZ$1.7 billion in 2020, an 11 fold increase. Investors became accustomed to these growth rates and so priced the stock as a growth stock. The share price even hit A$20 in 2020.

But then it came crashing back to reality. Today it is a steadily growing business with high quality earnings and a strong balance sheet. However the price still reflects some of the growth mentality of prior years rather than being more of a steady accumulator. Consequently, even after the recent price fall it is still only average in terms of its valuation score.

The balance sheet is very strong with a cash balance of NZ$969. Nevertheless, they have not paid dividends to date. The market is forecasting that this may be the year that changes with a modest dividend payment.

Overall this is a high quality business that has managed to navigate the sometimes tricky regulatory and consumer environments in China. For a consumer defensive business it generates solid growth and very good margins. If purchased at the right price it could represent a good addition to a portfolio.

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