A2 milk and four other infant formula stocks

Australia’s exporters are enduring a tough period, as the country receives the kind of trade/political retaliation threats from China that would not be out of place in a Sopranos episode.

The ugly news from the wine sector last week showed how devastatingly capricious Beijing can be. The Australian wine industry gave China exactly what China wanted in terms of the pricing of wine, and now it is accused of “dumping.”

Now Treasury Wine Estates, as the most prominent example, is facing a situation where its $4 billion business in China is rendered unprofitable at a stroke. TWE generates 45% of its $530 million-plus earnings in the Asian region, with a big chunk of that coming from China.

The wine industry joins the farming, seafood and coalmining as being appalled at the trade spat with China – in which a Free Trade Agreement (FTA) and decades of rules-based access mean precisely nothing within Zhongnanhai, the leafy leadership compound in Beijing.

If the Chinese leadership wants to send a message to anyone, it does so quite nakedly. And it is telling us that it wants to hurt Australian exporters.

Australia now taking China to the World Trade Organisation (WTO) over grain and wine exports, and there will be other cases, but despite China being a full member of the WTO and “bound” by its rules, does anyone think that Australia’s case will be vindicated and our exporters will be compensated for their losses?

While TWE faces the wrath of investors, shareholders in the big dairy exporters – particularly those in the lucrative infant formula market – would also be feeling nervous.

Not only are the big Anzac companies major players in this industry, they know that they are in China’s sights, because dairy giant China Mengniu has been forced to abandon plans to buy the Japanese-owned Lion Dairy milk processing businesses in Victoria, because Treasurer Josh Frydenberg won’t approve the deal (although Mengniu was allowed to take-over sector luminary Bellamy’s Australia last December.)

The infant formula exporters have all the approvals from the General Administration of Customs of the People’s Republic of China (GACC) and the State Administration for Market Regulation (SAMR). And they have established and lucrative markets, with (so far) fiercely loyal customers. But given the way that China’s Commerce Ministry blindsided the wine exporters – who can say their markets are safe?

The industry has been challenged heavily in 2020 with supply chain disruptions, in particular as COVID slashed the number of part-time-to-semi-corporate “daigou” operators mass-buying in Australia for export. Also, China is spending heavily to boost its domestic industry. Given the massive potential of the sector, it shouldn’t surprise anyone that the Chinese government has set a target of achieving 60% of infant formula sales in China coming from domestic manufacturers. Is it conceivable that trade actions could be used in this aim? Of course it is.

Here’s a look at the infant formula players. The caveat here is that analysts have not yet factored-in to their forecasts and valuations any increased likelihood of trade action.
 

1. A2 Milk Company (A2M:ASX)

Market capitalisation: $10.2 billion
Three-year total return: +21.8% a year
Analysts’ consensus valuation: $16.37 (Thomson Reuters), $15.658 (FN Arena)

A2 Milk relies heavily on doing business in China, with China-based retail sales channels accounting for 48% of its total infant nutrition sales, which reached $NZ1.42 billion ($1.3 billion), up nearly 34 per cent, in FY20. The company has achieved in the milk world almost the same kind of brand association that the likes of Uber and Afterpay have attained: a2 milk is a variety of cows’ milk that mostly lacks a form of beta-casein proteins called a1, and instead has mostly the a2 form. A2 Milk Company has developed the genetic test that determines whether a cow produces a2 or a1 type protein in its milk: other dairy companies can certainly produce a2 milk, but the onus is on them to differentiate their products from the trademarks of the A2 Milk Company Limited.

A2 Milk’s Chinese-language infant nutrition label range is its super-premium product – in FY20, the sales of this range more than doubled, to NZ$337.7 million ($315.9 million) and distribution expanded to about 19,100 stores. English-label sales surged 40% (the English-label is premium priced within the reseller and online channels, but is positioned as a more accessible range.)

A2M has been very successful in building a customer base in China that firmly believes in the premium nature of the product – think “tiger mums,” who want what they feel is the absolute best for their children – and that has been a case study of successful brand-building in China. The company is very confident that this supports its business in China. But would this survive arbitrary tariffs and suddenly altered rules imposed all the way from a big desk in Zhongnanhai?

A2 Milk will say “we are a New Zealand company: we just happen to be dual-listed on the ASX.”  A big chunk of its milk is Australian, although all of its infant formula comes from Kiwi supplier Synlait. Would China, in its anger, make the distinction?

Analysts still see good value in A2M – although it’s not a dividend payer – but investors have to consider at least the possibility that China could lob a trade grenade into the dairy industry.

2. Bubs Australia (BUB:ASX)

Market capitalisation: $432 million
Three-year total return: –2.3% a year
Analysts’ consensus valuation: 65.1 cents (Thomson Reuters), 61 cents (FN Arena)

China is a healthy market for Australian infant formula producer Bubs, which generates 27% — $2.6 million — of its revenue from China export sales. Bubs’ differentiation is that its products are based on goats’ milk. Despite channel disruption arising from COVID-19, Bubs saw a 29% increase in Australian infant formula sales in the September quarter, and also saw a 76 per cent increase in goat formula direct export sales to China over the 12 months.

It has signed a deal with joint venture partner Beingmate to start producing Bubs China label Goat Infant Formula in China. Through this joint venture, Bubs also secured a distribution agreement with Kidswant, China’s largest mother and baby store chain.

However, Bubs’ quarterly revenue was down 34% from $14.2 million in Q1 FY20 to $9.4 million in Q1 FY21.

Bubs isn’t a profit-maker at the moment, and analysts see it as trading above fair value.

3. Clover Corporation (CLV:ASX)

Market capitalisation: $308 million
Three-year total return: +41.4% a year
Analysts’ consensus valuation: $2.29 (Thomson Reuters), $2.285 (FN Arena)

While Victoria-based food technology company Clover Corporation does not make infant formula itself, demand for its omega-3 additives is being driven by infant formula demand in China. The company supplies micro-encapsulation technology enabling tuna, fish, fungal and algal oils to be added to infant formula, foods and beverages. Revenue rose by 15.1% in FY20, to $88.3 million, and net profit climbed 23.8%, to $12.5 million, largely due to this demand.

While improving the nutritional quality of infant formula has acted as a tailwind for the stock, the company is exposed to any downturn that Chinese restrictions would represent – it already gave investors a nasty shock in October, when the shares fell 20% on the back of a trading update that talked about lower-than-forecast orders from infant formula manufacturers in the first quarter of FY21, on the back of COVID-19. Because of this continuing uncertainty, Clover now expects revenue for the first half of FY221 to be down 15%–25% on the first half of FY20.

However, infant formula is not all of Clover’s business – it has been increasing its exposure to other food-and-beverage uses, in Europe and the US as well as Asia. Any Chinese trade action on infant formula would hurt Clover – but in the absence of that hypothetical, analysts like the way that Clover’s business is trending.

4. Nuchev (NUC:ASX)

Market capitalisation: $56 million
Three-year total return: n/a
Analysts’ consensus valuation: $2.10 (Thomson Reuters),

Goats’ milk products company Nuchev listed on the ASX in December 2019 at $2.60, and quickly surged as high as $3.77 – but the share price has retreated to $1.25. The most recent issue has been weak revenue, which more than halved in the September quarter. While sales through the “daigou” channel were disrupted by COVID issues, the company also blamed a transition to a new distributor.

Nuchev sells its products, including infant formula, in Australia, China and Hong Kong, mainly through its Oli6 brand. Similarly to Bub’s, Nuchev is trying to capitalise on the fact that goat’s milk contains more vitamins than cows’ milk, including 46% more vitamin C: there are medical studies that claim that it is easier for babies to digest.

Nuchev has nominated Singapore, Vietnam, Taiwan and South Korea as markets into which it can expand in the near-term – but the company is currently a loss-maker, and it couldn’t be expected that it would react blithely to any market access restrictions suddenly applied by China.

5. Synlait Milk (SM1:ASX)

Market capitalisation: $933 million
Three-year total return: –9% a year
Analysts’ consensus valuation: $6.56 (Thomson Reuters), $5.87 (FN Arena) 

New Zealand company Synlait is a major supplier of infant formula to its part-owner A2 Milk Company, and also supplies infant formula to its largest shareholder, China Bright Dairy. A2 Milk is Synlait’s biggest customer, and Synlait is a2 Milk’s sole supplier of infant formula. The duo wants to become less reliant on one another, with Synlait diversifying and a2 Milk moving into making formula on its own account. But for the moment, any slump in demand for A2 infant formula from China hurts Synlait.

The fact that Synlait is much more prominently a New Zealand company than A2M could help it avoid any backlash. At present analysts make a strong “buy” case for Synlait – although it does not pay a dividend, preferring to reinvest in its diversification strategy.