Amid hard times in the dairy industry, one company has found a winning formula. What's the secret and can it last? asks Christopher Adams
Thanks to a soaring share price, A2 Milk has been doing justice to its sharemarket ticker code - ATM.
Many investors will have banked tidy profits by cashing in on the 214 per cent surge in the dairy firm's shares over the past 12 months. Last year, A2 shares were the best performers on the New Zealand market.
Geoff Babidge, A2's managing director, has been getting in on the action, netting $3.6 million by selling some of his shares between October and early January as the price rallied, thanks to upgrades in the company's profit forecasts.
While the wider dairy industry struggles, A2 is profiting from its point of difference: the fact that its milk comes from cows selected to produce only a particular type of protein, known as A2 beta-casein, unlike most dairy products, which contain both A1 and A2 proteins.
The company claims the A2 variant offers health benefits over the more common A1 variety.
The successful marketing of that point of difference has helped A2 secure roughly 9 per cent of the Australian fresh milk market.
But it's the stratospheric sales growth of A2's Platinum infant formula which has driven the recent rise in earnings and the corresponding share price action.
Profit in the six months to December 31 saw an 80-fold increase to $10.1 million, boosted by a 340 per cent jump in baby formula sales across Australia, New Zealand and China, to $73.9 million.
The Platinum formula is made for A2 by Synlait Milk in Canterbury, using milk from herds chosen to produce only the A2 protein.
Since Platinum formula was launched in late 2013, its sales have grown to the point where they now provide more than half of A2's total revenue. The product accounts for almost 17 per cent of formula sales through Australian grocery stores and pharmacies.
But A2's rising sales across the Tasman aren't just the result of demand from Australian mothers and fathers. Instead, much of the infant formula is being used to supply the so-called "grey channel" out of Australia and into China. This involves traders buying product from Australian supermarkets, then selling it in China via a range of online platforms.
The grey channel boom reached such a frenzy last year that Aussie retailers found their shelves being stripped bare, and resorted to rationing the number of cans customers could buy.
Given this channel accounts for a significant portion of sales for [A2, Bellamy's and Blackmores], we see risks that these brands are unable to continue their recent growth, unless complemented by effective marketing of brand names.
Several factors are driving the grey market trade.
One is that Chinese shoppers like purchasing infant formula outside China because they believe it is less likely to be counterfeit.
There's also the fact that such exports can avoid Chinese taxes, meaning lower prices for consumers.
Many firms have ridden the grey channel to higher profits, and enjoyed higher share prices as a result. They include Australian health supplement maker Blackmores and rival infant formula marketer Bellamy's Australia.
However, questions are being asked about whether A2 can rely on the grey channel as a long-term, sustainable source of revenue.
Analysts say it faces a number of threats, including competition from the rise of Chinese free trade zones, through which formula can be imported officially while avoiding tariffs, and potential regulatory disruption.
"Given this channel accounts for a significant portion of sales for [A2, Bellamy's and Blackmores], we see risks that these brands are unable to continue their recent growth, unless complemented by effective marketing of brand names," said Naveen Patney, an analyst with Asian sharebroker CLSA, in a research report published last month.
It's worth noting that the kind of grey channel activities now happening in Australia were common in New Zealand until 2012, when the Ministry for Primary Industries cracked down on unregistered infant formula exporters operating on this side of the Tasman.
Xu Jun, Chairman China State Farms Holdings Shanghai and Geoff Babidge Chief Executive Officer of A2 Corporation at the A2 milk powder infant formula on the production line. Photo / Chris Miler
Forsyth Barr analyst James Bascand reckons sales of products destined for the grey channel account for 45 to 50 per cent of A2's infant formula sales in Australia and New Zealand.
That would value those sales at up to $33 million, or 44 per cent of total infant formula revenue, in the six months to December 31.
However Babidge says it's difficult to gauge how much A2 formula sold in Australia is ending up in the bellies of Chinese babies.
"We supply our key partners in Australia -- the major retailers and pharmacy outlets are obviously our biggest customers for infant formula," he says. "We are making domestic sales to those key customers and continuing to grow market share. That's what we're focused on."
A2 also distributes formula directly into the Chinese market, where it is sold through e-commerce platforms -- including Alibaba's Tmall -- and more than 1000 mother and baby stores in more than 50 cities.
Its direct sales, however, are dwarfed by those entering China via the grey channel.
A2 reported direct revenue from its China and near Asia segment -- which includes sales of fresh milk, formula and milk powder -- of $8.4 million in the six months to December 31, up from $1 million in the same period of 2014.
The rise of "daigou" -- which translates roughly as "buying on behalf" -- has been a Chinese phenomenon.
The focus in our view for both these companies will be on increased marketing efforts to build brand awareness in China.
In his report, CLSA's Patney detailed the routes used by daigou buyers in Australia to channel products through the grey market.
Direct mail is often used and, importantly, packages weighing less than 5kg can be labelled as gifts or for personal use, thus avoiding Chinese import tax.
Formula bought for A$25 a tin in Australia could be sold for A$45 in China, significantly cheaper than the A$80 to A$85 price tags for imported products sold in stores that had incurred taxes and duties, Patney says.
He says daigou buyers sometimes sell product to Australian traders, who then market it either directly to Chinese consumers through their own e-commerce platforms or sell it to distributors in China.
Finally, Chinese tourists also purchase products in Australia and gift them to friends and family on returning home, he says.
In addition to the threat posed by free trade zones, a relatively new development, Patney says the grey channel could become less attractive as a result of Australia's free trade agreement with China, which came into force in December.
A2's direct exports are subject to New Zealand's FTA with China.
Patney says the danger for A2 is in not generating the direct Chinese revenue required to offset its reliance on strong grey channel sales.
"While it's still early days, we believe A2 and Bellamy's are achieving solid [direct] e-commerce sales," Patney told the Herald. "The focus in our view for both these companies will be on increased marketing efforts to build brand awareness in China."
Bottles of milk are rinsed after being filled on the production line at the a2 Milk Co. plant in Sydney, Australia. Photo / Bloomberg
Bascand, of Forsyth Barr, says that before A2 reported its interim result last month, he had concerns about the firm's ability to maintain sales growth if China's ever-evolving regulatory environment clamps down on the grey channel.
"After the result, and having a chat to management on the investor call, I've got a lot more confidence around the investment in people and [Chinese] distribution that A2's undertaken over the past six to 12 months, all ahead of these theoretical but probable regulatory changes."
Until now, infant formula entering China via some e-commerce channels has avoided a requirement, introduced in May 2014, that baby milk products have Chinese labelling.
But a tightening of regulations around foreign-language labelling is expected, which would affect the trade in products sourced from Australian supermarkets, then sold in China.
Bascand says he expects a "lag" between such regulations coming into force, and A2 boosting direct sales to China.
"I think there will be some constraint on growth over the next six to 12 months once the regulation comes into place, but I'm a lot less worried than I was previously."
Brooke Bone, a portfolio manager with A2 shareholder Milford Asset Management, also thinks A2's grey channel trade faces risks.
"Any large, fast-growth channel is going to be a concern when there is an ability for it to be disrupted," says Bone. "So from a pure risk-mitigation standpoint we are worried about it and we talk to them about it."
On the other hand, Bone says the grey channel sales highlight the opportunity that exists for A2 in China.
The other thing is that China's Government is relaxing the one-child rules.
As opportunities go, it's huge: the Chinese infant formula market has been projected to grow to US$25 billion by next year.
"It's proving to us that there's demand for that product," Bone says. "Even if we do see some disruption ... we're assuming the other channels will pick up the slack to get that product up into market."
Babidge says A2 is well-placed to work through any regulatory changes in China.
"There's been speculation about further changes to regulation around access for infant formula," he says. "In conjunction with Synlait, we think we're well placed to work through that satisfactorily."
His comments are backed by the upgraded profit guidance A2 issued at its interim result, which doesn't suggest the company expects any major disruption to sales during the second half of its financial year.
The firm lifted guidance for full-year operating earnings before interest, tax, depreciation, and amortisation (ebitda) to $45 million- $49 million, up from a previous forecast of $33 million-$37 million.
It's unclear whether the health claims behind A2 are what is driving the brand's popularity with Chinese consumers, or just the more general demand for premium imported baby milk products.
Bone says Chinese parents do a lot of online research and A2's claimed health benefits are "perfect" for a product like infant formula.
"It's around increased learning, lower rates of autism," he says. "These are not necessarily proven scientific things but research out there that's on the western websites."
A2 milk was founded in 2000 by New Zealand scientist Corran McLachlan and multimillionaire farm owner Howard Paterson. Its market value has more than tripled to NZ$1.2 billion over the past year. Photo / Bloomberg
A2 chief scientist Andrew Clarke told the Bloomberg news agency that company surveys suggested close to 85 per cent of Chinese consumers reported some kind of discomfort after drinking regular milk. The company says drinking A2 milk can ease that problem.
Demand has exceeded our prior view of volume requirements.
As well as regulatory changes, there is also the danger that China's economic slowdown could cut consumer spending should it morph into a full-blown financial crisis.
Bone says a "hard landing" for the Chinese economy could hit infant formula sales, but Chinese parents tend to prioritise spending on products for their children.
"The other thing is that China's Government is relaxing the one-child rules so you're going to see an increase in the number of babies born and that's a positive."
Meanwhile, A2 also faces a big challenge at the New Zealand end of its supply chain -- keeping up with rampant demand for its infant formula, which has been facing stock shortages.
Babidge admits the firm has been "chasing its tail" on the supply front.
He attributes the challenge to the fact A2 has to order product from Synlait four months in advance.
"Demand has exceeded our prior view of volume requirements."
Babidge says the company is still experiencing stock shortages amid increased demand for product required for direct shipping to China.
"We've been up-lifting our orders from Synlait and whether that meets demand, time will tell," he says. "We're moving our orders in a balanced, managed way."
In the long run, Patney believes A2 has an advantage over its competitors when it comes to supply of raw ingredients, as the A2 type milk provides superior returns, encouraging New Zealand farmers to produce more of it.
CLSA put a "buy" recommendation on A2 when it started covering the firm last month.
Patney notes that other growth opportunities exist for the company in China outside formula, including in fresh and long-life milk.
For his part, Babidge says he's confident A2 can continue its momentum.
"Obviously our share price has been quite positive during recent times," he says. "We continue to have a view that this is a valuable company and has substantial growth prospects."
A2's rise
• Founded in 2000 by the late Howard Paterson and scientist Corran McLachlan.
