Seizing on a2 Milk's China formula

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<p><strong>Glenn Freeman</strong>: Morningstar has just announced its initiated coverage on a2 Milk. I'm speaking today to Morningstar's Adam Fleck about what has prompted us to pick up coverage of this company and some of the dynamics of a2 Milk itself, including its high exposure to infant formula sales within China.</p> <p>Adam, thanks very much for your time today.</p> <p><strong>Adam Fleck</strong>: Thanks for having me.</p> <p><strong>Freeman</strong>: Now, we're talking today about a2 Milk, which is a company that we've only just initiated coverage on. What does that actually mean? And what triggers coverage initiation for us here at Morningstar?</p> <p><strong>Fleck</strong>: It's a great question. We're always on the look for new companies that we think may have carved an economic moat or offer an opportunity for our investors to, frankly, make money. And we think we've hit the nail on the head here with a2 Milk. This has been one of the companies that has done very, very well of course on both the ASX and the NZX over the past several years. We think there's still opportunity here. We've initiated coverage with a 4-Star rating a narrow economic moat. So, we think we've found another company here that we didn't cover previously that has a sustainable competitive advantage.</p> <p><strong>Freeman</strong>: So, it is dual-listed company. You said there it's listed here in Australia and in New Zealand. How big is the operation here in Australia versus across in New Zealand?</p> <p><strong>Fleck</strong>: Well, the company is based in New Zealand. But if you look at the breakdown, Australia is a major market for them. The fresh milk business that a2 sells into Australia has been one of the legacy products and of course, I think, we've all seen in the dairy aisle at Woolies or Coles, the milk on the shelves. Australia is also really important because it sells a2 platinum infant formula in Australia that ultimately makes its way to China through Daigou and other distribution channels.</p> <p>New Zealand is an area where they are going to be growing going forward. Historically, a2 has not had the rights to sell fresh milk. They are going to start that this year. They also distribute out of New Zealand, again, to China. But right now, Australia is the bigger of the two countries that they are operating in.</p> <p><strong>Freeman</strong>: And so, infant formula, that's a huge part of their business model. How important is that within the overall profitability in Morningstar's view?</p> <p><strong>Fleck</strong>: Despite the fact that I think we've all seen a2 Milk on the shelves of dairy aisle of the grocery store, infant formula is the really key driver for a2 going forward. The company launched a2 platinum back in 2013 and it's been a tremendous growth story to the point now that it's about 80 per cent of revenue and because it's a higher-margin product, it's probably pushing north of 90 per cent of the company's total operating earnings.</p> <p>China is the really key growth driver here. If you look, most of a2 platinum ends up in China, either through direct distribution, or through indirect sales through third-parties in Australia. So far, a2 has already carved out 5 per cent market share in China, which is fantastic given that they have only launched just a few years ago. They are fighting competition from some of the global behemoths like Danone and Nestl&eacute;. But nonetheless, we think the company can generate another 1 point of market share annually going forward over the next 10 years getting to about 15 per cent. That's going to be about a 20 per cent growth rate for the business in China for infant formula which helps to support just a fantastic earnings growth outlook we have for the company.</p> <p><strong>Freeman</strong>: And just going back a bit to the initiation process that we've gone through, how long had you been actually looking at the company ahead of choosing to actually take it on under our coverage list? And what are some of the processes that you have to go through, some of the backend research that people are probably not aware of?</p> <p><strong>Fleck</strong>: This is a business that, again, despite us and Australia seeing this in the dairy aisle is principally an infant formula business and principally in China. And so, we needed to do a lot of research into the Chinese infant formula market. Of course, then we needed to have an opinion on how many births there would be in China going forward, what the market share for a2 looks like, what the overall market competitive dynamic looks like going forward. And we're fortunate, at Morningstar, we have a lot of global resources to be able to tap into. And so, we have an economic team, for instance, that focuses on China. They have put out research on the demographics going forward and concerns about falling birth rates, given simply a lower amount of child-bearing-aged women going forward, which is a population concern for China, no doubt, but we also think that a continued push toward foreign infant formula brands away from domestic brands given food scares in the past will help to generate total overall growth for that market going forward.</p> <p><strong>Freeman</strong>: You've given it a narrow moat rating under Morningstar's terminology, but it's also got a higher uncertainty rating and that sort of feeds back into that China story, doesn't it?</p> <p><strong>Fleck</strong>: That's right. The narrow moat rating really rewards, we think, the company for its brand and intangible assets, but there are risks that lead to our high uncertainty rating. It is essentially based on the science behind a2-only milk. On top of that, there is a significant competitive threat in China, particularly for infant formula. Nestl&eacute;, Danone, Mead Johnson, which is owned by Reckitt Benckiser, have vastly superior abilities to market their product, much deeper pockets and a much larger total global base to tap into. Nestl&eacute;, for instance, launched its own a2 product in China and while we think that's going to help expand the total market for a1 protein-free milk, there is risk that that could cannibalize some of a2 Milk sales. And then, finally, a2 relies on only a handful of suppliers. Principally, Synlait out of New Zealand has done a2's infant formula up to this point; Fonterra will be an important driver going forward as well. But that does risk supply shortages, price increases, or pressure should supply and demand actually be lower than we expect.</p>

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