Will A2 Milk turn sour?

They were some of the hottest stocks of calendar 2015.

Bellamy's (ASX:BAL) eight-bagged while Blackmores (ASX:BKL) rose more than sixfold as investors salivated over their growth prospects in China. A2 Milk (ASX:A2M), a relative laggard, increased ‘only' 268%.

Yet colleague James Greenhalgh wasn't convinced, noting a year ago that such heavily hyped and popular stocks often have a short shelf life (see Forget today's headlines – look five years out instead).

And since the start of calendar 2016, Bellamy's has plummeted 57% and Blackmores has fallen 53%. But with A2 Milk rising an additional 27%, was James wrong on this one, at least?

In preview, I suggest not. 

The bull case

Milk products usually contain a combination of the A1 and A2 proteins. However, A2 Milk sells milk and infant formula that only contains the A2 protein.

It claims that A2-only milk can be consumed by those who struggle to consume normal milk and points to scientific studies – some of which it helps fund – that seem to confirm this.

The bull case for A2 Milk is simple: protected by its patents and intellectual property, its branded products will continue to command premium prices both in Australia and overseas and growth – particularly in China – will be strong for many years. As such, investors are justified in paying premium prices for its stock too – A2 Milk sells for 30 times consensus forward earnings per share.

Yet despite its eye-watering multiple, there are a number of reasons why the bull case could be wrong.

Competition rising

Noticing A2 Milk's success, competitors have begun claiming that their products ‘contain A2 protein', which is true in the sense that they contain both A1 and A2 proteins. A2 Milk has commenced legal action to stop this but whatever the outcome, over the longer term the high margins that the company is generating will inevitably attract competition.

The company admitted as such when listing on ASX (ASX:ASX) in 2015, noting that even with its patents and other intellectual property, ‘there is a risk that competitors…may launch A1 Protein free milk products' and that ‘this risk may increase over time as [its] patents expire'.

Eighteen months later, two of A2 Milk's most important patents – one that involves testing herds to determine whether their milk contains just the A2 protein and another relating to breeding A2-only herds – have recently expired.

Nevertheless, the company believes its first mover advantage and remaining intellectual property including other patents will keep it in a ‘protected position' in core markets.

Perhaps they will, but I'd place my faith in the law of supply and demand instead.

Regulatory changes

As well as rising competition, A2 Milk will have to successful navigate recent regulatory changes in China.

To help improve food safety, news laws that come into effect in January 2018 limit manufacturers to selling only three brands in China and also tighten labelling requirements. This is expected to reduce the number of competitors from around 2,000 to 250 which, all things equal, should benefit A2 Milk. A2 Milk should obtain a licence but there is a small risk that it doesn't.

The company seems to be hedging its bets, noting in its 2016 Annual Report that ‘whilst there are changing regulatory dynamics in the China market…A2M remains confident in the medium term opportunities' (emphasis added).

The implication that there may be issues in the short term as a result of Chinese regulatory changes may be prescient. Bellamy's recently advised the market that manufacturers who were unlikely to get a licence were sharply discounting their products, and it appears Bellamy's has been forced to follow suit on the products it sells via Chinese e-commerce sites.

This discounting may also affect ‘daigou' sales in Australia, as they require a reasonable mark-up to justify the cost of buying product here and shipping it to China. 

At the very least, competitor discounting will be a good test of the company's claim that its A2 Milk infant formula as healthier than its competitors' products and that parents will still be prepared to pay a premium for it.

And despite describing the company as ‘pioneers' and ‘on an extraordinary growth and transformational journey', insiders appear less confident in the company's prospects. For example, chief executive Geoff Babidge has been selling large chunks of stock.

2017 good so far

So far 2017 has seen continued fast growth, with revenue for the four months to 31 October increasing 96% compared to 2016 and earnings before interest, tax, depreciation and amortisation (or EBITDA) by a whopping 473%. Part of the reason is that sales in this period represented a ‘significant seasonal build' for China's Singles Day on 11 November.

Given Bellamy's troubles I'll be interested to see how A2 Milk performed on Singles Day. If demand turns out to be less than anticipated, A2 Milk may also be forced to discount its products too.

Commodity product

Ultimately, although the company claims to be a ‘high margin, branded business' supported by its intellectual property, infant formula is a commodity product and competition is increasing.

Perhaps A2 Milk will continue to grow quickly for many years and justify its premium multiple, but there's very little margin for error should its growth be less than expected.

To get more insights, stock research and BUY recommendations, take a 15 day free trial of Intelligent Investor now. You can find out about investing directly in Intelligent Investor portfolios by clicking here.