Behind the Blackmores sell off

China consumer stocks have been hit with regulatory risk...but there may be long term opportunities.

Summary: Proposed new changes to regulations around how foreign products are imported to China through the “grey market”, or e-commerce channels, could slow down the growth of online sales for many Australian companies selling “clean and green” products…but long term opportunities may also emerge.

Key take out: Investors should be aware that volatility in this space is likely to be high for some time as regulation changes play out and companies chase higher earnings to justify share prices.

Key beneficiaries: General investors. Category: Shares.

Suddenly volatility is on the cards for popular China consumer related stocks such as Blackmores (BKL), Bellamy’s (BAL), A2 Milk (A2M). Driving the volatility is new taxes and regulations from Chinese authorities for imports through the “grey market”, or cross-border e-commerce sales.

In the second half of 2016 there was a rapid increase in sales to China for Australian “clean and green” products, such as baby formula and vitamins.  There has been an arbitrage opportunity for third parties to purchase products from the Australian retailer, then selling them to China through online stores such as Tmall and JD and AliBaba. The rate of growth caught suppliers by surprise, with many Coles and Woolworths supermarkets unable to meet demand. 

Now, new taxes and regulations are set to potentially slow some of the grey market and shift the demand to traditional sales channels. For companies with established strong branding in China the shift shouldn’t be a problem over the longer term, but may have an impact on transition. It needs to be highlighted that a majority of Australian exports to China are via traditional channels and won’t be affected. But there is ongoing uncertainty for the companies relying on the grey market as to how their sales with be affected.

Some of the proposed changes include:

-        > A list of products will be allowed to enter China’s free trade zones – Infant formula was included in the “positive list” subject to China Food and Drug Administration (CDFA) registration (with registration not required until January 1, 2018)

-       >  An 11.9 per cent cross-border e-commerce tax

-       >  A single e-commerce order can’t exceed 2000 yuan ($400)

-        > An individual can only purchase up to 20,000 yuan ($4000) annually from cross-border e-commerce stores.

On the same week the rule changes were announced PM Malcolm Turnbull was leading a 1000 strong delegation to meet with China-based trade contacts.

 By the end of the week, some of the share price losses  had reversed, as management teams convinced investors that they will be able to navigate the changes without too much of an impact.

However, there is likely to be further regulatory changes. What’s more, the criteria for new registrations are also yet to be determined. As a result, it is too early to quantify the exact impacts for most companies. 

Blackmores (BKL) was the worst hit, ending the week down approximately 17 per cent to $169.50. This included the stocks worst ever one-day decline from $203.88 to $176.96 last Monday. 

In early February, we highlighted the risk of high market expectations for China consumer stocks without a margin of safety for risks such as regulatory changes. The table below shows the share prices and PE’s at the time (read here: Hunting for the next Blackmores, February 8 2016.). Today, only BWX (BWX) and Capilano Honey (CZZ) have higher share prices. Vitaco (VIT) has suffered the largest decline, down 34 per cent. 

February 5 2016:

April 18 2016:

Company

Code

Share Price

Change from Feb 5th

Blackmores

BKL

$165.06

-13.1%

A2 Milk

A2M

$1.67

-8.2%

Bellamy's

BAL

$10.38

-18.9%

Bega Cheese

BGA

$6.02

-8.4%

Freedom Foods

FNP

$3.52

-4.6%

BWX

BWX

$4.44

15.3%

Vitaco

VIT

$1.57

-34.0%

Capilano Honey

CZZ

$21.23

4.1%

But despite the new regulatory changes many of these stocks still present some of the highest earnings growth opportunities in the market. Further share prices declines on regulatory fears, or earnings downgrades may provide long term buying opportunities.

Bellamy’s (BAL) released an announcement on Thursday with Managing Director and chief executive Laura McBain stating: “Bellamy’s has been successfully operating in China for over six years. Bellamy’s has a strong bricks and mortar business in China selling the company’s GB compliant formula. In addition, our products sold in China via “bricks and mortar” businesses already have labelling in Chinese.”

The Minister of Finance in China clarified that infant milk formula imported through online channels would temporarily not need to obtain registration documents, therefore enabling companies such as Bellamy’s (BAL) to continue with their e-commerce strategy in the short term.

Regulatory changes aside, most of the companies in the table above have re-iterated continued strong Chinese demand for their products. The same dynamic is in place, with Chinese consumers not trusting local manufacturers for many food and vitamin products. This has been the case since the milk poisoning scandal in 2008 that killed six children and left 300,000 seriously ill. 

Although there is short term regulatory uncertainty, some of the companies with established branding in China will argue that a slowing of the grey market may actually be a longer term positive - in regards to higher barriers to entry and sustainable earnings margins. That is, of course, assuming they have existing capabilities in traditional sales channels. 

Volatility in this space is likely to remain high, as the challenge of what price to pay for growth has only got more difficult with the potential regulatory impacts.