Not much has gone right for The a2 Milk Company recently.
In its fiscal year 21 (FY21), which ended on 30 June 2021, the infant milk formula and fresh milk specialist suffered a 30.3% decline in revenue to NZ$1.21 billion from the previous financial year. Gross profit dropped even more, falling 47.4% to NZ$509.7 million, because of write-downs from inventory overload at resellers and a big decline in a2 Milk’s high margin English-label infant milk formula products.
And things are not likely to improve in the next fiscal year with management providing some bleak remarks on the overall outlook for FY22.
As an investor with a vested interest in a2 Milk since July 2020, watching its share price slide 67% has, to put it mildly, not been a pleasant experience. The fact that the S&P 500 index has risen 47% over the same time makes it even more depressing.
So what went wrong?
1. Flat industry growth
Although a2 Milk is a company based in New Zealand, the bulk of its revenue is driven by Chinese consumers. As such, China is a big part of its growth. But in FY21, the China infant milk formula market’s growth rate fall from a high level in previous years to flat year-on-year. Moreover, total infant milk formula volume declined.
Part of the reason was due to a decline in newborns in China. The chart below shows the number of newborns in China from 2015 to 2020 and the forecast for the next 5 years.
2. International brands losing market share
There is also a change in consumption patterns among Chinese parents. Local brands have been winning market share against multinational corporations over the past few years. The chart below shows the decline in market share among multinational corporations.
From 2008 to 2018, Chinese consumers had a preference for international brands due to the 2008 Chinese milk scandal. In 2008, some Chinese suppliers added melamine to powdered milk to artificially boost protein levels. An estimated 54,000 victims were hospitalised and 50 babies died due to the contamination.
Understandably, Chinese mums lost confidence in local brands and began looking for alternative infant milk formulas from respected international companies. a2 Milk was one of the companies that benefited from this shift.
But with Chinese companies improving their products and finally regaining trust among consumers, local brands are starting to win back some market share in the last few years. In addition, there is a growing corner of the Chinese population who prefer to buy local brands simply because of rising patriotism in the country.
a2 Milk’s marketing team has likely seen a surge in this consumer-group – the company felt a need to include them in its recent Investor Day presentation.
The two new types of customers that the company showcased – the “Value-seeker mum” and the “China Pride mum” – are both consumer-groups that prefer to shop for local brands.
3. Poor channel inventory management
a2 Milk sells its infant milk formula to China via (1) a Chinese-label brand that is sold in China and (2) an English-label brand that is sold in Australia to Daigous and directly to consumers through cross-border e-commerce. (Daigous are Chinese resellers who purchase goods abroad to bring back to China for re-sell to Chinese consumers.)
In FY20, around 58% of a2 Milk’s revenue came from its English-label brand, the bulk of which likely ended up with Chinese consumers via Daigous and cross-border e-commerce.
But in FY21, it seemed like everything went wrong for a2 Milk for its English-label brand. During the year, its English-label infant milk formula revenue declined by a whopping 52.1%.
One of the major reasons for the decline was because resellers and Daigous had too much inventory. This was ultimately the fault of poor foresight and channel inventory management by a2 Milk’s previous management team. In essence, a2 Milk sold way too much inventory to Daigous and other resellers in the prior year who, in turn, could not move inventory fast enough as the COVID pandemic dragged on. As a result, the resellers and Daigous were left with ageing inventory and were forced to offer discounts to try to offload their expiring inventory.
Understandably, a2 Milk had to take initiative to reverse the situation and to stabilise pricing. First, the company offered to write down some of its reseller’s old inventory and even swapped out some of its distributors’ inventory. The company also restricted sales in the fourth quarter of FY21 to stabilise pricing and improve inventory flow.
All these actions resulted in lower sales for its English-label brand, lower margins due to write-offs and expensive swapping of products to resale channels, and a loss in market share in both cross-border e-commerce and Daigou channels.
What’s in store in the future?
Over the past fiscal year, a2 Milk’s management had to lower the company’s forecast for the year multiple times as some of the above factors seemed to have blindsided them. I think the company’s current management team has learnt a hard lesson and has declined to give specific guidance for the next fiscal year. However, it did provide an update to say that the first half of the year is going to be choppy.
In its trading update, a2 Milk said that its China-label infant milk formula sales are expected to be “significantly down” the first half of FY22 versus the comparable period in FY21. The company also said that its English-label infant milk formula sales are expected to be down in the first half of the fiscal year.
But can a2 Milk turn things around in the medium to long term?
In a2 Milk’s recent Investor Day event, a number of the company’s C-suite executives came together to explain their plan for the next few years.
1. Medium-term goal to hit NZ$2 billion in annual revenue
Management has set a target of achieving NZ$2 billion in revenue in five years. This is a 66% increase from FY21, but just 15.6% above a2 Milk’s peak revenue in FY20. As an investor who first gained exposure to the company just before things turned sour, I was hoping for more lofty ambitions by the company. But this is a start. The company provided this chart to show the areas they are targeting to achieve this goal.
From the chart, we can see that management is targeting broad-based growth across its current core geographies and to enter into emerging markets such as Southeast Asia.
Management also mentioned that they are targeting an EBITDA margin in the low to mid-twenties range. This is significantly lower than the 31% EBITDA margin achieved in FY20, but higher than the meagre 10% margin seen in FY21. The margin outlook is slightly disappointing, given the heights a2 Milk reached in FY20. But it is understandable as the high-margin English-Label brand is not expected to hit the highs of yesteryears in the next five years. The bulk of revenue growth will come from the lower margin China-label brand.
2. Chinese-label brand initiatives
To achieve their NZ$2 billion revenue target, a2 Milk’s management is targeting to double the company’s Chinese-label brand sales in China from NZ$390 million to NZ$800 million. The Chinese-label brand has been one bright spot for the company in FY21. While all other segments declined, the Chinese label brand grew in FY21 and won market share via both offline channels through its distribution network of mother & baby stores in China as well as direct online channels.
There are a few key ways to drive growth.
First, the company is looking to win market share in lower-tier cities where it is under-indexed. Lower-tier cities make up 84% of the total sales value of China’s infant milk formula market but only 61% of a2 Milk’s sales come from these lower-tier cities.
In fact, there is a large dispersion in market share between a2 Milk’s market share in upper-tier cities and lower-tier cities. In upper-tier cities, the company holds a 5.8% market share from mother and baby stores but in lower-tier cities, the company only commands a share of 1.8%.
There is a lot of room to grow in these cities and the company plans to increase its mother and baby store footprint in these areas. At the moment, a2 Milk’s products can be found in 18% of mother and baby stores, which account for 38% of total infant milk formula sales.
To win market share in lower-tier cities, the company is planning to get its product on the shelves of more mother and baby stores. The target is to be in enough mother and baby stores in China such that these stores, in aggregate, account for 50% of total infant milk formula sales in China.
In addition, there seems to be room for a2 Milk to grow its direct online channels.
Around 81% of the Chinese-label brand sales came from mother and baby stores compared to just 19% from direct online channels. While the online channels did grow by 18% from a year ago, there is still room to expand as other brands drive much more sales from online channels. The graph below on the right shows that a2 Milk’s direct online sales for its Chinese-label brand makes up only 19% of the total sales of its Chinese-label, much lower than other international players.
The key to driving direct online commerce growth is brand awareness. a2 Milk is planning to invest more in digital marketing, which should improve brand awareness in important online channels such as Tmall and JD.com.
Lastly, the company is planning to expand its product portfolio to increase its customer reach. It only has a single China-label brand that is in the ultra-premium range, the highest category for infant milk formula. To reach more consumers, a2 Milk wants to have a variety of brands at lower price points.
3. English-label brand recovery plan
As mentioned earlier, the English-label infant milk formula was the hardest hit in FY21. The pandemic affected commercial Daigou businesses hard and they ended up with excess inventory on their hands.
As Daigou lost momentum, the cross-border e-commerce channels were also hit as Daigous previously acted as social influencers who promoted a2 milk infant formula sales online too. Moreover, the shift toward local brands in China has likely led to both a near and medium-term impact on the popularity of a2 Milk’s English-label brand.
Although the company tried to paint a picture of recovery for the English-label brand, it seems like years will be needed before the brand reaches its glory days of yesteryears. a2 Milk is targeting to win back merely NZ$300 million in revenue in the medium term. For perspective, in FY20, the English-label infant formula revenue was NZ$1,081 million. The company is now targeting annual revenue of just NZ$820 million after five years.
Still, a2 Milk outlined some initiatives to win back sales. The first is to increase reseller support by upgrading brand awareness and to try to place English-label products in offline channels as a “showroom” for the brand.
Better inventory management should also better support prices over the longer term. And lastly, management highlighted an opportunity to expand its English-label infant milk formula portfolio. Like the Chinese-label brand, a2 Milk only has a single brand of infant milk formula at the premium to super-premium category. Expanding the product portfolio can allow a2 Milk to capture a greater portion of the market.
4. Diversifying to new products and geography
Another initiative mentioned was the opportunity to expand the a2 brand. The company is looking to leverage the a2 brand to launch new products. In October 2020, the company launched UHT in China with some success.
In addition, a2 Milk has already expanded into other geographies such as Canada and South Korea recently. There has been some success in South Korea too where the company started selling in December 2019. Monthly infant milk formula volume has steadily increased since then, albeit from a low base.
a2 Milk has also prioritised Vietnam, Indonesia, Malaysia, and Singapore as expansion opportunities, targeting NZD$100 million in sales from the growth of these new markets over time.
5. Growing the ANZ and USA liquid milk market
I won’t spend too much time on these initiatives as ANZ (Australia/New Zealand) is a mature market and the room for growth here is limited. Meanwhile, the USA is still a small market for a2 Milk. Between the two countries, the company hopes to grow revenue by around NZ$200 million in the medium term through market share wins by expanding its footprint in the USA and increasing its product portfolio there.
The bottom line: Uncertainty ahead
Shareholders of a2 Milk have been taken on a wild ride in the past few years. The company’s share price climbed from just A$2.00 five years ago to A$19.83 at its peak in 2020 as the company grew revenue quickly from FY16 to FY20. But the past year has been tumultuous for a2 Milk as its share price has since dived to less than A$6.50.
It seems like whatever could go wrong for the company in the last year has gone wrong.
But there are still a few bright spots worth highlighting. First, the company is financially robust and is still generating positive free cash flow despite the fall in revenue and profits. As of 30 June 2021, a2 Milk had NZ$875 million in cash and short-term deposits, equivalent to about 18% of its current NZ$ 5 billion market cap.
Management has outlined what seems to be a sensible plan to get the company back on firmer footing. The Chinese-label brand also seems to be doing well and is winning market share against the larger trend of international brands losing market share to local players.
Moreover, if a2 Milk reaches its goal of NZ$2 billion in revenue and margins in the mid-twenties range, I believe its share price will rebound strongly. But that’s still a big if.
There are still many unknowns going forward and the company is in unprecedented territory at the moment. Although a2 Milk has overcome challenges in the past, its future remains littered with uncertainty.
I’m expecting another rough interim report for FY22 and will be keeping an eye on further company updates throughout the year.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. Of all the companies mentioned, I currently have a vested interest in The a2 Milk Company. Holdings are subject to change at any time.