Something I have been considering recently is the idea that the baby formula sector may have doomed itself to mediocre performance from here. Hot companies like Bellamy's Australia Ltd (ASX: BAL), A2 Milk Company Ltd (Australia) (ASX: A2M), and Wattle Health Australia Ltd (ASX: WHA) may be set for disappointing future returns. Here's why:
- Share prices are high
A2 Milk, for example, is priced at 40x last year's earnings. Investment theory says that the higher share prices are, the lower the future returns for shareholders.
- Capital is rushing into the sector
Investors are all scrambling to get a piece of this hot industry. Whenever capital rushes into an industry like this, typically supply goes up, competition goes up, and prices and profits go way down.
- Most products are undifferentiated
When you have smaller companies like Wattle Health hoping to compete in the same room as larger ones like Bellamy's, it suggests that either Wattle is optimistic, or Bellamy's product is not that important to consumers (relative to other products which may have identical function at a cheaper price). More importantly, asides from brand power, it is hard to see a difference in quality or usefulness between various producers, which means that price could become an important attribute for consumers.
- Industry power is shifting
A2 Milk and co have been huge winners in part because they've been able to contract stodgy old manufacturers at cheap prices to produce their formula. There are only so many baby formula manufacturers and, with such hot demand for facilities – especially those with the vital CNCA (Chinese regulatory) stamp of approval – my bet is that manufacturers are going to find themselves with a much stronger hand in the future.
There are also a number of other unquantifiable considerations, such as the trend of daigou shoppers and the preference for companies to sell direct in China via stores and online. The uncertainty over the best sales channel for the long term could potentially lead to big changes in the sector's winners and losers.
Of course this all sounds very negative, but none of the above may play out. It is also important to consider alternative scenarios. For example, demand from China may prove so strong that there is room for a significant increase in supply and competition without hurting returns. That's a possible outcome and is one of the reasons I continue to hold my A2 Milk shares. However, given the price of baby formula (especially via Daigou channels), the overwhelming majority of Chinese consumers are currently priced out of the market. This creates opportunity for lower priced products to build mass appeal among the mainstream, and is another way that today's leaders like Bellamy's or A2 could be disrupted.
All in all I see very high expectations and considerable uncertainty (which should ordinarily be met with lower expectations) in this sector going forwards. Investors with large positions in baby formula producers may want to do some research on their company's competitive position and consider whether their holdings are too big.
