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Can the A2 Milk share price continue to grow amid China’s emerging competition?

A2 Milk Company Ltd (ASX: A2M) continues to report strong revenue growth in key markets like China and the United States (US). But with China’s encouragement of domestic players and emerging competition, what are the long-term prospects for A2 Milk share price?

Financial overview

A2 Milk’s full-year 2019 report outlined very strong results. Revenue went up 41.4%, while earnings before interest, tax, depreciation and amortisation (EBITDA) went up by 31.7%.

On a product segment basis, liquid milk revenue increased by 22.8%, contributing 13.4% to total FY19 revenue.

However, by far the largest contributor was infant nutrition – comprising 81.5% of total revenue. Crucially, FY19 infant nutrition revenue jumped a staggering 46.9%.

In the Australian and New Zealand market, A2 Milk boasts a record 11.2% market share. According to A2 Milk’s 2019 full year report, it is the “fastest growing major fresh milk brand in Australian supermarkets and remains the leading premium milk brand and the only brand ranged in all major Australian supermarkets.”

A2 Milk is also growing its market share in the key China market. The FY19 report detailed an increase in “Kantar Tier 1, Key A, B, C & D cities market value share”, up from 4.8% to 6.4%.

This is a positive indicator, considering the fate of other companies wishing to expand in China. The Blackmores Limited (ASX: BKL) share price, for instance, plunged after new regulation made it tougher for smaller daigou traders to buy up Blackmores vitamins.

However, while notching up strong results, many investors were disappointed by A2 Milk’s profit margin outlook, leading to a drop in its share price.

According to the Australian Financial Review, analysts were underwhelmed by the trading profit margin outlook, which came “materially below consensus of 31.7%.”

Further, it was not a happy growth story for every market A2 Milk operates in, with the company deciding to exit the UK liquid milk market after not gaining traction there.

Premium products and Chinese consumer trends

A McKinsey report surveying 10,000 Chinese consumers found that Chinese consumers are increasingly choosing premium over mass products. In fact, 50% now prefer to purchase the “best and most expensive offering, a significant increase over the previous years.”

Crucially, the report found that “foreign brands still hold a leadership position in that premium market.”

Not only that, and a boon for A2 Milk, a rising proportion of Chinese consumers “focus on a few brands, and some are becoming loyal to single brands.”

For example, 59% agreed with the statement “I would buy more famous-branded products if I had more money”, up from 41% in 2011.

If a foreign brand can offer a premium, quality product, the research suggests this brand will likely enjoy both good market share and brand loyalty moats over its rivals in China.

This is especially so for a product like infant formula. As a Deloitte report explained, during China’s 2008 melamine scandal, China’s top 4 infant formula brands were implicated.

To this day, trust in China’s biggest domestic infant formula brands is low, compounding the appeal of foreign-branded premium products. In line with this, an August 2018 report by NZMP forecasted a “five million tonne aggregate rise in dairy product imports projected by 2027” in China, the “largest in any animal protein category.”

These Chinese consumer trends may explain why A2 Milk is ramping up its marketing outlay.

The company recently struck a sponsorship deal with a reality TV show that follows celebrities entering motherhood for the first time.

Additionally, as the AFR reported, A2 Milk’s second half marketing expenditure was double that of the first half.

This marketing push also explains the NZ$44 million in EBITDA losses in the US market, with A2 Milk attributing the loss to “building brand awareness.”

The total FY19 marketing outlay was $NZ135.3 million, or 10.4% of sales. Importantly, this will grow to 12% in 2020.

Challenges

While foreign dairy brands are capitalising on China’s distrust of domestic brands following the contamination scandal in 2008, they should consider how long this local distrust will persist.

Chinese dairy brands have had more than a decade to improve their product quality and safety standards.

Indeed, the Chinese government is actively aiming to bolster local investment in dairy products, led by the $1.5 billion takeover bid of Bellamy’s Australia Ltd (ASX: BAL).

As Bloomberg reported, China “will support domestic dairy producers in acquiring or setting up overseas bases, encourage foreign dairy firms to invest in China, while tightening regulations on milk-powder imports and online sales platforms.”

Additionally, while many have pointed out the China market’s regulatory hurdles, fewer mention China’s dampened economic outlook.

Recent data revealed China’s economy is growing at the slowest rate in almost three decades.

A recent publication by the Reserve Bank of Australia pointed out that exports to China like milk “could be affected materially by a negative shock to growth in China.”

The publication notes that while the slowing of China’s growth since 2010 has been “orderly”, “risks remain elevated.”

Summary

A2 Milk is a well-run company with a sound management team and healthy balance sheet. Its recent growth track record is commendable.

Yet there are reservations about competition, regulation, and the market expansion in China, factors on which any significant share price appreciation relies.

Currently, the Wall Street Journal’s analyst ratings for A2 Milk have 5/14 analysts rating it a ‘Buy’; 6/14 a ‘Hold’; 1/14 as ‘Underweight’; and 2/14 a ‘Sell’.

It seems A2 Milk is in a holding pattern right now, and perhaps its investors should follow suit.

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Motley Fool contributor kprakapenka has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of and has recommended Blackmores Limited. The Motley Fool Australia owns shares of A2 Milk. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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