Alternative milk company a2 Milk has emerged from the fringe to become the sharemarket's undisputed darling.

The dual listed stock, once considered an oddity, now has a market capitalisation of more than $2 billion.

Its share price, which this week hit a record of $2.99, has risen from $1.90 a year ago and just 50c a year before that.

Clearly, a2 Milk's inclusion in the S&P/ASX All Australian 200 Index this month has not done its share price any harm.

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While its initial burst onto the New Zealand market in 2004 was met with scepticism, a2 Milk has been embraced in Australia, where it now has 10 per cent of the fresh milk market.

It has also had a meteoric run in infant formula, gaining 25 per cent of the Australian market in just a few years.

And in China - littered with the wreckage of western companies who thought they could cut it in the world's biggest marketplace - the company now has a respectable toehold with 2.6 per cent of the infant formula market.

While it may sound counterintuitive, a2's chief executive for the UK and China, Scott Wotherspoon, says the secret to its success in the People's Republic has been Australia, where the company has spent the past 10 years building its brands.

Scott Wotherspoon, chief executive of the A2 Milk Co for the UK and China. Photo / Supplied
Scott Wotherspoon, chief executive of the A2 Milk Co for the UK and China. Photo / Supplied

As with several other companies offering infant formula and health foods, the "daigou" traders - individuals and small businesses who buy product off retail shelves for re-sale in China - have also played an important part.

A2 Milk's products come from dairy cows that produce only the A2 type of beta-casein protein, whereas most dairy contains both A2 and A1.

Founded in 2000 by New Zealand scientist Corran McLachlan and the late Howard Paterson, a millionaire farm owner, the company has come a long way, though not without a few lean years.

Shane Solly, portfolio manager and analyst at Harbour Asset Management - which holds shares in a2 on behalf of clients - says investing in such companies needs patience.

"Sometimes companies don't always evolve the way you think they will, or in the time frame that you expect," he says.

The science

Wotherspoon does not see a2's run as a triumph of clever marketing - as some critics suggest.

Rather, he sees it as consumers taking on board the science and the opportunity for an alternative.

The company also spends a lot of money on marketing the claimed medical benefits of A2.

He points to last October's issue of the UK-based Nutrition Journal, which reported on a survey showing that consuming a2 Milk increased the natural production of the body's key antioxidant glutathione - widely recognised for its association with a range of health benefits - in milk-intolerant consumers.

Yet the issue is not black and white.

Across the ditch, a fight is brewing over the product labelling and health claims of a2 and those of its bitter rival, Lion Group.

Each company accuses the other of misleading and deceptive conduct in a legal battle that began when a2 sued Lion for putting a label on its Pura- and Dairy Farmers-branded milk, saying it "naturally contains A2 protein".

The case is to be heard in the Australian Federal Court in November.

The financials

In February, the company reported that its revenue hit $256.1 million in the half-year to December 31 - up 84 per cent on the prior corresponding period, driven mostly by its success in infant formula, led by its a2 Platinum brand. A2's net profit came to $39.4m, up 290 per cent. In China alone, revenue rose 348 per cent over the six months.

Managing director Geoffrey Babidge says a2 is aiming to build a global brand.
Managing director Geoffrey Babidge says a2 is aiming to build a global brand.

Managing director Geoffrey Babidge said at the time that the half-year result showed continued progress towards the company's objective of building a global brand based on the health and digestive benefits of nutritional products containing only the A2 beta casein protein.

"This has involved continuing to grow the established positions in fresh milk and infant formula in Australia while also investing in the key international growth initiatives in China, the United States and the United Kingdom," he said.

As Wotherspoon sees it, there is no question that the company's success in China got a kick-start from its performance in Australia.

"That has come from not only our success in infant formula, but from 10 years of brand building in Australia," he says.

When a2 launched its formula in Australia four years ago, the product was enthusiastically endorsed by the daigou traders.

Much of its popularity came from simple word of mouth - Chinese mums in Australia communicating with family and friends back home.

"We have built on that, so we have had a lot of word of mouth marketing, and social marketing, to push the brand hard in China."

Wotherspoon says a fair chunk of that 25 per cent Aussie market share comes from individuals reselling product back to China.

Regulation

A2's share price - along with others in the same boat - dropped last year when China moved to tighten up rules on the daigou sellers and instituted a 11.9 per cent tax on product sold through the unofficial channel.

The stock price didn't take long to recover, but others, such as Australian infant formula company Bellamy's, weren't so lucky. The episode showed how sensitive a2, Bellamy's and a handful of others are to the regulatory environment in China.

Last week saw a2 shares kick up, based on a perceived relaxation by the Chinese authorities on the daigou, after the Ministry of Commerce released a statement on the issue, though an English translation of the statement yielded little.

It did, however, show that the number of cities which can receive daigou-traded goods has gone from 10 to 15.

Wotherspoon says not much could be read into last week's edict. "We are always cautious about regulation and we take it very seriously," he says.

"It looks like it's good news for the cross border channel as a whole, but it is not the final article - I think that's clear.

"It does leave room for new detail and it's not clear what that detail is going to be.

"Whilst it does look broadly positive, we do need to be cautious as to what the final detail is going to be."

As a business, a2 looks at the direction and "travel" of regulation in China to try to understand where it is going.

For all its complexity, it seems a2 has managed the daigou dragon better than others. Wotherspoon says the key has been to prevent supply and demand in the channel from getting too far out of whack.

The big picture

In the big picture, the infant formula makers are heading into a period of profound change in China, with January 1, 2018, looming large.

With memories of the infamous melamine scandal still fresh in Chinese minds, food safety in this area remains a hot issue.

As it stands, there are hundreds of infant formula brands - too many for the authorities to properly track - so the regulators are limiting the manufacturers to just three brands apiece, come January 1.

Wotherspoon says some producers have already pulled brands from the market in anticipation of the new regulations.

From October, infant formula makers will start being told whether they have succeeded or failed in achieving registration. A2 Milk, with its "Platinum" infant formula, is already a significant brand in China, he says.

"We have got to get through those regulations in China and we are confident that we will."

A2 has been a market success story. As Harbour Asset's Solly sees it, investors have to be willing to add additional capital to companies like a2 when they are moving in the right direction and need more capital to grow.

"Investors need to do a lot of research to invest in these types of businesses," he says. "And investors have to be comfortable that not all emerging growth companies will do well."