With $10 billion shaved off a2 Milk's market capitalisation in less than a year, can the alternative milk and infant formula company recapture the stellar growth rates of the past?
A2 Milk, once one of the sharemarket's biggest companies, is today worth about $5.4b, down from $16b at its peak just a year ago. That plunge reflects the impact of four successive earnings downgrades.
Those downgrades were a rude shock to investors who had become accustomed to generous double-digit revenue and earnings growth, driven in no small part by the popularity of the unofficial "daigou" sales channel from Australia to China.
Daigou involves cross-border exporting by individuals or a syndicated group of exporters outside China, buying commodities for customers in the Peoples Republic. But with the onset of Covid-19, travel has been curtailed, severely limiting the trade.
It appears that the very thing that made a2 Milk great has become its Achilles heel.
A2 Milk and other infant formula players also face a declining birth rate in China, made worse by Covid-19. As well, competition from the domestic infant formula companies - particularly from market leader Feihe - has picked up.
The a2 Milk story, based on the premise that milk containing just the a2 beta protein can help people who have trouble digesting milk, has captivated the investment community for years.
But it remains a polarising stock: there are those who believe in the a2 concept and those who don't.
Regardless, a2 Milk - which effectively markets product that others have produced - has won plenty of converts, particularly in China, the world's biggest infant formula market.
Even before a2's latest problems, it wasn't all plain sailing.
It took a while to win over consumers, and investors, and soon after listing on the NZX in 2004 the company faced near-collapse.
Deep-pocketed early investors came to the party and a capital injection kept it in the game.
Its milk got an enthusiastic reception from consumers in Australia - where it now accounts for more than 10 per cent of the fresh milk market - giving it a springboard for growth.
But when it started into a2 infant formula, its growth, aided in no small part by daigou, took on a whole new dimension.
In 2015 a2 Milk's revenue was just $155m. By 2020 it had gone to $1.7 billion.
At end of 2019 the stock was recognised by financial journalists from the Bloomberg news agency as the best performing stock of the decade with a return of 16,150 per cent; a2's share price performance had far outstripped other high profile disruptive companies like Netflix, which returned 4000 per cent over the same period.
Now, with Australia, particularly the key city of Melbourne, suffering repeated lockdowns, that key daigou trade has been severely curtailed, meaning unsold product in a2 Milk's distribution channels will need to be bought back and destroyed.
Having been brought back to earth, the once-stellar a2 Milk is faced with an inventory problem.
The irony is that a2 Milk went into 2020 looking quite good.
The controversial tenure of chief executive Jayne Hrdlicka had ended. Long-serving CEO Geoff Babidge was filling in after Hrdlicka's acrimonious departure.
It was back to business as usual.
Then came Covid-19. Initially, a2 Milk benefited from the pandemic and the associated lockdowns, as consumers bought up large.
But as the year progressed, that trend went into reverse. By August the wheels were starting to fall off a2 Milk's fairytale growth story.
In September 2020 the company said it had started to observe emerging additional disruption to the corporate daigou channel, particularly due to the Stage 4 lockdown in Victoria.
"As a result of all these issues, we are now witnessing a contraction in the daigou channel beyond our previous expectations and without the replenishment orders that would typically be anticipated at this point," a2 Milk said at the time.
But one thing helps separate a2 Milk from many companies which are on the receiving end of a big external shock: despite its problems, the dairy marketer still has a strong balance sheet.
It has no debt and a cash position of $774.6m, although that is expected to change when it pays out $268.5m for a 75 per cent stake in Mataura Valley Milk.
Late last year, the market took a dim view of some big share sales by directors and executives when the stock was just shy of its peak.
Chair David Hearn sold 250,000 shares on August 24 for $20.31 per share, raking in just over $5m from the sale. And interim CEO Babidge reduced his holding from 400,000 to 300,000 shares, netting $2.037m.
Other executives also offloaded stakes but the biggest sell-off came from a2 Milk Asia Pacific chief executive Peter Nathan, who is credited for much of the company's early success in the daigou sales channel.
After exercising 800,000 options at 63c each, Nathan - who resigned early this year - sold 750,000 shares between August 24 and 26 at an average of $20.12, for almost $15.1m.
The share sales, while within the allowable "window", did not go down well with shareholders, says New Zealand Shareholders' Association chief executive Oliver Mander. "I'm not suggesting that they did anything wrong, but it was one thing that pricked the ire of investors."
Loosely sourced media reports pointing to class action lawsuit by shareholders against a2 Milk have proven to be unfounded, but the share price slump has nevertheless left many shareholders with their noses out of joint.
"I don't think our members are happy, put it that way," Mander says.
"And there could be a bit of anger as to how the company has managed to get itself into this position.
"Really, what it comes down to is shareholders' faith in the quality of decisions by directors and the information that supported those decisions."
Mander says the association has been in touch with a2 Milk over what it saw as a lack of communication with shareholders regarding its inventory.
"If you are a marketing company, inventory management is a critical part of what you do," Mander says.
"That's turned into a big lesson for them in terms of how they operate and the risks that they need to operate around."
There was no direct line of sight on what was going on and how much product the company's distributors were holding, he says.
"It does raise questions around risk management and how those risks were governed."
In the company's latest communication, issued in May, it said the trading dynamics in the China infant nutrition market have been and continue to be challenging for a2 Milk and many international competitors.
"The significant decline from the outlook provided in February reflects the impact of the lower than expected sales in 4Q21 versus prior plan and the further actions being taken to rebalance the channels by actively reducing sales in May and June.
"It will take some time to rebalance inventory levels and restore channel health," said a2 Milk.
Today, the question being asked is what next for a2 Milk, a company with essentially two products - fresh milk and infant formula - and with heavy exposure to one country, China.
Where is the growth?
"The problem with a2 is that, while it is still a good company, it has been previously priced for exceptional growth, and you really now have to question whether that is still available or whether it is now in a more normal phase of existence," says Castle Point Funds co-founder Richard Stubbs.
"We think that there are good reasons to think that that exceptional growth is gone.
"You are getting competitive responses from very large players in China, and in other parts of the world where a2 Milk still does not have an established distribution channel or supply," says Stubbs.
"It is now becoming monumentally difficult for a2 Milk to have the exceptional growth that it has had in the past.
"There are still opportunities for a business that is, in general, very well run and there is potential for product differentiation - all kinds of things - that they can do from here.
"But even at [today's] price you still have to factor in a very high growth rate.
"A lot of the success has been built around the daigou channel, which is an unorthodox channel. It's not really that controllable.
"It is difficult to predict what will happen there," Stubbs says.
With daigou, a2 Milk did the right thing and grabbed the opportunity with both hands, and had been very successful as a result, Stubbs says.
"But really, we are into the next phase with a2 which is, potentially, one of less exceptional and more orthodox growth and probably much higher competition," he says.
"It's probably a good thing for the business in the long run.
"And it's another good example of how having a good company is not necessarily a good investment if you buy at the wrong price."
A2 Milk has been popular with individual shareholders, and is often a hot topic of conversation in the internet's share investment chatrooms.
"It's a company with 'soundbites' that people can latch on to - it has done exceptionally well.
"It's gone from a tiny business to a massively valuable business that has executed really well.
"But, once again, that kind of dramatic growth can generate investor exuberance that far overshoots the long term intrinsic value of a business."
Veteran a2 Milk watcher and Harbour Asset Management senior research analyst Oyvinn Rimer says a2 Milk has always been a polarising stock and views on its future earnings are extremely diverse.
There is still a lot of uncertainty among analysts about what to expect in 2022.
"It is one of the biggest forecast dispersions of any of the companies that I have followed.
Can a2 Milk get its house back in order?
"There are a lot of hurdles between now and then that, should they go the right way and the new management team gels and they get their house back in order, there is a good chance they could do a lot better than consensus forecasts," Rimer says.
Product labelled in English and sold through the daigou channel fell, but Chinese-labelled product showed strong growth throughout the year.
Meanwhile, the competition has launched a2-style products.
"It's time for a2 Milk to show some innovation in the face of declining birth rates," says Rimer.
Coincidentally, the Chinese infant formula companies Feihe and Ausnutria have seen their share prices come under pressure since the start of he year.
The formula business is coming to terms with data showing the number of newborns in China plummeted 15 per cent in 2020 from a year earlier, with the onset of the coronavirus disrupting the economy and weighing on decisions to have a family.
China has announced that it will allow couples to have as many as three children, after census data showed a steep decline in birth rates, having scrapped its decades-old one-child policy in 2016.
"I personally think it is a very good brand and with a bit of luck on the registration front and a concerted effort by new management, which has been completely recycled now, they could do some good things, but it is particularly tough more than ever now with the macro environment and the decline in the Chinese birth rate," Rimer says.
And the days of "easy wins" and getting higher and higher-margin growth are over.
Now, a2 needs to boost spending on marketing, so the cost of growth is going to be higher than it has been using the daigou model.
"They could achieve good sales numbers but control over margins is where the biggest controversy exists.
"That is the key driver of the difficult forecast earnings outcomes.
"If anything, this has shown that they did not have the 'look-through' control of their inventory that they thought they had."
Going on the company's latest guidance, a2 Milk is expected to deliver sales in the year to June 2021 of $1.20 to $1.25 billion. The mid-point of its forecast EBITDA range is $141m.
But there are huge differences of opinion among analysts about what 2022 will bring.
Of 12 analysts who cover the stock, there is a 72 per cent difference between the highest and lowest EBITDA estimate.
"Whilst the turnover [sales] estimates only differ by 21.4 per cent from highest to lowest, there are big differences in the margin assumptions, reflecting differences in views around channel economics and the return of daigou," Rimer says.
Historically, the daigou channel has provided the lowest "cost to serve" as it required little marketing expenditure while managing to sell to consumers in China who would otherwise be difficult to reach.
Some analysts are optimistic that a portion of the daigou trade can return and therefore bring back some of the old shine to a2 Milk's financials, while others think daigou will be permanently lower, thus driving up the cost of growing sales through other channels which require more marketing support.
Harbour's own data suggests sales started to decline in October/November last year, kept falling to the end of March and have stabilised recently, but so far without a tangible rebound.
Sam Trethewey, portfolio manager at Milford Asset Management, says a2 Milk's work had become a lot harder over the past 18 months.
"You've got competition increasing in terms of the domestic players lifting their game, we have had declining birth rates due to Covid and that will be a head wind for a2 Milk for the next couple of years at least," he says.
"The daigou channel, which was a free hit for a2 Milk driving a lot their early success in 2015, 2016 when the stock really started to move, the economics of that have changed - they have shifted and it is unlikely to return in the same way that it was.
"The days of easy, strong growth are likely behind it."
Not all doom and gloom
But Trethewey says a2 Milk's brand strength is something investors will be watching very closely.
"The market is still there. The Chinese consumers, the mothers and infants, are still likely to want an alternative to domestic brands and a2 Milk is well positioned within the foreign brands to be there.
"It's difficult to know at this stage in what sort of way and at what cost."
Trethewey blames instability at the top for much of a2 Milk's woes.
"The management changes that have occurred over the last two years, from Geoff to Jayne, back to Geoff, and now David (Bortolussi) has not helped the management of the inventory issues that they have had," he says.
"The chances of the right decisions being made are obviously low when you have had that kind of chopping and changing at the top."
But despite recent problems, "its performance up until the issues that it announced last year was really world class," says Trethewey.
For Milford, a2 Milk was once the mainstay of its NZ equity holdings, right from 2012 when the share price was below $1.
Milford sold most of its holding late last year, but continues to monitor the company's prospects, says Trethewey.
The Shareholders Association's Mander says the events of 2020 will act to re-shape a2 Milk. "It is forcing the bull to wake up and smell the coffee.
"I see it as being a good thing in the long term.
"But will it get to $20 next week? Probably not. Will it be there in a couple of years' time? Who knows," Mander says.
"But they will wind up with a much more sustainable business, ultimately."