Sales of a2 Milk's infant formula within China remain robust but the slump in daigou sales has caught the market napping and forecasts for FY21 are downgraded sharply.

-Downgrade reflects problems in distribution, largely in Victoria
-Material uplift required in second half revenue to meet guidance
-Strong revenue growth continues in China direct channels
 

Just as a2 Milk ((A2M)) appeared to be cruising through the pandemic, a slump in sales in a particular channel has soured the outlook. Critically, the company asserts its downgraded guidance reflects disruptions in distribution and should be isolated to the first half.

The main contributor to the weakness stems from the Australian distributor and daigou (purchasing in Australia goods for sale in China) channel and reflects problems with logistics in the face of the extended lockdowns in Victoria.

Morgans was not surprised Australian retail daigou has been affected, given reduced tourism from China and few international students because of travel restrictions related to the pandemic, but now the much larger corporate daigou/reseller channel is evidently impacted by the stage 4 lockdown in Victoria.

Nevertheless, the broker believes recent weakness in the share price is a buying opportunity in a high-quality growth company, upgrading to Add from Hold, and also flags Singles Day on November 11 which will provide an indication of sales and brand health.

Macquarie agrees, should the impact be temporary and the implied demand materialise, the stock offers an opportunity, although suspects uncertainty will overhang until proven otherwise. If the stock becomes too cheap the broker anticipates some backstop to valuation in terms of potential M&A.

Bell Potter is not so confident and downgrades to Sell from Hold. A combination of weak trends observable from the trade data and the material uplift required in the second half, as well as the arrival of a new CEO, signal continued risk to earnings.

The broker points out in periods in which earnings uncertainty existed such as late 2018 and late 2019, a2 Milk traded in a range of 17-19x operating earnings (EBITDA) compared with guidance, which implies 19-20x. Bell Potter, not one of the seven stockbrokers monitored daily on the FNArena database, has a target of $13.75.

Maiden FY21 revenue guidance of NZ$1.8-1.9bn is lower than many brokers expected and includes a particularly weak first half performance, with guidance reduced to NZ$725m-775m because of lower daigou-related infant formula sales.

Margins

Ord Minnett makes the same interpretation and continues to envisage downside risk in the second half, reducing estimates by -10% for FY21 and -9% for FY22. The broker suggests the decline in daigou, which is a higher margin channel as marketing costs are much reduced, should be considered a significant headwind.

Moreover, the breadth and value of insider selling recently, as a percentage of overall shareholdings sold, has also rumbled investors for a while and this is now amplified following the disappointing update.

Credit Suisse re-bases FY21-23 estimates to factor in the disruption to corporate daigou and maintains operating margins, noting the company has also indicated more favourable procurement costs from Synlait Milk ((SM1)) and better gross margin performance than previously anticipated.

Hence, Macquarie is more confident in the operating earnings margin outlook, noting some reductions in discretionary expenditure and a small unwinding of the inventory provision taken at the FY20 result. The strong margin profile and potential upside, should the daigou disruption be temporary, is likely to ensure a more normal trading period in FY22 in the broker's view.

Daigou

The Australian retail daigou channel via grocery and pharmacy chains has been weak since February because of the pandemic. Hence, the company is actively managing inventory, although infant formula demand through direct China channels remains strong.

Still, UBS points out the strong push component in daigou sales is now missing, plus new customers are emerging that are more price sensitive and this limits the ability of the company's direct China channels to absorb the lost sales.

UBS believes there is grounds for a recovery in daigou-related sales as pandemic restrictions ease if a2 Milk can maintain Chinese online retail pricing and channel profitability.

Management expectations of a recovery in the second half include some improvement in daigou but no material re-stocking of the channel. A robust performance across the other aspect of the business is countering the impact somewhat, such as liquid milk sales, which are strong in Australia and the US.

Morgan Stanley also highlights that the China MBS (mother & baby stores) channel, which is 24% of FY20 infant formula sales, experienced revenue growth in August of around 77%, albeit this mostly reflected same-store sales growth rather than new distribution.

The database has four Buy ratings and three Sell for a2 Milk. The consensus target is $16.87, signalling 11% upside to the last share price. Targets range from $14.20 (Ord Minnett) to $18.14 (Morgans).

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