In a follow up to the bull case for the A2 Milk Company Ltd (ASX: A2M) share price, today I’ll be outlining the bear case against the company.
Since a high of $20.05 in June 2020, a2 Milk’s share price has effectively halved, primarily due to supply channel issues relating to its Chinese operations.
Over-reliance on China revealed
Management downgrades of revenue and EBITDA for FY21 arose from issues pertaining to the forced shutdown of global travel impacting Cross Border E-Commerce (CBEC) and daigou channels in China.
Pre-COVID, China was on pace to overtake Australia & New Zealand (ANZ) as a2 Milk’s leading geographic sector. Revenues and EBITDA from China were growing at 65.1% and 66.6% compared to ANZ’s growth of 14.6% and 19.9%, respectively.
The rapid share price fall is symbolic of China’s importance to a2 Milk’s long-term strategy, and the subsequent market premium investors were willing to pay.
With the Chinese growth story on pause, it’s difficult to foresee the catalyst for the shares re-rating.
The resurgence of domestic brands
The Chinese market has experienced a resurgence of local brands in recent years, on the back of increasing nationalism.
China Feihe, a local competitor to a2 Milk, has ambitiously stated it wants to capture close to one-third of the infant milk market by 2023.
The renewed interest in local brands has been somewhat countered by a2 Milk’s introduction of dual-label infant milk, which is printed in Mandarin rather than English. Nonetheless, the renewed interest in local brands may act as a headwind for future growth in the Chinese market.
No clear path to reopening
Despite the positive news surrounding vaccines, the path remains unclear as to when international borders will re-open and the daigou trade will be able to resume activity.
Furthermore, there is no guarantee that the same level of Chinese tourists and international students – a key driver of daigou activity – will return in a post-pandemic world.
The longer borders remain closed, the larger impact this will have on the a2 Milk share price.
Mataura Valley acquisition
In December, a2 Milk purchased a 75.1% interest in Mataura Valley Milk (MVM), a New Zealand milk manufacturer for NZ$268.5 million.
On the surface, securing future supply makes commercial sense.
However, one of the attractive features of a2 Milk was its capital-light business model. Manufacturing and production were outsourced to allow a2 Milk to focus on building its brand globally.
Moreover, MVM remains unprofitable and will require additional capital expenditure in subsequent years.
Personally, I would have preferred the company to return the NZ$268.5 million to shareholders and entered into purchase agreements to secure supply.
Now what?
While I’m keeping an eye out for any of the aforementioned bear scenarios playing out, I think a lot of the downside is already priced into the a2 Milk share price.
As a result, I think today is a good entry point for investors.
For those looking for a more positive investment case for a2 Milk, check out this article: The bull case for a2 Milk shares.
