Aussie infant formula companies ride the China boom

The Age, News. peter Nathan CEO of a2 milk. Pic Simon Schluter 14 May 2014.
The Age, News. peter Nathan CEO of a2 milk. Pic Simon Schluter 14 May 2014.

You can often see it at airports: International passengers, queued up to hand over luggage before boarding - striving for the elusive, but perfect packing combination by shuffling clothes, toiletries, kids' stuff and valuables in between their suitcase and carry-on bags.

While lined up at Melbourne Airport about 18 months ago, before boarding a flight to China, one Melbourne man was surprised to see the goods that were being unpacked and re-packed by the Chinese family in front of him.

The family group's suitcases were too heavy, so they were unloading tins of a2 Milk infant formula and putting them into plastic bags that they'd been given by airline staff, so that they could take them on board as carry-on luggage.

The quirky scene was another example of how Chinese families visiting Australia are helping spread the message about Australian infant formula.

At the time as this event unfolded, shares in a2 Milk, an Australian listed company with Kiwi heritage, were trading at about $1.65.

In the period since, they've risen more than four-fold, as the company's sales have grown and investors have looked to cash in on China's growing thirst for infant formula.

But an unusual thing happened on the stockmarket in the past fortnight. Aside from the ASX 200 busing through the 6000 point mark, shares in a2 Milk, the market darling of 2017 whose share price has more than tripled this year alone, actually went down four days in a row.

The stock eased 3.96 per cent on Friday November 3, followed by falls of 1.79 per cent on Monday November 6, 4.9 per cent on Melbourne Cup Day, and 1 per cent on Wednesday.

They were joined on this downward dip by fellow infant formula company Bellamy's Organic, which fell 2.67 per cent on November 3, then gained 0.24 per cent (3??) the next day, before falling 6.93 per cent (or 86??) on Cup Day.

For a2 in particular it was an unusual event. Because for, what seems like almost every week this year, the sought-after stock has climbed higher and higher.

As one analyst commented to Fairfax Media this week: "A2, it's the one that's really ridden the perfect wave. There's been no hitches along the way, it's done an extremely good job."

Year of recovery

While a2's basic story is one of a one-way climb, 2017 for Bellamy's Organic has been a year of recovery. After a tumultuous time over the summer of 2016-17 where its shares plummeted, Bellamy's has risen strongly throughout 2017. It was as low as $3.654 in January, but has since tripled to more than $11.

For both companies, perhaps the falls seen in the past fortnight will only be minor blips and profit-taking that have come after spectacular rises.

In 2017 the two companies have ridden a wave of investor optimism about both their performance, as well as optimism about their future prospects in the enormous China infant formula market.

A2, for instance, now has a market capitalisation of about $4.87 billion, a bigger market cap than names like Blackmores, Murray Goulburn and Bega combined.

The stock prices of small Australian infant formula companies have also surged this year, with the price of Bubs Australia growing about seven-fold, and Wattle Health Australia growing about 12-fold.

If these spectacular gains have flown under your radar, consider them alongside the ASX 200's general performance this year.

At the end of Thursday, when it closed at 6049 points, the index had risen 6.8 per cent since the last trading day of 2016, when it closed on 5665 points.

A fundamental foundation behind the boom in infant formula stocks over the past year or so is the rise of China, largely thanks to its vast middle class and the many millions of babies born into these families.

But that explanation alone is too simplistic to account for all the activity going on in the infant formula space.

Industry figures and observers say that succeeding in the China infant formula market is far more complicated and challenging than simply producing infant formula, putting it in a tin, stamping the tin with made in Australia, shipping it to China and waiting for the cash to flow in.

Point of difference

The companies with the strongest outlook have a point of difference. There is strong brand recognition and years of experience, they say.

A2's point of differentiation is that its product does not contain any of the A1 protein, while Bellamy's is that its product is organic.

The China infant formula market, according to one respected analyst, is potentially "a massive opportunity" for capable Australian infant formula companies.

But the market is also being serviced by international big-hitters with deep pockets and vast experience.

So what makes the China infant formula market so inviting to both Australian and other international producers? And why is there so much activity in this space at the moment?

Firstly, the Chinese middle class is estimated to be in the hundreds of millions, their incomes are rising, and the relaxation of China's one-child policy means more babies will be born.

Other international factors are also assisting.

Australia's reputation as a clean and green producer of high-quality foods is a blessing for Australian infant formula producers, especially in light of the food safety scandal in China in 2008 when six babies died and thousands more became ill after having Chinese-made infant formula.

The rise of the Internet and social media in China is also playing a role, making it easier for Chinese consumers to buy their preferred infant formulas and for Chinese daigou - which means "personal shopper" in Chinese - to highlight Australian infant formula to friends, relatives and other customers in China.

'Little Emperor Syndrome'

Another factor highlighted by one industry figure is the so-called "Little Emperor Syndrome".

This expression explains the circumstance whereby in China, there are often three sets of parents contributing towards the care of one infant, i.e. the child's parents and two sets of grandparents.

This can lead to a quest to buy the best things possible for the much-loved child.

A key factor that seems to be propelling investor sentiment in Australia over recent times is also the complex Chinese regulatory requirements, and the fact that some Australian companies have either hurdled them, or are expected to.

Under a tougher food safety and regulatory regime from January 1, infant formula sold in China must have been produced in a facility with approval from Chinese authorities.

This means the facilities must be certified by China's CNCA (Certification Accreditation Administration of the People's Republic of China).

The nutritional and scientific recipe of the infant formula products must also have gained approval from China's Food and Drug Administration (CFDA) for the product to be sold in China from January 1. The changes are tipped to dramatically slash the number of infant formula brands sold in China.

Peter Nathan, chief executive officer of a2 Milk Asia Pacific, has seen the role played by Chinese daigou first-hand while visiting Melbourne supermarkets.

Mr Nathan says he has seen daigou standing in the supermarket aisle, holding a mobile phone and filming a shelf of infant formula cans while talking about the stock into the mobile phone's microphone.

"The first time we saw it was literally two to three years ago, and now it's a very common occurrence," he says.

The WeChat touch

For a2, the combination of Chinese daigou, Australian supermarkets and the Chinese social media messaging application WeChat seems to have been a winning formula.

"It [WeChat] plays a massive role because [of] what it enables the Chinese to do," he says.

"And also very importantly Australia is in a similar time zone, so they can communicate in real time to their friends and their networks. And also, they can actually transact.

"What you'll find is they'll go into a store, in Australia, they'll actually take, often, a video and [say] 'this is a2, this is the one that everyone wants, this is the best brand.

"'Here it is, I'm going to buy it from Coles in Burwood. Here we are in Coles in Burwood, I'm going to send this over to you and now we're going to transact it.' So you can pay it in the PayPal system.

"So WeChat has been the technology which has allowed this entire channel to flourish, the daigou channel."

Mr Nathan is upbeat about the outlook for the infant formula market in China.

He says a2 is investing heavily in promotional staff who are stationed in Chinese "Mother and Baby" stores. It is also planning to advertise for the first time on Chinese television.

"We do believe that the market [in China] will continue to grow for the medium term," he says.

"There's some demographic drivers which will deliver that. Longer term it's harder to predict as to what will happen. But certainly in the medium term the market will continue to grow more quickly, than markets in the West."

Wonderful journey

Asked about the company's strong performance in 2017, he responds cautiously: "We're very encouraged by consumer engagement with our brand and the growth that we've had, and it has been a wonderful journey," he says.

At the other end of the scale to the likes of a2 and Bellamy's sits the infant formula company Bubs Australia. The company, headquartered in Sydney, now has a market capitalisation of about $275 million, and a stock price hovering around $1.

It also has a major point of differentiation to most other infant formula companies, because its infant formula is made from goat milk, rather than from cow milk.

The company was in the news last week, announcing that it had agreed to a deal valued at about $84 million that will guarantee it exclusive supply from the country's biggest goat milking herd.

Bubs will acquire 100 per cent of NuLac Foods in the deal, which produces a range of goat milk products.

The move was also strategic, because it will deliver Bubs a 49.9 per cent equity interest in a Melbourne factory which is currently a CNCA certified producer of adult goat milk powder and other dairy foods.

This gives the company the prospect of using that factory for its infant formula in future, although it isn't CNCA certified now for infant formula canning.

The company's CEO, Nicholas Simms, says goat milk formula makes up about 5 per cent of China's infant formula market.

"This is part of the opportunity that exists for us - there's one clear market leader which is a Chinese company that uses European product. And then there's a couple of New Zealand brands," he says.

"But the reality is there's daylight between the number one and the number two ... there's a clear number two position to be had," he says, before adding, "That's why I'm here."

Goat milk segment hits $1b

Mr Simms says China's goat milk infant formula segment was worth about $1 billion last year, but is growing.

"It's growing at about 50 per cent compound annual growth rate at the moment," he says.

"Goat is only approximately a 5 per cent share of the total infant formula market, but it's a premium [product] and it's growing very quickly as people are starting to understand the benefits of goat."

While it plans to sell in the China "Mother and Baby" store network, Bubs currently does not sell its goat milk infant formula in these outlets.

Currently, all of its infant formula arrives in China via "cross-border" sales. Despite this, Mr Simms estimates that Bubs now occupies about the fifth or sixth position in terms of goat infant formula sales in China.

"I think if we execute well the reality is the sky's the limit from where we are today," he says.

"It's absolutely a wonderful growth opportunity. But it really comes back to executing on the basics, and doing those properly and consistently and well. And if we do that, then at the end of the day we should be rewarded for that."

Wattle Health Australia is another Australian player hoping to make its mark in China.

Its infant formula is now in about 100 "Mother and Baby" stores in China, Chinese duty free stores and a couple of Chinese supermarkets, says the company's executive chairman and co-founder, Lazarus Karasavvidis.

The product is also widely distributed in Australia, he says. "Yes, we're at the start of the race, there's no doubt," he says.

"Our sales are still quite small as we build our brand. But we're starting to get cut-through as far as brand awareness is concerned."

Mr Karasavvidis says there are good reasons why investors are backing his company.

"We've secured supply, we've started to get brand awareness, we've secured the largest factory, we're well underway in the process of CFDA application to enter the world's largest market post the 1st of the 1st '18," he says.

No automatic rewards

Belinda Moore, an analyst with Morgans, agrees that the China infant formula market represents a big opportunity.

But she says the rewards for companies trying to succeed in it will not come automatically.

"In China there are actually thousands of players, when you include all the Chinese brands and everything else," she says.

"So it's a very competitive space. You've got some very big companies with enormous balance sheets, and very strong brand names and market presence.

"Certainly we think that Australia's infant formula companies have a massive opportunity in China. And those that have got a point of differentiation that are in the premium, or the ultra-premium category, are growing the strongest and making good margins.

"So we've seen huge success from the likes of a2. And look, Bellamy's went through a bit of a hard time in the last 12 months but under new management they've turned the corner and they're growing sales and earnings strongly again.

"A2 - it's the one that's really ridden the perfect wave. There's been no hitches along the way, it's done an extremely good job."

Ms Moore says the next scheduled event in the sector is a2's annual general meeting, on November 21.

"We're certainly expecting a very strong trading update," she says. "I suppose the question is though, is it factored into the share price [already]."

Tourists spread the word

Andrew Mitchell, from Ophir Asset Management which invests in a2, says China's new regulatory regime will significantly reduce the number of infant formula brands sold in China, presenting a significant potential opportunity for those approved to be in the market.

"There is no reason why one or two Australian brands can't take 10 per cent market share of the US$15 billion Chinese infant formula market," he says.

"We think in financial year 17 a2 Milk averaged around 2.5 per cent market share giving you an idea of growth available. The Chinese infant formula market on our calculations is $US15 billion in size and is growing at around 10-15 per cent a year."

Rabobank dairy analyst Michael Harvey says the Free Trade Agreement between China and Australia provides an important pathway for Australian infant formula producers.

But he also offers some other analysis of factors that he believes are helping sell Australian infant formula in China.

"You've got to keep in mind that Australia has something like a million tourists from China coming out to Australia every year," he says.

"You've got 100,000 Chinese students that come here for education. So you've got this deep connection with the Chinese consumer where they come out to our country, they see the clean air and the clean water and they build a really strong connection to that. And they make that assumption that the food that we produce is high quality and safe - which it is.

"So I think that provenance story is very true, because we have such a deep connection with Chinese consumers," he says.

From the cradle onwards, Australia's economic fortunes are increasingly tied to China.

This story Aussie infant formula companies ride the China boom first appeared on The Sydney Morning Herald.