Morningstar has downgraded its fair value estimate for infant formula maker a2 Milk, saying that while the company can still make solid gains, it faces near-term risks such as increased competition, marketing costs, and a glut of stock.

Morningstar equity Angus Hewitt, who now oversees coverage of the company, has revised the fair value estimate for the narrow-moat company to $9.30—a drop of 34 per cent.

At 3pm on Monday, the company was trading down 3.35 per cent at $5.34—a 43 per cent discount to the new Morningstar valuation. The company carries a narrow moat rating, which implies a ten-year competitive advantage.

The 52-week high/low for the company is $20.05/$5.44.

“A2 Milk's latest downgrade indicates our prior expectation—for the firm's share of the Chinese infant formula market to continue its rapid ascent—was too optimistic, particularly in English-label,” Hewitt said in a note on Monday.

“We think the firm has carved out a narrow economic moat, owing to its brand intangible assets. However, the firm's future success relies mostly on developments in the Chinese infant formula market, where we estimate a2 typically generates the vast majority of earnings.

“We expect the firm's value market share to climb to about 9 per cent by fiscal 2026 from more than 6 per cent in fiscal 2019, although competition, increased marketing needs, and channel gyrations related to COVID-19 present near-term risks.”

The a2 Milk Company - 1YR

A chart showing a2 Milk's share price movement over 1yr versus Morningstar's fair value estimate

Source: Morningstar Premium; data as of 17 May 2021 

The a2 Milk Company (ASX: A2M) is a New Zealand licensor and marketer of fresh milk, infant formula, and other dairy products that lack the A1 beta-casein protein.

Morningstar last week placed the company under review after the consumer defensive play reduced its near-term guidance for the fourth time since September last year.

Amid covid-19 restrictions and border closures, revenue in the first half of fiscal 2021 beat guidance but was still 16 per cent down on the same time a year ago as customers bought less than expected.

The company had expected full-year fiscal 2021 revenue of NZ$1.4 billion. But because of weak growth in its daigou/reseller channel and a glut of stock, it now expects revenue guidance of NZ$1.24 billion.

A key reason for a2 Milk’s moat rating is its strong brand and premium pricing. In a bid to preserve this image, the company has moved to destroy product rather than discount prices.

“Chinese-language labelled infant formula continues to see growth versus the prior comparable period despite COVID-19 pantry-stocking a year ago, and much of the pre-tax earnings margin impact was because of inventory write-downs,” Hewitt said.

Excluding the inventory impairments, Morningstar estimate fiscal 2021 EBITDA margin of 21 per cent.

A2 Milk’s future market share gains will be more gradual, particularly as it rebalances inventory.

“Pre-pandemic, a2 Milk had carved a meaningful brand position, as evidenced by its estimated 7 per cent pre-pandemic value share and premium pricing. However, we now expect it won't return to those levels until fiscal 2023.”

Another concern is the company’s longer-term ability to boost its market share in China. This is because a2 Milk’s Chinese-label formula increasingly competes with its English-label formula sold through alternative channels, which curbs or “cannibalises” sales.

Nor will the Chinese resellers, or daigous, continue to be the lynchpin for growth, Hewitt said.

“Retail daigou has been decimated amid Australian border restrictions, and recent corporate daigou support has failed to ignite a sufficient response in sales growth.”