Morningstar analysts expect shares in embattled infant formula company A2 Milk to rebound after they halved this year due to ongoing inventory issues.

Equity analyst Angus Hewitt says that while the days of high growth for the share price are over, he expects significant earnings per share growth for a2 Milk Company (ASX: A2M) over the next five years.

This is based on his expectation that the company will continue to capture more market share thanks to its strong brand and perceived product advantage.

A2 Milk closed yesterday at $5.49, down from highs of $13.41 a year ago. Shares currently screen as 'undervalued', trading below Morningstar’s fair value estimate of $7.60. The company has retained its narrow moat rating due to its strong branding.

“Shares in a2 Milk have fallen considerably since inventory issues first arose, leading to four near-term profit guidance downgrades during fiscal 2021," Hewitt says in a new special report.

"Inventory was piling up with resellers, leading to stifled reordering, exacerbated by the rapid decline in Chinese births since the onset of the pandemic. Fiscal 2022 is shaping up to be a similarly troubled year for a2, as the firm works through inventory issues and shifts focus to growing the Chinese label business.

"But the share price rout is overdone. We remain optimistic for a2's long-run growth potential in Chinese infant formula."

The a2 Milk Company is a licensor and marketer of fresh milk, infant formula, and other dairy products that do not contain the A1 beta-casein protein.

A2 relies heavily on daigou partners which is a reselling channel where goods are purchased in a country like Australia and shipped to consumers in China.

Hewitt expects a2 will have another worrying period in fiscal 2022 as it works through the inventory issues and begins to grow the Chinese label business before it experiences growth.

“Persistently high levels of inventory through reseller channels, which had stifled reordering from key corporate daigou partners over fiscal 2021, weight on market pricing, and led to ageing of available product," he says.

“A2 moved to destroy NZ$109 million in product in fiscal 2021, rather than discount, to maintain the brand’s premium perception – a sound decision given a2’s strong brand intangible assets which underpin our narrow economic moat rating.”

The company’s resellers now have fresh stock that has an expiry date a year from now. A2 is also working on tracing tins, cartons and pallets as well as monitoring daigous with QR code tracking on the tins.

“We forecast a2 growing value share to near-9% by fiscal 2026, from estimated pre-covid-19 highs of around 7% in fiscal 2020 and around 5% in fiscal 2021.”

Morningstar forecasts revenue growing at an annual rate of 15% through fiscal 2026.

China is crucial

Chinese consumers previously preferred Australian infant formula but are now willing to buy Chinese-made formula, according to Hewitt. This has emerged as a threat to a2 but he still believes it can grow its market share in the region.

“We think this shift in consumer preference has impaired a2’s brand equity, but we do not think a2 is now at a disadvantage,” says Hewitt.

Around a third of a2’s fiscal 2019 revenue came from the Chinese segment and 95% of the infant formula sold in Australia ends up in China via daigous.

When adjusted for country of consumption Hewitt estimates China represents more than 80% of revenue and the vast majority of the company’s earnings.

“[…] 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,” Hewitt says.

“We think the opportunity to double Chinese label market share to 5% is also achievable, and a2 has flagged increased marketing and distribution costs to support this business.

“A2's penetration is higher in top-tier cities, where premiumisation is already well-advanced, and we think there is opportunity for share gains in lower-tier cities where the birth rate is higher and trend toward premiumisation is more nascent.”

However, Hewitt points to declining birth rates in China and expects it to continue over the coming years which could limit a2’s propensity for volume growth. Covid-19 further impacted birth rates with anecdotal evidence showing people delaying pregnancy due to vaccination. This is not expected to be ongoing.

“With declining birth rates in China, and hence lower infant formula market volumes, we expect retail pricing growth will be more muted than the mid-single digit levels a2 has enjoyed in previous years as players compete for small numbers of customers,” he says.

Morningstar forecasts that price growth can be achieved through a2’s premium branding which will offset this.