Ever heard an advert for a2 milk and wondered what it is?

While most dairy cows produce milk that contains a1 and a2 proteins, consumers have flocked to dairy products that only contain a2 proteins amid perceived health benefits. New Zealand’s a2 Milk Co (ASX:A2M) has been a prime beneficiary of this shift as its brand became synonomous with the broader category.

a2 now accounts for around 11% of Australia’s fresh milk sales and is also home to Australia's leading infant formula brand through a2 Platinum. The company has also grown its share of the much larger Chinese infant formula market to around 7%.

These market share gains have come despite a2's generally premium pricing, which suggests that consumers are willing to pay up for the brand.

a2's apparent pricing power and capital light business model leave Morningstar’s Angus Hewitt confident that a2 can generate excess returns on capital for at least another ten years. This underpins his Narrow Moat rating for the company.

Why did a2 Milk shares fall?

a2 released its fiscal 2024 results on Monday August 20. The numbers were solid in isolation, with net profits up by 8%. But investors were spooked by the company's management team providing weak forward guidance.

This stemmed largely from production issues at key supplier Synlait, which produces a2 branded products for the key Australian and Chinese markets.

The company forecast mid-single digit revenue growth in fiscal 2025 and margins also look set to suffer as a2 relies more on air-frieght. The firm's Matura Valley business, which was acquired in 2021, also looks set to reach profitability later than expected.

The long-term view

To reflect these changes, Hewitt trimmed his profit expectations for 2025 and 2026 by 12% and 4% respectively. Nonetheless, he thinks the supply issues are transitory. His long-term view on the company is essentially unchanged.

Hewitt expects that a2 Milk can average annual sales growth of around 8% over the next five years and grow earnings at a double-digit clip over that time. Most of this growth is set to come from China.

While low birth rates look likely to stunt growth in the country’s infant formula market, Hewitt thinks that a2 Milk can continue to take market share and benefit from a willingness to pay up for its brand.

Uncertainty meets opportunity

Hewitt has attached an Uncertainty rating of High to his valuation of a2 Milk.

This reflects several factors, including a2’s dependence on consumers continuing to believe in the relative health benefits of dairy products lacking in a-1 proteins. Studies looking for major health benefits have been inconclusive so far, and any evidence to the contrary could hurt growth in the category.

Although a2 clearly has a strong brand in China and is making headway in the country, brands owned by much larger companies such as Nestle, Mead Johnson and Danone could offer stiff competition. If these companies throw their immense resources behind bigger marketing campaigns, a2’s chances of capturing significant share in China could fall.

Hewitt’s research has also noted a2’s dependence on a small number of suppliers. While this risk appears to have come home to roost given the issues at Synlait, Hewitt thinks this setback could present an opportunity to long-term investors.

His Fair Value estimate of $7.20 per share (in Australian dollars) is around 27% higher than a2 Milk’s current share price of $5.65. The shares now command a four-star Morningstar rating. But don't forget, individual shares should only be considered in the context of a deliberate investing strategy. Go here for a step-by-step guide to building yours. 

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Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn more about how to identify companies with an economic moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.