IF in the Chinese market

Maybe it's a wise move on the part of KTD to not be focusing on growth in the IF market in China.

The infant milk formula sector could be primed for another round of disruption and dislocation flowing from the critical Chinese market.

Chinese brands continue to challenge the growth of Australian and foreign brands within China while a growing risk of further regulatory changes could trip up offshore formula producers.

Only two years after the infant milk formula sector was thrown into turmoil following a crackdown on imported formula by Chinese regulatory officials, investment bank Citi has raised the spectre of new regulations being enforced.The earlier crackdown sent shares in some of the nation’s biggest producers, like Bellamy’s and a2 Milk, crashing. 

In a new report to clients, Citi has slashed earnings expectations for both a2 Milk and Bellamy’s over 2019 and for Bellamy’s in 2020.“We see further risk to foreign brands from changes to Chinese infant formula product standards,’’ Citi analyst Sam Teeger said in the report.“If implemented, these changes may require re-registration with the State Administration for Market Regulation (SAMR) a process which may be complicated further by the requirement of on-site inspections. “Notably, a2’s China label and other foreign brands do not currently comply with the draft standards; and this may also be a risk for Bellamy’s reformulated/potential China label product.”When the first round of regulations and registrations were released by China it saw shares in leading suppliers collapse.

Bellamy’s shares fell more than 40 per cent and a2 Milk was also dragged down, with falls of more than 10 per cent as investors panicked that the crucial growth market in China could soon dry up.Australian-made infant milk formula has become hugely popular in China following scandals in the country that saw poisons found in some products that led to tens of thousands of babies falling ill and at least 12 infant deaths.

It saw Chinese personal shoppers create a new “daigou” industry in Australian supermarkets, with personal shoppers buying them out of infant milk formula to send the products back to their Chinese customers, leading to fights in the supermarket aisles and the chains placing restrictions on the number of tins customers could buy.In the last year, new Chinese regulations have come into place and the share prices of Bellamy’s and a2 Milk have recovered as they continue to grow their market share within China.

But Mr Teeger believes the success for foreign brands in the Chinese infant formula market has been supported by a local preference for imported formula, largely due to domestic safety incidents, and this could now be threatened. The analyst has trimmed a2 Milk and Bellamy’s forecast 2019 earnings per share by 2 per cent and 9 per cent respectively.

Citi has also cut Bellamy’s expected 2020 earnings per share by 11 per cent to reflect its expectation of further delays in SAMR registration.

Mr Teeger believes the tighter Chinese regulations could help tip the scales in favour of domestic brands.“The infant formula registration system, effective from 1 January 2018, has given Chinese infant milk formula (IMF) brands increased appeal through consolidation of the domestic IMF industry into the hands of larger, more reputable players, increased product safety standards, and increasing barriers to entry for foreign brands. “Domestic Chinese brands currently account for roughly 77 per cent of SAMR registrations; and we see further risk to foreign brands from site inspection requirements and changes to product ingredient standards,” he said.Citi estimates that as of 2018, Chinese brands held a 47 per cent market share in infant formula, which has been steadily recovering since the trough in 2015 of 40 per cent.

Alongside the registration system, domestic brands have also invested heavily in premiumisation and product quality, captured faster-growing lower-tier cities, and benefited from fading safety concerns.

However, Mr Teeger believes there is still some growth in the pipeline for a2 Milk and Bellamy’s as they navigate new regulations in China.“a2 and Bellamy’s are still relatively small players in the Chinese IMF market, and their fast-growing niche categories suggests that they will continue to outpace overall market growth in the medium-term and either win market share in the case of a2, or maintain market share in the case of Bellamy’s. “We forecast a2 and Bellamy’s to grow sales at an average of around 24 per cent and roughly 8 per cent respectively from fiscal 2019 to 2022 and we have a2 growing faster than Bellamy’s given better existing momentum.’’“We forecast a2 to continue to win share from its expanding distribution and position within a super-premium niche within the Chinese IMF market, although increased competition may mean market share gains will become more challenging. “Given Bellamy’s does not currently possess SAMR registration it may have relatively more flexibility in making its China label more compliant with the outlined draft standards.

However, these standards could change materially before they are finalised, and changing the current recipe would require resubmission or amendment of Bellamy’s current SAMR application (submitted in December 2017), which could delay China label sales further