The market has a habit of overestimating megatrends at the start and underestimating their duration. As hype builds, investors overpay for stocks leveraged to powerful trends and overlook them when they inevitably fall towards fair value.
A handful of Australian and New Zealand stocks exposed to China’s seemingly insatiable appetite for complementary medicines and infant formula are a case in point.
Vitamin manufacturer Blackmores (ASX Code: BKL) soared tenfold to $220 over two years to January 2016 – a remarkable re-rerating for an 86-year-old company. Sales leapt on Chinese vitamins demand, and earnings doubling in the past financial year put a rocket under the share price.
Chart 1: Blackmores
Source: ASX
The A2 Milk Company (A2M) soared from a 49-cent issue price after a dual listing on ASX in March 2015 to $2.19 last month. A2’s FY16 result, released in August, beat expectation: revenue jumped 127% and underlying earnings (EBITDA) rose 1,644% (off a low base).
A2 achieved more than 800% growth in its infant formula sales in China over FY16. Its NZ heritage and strength in speciality dairy products are ideal for the Chinese market.
Chart 2: A2 Milk
Source: ASX
Rival infant-formula producer Bellamy’s Australia (BAL) has also starred. The Tasmanian company raised $25 million through $1-issued shares in an August 2014 ASX Initial Public Offering. A little over two years later, those shares trade at $13.86, having peaked at $16.50.
Like A2, Bellamy’s is delivering staggering growth. Revenue rose 95% to $245 million in FY16 and underlying earnings (EBIT) leapt 342% to $54.3 million. Bellamy’s China revenues soared 331% amid strong growth in direct trading with Chinese enterprises and customers.
Chart 3: Bellamy’s
Source: ASX
Investors new to these stocks might shake their heads in disbelief at triple-digit revenue growth and in some cases ten-fold share-price gains. As booms go, Chinese demand for wellness and baby products has been as good as it gets for investors.
Overhyped, overvalued at the peak
But every stock has its price. At its peak price, Blackmores traded on a forward Price Earnings (PE) multiple of almost 40 times. A2 and Bellamy’s were on a trailing PE of about 60 and 36 respectively – nosebleeding valuations for mid-cap companies with limited listing history.
The stocks were ripe for a correction and short sellers were betting on heavy price falls. Bellamy’s, for example, was among the market’s most shorted stocks in July.
The bears were justified. Blackmores was crunched after announcing in its FY16 results in August that first-quarter sales in FY17 would be down on the same period in FY16.
Retailers destocking vitamin products and exporters changing the channels through which they acquire vitamins have weighed on sales. So-called “grey exporters” who buy vitamins from our retailers and export them to China are increasingly buying straight from the manufacturer.
The news spooked investors. Blackmores has tumbled to $120 – about $100 from its peak, and flirting with the 52-week low of $107.
A2 and Bellamy’s have also been volatile this year, though less so than Blackmores. Bellamy’s is down 16% from its peak and A2 is off 20%. China’s introduction of tougher regulations in the infant-formula market, including higher taxes and restrictions on what infant-formula providers can sell in the region, worried investors.
With their share prices well down this year, is it time to buy Blackmores, A2 and Bellamy’s?
Strong tailwinds persist
The thematic of Asia’s burgeoning middle class spending more on complementary medicines, such as vitamins, will persist for years and if anything quicken. The global middle class is expected to expand from 1.8 billion people in 2009 to 4.9 billion in 2030 and Asia will represent two thirds of it by then, on OECD forecasts.
Demand for infant formula in China will continue to grow rapidly and its government’s clampdown on providers in this market should help A2 and Bellamy’s in the long run by weeding out smaller operators.
The regulatory changes limit registered factories in China and offshore to producing three infant-formula brands and three products within that brand, meaning a maximum of nine products for sales. Bellamy’s is a top-three priority customer with its manufacturers and canners because of its size.
A2 and Bellamy’s have done a good job of responding to China’s regulatory change and both stocks have recovered some of their recent share-price losses.
Towards fair value
Blackmores, A2 and Bellamy’s have come back towards fair value after recent share price falls. Insightful share-valuation service Skaffold suggests Bellamy’s is trading 6% above its intrinsic or true value. A2 is 5% above fair value and Blackmores 2% above.
Each stock traded well above fair value at its peak and yet again reminded investors why it pays to be patient with high-growth stocks and buy into them during sustained periods of price weakness. Chasing them higher as they go from one peak to the next is dangerous.
A2 and Bellamy’s are both well-run and have good long-term prospects. But I’m wary of Chinese regulation in this market and the potential for policymakers to surprise with more policy changes. Investing in companies that are so exposed to one theme – Chinese infant-formula demand – and to regulatory risks that are so unpredictable elevates the risk.
It’s still unclear how the market will respond to China’s regulatory changes in infant formula. As mentioned, it should help higher-quality producers such as A2 and Bellamy’s, but there is uncertainty and both stocks would be hurt by any regulatory surprises.
Blackmores stacks up
Blackmores is the pick of the three. It has more tailwinds than Chinese demand: baby boomers who are swallowing more vitamins and continued growth in complementary medicines in western countries as the population ages are powerful themes. Blackmores would take a hit if its China’s operations stalled, but it has other growth engines to keep going.
Blackmores arguably has a stronger competitive advantage and “economic moat” than A2 and Bellamy’s, which sell more commoditised products. As a market leader, Blackmores’ long-established brand and reputation for quality and safety are valuable assets and provide some pricing power in a market that has relatively low barriers to entry.
The downsizing of “daigou” resellers – entrepreneurs who buy vitamins from Australian retailers and export them to China – should eventually benefit Blackmores if these resellers buy directly from the manufacturer to avoid the retail mark-up. Rival manufacturer Swisse Wellness recently said its daigou resellers had fallen from 100,000 earlier in the year to 20,000, as part of the company’s strategy to better manager vitamin supply and demand.
Relying more on direct sales to China, and less on entrepreneurial resellers who raid retail vitamin shelves, makes long-term sense for Australia’s vitamin manufacturers.
On valuation, Blackmores is trading on a forward PE of about 20 times FY18 earnings, according to consensus analyst estimates. That is not excessive for a company that leads its market, has a good history and brand, an expanding footprint in China, and is well positioned to deliver continued rapid growth.
Four of seven broking firms that cover the stock have a buy recommendation, two have a hold and one a sell, consensus analyst estimates show. A median share-price target of $135 suggests Blackmores is a touch below fair value. Morningstar values it at $154.
Blackmores is no screaming buy. It looks to be trading a touch below fair value and further price falls would not surprise given the extent of gains over two years, market skittish about its sales guidance and ongoing uncertainty over Chinese regulation.
I’d like to see the price consolidate and more of a base form on its chart: it’s not a great looking chart right now from a technical-analysis perspective.
But for a stock that traded well above fair value for much of 2016, recent price falls have provided a window of opportunity for long-term fundamental investors seeking exposure to the China wellness and complementary medicine trend. The window is not wide open; but there’s enough value to suggest investors should look closer, provided they can stomach potentially short-term volatility in stocks exposed to an less predictable Chinese market.
- Tony Featherstone is a former managing editor of BRW and Shares magazines. The information in this article should not be considered personal advice. The article has been prepared without taking into account your objectives, financial situation or particular needs. Before acting on the information in this article you should consider the appropriateness of the information, with regard to your objectives, financial situation and needs. Do further research of your own or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at Sept 8, 2016.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.