​As America’s infant formula shortage hits the headlines, investors are seeking to trade the news and capitalise on the U.S.’ need to import formula.

The nationwide formula shortage was created by a shutdown of Abbott Nutrition’s plant due to contamination issues, which accounted for +40% of the market, along with ongoing pandemic-related supply chain issues. In response, the Food and Drug Administration (FDA) is fast-tracking approvals to import infant formula.

Bubs Australia (BUB.ASX) bagged a widely reported deal to provide 27.5 million bottles of infant formula to the U.S. government, as tweeted by President Biden. The stock rallied 40% in response.

With hopes of replicating these gains, investors may now be looking to Bubs’ peers.

The a2 Milk Company Limited (A2M.ASX) is one that’s making watchlists. The company, which sells milk products containing the a2 protein type, has also applied to the FDA to supply formula.

Yet so far, of the 26 companies that have applied to import tins, only two have been approved. And, as of this week, Abbott’s plant is back up and running so there is little certainty around how long the supply issues will last.

I won’t speculate on whether the FDA will grant a2 Milk approval — that would make it one for the punters.

Investors, on the other hand, should evaluate a2 Milk on its current operations. If a U.S. government deal does eventuate, it would come as a bonus (although given its market cap, the relative upside is smaller than Bubs’), rather than a reason to invest.

On that basis, a2 Milk is not without issues.

The company generates around half of its revenues from China, presenting the usual political and legislative risks, plus challenges such as a declining birth-rate and a government push to lift domestic infant formula production.

The share price is at 5-year lows and has been in a downtrend since peaking two years ago. Rather than offering value, its earnings have also sharply declined over that period, and it is trading on a PE ratio of 142x, as compared to the industry’s ~28x.

​Most that have followed the ASX for the past 5+ years know what The a2 Milk Company (A2M.ASX) do. In that time A2M has gone from market darling to one of the most disliked stocks on the ASX. A2M was one of the few stocks to hold up well (relatively) during the initial Covid selloff, however the market was overlooking the fact that a key driver of their business to date was international students from China buying up baby formula and sending it home, an arbitrage that hedge funds would be jealous of. Without the usual influx of new and returning international students, A2M has suffered.

In 2020 the A2M Chairman was seen selling shares just before an earnings downgrade. This is a massive red flag for shareholders and understandably sparked huge controversy. More recently, there was a class-action lawsuit brought against A2M on behalf of shareholders as a result of their poor governance and disclosure. A2M are also experiencing inflation headwinds as input costs rise.

There is a massive shortage of baby formula in the US and competitor Bubs (BUB.ASX) has been a huge beneficiary, winning a deal to supply 1.25m tins of formula to the US. A2M hopes to join BUB and recently submitted an application to the FDA. This is awaiting approval and could be a short-term catalyst to boost A2M’s falling share price.

A2M are a shadow of the business they were pre-Covid, suffering numerous setbacks since 2019. There is a potential short-term catalyst in winning a contract to supply formula and they should see a boost as international students return. That said, it’s hard to see much real upside. A2M will begin to taper on marketing costs which should see boosts to the bottom line but it would be a hold/sell. By no means would it necessarily be a short but, looking at it from an opportunity cost perspective, there are far better opportunities out there.

Just an opinion, make sure you do your own research!

One to put out to pasture?

A2M produces and sells liquid and infant formula milk (IFM) from cows who produce only the A2 protein (supposedly gentler digestively), as opposed to those who produce both. This is the company’s key differentiator and justification for premium pricing.

Key markets: China (46% of revenue); ANZ (43%); USA (5%) and the remainder to other. IMF is 71% of total revenue.

Historically, the Company benefited greatly from the “Daigou” trade into China, which is individuals physically transporting the product via travel to China. While the Company worked on official channels and distribution, its “dirty secret” was its heavy reliance on Daigou which was brutally exposed by the onset of the pandemic when borders were closed to non-essential travel. The Company hasn’t recovered from this and was required to take inventory write-downs and the subsequent fall in the share price has led to a class action lawsuit.

Results for H1 FY22 compared to H1FY21 revealed 2.5% decrease in revenue to NZ$661m but a 45% decline in EBITDA to NZ$98m due to the significant marketing spend required for sales through official channels. At the H1 FY22 run rate, that is an 8 June 2022 EV/EBITDA multiple of ~16x (based on AUD values).

In July 2021 the Company closed the acquisition of 75% of Mataura Valley Milk, a NZ dairy nutrition business, for NZ$268m. For the five months to 31 Dec 2021 it contributed a NZ$10m EBITDA loss on NZ$39m of revenue.
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The Company has guided to increased revenue growth in FY22 H2 but, critically, not a corresponding increase in earnings. This combined with a slowing birth rate in China, a non-performing acquisition and the distraction of three class action lawsuits means, on a multiple of 16x, it is one to avoid until earnings growth can be demonstrated.