Coronavirus and China’s economic growth.
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The A2 Milk Company Ltd (ASX: A2M) share price has withstood the coronavirus shocks so far. But long-term, what does COVID-19 mean for a2 Milk’s China interests?

A few months ago, we reported that one of a2 Milk’s upcoming challenges could be a dampened economic outlook in China.

We cited a recent publication by the Reserve Bank of Australia (RBA) that warned exports to China — like milk — “could be affected materially by a negative shock to growth in China.”

The RBA went on to say that while the slowing of China’s growth since 2010 has been “orderly”, “risks remain elevated.”

Importantly, the RBA concluded that there was a “broad range of potential triggers for a severe slowdown in the Chinese economy”, including an “external demand shock or a financial system shock.”

A separate report by the RBA, focusing on China’s long-term growth trajectory, concluded that “China’s period of ‘above-normal’ growth is drawing to a close.”

Mind you, these were forecasts that necessarily excluded the current coronavirus pandemic and its vast economic impact.

So what is China’s economic outlook now following the coronavirus pandemic? And what does that mean for a2 Milk?

China’s economic slowdown before the coronavirus

Recently, the RBA’s Economic Analysis department extrapolated China’s trends estimated over the past 10 years and their results “indicate that, if recent trends were to continue, it is possible that GDP growth could halve from current rates by 2030.”

China’s consumption growth has also slowed down, in line with household income slowing, too. This led the RBA economists to note that this “slower growth in domestic demand has weighed on imports.”

Even if China’s GDP growth halves from its current rate by 2030, will that materially impact a2 Milk sales in China?

Why have a2 Milk shares performed so well lately?
Since the start of January, a2 Milk shares are up 14.5% to $16.38 at the time of writing, withstanding the panic-selling of other S&P/ASX 200 Index (ASX: XJO) shares in recent weeks.

It could be that investors think a2 Milk shares are a great defensive play since the company’s business is non-cyclical and enjoys strong demand for what many consumers think are essential consumer staples.

a2 Milk 1H20 highlights

Revenue was up a significant 32%, totalling NZ$806.7 million, while earnings before interest, tax, depreciation and amortisation (EBITDA) was up a healthy 21%, reaching NZ$263.2 million. The EBITDA margin was 32.6%, with the company reporting that this was better than expected due to its stronger underlying gross margin.

Infant nutrition was the biggest contributor to sales revenue with NZ$659.2 million, up 33%.

Further, the company reported a robust NZ$618.4 million cash on hand, suggesting it is well equipped to handle any headwinds ahead.

This was further supported by a2 Milk’s strong balance sheet and no debt.

Why is China important for a2 Milk?
a2 Milk’s China label infant nutrition products saw large growth in 1H20 with sales of NZ$146.7 million, a staggering increase of 100% and the company’s largest product segment increase by region.

Contrastingly, a2 Milk’s infant nutrition sales in Australia and New Zealand (ANZ) grew 9.5%.

a2 Milk’s China and other Asia regions segment revenue totalled NZ$317.2 million in 1H20, up a massive 76.7% increase. This segment also saw EBITDA up 60.3%.

Compare this with the company’s ANZ segment revenue of NZ$460.2 million, up ‘only’ 10.0%, with EBITDA up 18.7%.

It seems a2 Milk’s ANZ segment revenue is maturing, with the China market accounting for a critical portion of the company’s revenue growth. Therefore, if the demand from China slows, a2 Milk’s maturing ANZ segment will not be able to counterbalance the slowdown in the China market.

a2 Milk’s management is aware of China’s importance. In its 1H20 results report, the company stated, “following a detailed strategic review in 2019, we stepped up investment in our China label infant nutrition business considerably in 2H19.”

Further, the company has expanded its team in China and increased distribution to 18,300 stores (up from 16,400 at the end of 2H19).

a2 Milk’s FY20 outlook
When A2 Milk released its 1H20 results on 27 February, it did mention the coronavirus (COVID-19) when assessing its FY20 outlook.

The company stated, “there is uncertainty around the potential impact to supply chains and consumer demand in China resulting from COVID-19 and we continue to monitor the situation closely.”

When household incomes tighten over the coming months, as they already are with millions losing jobs worldwide, will consumers treat a2 Milk’s products as premium luxuries or essential consumer staples?

a2 Milk thinks the latter is more likely, writing, “given the essential nature of our products for many Chinese families, demand is strong, particularly through online and reseller channels.”

Importantly, a2 Milk reported that revenue for the first 2 months of 2H20 was above expectations. Could this be attributed to panic-buying and stockpiling?

It will be pertinent to see the revenue results for the remaining 2H20 months, the months that will see the worst economic fallout from the coronavirus.

In any case, a2 Milk concluded, “this is a dynamic situation and at this stage we are unable to quantify the impact, either positively or negatively, for the full year.”

A perfect summary of where we find ourselves right now.

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But you will have to hurry — history has shown the market could bounce significantly higher before the virus is contained, meaning the cheap prices on offer today might not last for long.

Patancheru police on Tuesday conducted searches on a milk factory in Pashamailaram industrial estate on the city outskirts and seized adulterated dairy products, particularly curd and cheese (paneer).

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