Charlie Munger once said "you must value the business in order to value the stock." His investing partner, Warren Buffett, said that the "key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage."
When you buy A2 Milk Company Ltd (ASX: A2M) shares, you are buying a stake in a liquid milk and infant nutrition brand with a sound management team, strong financials, and commendable recent growth track record.
However, even though the premium milk and infant formula industry is growing, especially in key markets like China, what can be said about a2 Milk's competitive advantage?
Google's early competitive advantage was its superior search engine. Investing in Google then was investing in an unrivalled product.
But to invest in a2 Milk shares is to endorse a business with a narrow product range that rests on one competitive advantage – the absence of the A1 protein found in most dairy milk.
Is this strong enough? Let's take a closer look.
The wonders of A2 protein
The Australian Financial Review's (AFR) recent description of A2 milk contained a common take on A2 Milk's professed edge: "a2's advantage is that its products contain only the A2 beta casein protein type, which is reported to have greater digestive benefits."
Instead of other milk products, which contain both the A2 and the A1 protein, a2 Milk sells products comprising exclusively of the more digestively friendly A2 protein, thanks to a gene-testing procedure patented by the a2 Milk company.
a2 Milk sells its competitive advantage by stating that "there are many people who feel uncomfortable after they drink ordinary milk or lactose-free milk yet they can enjoy a2 Milk™ without discomfort."
But is this advantage substantiated?
The evidence against
a2 Milk did not always stake its market advantage solely on digestive ease.
In a2 Milk's 2008 annual report (back when it was still a NZAX-listed company), both the Chairman and the CEO wrote about the "growing consumer awareness of the benefits of a2 Milk for medical conditions such as heart disease, autism and the reduction in the incidence of childhood diabetes."
The company even petitioned Australian and New Zealand regulators to put a health warning on regular milk. The petition was denied.
In 2009, the European Food Safety Authority released a 107-page review on the status of A1 and A2 milk. The review found that a cause–effect relationship between the intake of A1 milk and "any suggested non-communicable diseases cannot be established."
As a result, it did not recommend any formal risk assessments of A1 milk products.
Additionally, both the New Zealand government's national food safety authority and Food Standards Australia New Zealand saw no need to distinguish between A1 and A2 milk based on the available evidence.
These findings have landed a2 Milk in hot water with regulators over advertising. In 2004, the Queensland Health Department fined A2 Milk marketers for making false and misleading claims about A2 milk's health benefits.
In 2012, the UK Advertising Standards forced a2 Milk to "remove claims from its A2 milk ads that it was suitable for those with a milk allergy or lactose intolerance."
Dr Nicholas Fuller, Research Fellow at the University of Sydney, concluded that, given the available evidence, "for less than half the price per litre, the [common commercial milk] would be the favoured option."
This is a worrying conclusion for investors thinking about the long-term prospects of a2 Milk sales.
Supporting evidence
a2 Milk's website contains a page for supporting evidence, including a 2017 systematic review, which surveyed 39 relevant peer-reviewed studies that investigated the gastrointestinal effects of A1 versus A2 proteins.
However, the review of these studies was not a clear slam dunk for A2 Milk.
While the review did find that "the overall evidence … in animal trials and in vitro studies can be considered conclusive," the authors reported that there was a "limited number" of human studies and that "further research is required in humans to investigate the digestive function effects of A1 relative to A2 in different populations and dietary settings."
Additionally, there was a medical trial in China sponsored by a2 Milk that tested 45 participants drinking either regular A1 milk or A2 milk. The study's research team found that participants who drank only A2 milk reported no gastrointestinal disturbance, while those who drank A1 milk reported bloating, inflammation and constipation.
However, CSIRO's Dr Malcolm Riley thought the "randomised controlled trials are showing fairly small differences that one might say are not important enough to matter."
Finally, the previously mentioned Dr Fuller did point out that "for those who self-report an intolerance to milk or are lactose-intolerant, A2 milk may be a suitable selection to prevent commonly reported upset stomach complaints, but so too is lactose-free milk."
However, a2 Milk states on its website that its milk "contains the same quantity of lactose that is found in standard milk and will not resolve any medically diagnosed lactose intolerance."
Intolerant competition
The point about lactose tolerance is important and raises a question: why don't consumers with a self-reported intolerance to milk or lactose abandon A2 Milk for lactose-free milk or milk alternatives like soy or almond?
For example, Liddells Lactose Free 1L Full Cream is retailing for $2.25 at Woolworths Group Ltd (ASX: WOW). Comparatively, a2 Milk's 1L Full Cream is retailing for $3. Woolworths also stocks its own Woolworths' branded lactose free full cream milk for $2 a litre. Both Macro Organic Soy Milk 1L and Almond Breeze's Unsweetened 1L almond milk also retail for $2.
Why do people buy a2 milk?
If there are lactose-free options out there, why do people buy a2 Milk? Who is a2 Milk's target audience?
In ABC's Landline report on A2 Milk, a customer was asked whether they would pay a dollar more for A2 protein milk and responded: "most definitely; health has to come first."
This 'health first' sentiment is key to a2 Milk's success and an understanding of its target market. Do dry scientific findings sway the 'health-first' customers? Maybe they are not purchasing the produce of peer-reviewed studies but the placebo-like peace of mind.
Maybe certain people who experience challenges drinking conventional cows' milk are willing to pay a "may" premium; that is, pay extra for milk that may provide digestive benefits.
This is doubly so when the customers are parents purchasing a dietary staple for children they want to do the utmost to protect.
Take, for example, a recent AFR piece, where A2 Milk CEO Jayne Hrdlicka mentioned a sponsorship with a reality TV show that follows celebrity, first-time mothers. Importantly, Ms Hrdlicka revealed that the sponsorship meant "we were very high profile, targeting our core target consumer."
Consequently, A2 Milk's core target consumer seems to be first time, affluent mothers.
However, the target consumer may not always respond positively. For instance, A2 Milk recently withdrew from the UK liquid milk market. It seems the marketing about the potential health benefits did not cut through. This is interesting, because a product consumers know to be more beneficial to one's health than all its rivals would surely not struggle to find traction.
Foolish takeaway
Milk, a dietary staple, will always seize the attention of caring and watchful parents when it is marketed as less risky and more digestively beneficial than standard milk.
Therefore, I believe a2 Milk's long-term prospects rest on how well it positions itself as a 'health first' hedge against discomfort and more, how the science settles, and how prominently that science is reported in the news and advertisements.
As there is no current evidence to suggest a1 milk consumption is dangerous or leads to elevated incidence of disease, a2 Milk must focus its messaging on the digestive friendliness of a2 Milk instead.
But customers are naturally more incentivised to pay extra to avoid heart disease over tummy troubles. So can the narrowed health advantage of a2 milk over its cheaper rivals ensure continued growth?
Whatever the case, the reining in of A2 milk health benefits means the health-first factor is harder to sell on its own. Marketing will be crucial, and only time will tell if its marketing message can continue to resonate.
