Monday, October 22, 2012

Mead Johnson's Prospects

Mead Johnson $MJN is the sort of stock that should be working in this marketplace. Its mix of infant and children’s nutritional food implies relatively stable end markets in the developed world and there is the long term story of the emergence of the middle classes in the emerging world. I decided to take a closer look at the stock and the sector to see if there might be a buying opportunity here.

The Competition and What it is Saying

The long term growth story is a combination of demographics and economics. China and India are believed to account for a third of all global birth. In addition, they are both seeing the creation of the kinds of middle class that buy nutritional foods for their infants and children. And everybody knows it.

For example, Pfizer $ announced that it wanted to sell its infant nutrition business and it had no trouble finding a buyer in Nestle who paid 20x EBITDA to buy it. I think this was a great bit of business from Pfizer and allows it to continue its drive towards refocusing the company on its core competencies. It is also an indication of how keen multinationals like Nestle are in establishing a presence in this category within emerging markets (EM). The other key players are Danone (NASDAQOTH: DANOY.PK), Heinz (NYSE: HNZ) and Abbott Labs (NYSE: ABT) also has a nutrition division.

Mead Johnson is the only pure play. Danone’s baby nutrition sales make up about 20% of its total sales even though they increased 13.6% on a like for like basis in the last quarter. Volumes were up 7% and I suspect it took market share from Mead Johnson. Danone’s Dumex is a brand leader in China in infant formula and the company is historically strong in EM. This is even better news when you consider that baby food in Asian markets tends to have higher margin than in developed markets. NestlĂ©’s deal with Pfizer gives it an immediate high single digit share in China and as Pfizer’s former infant nutrition business had over 80% of its sales in EM it has also given it strength there.

Infant nutrition is only a small part of Abbott Labs total sales so it is hard to look at it as a nutrition play however I think Heinz could be worth a look. Unfortunately, it doesn’t break out the nutrition sales by geographic region but it is safe to assume that increased nutrition sales in EM are partly behind the 19.3% organic sales growth recorded in EM last quarter. It only makes up around 10% of total sales but other parts of Heinz’s business (Ketchup/Sauces) are quite stable so nutrition could act as a growth kicker for the stock.

China Slipping?

The category is highly competitive and with Danone, Nestle and Heinz all making aggressive recent moves to chase growth in EM to counteract weaker prospects in their domestic markets it would not be surprising if Mead Johnson’s market share come under pressure. Indeed, it lost market share in the last quarter. Is it anything to worry about?

The answer is yes and no.

Yes, there is no doubt that China is going through a de-acceleration of growth right now and the company noted that the more discretionary parts of the business (children as opposed to infant food) were more affected in the last quarter. As for the market share loss, this was attributed to the timing of price increases and promotions. I’m not so sure. Danone has significant company sales in geographies like France and Spain and with weakness in these markets it is natural that it should want to increase sales elsewhere. A quick look at its numbers for baby nutrition reveals that the 13.6% rise was made up of 7% volume growth and 6.6% value. In other words, this wasn’t about pricing. Danone just got better.

On a more positive note, Mead Johnson tends to run its business a bit differently in China. It tries to hold pricing high by keeping customer inventories relatively low. This has a tendency to reduce sales growth but keep margins up. It also means that when pricing is increased there will be pressure on volumes. Another issue that Mead Johnson had to deal with is the error made by a Chinese University which accused it of selling baby formula with unsafe ingredients in it. Despite the allegations being proven to be false, these stories do have an effect. The Chinese still remember the Chinese milk scandal in 2008 where local producers adding melamine to milk led to six babies dying and hundreds of others being hospitalized.

The frustrating thing for Mead Johnson is that this hit the non-discretionary part of its sales (infant) while the more discretionary element (children) sector saw some category slowness due to a weaker economy.

In summary, the competitive environment is tough but there are mitigating circumstances for the market share loss.

Worth Buying?

Frankly I wouldn’t get too worried about a quarter or two of lost market share in China. It is the biggest market for the category but there are other geographies (Indonesia, India etc.) which also have great growth prospects. The long term story is still intact, even if it is going to suffer some marginal and minor peaks and troughs along the way. The company is describing the last couple of quarters as a ‘bump’ and I think it makes a good case. China’s growth maybe slowing but the middle class is still growing and having children.

 My concern with Mead Johnson is not with the company but with the stock price. Recall that Nestle bought Pfizer’s nutrition arm for 20x EBITDA and it is believed to have paid that price because Danone might have been interested too.  Now consider that Mead Johnson trades on over 16.2x the same multiple. That is hardly cheap compared to the takeover price paid in a competitive marketplace for a significantly positioned asset. A PE ratio of nearly 27x and a free cash flow yield of around 3.5% doesn’t make the stock look cheap either.

Long term prospects do look great but investors have to ask themselves what kind of evaluation premium they really want to pay for double digit EPS growth for a company in competing with some industry heavyweights. I can’t help thinking that 27x earnings is not the answer. Nonetheless, a great stock to monitor.