Sunday, December 9, 2012

Time to Buy Mead Johnson?

I write these articles as part of an investment process I make with my own money so unlike most writers, my conclusions are likely to be more towards not buying a stock rather than piling in. I’m not going to apologize because that is the way it is supposed to be. Investors shouldn’t buy every stock they look at immediately and sometimes the process can take months, years, or never. I mention this with regards to Mead Johnson's (NYSE: MJN) latest set of results that were received poorly. I like the stock and the sector and suggested it was worth monitoring in an article linked here. So it’s time to do just that. Is it time to buy in?

When Richly Priced Stocks Fail

The last time I looked at this company I remarked that I didn’t feel like paying an enterprise value that was 16.2x EBITDA when Nestle had paid 20x EBITDA for Pfizer’s (NYSE: PFE) nutrition arm. In any case, Nestle paid a high price but there isn’t enough of a premium – Danone is rumored to have also been interested- to make Mead Jonson look cheap. Moreover, Pfizer’s divestiture was part of an ongoing restructuring program. It wanted to sell. All of which led me to conclude that Mead Johnson was expensive and we all know that richly rated stocks will fall hard if they disappoint.

Unfortunately, Mead Johnson did disappoint, but what was the underlying reason for it?

Was it the Market or Was it Mead Johnson?

With this sort of question you have to appreciate that global market conditions do affect operational decisions at companies. In other words, the market does- despite whatever a deluded management consultant will tell you- shape companies operational and administrative strategies.

In this case, Mead Johnson is faced with some global competitors of which, it is the only pure nutrition play. Nestle, H.J. Heinz (NYSE: HNZ), Danone and Abbott Labs (NYSE: ABT) all compete in the space. They are global companies with the resources to subsidize grabbing market share in key growth markets. Danone is the market leader in infant formulation in China, and is usually viewed as the best positioned within emerging markets.

The story of the last quarter was consolidated decline in the developed world coupled with a slowing of growth in emerging markets like China. The US is slowing primarily because of declining birth rates and a sluggish economy while its European operations are also dealing with reimbursement changes as governments seek to cut expenditures.  Throw in slowing growth in China –caused by a slowing economy and a reduction in consumer confidence- and you have the perfect conditions for a cut throat price war as multi-nationals fight hard for positioning.

Unfortunately, while these forces were taking shape Mead Johnson was increasing prices, a bad move which cost it around 3.5 points of market share and it has been fighting to recover that lost share while dealing with lower than expected sales thanks to its distributors taking longer to run down inventories.

What the Industry is Saying

A quick look at the most recent reports from its rivals reveals much about how competitive the last quarter was. Within baby nutrition Danone managed to record a global 3.6% rise in volume and 7.9% growth in value leading to overall growth of 11.5%. This may seem good, but consider that the previous period saw 7% volume growth with a 6.6% growth in value. In other words, volume growth slowed down in relation to value in the last quarter.  This is what you might expect in a price competitive environment. With regards to China, Danone has an excuse in that it is completely revamped its market leading Dumex range of products.

Turning to Heinz it’s impossible to see exactly what its nutrition sales were to emerging markets (they are not broken out) but it’s fair to assume that the near 20% rise in organic sales to emerging markets contained a large amount of growth from nutritional sales. We know from subsequent presentations that nutrition makes up around 10% of sales.

Another company worth looking at is Johnson & Johnson (NYSE: JNJ) whose baby care products are a kind of proxy for overall spending in the infant sector. Frankly it has been under performing in baby care in the US for a while now and this is in line with the general weakness in the US. However its international baby care sales were negative in the last quarter too. This suggests that the infant sector might not be as recession resistant as many people are hoping it will be.

Last but not least is Abbott Labs which appears to be firing on all cylinders in the category. Its pediatric nutritional sales in the US were up 15.9% and on a constant currency basis its sales were up 7.3%.


I suspect the likes of Abbott Labs, Heinz and Danone have taken market share from Mead Johnson. The latter chose the wrong time to implement aggressive price increases and its management spoke of ongoing aggressive price discounting in China. The good news is that via increased promotional activity and increased focus on trade execution Mead Johnson is claiming to have recovered two points of the market share loss. The bad news is that its traditional strategy of holding pricing is likely to come under pressure as others continue to discount.

Constant dollar sales guidance has already been lowered from 8-9% toward 6-7% for the full year and the near term trend of the economy in China and socio-economic climate (birth rates in the US & Europe) is not in its favor either.  I suspect things will get worse before they get better for the company and how many times have we seen managements be overly optimistic about timescales for customers running down inventories?

Moreover, on a PE of 23 and weaker prospects, the stock is still far from value. If the market falls out of love with the long-term-emerging-middle-class-in-China growth story than it could get a bit cheaper yet.  I happen to buy the story and think that Mead Johnson will probably get through this difficult patch okay but, I don’t think now is the right time or evaluation to chase the stock.

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