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Mead Johnson Nutrition: Industry Dynamics Not A Formula For Success

Summary

Mead Johnson is a leading infant nutrition business with significant market share in the United States and presence in many other markets.

The company has targeted emerging market growth in order to escape anemic birth rates in mature markets, with China as the ultimate prize.

Result have been quite disappointing since at least the beginning of 2015, with rapid marketplace changes in China and foreign exchange fluctuations impacting the company's top line.

The stock has maintained its premium valuation despite significant operational headwinds resulting from increased competition: valuation not attractive at all.

Mead Johnson Nutrition (NYSE:MJN) probably does not require much introduction; it is an infant nutrition business that owns famous brands like Enfamil and Enfagrow. The business was spun off from Bristol-Myers Squibb (NYSE:BMY) in 2009 and its stock has delivered more than a triple since then. The attractive part of Mead Johnson's story is well known. It is a branded business, with substantial pricing power and attractive market share positions in a lot of countries.

Next to that, Nestlé (OTCPK:NSRGF), Danone (OTCQX:DANOY) and Abbott Labs (NYSE:ABT) are the only major competitors in many of its markets, although these four contenders are not all necessarily well-established in all. For example, the United States is pretty much divided between dominant contenders Abbott Labs (with Similac) and Mead Johnson (with Enfamil). According to Statista, Mead Johnson had infant formula market share of 39.6% in the United States during 2015.

Of course, there are a host of smaller competitors active in every market where the company competes, like Heinz (NASDAQ:KHC) for instance, but most of those companies do not have the same scale enjoyed by the big four. The industry has seen significant consolidation in recent years, most notably through the buyout of Numico by Danone in 2007 and Gerber and Wyeth Nutrition by Nestlé in 2007 and 2012 respectively.

Mead Johnson has been mentioned as a buyout target ever since it was relisted as a separate company. Danone was seen as the most obvious suitor, given the complementary strengths of Danone's and Mead Johnson's nutrition businesses. Rather unexpectedly, Danone decided to make a play for WhiteWave Foods (NYSE:WWAV) instead, which in my opinion makes a Mead Johnson buyout significantly less likely.

A bigger concern is the significant increase in infant formula manufacturing capacity globally, in anticipation of Chinese growth, which seems likely to lead to more competitive industry dynamics.

Industry dynamics

With the exception of Abbott's nutrition unit, the infant formula business has moved away from its healthcare roots and towards the branded packaged foods business. To a large degree, this is reflective of the changing nature of the business, which in earlier times used to focus its product marketing on pediatricians. Over the past decades, it has moved towards targeting the consumer directly through advertising, at least in those markets where that is allowed by law.

What you often notice in infant formula advertising is a statement saying breast feeding is the preferred option. This messaging is prescribed by the WHO's International Code of Marketing of Breastmilk Substitutes, which is not legally enforceable and not adhered to very strictly by some companies. Of course, infant formula companies have every incentive to sell as much formula as they can deliver, but it is important for the industry to balance this commercial interest against other societal interests.

Reputational risk in the industry is high; product contamination for instance can severely impair a brand, as we have witnessed in China in 2008 and with the Fonterra recall in 2012. Industry barriers to entry are generally conceived to be quite high, given the strength of the entrenched brands, the sensitive nature of the product and the established relationships with healthcare professionals.

The most obvious negative characteristic of the industry is the anemic growth in birth rates in most Western markets. Obviously, this leads to severe challenges with regards to expansion of sales volumes in such markets. Mead Johnson and its competitors have tried to counter this challenge by expanding their product ranges into more advanced age brackets and products for expecting mothers, but such initiatives have met with different rates of success.

Products for older infants are often referred to as follow-on milk or toddler milk and are identified by a range of numbers featured on the product packaging (to maintain some clarity for the consumer). Certain brands are all the way up to 6 formula stages by now; Danone's Nutrilon stage 6 formulas are intended for toddlers beyond the age of three.

The products that can be safely assumed to be the best-sellers, are the ones usually referred to as stage 1 formula, which in the case of Enfamil Infant is intended for infants between 0-12 months (stages vary between manufacturers). Formula products for expectant mothers are sometimes identified with a zero.

The proliferation of different formula products is probably a direct result of stagnating volumes in Western markets; I am not a pediatrician, but it seems to me that the formula companies' commercial need for toddler formula sales outstretches the dietary needs of most toddlers. At the same time, the actual need for these products is not relevant in a commercial sense, because they do actually sell pretty well.

Mead Johnson's revenues for 2015 consisted of 59% of infant formula sales and 39% children's nutrition sales for instance (2% of sales consist of other products). Mead Johnson distinguishes between the two on the basis that infant formula is designed as a breast milk replacement, while children's nutrition products are intended to supplement a normal diet.

Given the distribution between the two product categories, it is safe to say that a significant amount of infants do not move into the more advanced formula categories as they grow older, but transition entirely to regular foods instead.

However, given the natural urge of most parents to give their children the best, I would expect that the formula companies will succeed in expanding children's nutrition sales as a percentage of revenues over time.

Promise of growth

The most obvious course to create value for all infant formula companies remains emerging market growth, which is exactly what Mead Johnson and the other three have aimed for. The holy grail of the global infant formula market is China, with an estimated 16.5 million births per year and rapidly rising incomes. The relaxation of China's restrictive birth policies should be expected to have a positive impact on the number of births going forward, perhaps allowing the country to reach as much as 20 million births annually. The US by contrast has roughly 4 million births per years.

Mead Johnson and its international competitors all have managed to establish footholds in the Chinese market, but have met significant challenges as well. The 2008 melamine scandal in China has led to severe distrust of the domestic food chain among Chinese consumers, who have increasingly looked across the border for their infant nutrition needs.

Meanwhile, domestic dairy producers, as well as new entrants, have waged aggressive campaigns to secure market share in infant formula. The result has been an extremely competitive market where consumer preferences have developed rapidly and many companies have been blindsided by quick-paced developments.

Mead Johnson has been one of the companies caught off guard in China. The attractive MSD rate of growth recorded in the company's top line in recent years, turned into a significant decline of -7.67% during 2015 with continued unattractive performance in H1 of 2016. Not surprisingly, given Mead Johnson's issues in China and foreign currency adversity, the decline was driven by emerging markets, with volume in Asia down by -6% and Latin America down by -4% during 2015.

Reported revenues were even less pretty, with Asia down by -11% and Latin America down by -13%. Given the...


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