Is this Stock the Mother's Milk?

Marshall is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The major baby formula companies were under pressure last week on reports that China is launching an investigation related to price fixing among the major formula companies. Mead Johnson (NYSE: MJN) is taking the most heat and its stock has fallen off a cliff. 

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It's only fair that Mead Johnson is being pulled down the most, given nearly 80% of its revenues are derived form the Asia and Latin America markets. 

Its key products include the Enfa brand baby formula.  59% of its sales have to do with infant formula while 38% centers around children's nutrition. Mead has partnerships with global distributors that include Wal-Mart and DKSH International, accounting for 11% and 15% of 2012 sales, respectively. 

Chinese finger trap? 

Despite the recent news of possible price fixing, it wasn't too long ago that the country was rocked by baby formula scandals. In 2008 there were various cases of formula tainted with melamine, resulting in the death of six babies. 

Then in 2011, China’s largest milk producer, China Mengniu Dairy, said moldy cattle feed had led to excessive toxin levels in its milk. Just last year, major milk producer, Inner Mongolia Yili Industrial Group, recalled formula tainted with mercury. 

This leads to a limited supply of formula, which gives the major formula companies a huge opportunity. Baby formula sales in China grew 29% last year to over $15 billion, which is four times the size of the U.S. market. 

Mead Johnson appears to be one of the strongest companies in the industry. This is the 20th year that Mead Johnson has been manufacturing formula in China. 

The formula market 

Danone (NASDAQOTH: DANOY.PK) is one one Mead's top competitors. The company is a France-based business that produces fresh milk products, baby foods, biscuits, cereal products and medical nutrition products.  It also co-produces bottled water. 

Danone operates across Europe, Asia and the Americas. In early 2013, it took a minority stake in Centrale Laitiere, and in May 2013 it inked an agreement to acquire an equity interest of over 90% in Happy Family, a baby food producer.

Yet, fresh diary products remains its largest segment, accounting for over 55% of sales, with baby nutrition in a distant second, accounting for 20% of sales. The other weakness for the company is its exposure to Europe, where 40% of 2012 sales were derived from the continent. 

The other key company in the formula market is Abbott Laboratories (NYSE: ABT). Abbott is a diversified healthcare products company that focuses on nutritionals, diagnostics and generic drugs. The company also spun off its R&D based prescription pharmaceuticals business in early 2013, now trading as AbbVie

Based on its new structure, Abbott is expected to see nutritionals generate some 30% of revenues, while pharmaceuticals will be about 23%, diagnostics 20%, vascular products 14%, and other products 13%.

And much like Mead, Abbott earns a large portion of revenue from outside of the U.S. -- over 70% in 2012. For 2012, emerging markets made up 40% of revenue, but Abbott expects emerging markets to make up 50% of sales by 2015. 

While the company is heavily diversified with nutrition, medical devices, and pharmaceuticals products, its nutritional segment is showing the best promise. The segment posted growth in 2012 with brands that include Similac, PediaSure, and Ensure. Its nutrition business launched 80 products in 2012 and Abbott expects to launch another 70 in 2013. 

Got milk?

Since we're talking about baby nutrition, it's only appropriate to transition the conversation over to milk. The American Academy of Pediatrics recommends breastfeeding infants until they turn one, and then introducing whole milk into their diet. 

One of the leading distributors of milk in the U.S. is Dean Foods (NYSE: DF). Earlier this year, Dean Foods spunoff its WhiteWave segment, and before that, the company sold off its Morningstar division -- now allowing the company to fully focus on its milk business. Dean Foods also used a portion of its $1.45 billion from the sale to retire debt. Given its 13.7% annualized expected 5-year EPS growth rate, Dean Foods is is still an undervalued play. 

Dean Foods expects volumes to fall in the low-to-mid single digit range in fiscal 2013, but it's focusing on efficiency improvements, where the company anticipates operating income to increase in the low-to-mid single digit range.  Helping drive this growth has been a focus on cost reduction, including headcount reductions, and in 2012 the company saved over $300 million under the program it started in 2009.

Hedgie sentiment

At the end of the first quarter, there were a total of 39 hedge funds long Mead Johnson, a 15% increase from the previous quarter. This includes billionaire Stephen Mandel's Lone Pine Capital with the largest position -- worth some $544 million and making up 2.8% of its 13F portfolio (see Lone Pine's high upside picks).

Meanwhile, Dean Foods also has robust hedge fund interest, with 38 hedge funds long the stock -- a 31% increase form the previous quarter. The top investment fund is Adage Capital Management, with a $76 million position (check out Adage's high yielders).

Abbott had 31 hedge funds long the stock, a 43% fall from the previous quarter. The top hedge fund owner is Mason Hawkins' Southeastern Asset Management, with a $514 million position that makes up 2.3% of its 13F portfolio (see Southeastern's top stocks).

Bottom line

With the pullback in the stock, Mead is now trading cheaply based on historical standards. 

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I believe that the pullback in the stock presents investors with a compelling investment opportunity as Mead has impressive exposure to the fast growing Latin American and Asia markets.   Meanwhile, the company also has some of the best exposure in the nutrition market -- 60% formula and 40% child nutrition. This should be one of the fast growing markets in he future, supported by a rising population and income.

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Marshall Hargrave has no position in any stocks mentioned. The Motley Fool owns shares of Dean Foods Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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