Probing Into Infant Milk May Just Be the Beginning

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In early July, in hoping to restore consumers’ confidence, China is investigating several major foreign milk powder sellers for possible price manipulations and breaching of Chinese antitrust law. The pricing of infant formula sold by Abbott Laboratories (NYSE: ABT), Mead Johnson Nutrition (NYSE: MJN), Nestle (NASDAQOTH: NSRGY), Danone, and Royal FrieslandCampina NV are being investigated.

The bigger picture

The investigation may be part of China’s broader plan to boost consumption of domestic products. While mothers turned away from Chinese milk powder in 2008 due to melamine contamination, the Chinese government has tried to crack down continuously on food safety problems. It appears that the Chinese government is interested in bringing the supply chain under control of Chinese companies through the consolidation process. The Chinese Ministry of Industry and Information Technology also indicated that integration of the milk powder industry was expected to involve 10 large companies with revenues exceeding 2 billion yuan ($326 million) in two years.

According to People’s Daily, foreign and local companies were equal before the law, but the foreign firms should not raise prices frequently and abuse their competitive advantage. Analysts speculate that the investigation could result in fines and tougher rules governing imports into the infant milk market, which is expected to reach $25 billion by 2017. The investigated firms could face fines ranging from 1% to 10% of their annual sales. Ultimately, foreign brands may have to rely on their Chinese partners to expand access into the Chinese market. Some foreign players have increased their prices by up to 30%, nearly double that of local milk powder brands.

What are foreign players doing?

While foreign brands currently account for 70% to 80% of the market, especially in first-tier cities, 82.3% of the 3,019 respondents  to a survey conducted by sina.com.cn said that foreign producers should be investigated, as prices have increased so much. This time, Chinese authorities are focusing the investigation on prices the foreign companies required retailers to charge, instead of accusing foreign suppliers of collusion in setting prices.

Nestle and Danone’s infant-nutrition units immediately cut prices after the investigation began. Wyeth, owned by Nestle, will lower the prices of some baby-formula products by as much as 20%. The company also canceled the price increase for its S-26 range of milk powder. Wyeth’s price reduction is expected to reduce its revenue by $73 million in the next 12 months. On the other hand, FrieslandCampina NV will reduce prices by 5% for all its products in China. Lastly, Abbott and Mead Johnson Nutrition just announced it will cut prices by 4 to 12% and 7% to 15% in China, respectively.

What now?

In essence, while most of the foreign companies being probed cut prices, lower pricing may further intensify the competition between local and foreign companies. While the Chinese government's ultimate goal is to increase the presence of local suppliers, more actions may be taken by the Chinese government.

While long-term growth remains positive for the infant nutrition category in emerging markets, near term headwinds are expected for Mead Johnson Nutrition, as the top market share holder in China. With the ongoing investigation and the price cutting, profit margin will be compressed for Mead Johnson Nutrition. Wells Fargo downgraded Mead Johnson Nutrition to Market Perform, and lowered its price target to $77.00.

On the other hand, Abbott Laboratories is much more diversified and has less than 3% of its overall sales in China, meaning it is better positioned to withhold the impact from the investigation and price cutting. Nestle indicated that the Chinese government’s probe will have no “reasonable material impact” on Nestle's margins in China in the long term. Nestle' management does not expect the investigation to spill over into other products, and any short-term effect from the probe will be offset by a stronger growth in its other businesses. At the same time, Nestle is also working with the Chinese authorities to help improve food safety.

However, all the companies being investigated need to prepare for the possible tightening of import control and increasing of price monitoring, as the Chinese government steps up to boost consumption of local products.

The probing of foreign companies may not solve the real demand issues in China. Chinese consumers continue to prefer foreign infant milk formula due to food safety concerns for local products. Furthermore, with increasing income and the one child policy, pricing may be less a concern versus quality. Unless the root safety and quality issues can be addressed and fixed for local suppliers, the demand for foreign infant milk formula will remain strong.

Takaway

The investigation into infant formula will probably not be the last step for the Chinese government's efforts to level the playing field for local companies. Investors need to stay cautious with companies that rely heavily on Chinese consumption. However, it may be a good opportunity to establish long-term positions for diversified companies, such as Abbott Laboratories and Nestle. With their strong diversification, both geographically and product mix, the short-term impact should be minimized. Most importantly, these two companies will have more flexibility to adjust for possible regulation changes and stay competitive. 

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