Baby Food: Go Long If Mr. Market Exaggerates the Effects

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

According to a survey by Credit Suisse, in China, 90% of respondents pay attention to food safety in their daily lives and 76% care more about food safety than a year ago. I do not blame them. In recent years, there have been reports of clenbuterol-contaminated pork, harmful chemicals in steamed buns, poisonous bean sprouts or even melamine contaminated milk, among several other food-contamination issues.

Babies in danger

In 2008, a baby formula poisoning scandal that killed some Chinese infants and contaminated many more shocked the country. As a result of the scandal, imported powdered milk became extremely popular and a key ingredient into the life of many Chinese families.
Companies like Danone (NASDAQOTH: DANOY.PK) , Nestle (NASDAQOTH: NSRGY) and Mead Johnson Nutrition Company (NYSE: MJN) have been profiting from this trend through taking advantage of their huge pricing power. Nowadays, easy profits might suffer a halt. The Chinese government is pushing companies to cut prices aggressively in order to protect affordability in this $14.5 billion market.
Danone has already announced that it is willing to cut its baby formula prices by as much as 20%, which, according to Citibank, will cut up to 2% off the company’s forward earnings. Nestle and Mead Johnson are also expected to cut their baby formula prices although not with as much impetus as Danone did.
Nestlé said that Wyeth (the infant nutrition subsidiary Nestle bought in 2012 from Pfizer for $11.85 billion) “assessed its pricing practices and decided to improve certain sales and marketing practices (...) in order to meet the National Development and Reform Commission (NDRC) concerns with respect to the affordability of infant formula to the Chinese consumer.”
That said, a cut on baby food prices would not affect Nestle's bottom line as much as it will affect Danone or Mead Johnson (given Nestle's huge size and diversification). I would expect (according to the company's words) Nestle to cut prices by as much as 11% and keep its prices stable until late next year. This would affect Nestle's overall bottom line by less than 0.5%.
Mead Johnson is a much smaller company than Nestle and Danone. The company's sales (expected at around $4 billion in 2013) are just a small share of Nestle's $100 billion top-line. As a result, a 10% to 20% price cut in its Chinese revenues would be a big hit to the company's top and bottom lines. If we assume a base of $700 million of mainland China sales, and reduce it by 15% for the price cut, we would be reducing its bottom line by $105 million, or 16% of 2013's expected net income. 

A bright future ahead

My educated guess is that Danone, Nestle and Mead Johnson will continue to benefit from their powerful baby food brands going forward despite the short-term effects price controls might have on profits. After all, when you want food for your baby, you want something safe. Once you have a product you trust in, you do not buy anything else.
Barriers to entry into the baby food industry are, indeed, really strong. In the long term, Danone, Nestle and Mead Johnson will continue to enjoy their huge pricing power on the growing Chinese baby formula market. As a result, I would take advantage of any short-term valuation weakness any of these great businesses might suffer. You already have the figures above. Go long Nestle if it goes down by more than 0.5%, buy Danone if it goes down by more than 2% and buy Mead Johnson if it goes down by more than 16%.

The Motley Fool's chief investment officer has selected his No. 1 stock for this year. Find out which stock it is in the special free report: "The Motley Fool's Top Stock for 2013." Just click here to access the report and find out the name of this under-the-radar company.

Federico Zaldua has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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!

blog comments powered by Disqus