The Risk in This Emerging Market Play


Perhaps it's a sign of how well the markets have done in the last year that Mead Johnson Nutrition's stock price is basically flat over the period. It's been a difficult 12 months for the infant and child nutrition company. Not only have its near-term earnings expectations been reduced, but there is a growing amount of uncertainty over its long-term prospects as well.

Mead Johnson's Long-Term Story
The company is attractive to investors because it offers defensive growth within emerging markets. It lumps together its emerging market operations in a segment called Asia/Latin America.

source: company accounts

The long-term investment thesis is simple. Developed markets will provide relatively stable demand, and the growth kicker will come from higher birth rates in emerging markets. Furthermore, a growing middle class in the developing world will increasingly demand better nutrition for their babies and children.

It's a compelling story, and Mead Johnson represents the purest way to play it. Others think so too, because Pfizer had no trouble selling its infant-nutrition business to Nestle (ADR) for a hefty 20 times earnings before interest, taxes, depreciation, and amortization. The price that Nestle paid highlighted the strategic importance of obtaining market share in emerging markets. For example, it immediately gave Nestle a high single-digit share in China. Moreover, Pfizer's unit generated over 80% of its sales in emerging markets.

The benefits outlined above have not been lost on investors, and the stock has traded in a P/E range of 20 to 35 since early 2010. However, there are a couple of warning signs that investors need to consider.

Developed Markets, Developing Problems
The first concern can be seen by tracking Mead Johnson's segment revenue and EBIT margins over the last few years. Declining birth rates in the West have led to falling sales and margin pressure. Indeed, its North American/European margins have fallen from above 30% a few years ago to barely 20% now.

source: company accounts

In addition, the last few years have been difficult for Western consumers, and the lack of pricing power has been evident across many retailers in the U.S. On its conference call, Mead Johnson argued that U.S. births were in line with the prior year, and investors hope that this is an inflection point. Indeed, management is continuing to invest in the expectation of better days ahead. According to Peter Leemputte in the company's most recent conference call, "I would point out that we have made a decision consciously to continue to invest in this business for when the recovery comes."

The underlying question is whether the declining birth rate in the Western world is a short-term consequence of a slower economy, or part of a longer-term social trend? If it's the latter, then Mead will be investing in the expectation of growth that will not occur.

Emerging Markets, Emerging Problems
Emerging markets generate the majority of the company's profit, and margins and growth rates are significantly higher. Indeed, Mead Johnson and the rest of the infant-formula industry in China enjoyed some favorable market dynamics. For example, the baby formula scandal in 2008 largely affected local producers, thereby creating the ideal environment for foreign producers to be able to charge a premium. The situation led to good growth for the foreign players, but it also led to increased jostling for market share.

Consequently, Mead Johnson found itself losing market share in China in 2012, as the likes of Danone (ADR) and Nestle fought hard to counteract weak sales in European markets. Mead was therefore forced to reduce shipments to distributors in order to get inventories back to normal levels. The plan worked - Mead claims that its market share has now been stable for the last four months, but this also may be a sign of strong competition.

Another potential problem is political in nature. The premium prices in China did not go unnoticed by the regime, and an antitrust probe was subsequently launched into price fixing in China. The result was that six infant-formula companies were fined, including Mead Johnson, which had to pay a $33 million penalty.

In addition, Mead Johnson reduced its prices in China by 7% to 15% , and Danone and Nestle made similar moves. Mead Johnson's price cuts took place in mid July, and were forecast to reduce annual sales by $55 million to $65 million. On the one hand, these figures only represent around 1.4% of its forecast sales for 2013. On the other, they present a warning over potential political risks in the future.

In addition, whenever companies cut prices across an industry, there will be uncertainty over which businesses will end up winning/losing market share. Will Mead Johnson end up losing market share out of this?

Where Next for Mead Johnson?
The company faces some fundamental questions over long-term demand from developed markets, and near and long-term risk from emerging markets. For different reasons, margins could come under pressure in both segments in the future.

However, with a current P/E ratio of around 25 times, the market doesn't seem to want to stop believing in its prospects. This is understandable because outside of China, the company has been performing well, and it is still forecasting constant-currency revenue growth of 8% for 2013.

However, analysts now predict EPS growth that only approaches double-digits for the next few years, and Mead Johnson's valuation is looking stretched for the risks involved in both of its segments. This is one for the monitor list.

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