Chinese parents’ distrust of local milk has elevated foreign baby-food brands into luxury goods and allowed companies from Danone to Mead Johnson Nutrition Co. (MJN) to fatten margins. Those plump profits are at risk.
The troubles started this month as state-controlled media reported China’s government was investigating them and other overseas competitors for possible price fixing. Within days, Danone and Nestle SA (NESN) slashed some prices by as much as 20 percent. Mead Johnson, the country’s largest infant formula seller, announced its own cuts July 10.
A spate of food-safety scandals have fueled frenzied demand for foreign formula from nervous Chinese mothers, whose bulk purchases have opened the way for the top four international producers to control more than a third of the industry. At stake is an almost $16 billion infant formula market that Mintel Group estimates is more than four times the size of the U.S. International companies will likely suffer even if price cuts result in higher sales.
“Even as lower prices trigger increased demand and higher sales, it is unlikely to offset lower margins,” said Jon Cox, head of Swiss Research at Kepler Capital Markets SA.
The investigation offers a window into how government scrutiny in China can create a sudden roadblock for foreign companies expanding there.
D.A. Davidson & Co. lowered its earnings estimates on Mead Johnson and cut its price target on the stock to $75 from $80 after the company’s price reductions.
“We believe these changes were made in consultation with government authorities but there can be no assurance that this is the only pound of flesh that the government will want for alleged anti-competitive activities,” D.A. Davidson analyst Timothy Ramey wrote. China has been the “big story” for the company so “any reversal or diminution of growth from this market scares us,” Ramey said. Mead gets about 30 percent of annual revenue from China, according to data compiled by Bloomberg.
Baby food businesses of Danone (BN), Nestle’s Wyeth brand, Abbott Laboratories (ABT), Mead Johnson Nutrition Co. and Dutch producer Royal FrieslandCampina NV are under investigation, the official People’s Daily newspaper said on July 2.
The official Xinhua news service described the investigation as a probe into “possible price fixing.” Citing the nation’s top economic planning agency, the National Development and Reform Commission, Xinhua said the brands have been accused of “violating anti-monopoly laws via high prices and limited market competition.” The companies have said they are co-operating with the NDRC and all have cut prices.
China has targeted foreign brand pricing in the past. Unilever, the world’s second-largest consumer-goods maker, was fined 2 million yuan ($326,000) in 2011 for telling the media about plans to raise prices, which the Chinese government said led to hoarding in some cities. The exact allegations and scope of this month’s milk-powder investigation are hard to pin down, said Kent Kedl, managing director for Greater China and North Asia at global risk consultancy Control Risks.
In China “you’re never quite sure where the next thing is going to come from,” said Kedl.
It’s also impossible to know if the government’s crackdown on foreign milk producers is really about high prices or supporting local milk producers.
China’s government is looking to improve its domestic industry, analysts from Wells Fargo (WFC) wrote in a July note. The government has said it will strengthen entry requirements and provide financial incentives for producers to own their raw material supply chain. It is also encouraging mergers between local producers to make them more competitive.
Morgan Stanley on July 5 downgraded Glenview, Illinois, based Mead Johnson’s stock to an equal-weight rating, similar to a hold, partly because of China’s push to support domestic manufacturers. The analysts reduced their 2013 earnings estimate on Mead by 5 cents a share to $3.22.
Mead Johnson, which saw China operating profit rise 12 percent to $870 million last year, is cutting prices on main products in the country by up to 15 percent. The company is looking for “potential offsets” globally and co-operating with the NDRC’s antitrust review, it said in a July 10 statement.
Paris-based Danone reported first-quarter sales growth that beat estimates as China safety worries helped drive a 17 percent jump in baby-nutrition revenue. Vevey, Switzerland-based Nestle reported first-quarter infant-nutrition sales increased at least 10 percent, faster than the company’s overall growth.
Checks by Bloomberg News and Mintel Group data show price jumps of between 25 to more than 40 percent in China on some foreign brands since 2008. Annual food inflation averaged about 7.8 percent in China from 2008 to 2012.
Product prices are subject to inflation and investments in innovation, making it harder to compare past and present prices, FrieslandCampina said in a statement, adding that its products offer “good value.” The investigation will have no “reasonable material impact” on Nestle’s margins in the long term, Chief Executive Officer Paul Bulcke said at a press conference in China.
Abbott, Mead and Danone did not reply to e-mailed inquiries seeking comment on the impact to profitability. Danone’s Dumex baby food brand has internally reviewed provisions of anti-trust law to ensure its operations are in compliance, the company said earlier this month.
Baby Food Boom
The probe could create some problems for the homegrown industry. Foreign companies may introduce more inexpensive products, putting pressure on cheaper local brands, said Hong Kong-based Standard Chartered analyst Charles Yan.
“If foreign producers lower the price, Chinese will be happy to buy more of imported brands,” Yan said.
The domestic companies with the most to lose may be Inner Mongolia Yili Industrial Group, Yashili International Holdings Ltd. (1230) and Zhejiang Beingmate (002570) Technology Industry & Trade Co. because they have the highest market share among the local brands, said Matthew Crabbe, Asia Pacific director of research at Mintel Group.
Zhejiang Beingmate, the Hong Kong-listed arm of China’s second-largest baby formula company by market share, has said it will cut product prices by up to 20 percent to be more competitive.
Guangzhou, China-based Biostime International Holdings Ltd. (1112), the only local producer named in the probe so far, has lost 24 percent since June 27 when it announced it was being investigated. In a statement, the company said it has not raised prices since 2008 and declined to comment on the probe’s impact on profitability. The company has said it is offering a discount of about 11 percent on infant formula products through reward points.
With several companies operating in the industry, it may be hard to prove that they are monopolies, said Kedl of Control Risks. That may still not satisfy the regulators.
“We have seen in the past that when the regulators start looking at something under one motivation, it sometimes changes in the middle,” he said.
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