Investors are almost always willing to pay up for growth, particularly when it's in a sector where growth can otherwise be hard to come by. But Mead Johnson Nutrition (NYSE:MJN) shares seem to take that a little too far. There's no arguing that the company's heavy exposure to faster-growing emerging markets is a big plus, not to mention its strong share in what is effectively becoming a global oligopoly. Even so, investors shouldn't ignore the risk of further margin pressure and the possibility that they're paying too much for these shares.

Top Investment Trends For 2013: We go over a few investment trends for you to think about for 2013.

More Than a Sigh of Relief for Fourth Quarter
Investors responded very favorably to Mead Johnson's fourth quarter earnings, and it's not too hard to understand why. Concerns about the company's share and profits in China had been worrying investors, and this quarter would seem to show that those worries are at least somewhat overblown.

Revenue rose nearly 8%, with 2% growth in global volumes and 5% growth in pricing. Sales in North America and Europe were up 4%, as volume declined 1% and price increased 5%. Sales in Asia and Latin America were much stronger, however, rising 9% in constant currency terms on 3% volume growth and 6% pricing growth.

Profitability likewise improved. Gross margin was flat on a year-on-year basis, but adjusted operating income rose 19% and operating margin expanded by two points. Profit performance reversed the sales trends. Operating profits in North America/Europe rose 39% (and margins expanded seven points), while profits in Asia/Latin America rose 4% with another point and a half of margin contraction. For this quarter at least, the margins for both segments were roughly even.

SEE: How To Decode A Company's Earnings Report

China and Mexico Today, the World Tomorrow?
One of the frequently-mentioned investment positives for Mead Johnson is its huge emerging market exposure. About 70% of the company's sales come from emerging markets, making it one of the most EM-exposed companies out there, and giving it considerably more exposure than others like Danone (OTC:DANOY) and Abbott Laboratories (NYSE:ABT).

What's interesting is that it's not especially diverse exposure at this point. Only a few markets - China, Mexico, Philippines - make up about 70% of those sales, and large markets like Indonesia, Vietnam, India and Brazil remain. Penetrating these markets won't necessarily be easy, with cultural issues like preferences for breastfeeding, economic issues like consumer income and various marketing/distribution issues, but the potential is still there.

On the other hand, developing these markets will require a lot of capital and brand-building, and rival Nestle (OTC:NSRGY) already has certain advantages in that regard. Pricing could also be a challenge. Mead Johnson's formula already sells at a 25% premium to U.S. prices (about two-thirds of which is due to China's VAT), and I'm not sure those prices are sustainable.

SEE: The Risks Of Investing In Emerging Markets

Could Cost Pressure Become an Issue?
While I like Mead Johnson's long-term revenue growth potential, I'm a little concerned about the company's long-term margins. As mentioned above, costs will likely be involved in growing the Chinese market (moving from larger to smaller cities) and expanding the business in other large markets like Brazil and Indonesia. I'm also concerned about the potential for input costs to further pressure margins.

Milk producers like Dean Foods (NYSE:DF) have been struggling with industry overcapacity, but the low margins and returns on capital do seem to be pushing suppliers out of the business. On the other side, companies like BASF (OTC:BASFY) are consolidating the suppliers of high-grade fish oils (and fatty acids like DHA are important ingredients). With Mead Johnson's products already going for a steep price in China and the company's WIC contracts limiting pricing/margin power in North America, I think it's a concern that investors should at least consider.

The Bottom Line
I understand why Mead Johnson is popular. Infant nutrition is less economically sensitive than many other markets, and Mead Johnson is a pure play. Moreover, it's an excellent play on the growth (both population and economic) of emerging markets, but it carries the benefits of a liquid U.S. listing, U.S. auditing and reporting standards, and so on.

Even so, I'm not excited by the stock's price at these levels. I think Mead Johnson can grow revenue at a high single-digit rate for the long term, but I have my doubts that the company will be able to significantly improve margins or its cash conversion cycle in the near-term (and if it does, it may well cost the company growth). Accordingly, the stock is well ahead of my fair value target today, and I would only consider these shares as a trade at best.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

Related Articles
  1. Investing

    Build a Retirement Portfolio for a Different World

    When it comes to retirement rules of thumb, the financial industry is experiencing new guidelines and the new rules for navigating retirement.
  2. Options & Futures

    Use Options to Hedge Against Iron Ore Downslide

    Using iron ore options is a way to take advantage of a current downslide in iron ore prices, whether for producers or traders.
  3. Stock Analysis

    Net Neutrality: Pros and Cons

    The fight over net neutrality has become an amazing spectacle. But at its core, it's yet another skirmish in cable television's war to remain relevant.
  4. Markets

    Why Gluten Free Is Now Big Business

    Is it essential to preserving your health, or just another diet fad? Either way, gluten-free foods have become big business.
  5. Professionals

    Chinese Slowdown Affects Iron Ore Market

    The Chinese economy's ongoing slowdown is having a major impact on iron ore demand.
  6. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  7. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  8. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  9. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  10. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  3. Sucker Yield

    When an investor has essentially risked all of his capital for ...
  4. PT (Perseroan Terbatas)

    An acronym for Perseroan Terbatas, which is Limited Liability ...
  5. Ltd. (Limited)

    An abbreviation of "limited," Ltd. is a suffix that ...
  6. BHD (Berhad)

    The suffix Bhd. is an abbreviation of a Malay word "berhad," ...
RELATED FAQS
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!