Mead Johnson Nutrition's Valuation Looks Bloated

By Stephen D. Simpson, CFA | January 31, 2013 AAA

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.

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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.

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