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Tap Into This Unexpected Chinese Market For 25% Upside

Tuesday, November 12, 2013 - 1:00pm

One of the most underappreciated areas of health care is also instrumental for human development. Baby formula isn't exactly a market that many investors would consider a growth industry -- but that could be about to change.

The United Nations estimates that the world's population could hit 11 billion by 2100, up from a current 7 billion. That's many more mouths to feed. One of the biggest markets for baby formula is China: With 1.3 billion people and a birth rate of 1.2%, that's 15.6 million babies a year.

The baby formula market is huge and growing -- so what's the best way to invest in it?

Mead Johnson Nutrition (NYSE: MJN) is the only pure-play pediatric nutrition company, and one that has a strong presence in China, to boot.

Mead covers all stages of pediatric development, from newborns to 5-year-olds. It generates over 75% of its revenue from outside the U.S., most notably from China, which accounts for over 25% of its revenue. Infant formula makes up around 60% of revenues, with children's nutrition accounting for the other 40%. Mead's major products are sold under the Enfa brand.

Mead was spun off from Bristol-Myers Squibb (NYSE: BMY) in 2009. It hasn't been easy for Mead investors over the past couple of years, but things may be about to change: A cycling out of bad news could lead to a relief rally, while a rising middle class in China is driving long-term growth.

MJN has been on a roller-coaster ride over the past few years, with the latest pressure coming from a U.S. inquiry into Mead's China business.

Despite these pressures, the big news for Mead is that it has the opportunity for gains in market share, thanks to hiccups by major competitors.

Abbott Laboratories (NYSE: ABT) and Danone recently recalled products in China due to a contamination scare. A different setback for Danone -- allegations that its sales staff bribed hospital officials -- presents another opportunity for Mead to grab market share.

As a result of the contamination scare, the Securities and Exchange Commission made an informal request for documents from Mead. What should investors make of the SEC's request? It's a routine inquiry, not a formal investigation, relating to Mead's payments in China, where the company has been operating for over two decades. By comparison, top competitor Danone has been operating in China only since 2005.

Mead also launched an e-commerce site in July, exposing Mead's products to even more potential consumers. Mead is also seeing serious growth in the Southeast Asian market, namely Thailand, Singapore and Malaysia, which should only accelerate its growth in the region.

Meanwhile, the growth story for China as a whole appears to be intact. The country's economic growth is still strong, and it's no secret that the middle class is bustling in China. Some estimates project the Chinese middle class will account for half the country's population by 2050.

Perhaps most importantly for Mead, China is already the world's largest formula market. This is due not only to the large population but also to the fact that few Chinese mothers choose to breastfeed, for several reasons. These include the relatively high number of cesarean sections in the country, as well as the widely held belief that mothers should rest (and not nurse) for the first month after birth. Formula also helps babies put on weight more quickly, and in China, a chubbier child is considered a healthier child. All in all, fewer than 30% of Chinese mothers breastfeed in the first six months after birth.

Another factor driving the Chinese formula market is safety concerns. Over the past decade, there have been a number of health issues related to Chinese makers of baby formula, which has left the door wide open for the likes of Mead. Non-Chinese formula makers now own over a third of the Chinese formula market. This includes Mead with nearly 15% of the market share, compared with Danone, with less than 10% -- so it's easy to see just how big the market opportunity is for Mead.

Risks to Consider: Mead is heavily leveraged toward China, which can be a volatile market. Any hiccup in middle-class growth could weigh on revenue and earnings growth. Mead is also tied to the broader economy, so another economic slowdown could lead to consumers trading down from Mead's products to cheaper alternatives.

Action to Take --> Buy Mead with upside to $100, which assumes the company should be trading at 28 times its expected 2015 earnings per share (EPS) of $3.58. What really has the potential to push Mead to $100 a share in the near term is a "clearing out" of the bad news and market share gains. Mead also offers investors a modest 1.7% dividend yield.

P.S. Did you know China controls the majority of the global market of certain commodities that are instrumental in the production of high-tech devices? That's part of the reason StreetAuthority expert Andy Obermueller is expecting a severe supply crunch this year. To learn what investments Andy's recommending in response to this threat, click here to read his latest report.


Marshall Hargrave does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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