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Mead Johnson Nutrition CO (MJN), Nestle SA Reg Shs. Ser. B Spons (ADR) (NSRGY): The Risk in This Emerging Market Play

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Perhaps it’s a sign of how well the markets have done in the last year that Mead Johnson Nutrition CO (NYSE:MJN)’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 Nutrition CO (NYSE:MJN) represents the purest way to play it. Others think so too, because Pfizer had no trouble selling its infant-nutrition business to Nestle SA Reg Shs. Ser. B Spons (ADR) (OTCMKTS:NSRGY) for a hefty 20 times earnings before interest, taxes, depreciation, and amortization. The price that Nestle SA Reg Shs. Ser. B Spons (ADR) (OTCMKTS:NSRGY) paid highlighted the strategic importance of obtaining market share in emerging markets. For example, it immediately gave Nestle SA Reg Shs. Ser. B Spons (ADR) (OTCMKTS:NSRGY) 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 Nutrition CO (NYSE:MJN)’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 Nutrition CO (NYSE:MJN) 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 Johnson Nutrition CO (NYSE:MJN) 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 Nutrition CO (NYSE:MJN) 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.

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