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Mead Johnson Nurtures Growth Prospects

Strong brands and attractive industry dynamics should keep the company's returns high.

With a wide moat based on strong brands,

Growth and profitability will be dictated by Mead Johnson's ability to capture share in emerging economies, which feature fragmented formula industries bifurcated between low-cost local producers and premium labels. Low-income consumers cannot afford high-end products, so the customer pools are distinct, with buyers trading up as their incomes rise. In the higher-end segment of the market that Mead Johnson targets, growing striation has resulted in a variety of product lines at different price points, playing into the firm's ability to differentiate based on quality using its research. The company's effort to introduce a superpremium formula into China is illustrative of Mead Johnson's ability to respond to market dynamics, as is its introduction there of Dutch-made formulas that respond to local concerns about the safety of Chinese-manufactured items.

Mead Johnson's emerging-market operations are built on robust returns in developed markets, particularly the United States. While growth in these regions should remain in the low single digits, the firm's scale and relative insulation from private-label competition should enable it to generate significant economic profits for years to come. The benefits of market maturity are offset by increasing regulation and efforts to promote breastfeeding. We also see the firm's expanding line of child nutrition products as a growth source.

Leading Share in Key Markets We conclude that Mead Johnson has a wide economic moat, built on the strength of its brand intangible assets in the difficult-to-penetrate infant formula category as well as its cost advantages that prevent competitive entry due to the significant expenditures required for sales, marketing, and research and development.

Mead Johnson has generated strong returns on invested capital since its spin-off from Bristol-Myers in 2009, most recently 58.8% in 2014. We forecast that the company will continue to generate returns well in excess of our cost of capital estimate (although at a slightly lower rate than recent levels), at 55% on average between 2015 and 2019.

With leading share in key markets (mid-40s in the U.S. and low double digits in China, which account for 24% and about 35% of sales, respectively), Mead Johnson has established brand intangible assets in a category in which consumers are focused on quality far more than price. The company's standing is built on the strength of its reputation for scientifically proven value-added products. Given the importance placed on early-childhood nutrition in the academic and healthcare communities, new parents are especially sensitive to the quality differentiation, creating room to price at a premium for a more advanced product. This dynamic has also historically kept private-label penetration in the sector at a negligible level.

The firm monetizes its reputation through an extensive sales and marketing organization that targets new mothers and, more important, doctors. Its salesforce's relationships with healthcare providers are particularly vital due to the supposed benefit of staying with one (tolerated) brand of formula rather than changing midway through the child's development; this perceived switching cost favors the formula brand that can quickly reach the new parent through a trusted source (the doctor). The healthcare relationships are ultimately what ensure that the company's brand equity endures despite an end user that graduates from its infant nutrition products within a few years. While customer acquisition costs are high due to the sales effort as well as Mead Johnson-created apps and websites with information for new parents ($639 million advertising and promotion expenditure in 2014 constituted 14.5% of sales), the company can justify the investment due to the brand loyalty and margins that formula exhibits; the cost of emulating this approach is a deterrent to entry. This cost advantage also manifests itself in research and development, where Mead Johnson is able to dedicate about 2.5% of sales (a little over $100 million) annually to creating clinically demonstrated products that strengthen the core of its science-based brand appeal.

Emerging Markets Hold Promise Consumers in emerging markets have been especially sensitive to quality concerns, actively seeking foreign-branded products. After the melamine-tainted milk scandal in 2008 that killed six infants and sickened 300,000, Chinese parents have especially moved toward international labels. More recently, distrust of local brands has led parents to seek imported formula through authorized or unauthorized channels over domestically produced product (irrespective of the origin of the brand of the home-produced item). Mead Johnson is benefiting by importing Dutch-manufactured formula into China, an avenue only available to large-scale global producers. The imported product already accounts for 28% of the company's sales in China even though it was only launched in April 2015.

In the U.S., the Department of Agriculture's Women, Infants, and Children program further advantages incumbent brands by subsidizing a portion of formula purchases. As parents of approximately half of children born in the country qualify for WIC benefits, the contracts under which states select a single manufacturer as the exclusive provider of WIC formula are essential to meaningful participation in the marketplace. Companies receiving a WIC contract tend to post 85%-95% market share in that state, as the subsidies produce indirect effects such as improved placement in stores, word-of-mouth marketing to non-WIC participants, and upsells of other products not covered by the program. While the prices paid by the government are a fraction of retail values, the subsidies are not enough to cover all of a child's needs, resulting in parents supplementing subsidized formula with additional full-priced purchases to round out the diet. As the vast majority of parents switch formula only when there are tolerance problems, this gives winning manufacturers effective control over the market for the duration of the contract term (usually three to four years; the majority of contracts are renewed with the incumbent retaining the relationship). Mead Johnson is currently the WIC contractor in 18 states and supplies formula for about 45% of WIC births. Only companies with a national formula brand can bid for WIC contracts, effectively limiting the field to existing large manufacturers.

In all markets, the competitive dynamics governing the industry create a tendency toward consolidation. Mead Johnson, Abbott ABT, and Nestle NSRGY virtually control the U.S. market and have for decades; similar dominance is exhibited by the leading players in other developed countries. There is more stratification in emerging markets as low-cost local brands are able to sell a less-advanced product, particularly when dairy prices are low. The customers that low-cost competitors target are not otherwise able to afford a higher-quality, aspirational foreign product. As incomes in these regions rise, however, we expect the fragmentation to consolidate behind leading premium players, in line with developed-market norms.

Mead Johnson's growth engine has been its pediatric nutrition portfolio, targeted at supplementing the dietary needs of children aged 12-36 months. This segment is far less regulated and as such represents a way for the company to extend the value of its brand further into childhood while enjoying greater flexibility. As parents tend to be formula brand-loyal, many who feed their infants a particular brand of formula will continue the relationship with the trusted manufacturer as the child graduates to nutritional supplements (and will probably return to that favored brand if they have additional children).

Risks Include Product Safety Worries and Regulation The main risks to our valuation relate to product safety, regulatory impacts on demand generation and competitive balance, and commodity volatility.

Product safety scares can have a big impact in the sector, as shown by ongoing consumer distrust of local Chinese formula companies in the wake of the 2008 melamine contamination scandal. Any safety issue, whether perceived or real, could deal lasting damage to Mead Johnson's brands.

Formula marketing is highly regulated in developed markets, and as governments seek to encourage breastfeeding, restrictions have become more onerous. While U.S. and European Union regulations affect product labels and marketing practices, local governments and hospitals have taken varying stances on sampling, brochures, and other advertising tactics. A meaningful unfavorable groundswell could reduce the value of the medical sales relationships that bolster Mead Johnson's moat. Separately, Chinese trade rules that favor foreign formula makers could reverse and, in the worst case, the government could attempt to promote the local industry at the expense of foreign firms. The same dynamic applies in other economies with interventionist governments.

Mead Johnson is exposed to commodity volatility, especially in input costs (mostly dairy) and foreign exchange. Low dairy prices have sparked price competition as firms use expanded margins to finance share gains. The foreign exchange issue is exacerbated by sudden devaluations and capital controls (such as in Venezuela) and occurs in an unfavorable U.S. profit repatriation environment.

On the upside, female workforce mobilization and product improvements may reduce the impetus for adverse government action for practical and scientific reasons. Product advances may reinvigorate developed market growth, overcoming biases against bottle feeding in the parenting zeitgeist. Lastly, untapped regions (such as Africa, the Middle East, and India) may provide fertile ground for expansion.

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