Mead Johnson Nutrition: Is Low Milk Prices Really A Negative?

| About: Mead Johnson (MJN)

Summary

Mead Johnson’s fourth quarter results dragged down by both currency and product mix ASP effect.

Outlook for milk prices and currencies continue to drag Mead Johnson lower.

Fears of lower milk prices misplaced from a historical basis.

Valuations from an earnings and cash flow basis undemanding.

I am currently long MJN and will look to add on any dips.

Introduction:

Mead Johnson Nutrition (NYSE:MJN) reported fourth quarter results that matched analyst's estimates for top line, but beat estimates for bottom line. Despite this, earnings for the year still came in 3.3% lower than the previous year, dragged down by a mix of currency and product mix differences. The challenging outlook has seen MJN correct by over 11% on a year-to-date basis. Despite the more challenging outlook from lower milk prices and currencies, which have seen downgrades by analysts, I think 2016 will see some moderation in terms of the effects of these headwinds. On the back of these downgrades, I see an opportunity to accumulate more shares of MJN.

Fourth Quarter Results in brief

The fourth quarter of 2015 saw some improvement in China and Hong Kong sales, which saw a 2% growth from the third quarter despite facing higher price based competition in the fourth quarter from the local Chinese players. The sales in all geographical segments were also adversely impacted, most notably in China and Asia, where the strong dollar for the most of 2015 moderated gains for MJN.

While I acknowledge fears of the stronger USD facing MJN at the moment, I think 2016 should see some stabilization in the USD, which will mitigate the effects of foreign currency fluctuations on their financials. The result is that MJN should see some share price stability in 2016.

Low milk prices a negative. Really?

One of the reasons for the sell down in MJN over the past one-year is the decline in the price of milk due to supply problems plaguing the global economy. You can see the collapse in the price of milk below.

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Source: Bloomberg

The fear from the street is that falling milk prices make increasing the price of their infant milk powder difficult. This however, is mitigated by the potential increase in milk volume that will be sold in China following the abortion of their one child policy in October last year.

The Chinese government's support for their own milk industry through generous tax subsidies has allowed the Chinese players to embark on aggressive price competition in the sector. This places pressure on companies like MJN who have always adopted a premium-pricing model in the industry. Therefore, the falling milk prices in my view, better allow MJN to address such price competition by offering steeper cash discounts in China.

Their recent partnership with JD.com (NASDAQ:JD) will also further their expansion online and allow them to leverage on JD's network in the third- and fourth-tier cities. The depressed milk prices will also allow them to reach out to parents in the third- and fourth-tier cities at a slightly lower price as they will also be likely to be more price-sensitive.

Key Operating Metrics: Valuations

Based on their last closing price on the 28th of January, MJN is trading at 20x earnings, which is not overly expensive at this level. Regular followers of MJN will also know my preference for the price to free cash flow measure, which is currently trading at 19.2x vs. their peer's 69.5x. I think the lower than peers valuation now should give investors comfort in holding the shares of MJN during this turbulent period as management step up their share repurchase program.

Click to enlarge

Source: Bloomberg

Currency Risks

While unlikely, I think one of the biggest fears is the continued devaluation of the RMB against the USD that we saw in the summer of last year and at the beginning of this year. I think the Chinese government might moderate the pace of expansion of the RMB, but I will admit that it is difficult (or impossible) to figure out the intentions of the Chinese government. Any further devaluation in the RMB will hurt sales of MJN.

Conclusion

The low price of milk seems to be a concern for analysts and the street presently. Historically, the low price of milk has been a positive for MJN as they have always been slow or have avoided passing on such cost savings to the consumer. The effects of the low milk price have also already been translated into higher margins for MJN, for FY15, gross margins are 320 basis points higher than FY14. Therefore, the current panic seems a little overdone in my view, and I will be looking to add to my position on any dips.

Disclosure: I am/we are long MJN.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.