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Mead Johnson Nutrition (NYSE:MJN)

Q2 2012 Earnings Call

July 26, 2012 9:30 am ET

Executives

Kathy Ann MacDonald - Vice President of Investor Relations and Acting Corporate Controller

Stephen W. Golsby - Chief Executive Officer, President and Director

Peter Kasper Jakobsen - Chief Operating Officer, Executive Vice President and Director

Peter G. Leemputte - Chief Financial Officer and Executive Vice President

Analysts

Kenneth Goldman - JP Morgan Chase & Co, Research Division

Edward Aaron - RBC Capital Markets, LLC, Research Division

Matthew C. Grainger - Morgan Stanley, Research Division

Eric R. Katzman - Deutsche Bank AG, Research Division

Jason English - Goldman Sachs Group Inc., Research Division

David Driscoll - Citigroup Inc, Research Division

Bryan D. Spillane - BofA Merrill Lynch, Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Mead Johnson Nutrition Second Quarter 2012 Earnings Conference Call. My name is Chanel, and I'll be your coordinator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the presentation over to Kathy MacDonald, Vice President, Investor Relations. Please proceed, Kathy.

Kathy Ann MacDonald

Thank you, and good morning. Welcome to Mead Johnson's second quarter conference call. Speaking today will be Steve Golsby, our Chief Executive Officer; Kasper Jakobsen, our Chief Operating Officer and CEO-elect; and Pete Leemputte, our Chief Financial Officer.

Before we get started, let me remind everyone that our comments will include forward-looking statements about our future results, including statements about our financial prospects and projections, new product launches and market conditions, that constitute forward-looking statements for purposes of the Safe Harbor Provision under the Private Securities Litigation Reform Act of 1995.

Keep in mind that our actual results may differ materially from expectations as of today, due to various factors, including those listed in our Annual Report on Form 10-K, Quarterly Report on Form 10-Q and Current Report on Form 8-K, in each case, as filed with or furnished to the Securities and Exchange Commission and our earnings release issued this morning, all of which are available upon request or on our website at meadjohnson.com.

In addition, any forward-looking statements represent our estimates only as of today and should not be relied upon as representing our estimates as of any subsequent date. While we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so even if our estimates change.

To be respectful of your time, I will now turn the call over to Steve.

Stephen W. Golsby

Thank you, Kathy, and good morning, everyone. As you've likely read in our press release, Mead Johnson delivered sales growth of 11% on a constant dollar basis in the second quarter. This was delivered by continued strong performance from the emerging markets of Asia and Latin America, the benefit from our Argentine acquisition completed late in the first quarter and the improving comparison in our North America/Europe segment we saw flat sales versus the prior year excluding the impact of foreign exchange.

Our recovery from the impact of the misleading U.S. media reports of alleged product contamination last December is quite evident, and we're confident that progress will continue in the second half of the year.

Non-GAAP earnings of $0.83 per share were up 15% from the $0.72 per share reported in the second quarter of 2011. Earnings increased due to strong sales growth, a favorable foreign exchange comparison, lower administrative costs and a reduced tax rate.

These were partially offset by a lower gross margin due in large part to higher dairy cost in North America, increased investments in advertising and promotion and the timing of pension settlement expenses.

While we are justifiably pleased with first half 2012 results, we expect lower growth in the second half of the year, due in part to a weak global economy. With several European countries now in recession and the continued weak performance of the U.S. economy, economic growth and consumer spending in key exporting markets, most notably China, have slowed. Consequently, we're experiencing a reduction in the rate of category growth in China. Despite this near-term softness, we have continued high confidence for longer-term category growth in China, supported by a rapidly growing middle class. Kasper will go into more detail on market share trends in China, but it's also clear we gave back some market share in the second quarter after exceptional gains over the last few years.

We believe this is a temporary phenomenon, and our clear intent is to rebuild share growth in the second half of the year. As we stated previously, the market in China is highly competitive and we will inevitably see share fluctuations from time to time. We have operated in China for almost 20 years and have seen and overcome bumps in the road in the past. We're confident in our business model, strategies and investments, and we intend to continue to deliver compelling growth in China over the medium and longer term.

We currently anticipate full year global sales growth of 8% to 9% on a constant dollar basis, down from the 9% to 11% guidance in our last call. While our growth in China has slowed, we continue to see strong performance across markets in Southeast Asia and Latin America and an improving position in the United States. In absolute terms, our projected sales growth in 2012 remains very strong. We continue to expect non-GAAP earnings on a full year basis to range from $3.04 to $3.14 per share. There are always a number of moving parts at work, and 2012 is no exception. A sustainable and lower tax rate coupled with favorable foreign exchange gain is expected to offset the impact of lower sales growth.

While maintaining our guidance for strong earnings growth, we are, of course, mindful of greater risks in the current operating environment. Nevertheless, we will continue to increase investment behind the business given our high confidence in category growth and our proven strategies.

I will now turn the call over to Kasper, who will provide more details on our operating performance. And I will return at the conclusion of our prepared remarks to wrap up and address your questions.

Peter Kasper Jakobsen

Thank you, Steve, and Good morning, everyone. I'll review the operating results and future expectations by segment, starting now with Asia and Latin America.

Second quarter sales grew 16% on a constant dollar basis versus prior year. Excluding our joint venture with SanCor in Argentina, sales were up 13% on a constant dollar basis. As we indicated in our last conference call, higher pricing contributed more significantly than in the recent half, adding 9% to sales growth with 7% from volume. Price increases were broad based across both Asia and Latin America. The 13% organic growth rate was down from 20% in the first quarter. Moderating growth in China was the key driver of this. We've cautioned since last July that sales growth would not keep up with the rapid pace of 2011. That is now evident.

We have seen both slowing category growth and a somewhat weaker market share during the second quarter. Let me now address each factor separately.

At a recent investor conference in Paris, Steve noted that industry growth was slowing in China. Nielsen retail data shows that the first quarter growth rate for both the category and the premium segment in which we compete was cut in half versus the prior year. The latest data would indicate that there has been no improvement in growth rates, as we move through the second quarter. While we recognize that growth in any emerging market can vary from period to period, we remain confident in China's and our own long-term growth prospects. The underlying dynamic that drive growth in our industry and our company remain unchanged.

Let me now address the topic of China market share. It is not uncommon for shares to fluctuate period to period, depending on the timing on competitor's relative price increases and on promotional activity. Bearing in mind that Nielsen captures only about 1/3 of the Chinese retail market, it appears our value share held relatively flat in the first quarter but declined between 1 and 1.5 points in the second quarter. We attribute this to the timing of price increases and promotional activity.

As I mentioned in our last call, we raised prices significantly in late April as we started to ship new product with higher expert recommended DHA levels. Our pricing action was designed to cover 2 years of cost inflation, as we did not increase prices in China during 2011. My experience tells us that temporary swings in market share are not uncommon during a price transition of this magnitude. Share often softens for a period of several months, but pricing is ultimately absorbed by the market. Importantly, price increases at retail lacked those to distributors and ours did not become apparent to consumers until mid-May.

As a result, we believe we may continue to see share pressure, as we move through the third quarter but expect share to strengthen in the fourth quarter. A very similar effect was seen most recently in 2008 when pricing was raised in response to significant increases in dairy costs. We do believe the impact of our price increase was exacerbated somewhat by more aggressive competitor promotions in advance of upcoming relaunches and by the generally weaker economic climate, which has adversely affected consumer spending.

At our Investor Day last October, we detailed the low level of system inventories held by our distributors and retailers in China compared to our competition. We believe this is important in maintaining price discipline in a market that is -- where it's not wholly uncommon for product to be bought and sold outside of normal channels by independent wholesalers.

In light of slowing growth for the category and recent softer market share, we are determined to constrain sales for distributors as necessary to prevent any buildup of excess inventory. This will affect the growth rate for the Asia/Latin America segment and the company in total during the third quarter in particular.

We expect to see a return to higher growth in China during the fourth quarter, as our product innovation and pricing takes hold. Our confidence is supported by the success of similar product upgrades launched late last year in both China and Hong Kong where we gain share as a consequence.

Turning to the rest of the segment. Strong double-digit growth was seen across -- during the second quarter across the majority of markets in the rest of Asia and in Latin America. In Southeast Asia, we delivered significant growth in Vietnam and in the Philippines, both markets where we have seen disappointing sales growth over the last 3 years. Thailand, our fifth largest market, has seen growth accelerate despite problem at a third-party owned facility, adversely affecting supply of ready-to-drink children's products. This problem will slightly reduce second half sales growth, but we expect to have the ready-to-drink supply fully restored before the end of the year.

Sales throughout Latin America were very strong. Excluding the impact from the Argentine acquisition, we posted constant dollar sales growth above the 13% organic growth rate for the segment as a whole. The Argentine acquisition is being rapidly integrated and performing in line with expectation. This further improves our growth outlook for Latin America. Please note, there was no earnings per share contribution in the second quarter from the joint venture as interest expense offset the profit contribution from operations.

Wrapping up the discussion in Asia and Latin America, we expect 2012 annual sales growth to approach the mid-teens on a constant dollar basis. While obviously lower than our earlier expectations for growth in the upper teens, this is still a very strong performance and in line with growth delivered prior to the record setting pace of 2011. But of course, I would like to note that this is off a much higher sales base and in a challenging global economy.

Although, we don't provide quarterly guidance, I do want to mention one additional timing factor that will affect second half sales comparisons to the prior year. We went live with SAP in Asia in October of 2011. And customers built their inventories in advance of that transition. As a result, third quarter comparisons will be tougher than those seen in the second quarter.

Turning now to the North America/Europe segment. We reported flat sales on a constant dollar basis. This is a significant improvement compared to the 11% decline seen in the first quarter. We continued to recover market share in the U.S., and pricing for the segment was up 5%. We gained in both North America and Europe. Volumes were down by the same amount. That drop can be almost entirely attributed to the U.S. business. The single largest factor for the comparative volume decline in the U.S. was the temporary benefit seen in the first half of 2011 from a competitor's product recall in late 2010. That factor is now largely behind us and will not affect sales comparisons in the third and fourth quarter of 2012.

Clearly, the second factor driving lower volumes was a share decline caused by the December 2011 media headline. In our last call, I mentioned the sales for the newborn SKU had recovered to pre-event levels. A newborn product had been directly associated with the misleading report and is used by infant under 3 months of age.

Further progress has been made in the second quarter. Market share among 3-month-old infants is now slightly above the level seen in the first quarter of last year. That's particularly good news by second half comparison because these infants will be aging into a heavier consumption period, giving us confidence in a complete recovery.

On a full year basis, we expect North America and Europe sales to be down in the low- to mid-single digits, a bit better than our earlier guidance. This reflects slightly higher market share expectations in the U.S. in the second half of the year.

To wrap up, I'm pleased with the continued growth in the second quarter from the emerging markets of Asia and Latin America and with a stronger recovery in the U.S. We have seen slower growth in China versus 2011 not only from the category but also from share pressure in the recent quarter. Our businesses weathered certain -- uncertainties in the past. Our strong brand equity, product innovation and our proven sales strategies give us confidence in our ability to restore share and to continue to prosper in this important market. I'll also remind you of our significant presence in Southeast Asia and Latin America. Both south [ph] regions are performing well and contribute together. Sales were an excess of the China-Hong Kong market. We have increased demand generating investment spending throughout our global portfolio, and we are committed to continuing these investments growth through the remainder of the year.

Let me now turn the call over to Pete, who will provide you with further financial highlights. Pete?

Peter G. Leemputte

Thanks, Kasper, and good morning, everyone. All my comments will focus on our non-GAAP results.

Kasper detailed our constant dollar sales trend, so I will concentrate on foreign exchange impact. During the quarter, the dollar strengthened against the euro and the Australian dollar, and also against 2 key currencies in Latin America, Brazilian real and the Mexican peso. But that impact was mitigated in small parts, as the dollar weakened slightly across Asia where we generate half of our sales. Overall, a stronger dollar reduced sales by about 2% in the second quarter. We expect full year sales to be reduced by about 1% from foreign exchange if current exchange rates are maintained.

Despite an unfavorable sales impact, there was no translation impact in our bottom line in the quarter. Remember, we source products for Asia in large parts from our plant in The Netherland and also from a third-party supplier in Australia. As we have limited sales in Europe and none in Australia, we have a short position with both currencies, driving a noticeable cost benefit when the dollar strengthened. This helps to offset the unfavorable foreign exchange impact on sales.

As I mentioned at our Investor Day last year, we also get some protection from the remeasurement of dollar-denominated balance sheet account in our overseas subsidy areas when the dollar strengthened. That occurred in the second quarter when we saw remeasurements gains of about $0.04 per share. Note that if the U.S. dollar were to weaken in the second half against the euro or Aussie dollar, these remeasurement gains could reverse in whole or in part.

EBIT margins of 25.2% of sales came in 70 basis points ahead of the second quarter of 2011. Driven by a 150-basis-point decline in gross margins, more than offset by a 220-basis-point reduction in operating expenses. If you look at segment EBIT margin, you'll see that we delivered 34.2% for Asia and Latin America, the same level as the prior year. And we reported a big improvement for North America/Europe compared to the prior quarter. EBIT margins in North America/Europe were 23.5% in the second quarter, basically double the 11.8% seen in the first quarter. We expect additional progress in the second half as our non-WIC market share recovers in the U.S.

Gross margins were 63.2%, down from 64.7% last year. The decline is completely attributed to the North America/Europe segment where we are facing significantly higher dairy costs in the prior year. Also, lower production volumes in the U.S. drove unfavorable fixed cost absorption, with higher pricing and good productivity gains providing some offset. Please note that the pricing gains in our emerging markets often accompany increased product innovation and as a result, do not necessarily translate into higher gross margins.

As we have moved through 2012, there has been a continued decline in stock prices for most dairy raw materials. Given that there is a 7-month lag on average between stock pricing and our cost of goods sold, any recent trends will not have a meaningful impact this year. And the one exception to weaker commodity prices has been lactose, which accounts for about 10% of our total dairy buy. Lactose prices are up over 60% versus last year. They have continued to rise in 2012, partially reducing the benefit from other dairy inputs.

While we expect to see some benefit from lower dairy costs as we enter 2013, it is quite premature to expect that benefit would continue indefinitely next year. For example, drought conditions in the U.S. are already driving up global grain prices. This will result in higher feed costs and will also increase agricultural oil prices for us as well. Ultimately, dairy costs may rise as a consequence.

On a full year basis, we expect gross margins to come in around 62.6%, a 20 or so basis point decline from our prior guidance. Since China carries higher gross margins, we see an unfavorable mix impact with softer growth in that market. Also note that the decline versus the 63% gross margins in 2011 is affected by the Argentine acquisition as I stated in our last call. SanCor will manufacture products for the JV and will retain some manufacturing profit as a result.

Operating expenses of 38% of sales were down by 220 basis points in the second quarter when compared with 40.3% in the prior year. We will note, this was not driven by any reduction in demand generation spending. Advertising and promotion expenses increased by 50 basis points to 14.7% of sales compared to the prior year.

And if you look at sequential operating expenses, apply the balance sheet remeasurement gains and pension settlement expenses, spending actually grew by $33 million or about 10% in the second quarter versus the first quarter.

The drop in operating expenses on a percentage of sales basis was largely driven by lower general and administrative costs coupled with a translation effect from the stronger dollar. G&A fell due to the elimination of shared service overlap cost seen last year before we completed the SAP installation and lower incentive compensation accruals.

I already mentioned the balance sheet remeasurement gains of about $0.04 in the second quarter. This was offset in large part by the timing of pension settlement expenses, which came in about $0.03 per share. Both items appear in other expenses and income on our earnings statement. Pension settlement expenses are triggered under accounting rules for our frozen defined benefit pension plan, when lump-sum payments exceed annual pension expense, forcing the immediate amortization of any deferred expenses for those retirees. Last year, the expenses were triggered in the fourth quarter. This year, it hit earlier due to the low interest rate environment, which employees will consider in determining the timing of their retirement. Low interest rate, obviously, drive a higher lump-sum payout.

On a full year basis, we expect operating expenses measured as a percent of sales to center around 38.8%, a slight reduction versus spending noted in our last call. Again, demand generation expenses measured in dollars is not being reduced from current levels in light of slightly slower projected sales growth. That would cause operating expenses to increase on a percentage of sales basis, but the effect is more than offset by favorable foreign exchange impact. And we're seeing slightly greater reductions in G&A expenses than previously thought.

Turning to taxes. Our effective tax rate or ETR for the second quarter came in at 25.8%, bringing our first half rate to 26.6%, down from 29.7% in the first 6 months of last year. On our full year basis, we now expect an ETR between 26% and 27%. Our prior guidance assumed a tax rate between 27.5% and 28%. The expected decline reflects a number of factors including a favorable geographic mix and higher manufacturing incentives. More importantly, we expect to sustain the lower rate in 2013 with potential for further reductions beyond. Our cash balance at the end of June was $787 million, up $127 million from March.

Capital spending consumed $50 million in cash during the first half of 2012 but is expected to pick up significantly in the second half, as construction is now underway in Singapore for our new spray dryer. This facility will allow us to more efficiently meet growing long-term demand in Asia. Full year capital spending remains unchanged at $200 million. Depreciation and amortization expense is estimated at about $80 million for the year.

We repurchased 330,000 shares of stock in the second quarter, bringing our year-to-date buyback to 550,000 shares, consuming $44 million of cash. The principal objective of our repurchase program is to offset the impact of dilution from employee equity reward. But we can and will be opportunistic around the timing of any buybacks. Our strong cash flow allows us to aggressively invest in our business, while returning capital to shareholders through a healthy dividend payout and share repurchase program. And for those who pay attention to book equity, you'll note that we ended the second quarter with our first positive balance of $2 million. That's a $900-million improvement from the deficit seen following our IPO just over 3 years ago.

Pulling all the numbers together, 2012 sales are expected to grow between 8% and 9% in constant dollars compared to the 9% to 11% in our last conference call. Constant dollar sales growth for Asia and Latin America is now expected to approach the mid-teens, but the North America/Europe segment is expected to be down in the low- to mid-single digits. Currency impact will reduce reported growth by about 1% versus the prior year. Growth rates in the third quarter for Asia/Latin America will be down notably versus the second quarter for several reasons, including the need to manage distributor's inventory tightly in light of slowing growth in China. In addition, net quarter sales comparisons for the segment will be unfavorably impacted by the timing from last year's SAP launch in Asia and supply shortfalls for our ready-to-drink product in Thailand. A healthier growth profile will return as we improve share in the fourth quarter.

We estimate the decline in full year sales growth would reduce earnings about $0.10 per share using the midpoint of our guidance. But we are maintaining our full year earnings estimate in a range between $3.04 to $3.14 per share. Softer growth is offset by a number of factors. First, we saw balance sheet remeasurement gains of $0.04 per share in the second quarter. Although there is some risk, the volatile situation in Europe has seen some of this reversed in the second half.

A lower effective tax rate is the second factor. An ETR of 26.5%, again using the midpoint of our range, will generate $0.05 and higher earnings versus our prior guidance. And additional G&A reductions add another $0.01 or so to the bottom line.

With that, let me turn the call back to Steve.

Stephen W. Golsby

Thank you, Pete. To conclude, despite near-term challenges, we remain on track to deliver the strongest earnings performance in our history with excellent emerging market sales growth. We remain confident in our strategies and our business model, as well as the continued category growth projections over the next several years and are increasing our investment to drive sustainable high performance.

With that, let me turn the call over to the operator to open the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Ken Goldman, JPMorgan.

Kenneth Goldman - JP Morgan Chase & Co, Research Division

To what extent are you surprised by the degree of the China slowdown in the category? I'm asking because infant formula is generally considered pretty a stable item. So are you just seeing fewer people entering the category as the middle class slows maybe? Or are some people actually exiting the category, who previously were in it, even if only temporarily? I'm just curious because if it's the latter, that might suggest the product is maybe less of a staple than perhaps we believe in that country? Or is that not even the right way to think about it?

Peter Kasper Jakobsen

Ken, this is Kasper. Thanks very much for your question. It's an excellent question of course. As you know probably even better than I do, GDP growth in China has slowed from above 8% to 7.5% or so, and this may cause a temporary slowdown in our industry as well. Because the children's business is more discretionary, we believe this segment of the category has slowed more than the infant category. Although, this may raise some short-term concerns, the outlook for the middle class is expected to continue to expand, and this certainly reinforces our belief in the long-term potential of the category. In other words, we remain very confident about the potential for the China business to be a much larger business in the long term. But we recognize that there are going to be periods of weaker growth as we move through that -- through those years.

Kenneth Goldman - JP Morgan Chase & Co, Research Division

And are you seeing people exit the category? Or is it fewer people entering?

Peter Kasper Jakobsen

I think it's a slowdown in -- a temporary slowdown in the number of people entering the category as a function of the economic slowdown.

Peter G. Leemputte

And that's backed up, Ken, by the fact that the market share decline is much more noticeable in later-stage formulas and the children's nutrition categories as opposed to infant formula.

Kenneth Goldman - JP Morgan Chase & Co, Research Division

Okay. Have you thought about lowering price, promoting more, taking some actions to preserve some volume in that -- in the children's category? Or is that not on the table right now?

Peter Kasper Jakobsen

As you can imagine, we've -- I think I mentioned in the sort of prepared remarks, that we feel very confident in the strategies that we have tested over many years in our category. We sort of understand what drives demand in this category and how it works. And we obviously are considering a whole range of options. But we are not panicking based on what we are seeing. We've seen these kinds of temporary fluctuations in market share before as relative pricing adjusts in the market, and we don't believe this is any different.

Kenneth Goldman - JP Morgan Chase & Co, Research Division

Okay. And then just one last one. To what extent -- I mean, given the GDP drop or deceleration, is this what you expected? Or is the deceleration in the category a greater deceleration than you might have expected? Because China is still growing pretty quickly, but if you're category gross was cut in half, that seems like a pretty extreme number. And I'm sure -- I'm just curious if this caught you guys offguard, and I'm not trying to be critical. I'm just curious if it was more or less than what may you have expected.

Peter G. Leemputte

Well, I think it depends on what point in time you're talking about. If you look at the Nielsen data quarter-to-quarter, you can see it bounce around. So we -- honestly, now in hindsight, the category in total has grown at a 7% rate literally from the fourth quarter of last year through today. So we've got 9 months of that and it's very difficult sitting in -- sitting here in January, for example, to say that, that was going to be the case. I think it's a bit softer than what we had expected 3 months ago. We would have expected it to be a little bit higher. So that is one of the factors that's driving us to reduce our top line sales growth, and the market share is the other piece of it.

Operator

Our next question come from Ed Aaron, RBC Capital Markets.

Edward Aaron - RBC Capital Markets, LLC, Research Division

In the prepared remarks, you mentioned kind of 2008 is maybe a comparable period where you saw a temporary share drop followed by a recovery after you took some price. How similar are the competitive dynamics today when you kind of consider any differences in how your competitors are behaving now versus then and also that the melamine crisis was a factor back then as well?

Peter Kasper Jakobsen

There's never a -- as one searches back in history in these situations, there's never a perfect example of -- that matches the current circumstances. But we believe it's a pretty good indicator. And it is very common to see some setback in volume when you make these kinds of adjustments. I guess, what is different is that the slowdown in China's general economy is obviously a unique factor that is prevalent now and was not present in 2008.

Peter G. Leemputte

And I would add to that, Ed, that -- but first of all, you mentioned melamine. That really was -- that happened after the price increase. The price increases we took were more in the first half of 2008, and it was in response to the dairy prices nearly doubling late 2007, early 2008. So it was more likely that our competitors were probably increasing price at that point in time. The other factor you compared to it right now, and we held off last year from the price increase as Kasper mentioned. And there's other competitor factors out there were discounting or promotional activity is at a relatively high level, particularly in advanced system product launches or relaunches that are going to happen by our competitors. So the dynamic is a little bit difficult -- more difficult, I'd say, today than probably in that period.

Edward Aaron - RBC Capital Markets, LLC, Research Division

And just as a quick follow-up, I just wanted to see if could maybe push for a quantification of the constant dollar growth that you expect in Q3 on a total company basis.

Peter G. Leemputte

We don't give quarterly guidance, but just if you do some simple math, take the midpoint of our sales guidance range, which is 8.5%. Then, compare it to the midpoint of the prior guidance to 1.5% decline in sales growth rate, so very significant growth for the company. You know that 1.5% equates to $55 million. And what I would tell you is that a good piece of that should come through in the third quarter. And layer on top of it, the SAP impact that I mentioned and the situation in Thailand, which is temporary, and you can come up with an estimate.

Operator

Our next question comes from Matthew Grainger, Morgan Stanley.

Matthew C. Grainger - Morgan Stanley, Research Division

Just 2 follow-ups on China. When you look across the scope of the market, we've obviously heard from other consumer companies that the slowdown in other consumer categories has been somewhat concentrated in larger coastal Tier 1 cities, a bit less of an impact in Tier 2, Tier 3. Is that consistent with how your business is performing? Are you seeing any shift from growth in new versus existing markets? And then, one sort of longer-term question, even as recently as January, I think when you were looking at the outlook, you referred back to the growth you saw during 2008 to 2010, sort of more in the lines of mid-20s to 30% growth as sort of a benchmark looking forward. Can you give us any sense of what you see as a level of sustainable sales growth in China once we get beyond the macro issues and the competitive issues we're facing now?

Peter Kasper Jakobsen

Matthew, this is Kasper. Thanks very much for the question. I don't think, as we look at our data, we would see enough of a difference between different tiers and different regions to try and characterize by region or by size or city the slowdown in the category. I mean, there are differences as there always are when you look at statistics and break them up, but I would be very cautious about trying to characterize that. And I do want to just mention that our business in Hong Kong continues to perform very, very strongly indeed, and so therefore, I'm a bit shy of jumping on characterizing it the way that you just did in terms of the coastal areas and the big cities. We don't give sales guidance, as you know, by country or by quarter, so I don't know that we want to get drawn into speculating about what the long-term sustainable growth rate is in any particular market we participate in. I'll let Pete comment if you'd like to add anything.

Peter G. Leemputte

There is nothing that we see that would give us pause in terms of expecting very solid and meaningful growth out of China in the longer term. Many of you were looking at the Nielsen data, which would show a volume decline in China last year. I would point out that when you consider what the growth at is seen in the Hong Kong market and most of that growth is going across the boarder into Southern China, we believe there wasn't really any meaningful volume decline and maybe a slight increase, number one. And number two, the thing I would refer you to support that thesis that we have is when you consider the consumption per infant for formula and for children's growing-up milk, China is at roughly 1/3 the level of the developed markets of North America and Europe. And we do think there should be both meaningful volume growth over time as well as price growth that we would drive from innovation.

Stephen W. Golsby

This is Steve. Without wishing to labor the point, I think this is so important. I will add and reiterate that I fully understand why people at a macroeconomic level are concerned by the slowdown in China, but we are talking about 7.5% GDP growth, and people by and large believe that will pick up again through next year. Secondly, we've been in this market for 20 years. We've built a leadership position with the market share of around 15%. We're talking about small fluctuations in the great scheme of time from that. And I think the fundamental demographics of the China market are incredibly compelling. Most statisticians believe that the middle class will almost triple in size in the next 20 years. And even if only one baby is born into each middle class family, that is significant category growth. There is also rumors, as Pete said, to drive consumption for infant. There's pricing potential, and of course, there's potential for us to grow share as we've done significantly in recent years. And we have great confidence in our science, in our quality and our business model. So I -- we're humble about our current experience, so we understand your concern, but you've got to put it into perspective.

Operator

Our next question comes from Eric Katzman, Deutsche Bank.

Eric R. Katzman - Deutsche Bank AG, Research Division

I guess the first question, Steve, when you made your presentation at our conference in Paris, you highlighted that the overall category growth expectations from 2012 to 2017, I actually think you raised those a little bit. But at the same time, you must have known that China was decelerating a bit. So maybe you can just kind of talk a little bit to the -- that global CAGR and why you still have comfort that, that was actually increased.

Stephen W. Golsby

Thanks, Eric. We were using ERC data, which we've done consistently over the last 3 years. We believe it's the best source of global category data. And what I showed in Paris, Eric, was a slight slowdown in percentage terms for the category to 7.5% over the next 5 years, and I, of course, described our ambition to grow ahead of that. I think what you may be remembering is the -- that in absolute dollars, of course, as the category will get bigger, then the growth becomes greater even though the percentage might slow little. Now you're right to say that ERC put those estimates together some time back, and I dare say they are now looking at Nielsen data in China and their own data sources, and we may see some modest revisions downwards in the short term. But I reiterate, I don't see any fundamental change in that outlook.

Eric R. Katzman - Deutsche Bank AG, Research Division

Okay. And then as a follow-up, Pete, I think you mentioned some of the factors that would offset the roughly $0.10 impact from the revenue shortfall. But you -- I don't think you mentioned an improvement in the U.S. market. Are you factoring that in at all? Or is that just kind of -- you're still -- that's coming in line with your expectation, so there is no change on that side?

Peter G. Leemputte

No, we factored that in as well. What I said was the net impact of slower growth and re-depth [ph] from the company's perspective, with a bit softer growth in China offset by a bit higher expectations for the United States. That was $0.10, so it was incorporated in that.

Operator

Our next question comes from Jason English, Goldman Sachs.

Jason English - Goldman Sachs Group Inc., Research Division

Shifting gears. Latin America. The growth sounds like it's pretty impressive. You're gaining momentum there. Can you talk to us or help us quantify the margin differential between Latin American and China?

Peter G. Leemputte

Sure. I think it's definitely lower in Latin America than it is in China. As we've said in the past, China has some of the highest prices we see in a global basis, some of that being driven by a very favorable foreign exchange rate with the dollar weakening. But -- and obviously, the cost of labor is lower than what we see in many markets in Latin America. I will tell you there just isn't a supply of sales reps sometimes in some markets like Brazil, so our labor costs tend to be a bit higher, and we tend to see slightly lower gross margins as well. So it is a bit lower, but I don't want to -- we don't quantify it by segment.

Peter Kasper Jakobsen

No, I can perhaps add, Jason, that if we look at the gross margin in our Latin American business, they are not materially different from our global average.

Operator

Our next question comes from David Driscoll, Citi Research.

David Driscoll - Citigroup Inc, Research Division

Steve, Kasper, can you just quantify for us what Mead Johnson sales growth was in China during the quarter?

Peter G. Leemputte

We don't give country information. Just take a look at what Kasper said, which was the segment growth on an organic basis went from 20% in Q1 to 13% in Q2. I will say it was very meaningful and double digit in China/Hong Kong.

David Driscoll - Citigroup Inc, Research Division

Okay. And then to follow up here, you made the very interesting comments about how the share progresses over the year. I want to understand a little bit more about your fourth quarter commentary. Basically, how can you be sure about increasing share in the fourth quarter? And then one point that may sound like a detail, but I think it's a bigger point, is this a year-over-year comment or a sequential comment? And then let me just finish off with one other thought, so you can see where I'm coming from. So it sounds like you think that this is a consumer acceptance issue on your new pricing scheme. However, if competitor pricing activity, i.e. higher promotion, hurt you in the quarter, then it would sound like the category has gotten more price sensitive and versus many conversations that we've had in the past, this seems like a fairly considerable change where past trends were definitively in China towards the premium category. Consumers were running away from those lower-priced products straight into your arms in the premium end, and so all of the commentary would seemingly suggest a fundamental change to how the consumer's behaving versus how they previously did. And then that would make the fourth quarter commentary that much more difficult to really get your arms around on the outside gear why its so logical that market shares should improve.

Stephen W. Golsby

Those are excellent questions, and you've asked several. I'll try to address them as best as I can, and Kasper and Pete will jump in. So in the current economic climate in China, you're hearing many companies talk about lower confidence in -- among consumers and lower spending, and we are clearly not immune to that. Generally, our category's less price elastic compared to other companies in food and beverage category, and I believe that's still the case. Although more than half of our business across Asia and Latin America and in China is in the discretionary children's category for children of above 1 year of age, over 90% of the market is now at premium prices. So the pricing sensitivity and promotional sensitivity we referred to is not trading between the low and premium-priced segment. It's trading within the premium segment. As we took pricing, coinciding it with innovation, but as competitors prepared for their own relaunches and promoted back their prices, those relaunches are happening now and in the next several weeks. We have confidence in the fourth quarter. You're right that we're talking about sequential share. So we're talking about an improvement from where we are today, a market improvement. We're confident because we have a lot of experience of how long it takes for pricing to adjust. We know what our competitors' strategies are. We know how impactful the Smarties [ph] relaunch has been in Thailand and Hong Kong. We are -- we only have one business, and China is our largest business. So you can imagine how determined we are, how focused we are on addressing this bump in the road. And I have every confidence that the people and the investments that we're putting into this will have an impact, David.

David Driscoll - Citigroup Inc, Research Division

And maybe just one final question for Pete. Did -- I apologize if you said it, Pete. But did you quantify what you the effect of the volume pre-buy was on your China business. I believe that occurred last quarter, so there would have been some kind of detrimental effect on volumes in the second quarter.

Peter G. Leemputte

The volume pre-buy with regard to dairy raw material? Are you asking with regards to...

David Driscoll - Citigroup Inc, Research Division

No. Pete, I thought that you announced the price increase in China, and that in the first quarter, your volumes in China benefited as customers bought product ahead of the implementation of the price increase, and that would have a second quarter effect as you would have lower volumes because they already bought some.

Peter G. Leemputte

Oh, I understand. Yes, basically the question is do we see any pantry loading prior to the price increase getting out. It's very difficult to say if we've seen that or not. It's -- we don't think there was a material impact from that factor going on.

Operator

Our next question comes from the line of Bryan Spillane, Bank of America.

Bryan D. Spillane - BofA Merrill Lynch, Research Division

Just a couple of points of clarification, I guess. First, in the Asia/Latin America segment for the quarter, sales growth x SanCor was up 13%. How much -- how did that affect the volume price mix split? Was SanCor all volume? Or did it also -- would it also have an effect on the price mix?

Peter G. Leemputte

Yes. It's a good question, Bryan. If you look at -- we reported 7% volume growth for Asia/Latin America. It would have all been volume. And when you do the math, SanCor accounted for about 1/3 of that 7%.

Bryan D. Spillane - BofA Merrill Lynch, Research Division

Okay. And then I think in the first quarter, you'd commented that China was up about 20% volume in the first quarter. So do you have a volume figure for China for 1Q?

Peter G. Leemputte

We don't give that. What Kasper indicated was that our price increase became effective in April, earlier in the second quarter. So most of what we would have seen in China/Hong Kong would have been pricing.

Bryan D. Spillane - BofA Merrill Lynch, Research Division

Okay. And then when we look at the third quarter, the -- I just want to make sure I'm clear on this point. The constraining or restricting distributor inventories in China, its not that they're carrying too much inventory. It's not that there's a -- there's like been a build up of inventories. It's just that you're trying to actually have them carry less inventory. Is that right? Meaning less that they normally would have.

Peter Kasper Jakobsen

No. I think we are absolutely determined to make sure they carry no more than they normally have. As the category has slowed down and as our share softened slightly, we obviously want to be absolutely sure that we don't sell in an amount of inventory that would cause them to exceed normal levels.

Bryan D. Spillane - BofA Merrill Lynch, Research Division

Okay. And then just the last point...

Peter Kasper Jakobsen

Sorry. To add to that, Bryan, but the -- I think we've taken a great amount of pride on keeping our inventory levels very tight. We believe that's really essential for both ensuring some kind of order in terms of pricing in the market, and we also just believe that it's good business discipline. We're not going to stray away from that philosophy in order deliver result in individual quarters. I mean, what we are focused on is running this business for the long-term good of the shareholders. We'll -- and we need to stick to that.

Bryan D. Spillane - BofA Merrill Lynch, Research Division

And then just one last question, given the -- there's a bit of -- there's a bump in the road. Is there any possibility that you'll increase your demand generation spending in China/Hong Kong, whether that's more marketing or merchandising or maybe being sharper on promotional price points? Is that an option that you have as you watch the situation evolve to actually increase your demand spending?

Peter Kasper Jakobsen

It's certainly an option that we have. We do believe that we are spending competitively and that we are in obviously kind of being such a fantastic growth opportunity for us. We are investing very aggressively in that market. We're not changing that stance materially, but it goes without saying that in a global portfolio and within a business of our size, we are constantly reassessing whether or not our resource allocation across geographies or across market is the right one. I don't know if that answers the question. We certainly have the ability to do it, but we are very happy with our investment levels also.

Stephen W. Golsby

I think as I wrap up the call, I'll just remind we've been public company for 3 years. We've been talking to you on these quarterly calls for 3 years. I'm -- I would encourage you to go back to some of the calls we had in 2009, 2010 and contrast the growth that we're delivering and guiding you towards now. And you'll see a very favorable comparison, and you'll hear us talk about similar bumps in the road. And our track record of overcoming them is impeccable.

So with that, I will thank you once again for your attention, your engagement, and we look forward to seeing you all soon. Thank you, operator.

Operator

Thank you. Ladies and gentlemen, that concludes the presentation. Thank you for your participation. You may now disconnect. Have a great day.

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