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Mead Johnson Nutrition (NYSE:MJN)

Q3 2012 Earnings Call

October 25, 2012 9:30 am ET

Executives

Kathy Ann MacDonald - Vice President of Investor Relations

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

Diane Geissler - Credit Agricole Securities (NYSE:USA) Inc., Research Division

Jason English - Goldman Sachs Group Inc., Research Division

Timothy S. Ramey - D.A. Davidson & Co., Research Division

Victoria Watson Collin - Atlantic Equities LLP

Bryan D. Spillane - BofA Merrill Lynch, Research Division

Amit Sharma - BMO Capital Markets U.S.

Robert Moskow - Crédit Suisse AG, Research Division

David Driscoll - Citigroup Inc, Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Mead Johnson Nutrition Third Quarter 2012 Earnings Conference Call. My name is Lisa, 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 third quarter conference call. Speaking today will be Steve Golsby, our Chief Executive Officer; Kasper Jakobsen, our Chief Operating Officer and designated CEO-elect; and Pete Leemputte, our Chief Financial Officer.

As we start, 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 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.

Given that you are in the midst of the earnings reporting season, we will be respectful of your time, and I will now turn the call over to Steve.

Stephen W. Golsby

Thank you, Kathy, and good morning. As you've likely read in our press release, Mead Johnson delivered sales growth of 1% on a constant-dollar basis in the third quarter. As described in our last conference call, we expected a low rate of growth in the quarter. There were 3 key factors that we said would impact our results. First, we described the loss of market share in China and the actions that we would take as a result. Second, we reminded you of higher sales in the third quarter of 2011, attributed to retailer purchases in advance of our Asia SAP implementation. And third, we stated that there would be lower sales in the second half of 2012 of our ready-to-drink children's product in Thailand, resulting from a temporary supply disruption.

Since China is the most significant of these 3 factors, let me offer a few brief comments on that important market. We attribute a significant part of the China market share loss to a double-digit price increase that accompanied the second quarter launch of a product upgrade, raising DHA to expert-recommended levels in our children's products.

Our pricing action was designed to cover 2 years of cost inflation as we did not increase prices in China during 2011. Typically, with a price increase of this magnitude, we will see a temporary drop in market share, but the impact was exacerbated by more aggressive price promotions by competitors.

As a result of lower-than-anticipated share and slower category growth in the food and baby store channels, our distributor inventory have grown. Consequently, we worked with these distributors and constrained sales to levels below retail demand in the third quarter.

While lower market share and distributor inventory reductions in China obviously impacted our sales growth, we are very pleased with the progress on both fronts, with further improvements expected in the fourth quarter. Kasper will provide a more detailed update shortly.

Turning back to our financial results, the reported 1% growth in constant-dollar sales does not provide a full understanding of our underlying performance. When you exclude the impact from distributor inventory reductions in China, eliminate last year's benefit from higher shipments to customers in advance of our Asia SAP launch, as well as the impact from the Thai supply disruption, sales growth for the company in the third quarter would have approached 6.5%.

Beyond China, we once again delivered strong double-digit sales growth in the emerging markets of Southeast Asia and Latin America. One particular highlight was the exceptional organic growth in Latin America, complemented by the strong performance of our recently acquired business in Argentina.

Sales in the developed markets of North America and Europe saw a 4% decline, with tougher comparisons in Europe following our distribution model change in 2011. Our U.S. market share continues to improve, but category sales year-over-year have been influenced by a decline in infant formula consumption and slightly lower births.

Non-GAAP earnings of $0.71 per share were down 9% from the $0.78 per share reported in the third quarter of 2011. Earnings were lower from an unfavorable foreign exchange comparison, heavier investments in advertising and promotion, along with the timing of pension settlement expense. These were partially offset by lower general and administrative costs and a lower effective tax rate, reflecting in part a sustainable rate reduction compared to 2011, as well as a nonrecurring benefit arising from factors associated with prior year's earnings.

When we entered 2012, we indicated that we would make larger demand-generation investments and have done so. A&P spending was 15.1% of sales in the third quarter and stands at 14.2% of sales on a year-to-date basis, up from 13.5% in 2011. We plan to continue to increase our investments in demand creation given our strong belief in the sustainable growth of the business despite short-term challenges and lower growth in the second half of this year.

Turning to our full year outlook, we will have another challenging comparison in the fourth quarter. Despite the expected further recovery in China market share and the resulting improvements in sales growth rates for the Asia/Latin America segment and the company, compared to the third quarter, we will continue to work with our Chinese distributors to further reduce their inventory. We remain committed to entering 2013 with the China inventories at a reduced and appropriate level, well below the industry average, to support the business moving forward.

We now anticipate reporting full year global sales growth in a range from 6% to 7% on a constant-dollar basis. When compared to our prior guidance, the decline in sales growth is largely attributed to China. Since we have delivered 7% global sales growth on a year-to-date basis, the midpoint of our full year sales guidance implies that the growth rate in the fourth quarter was still below the full year average due to the actions I have described to further reduce distributor inventories in China.

Nevertheless, we project improving end market sales in the fourth quarter and growth will be higher than the third quarter as we continue to make progress recovering market share in China.

We expect non-GAAP earnings, on a full year basis, to be in the range of $3.02 to $3.07 per share. Pete will go into more detail shortly, but reduced sales growth is the biggest contributor to the change in our estimates.

It should be noted that the midpoint of this range is consistent with our original guidance in January, with volatility in China accountable for changes issued.

I'll now turn the call over to Kasper, who will provide more details on our operating performance. After Pete reviews the financials, I will return to close our prepared remarks and address your questions.

Peter Kasper Jakobsen

Thank you, Steve, and good morning, everyone. I will review the operating results and expectations by segment, starting firstly with Asia and Latin America. Third quarter sales for Asia/Latin America grew 3% on a constant-dollar basis versus the prior year, with price contributing 8% to growth, while volume declined by 5%.

The key drivers of the volume decline came from a, our determination to reduce distributor inventories in China to match consumer demand; b, the 2011 SAP-related pre-buys in Asia; and c, the temporary supply disruption to our ready-to-drink products in Thailand.

These 3 factors combined reduced sales growth for the segment by 8 percentage points. While the loss of market share in China was a further contributor to the volume decline, it was more than offset by solid gains in the rest of the Asia/Latin American segment and by contributions from the acquisition in Argentina.

Turning now to a bit more detail on China. Final market share data, now available, shows that we lost close to 3.5 points of market share from the beginning of the year to our low in the middle of this year. I shall return to this topic and improvement seen since shortly.

Before I do, let me remind you that during our last conference call, we highlighted the need to help our distributors reduce their inventory levels given the drop in our market share and somewhat slower category sales growth seen in the first half of the current year.

Our distributors paid cash in advance, and we pride ourselves on keeping inventories at industry-leading low levels. We believe this is important for maintaining price discipline in a market where it's not uncommon for a product to be bought and resold outside of normal channels by independent wholesalers.

We are also committed to the continued profitable growth of our distributors. To this end, we've identified additional opportunities to manage inventories more efficiently going forward. Consistent with these commitments, I'm happy to report our distributors made excellent progress on reducing inventories within the third quarter, and our distributors ended the quarter with inventories at or below the China industry average. Despite this, further inventory reduction is anticipated for the fourth quarter to ensure that we enter 2013 in the strongest possible position.

I would now like to talk more specifically about current competitiveness and the evolution of underlying Chinese consumer demand for our products. As Steve mentioned, a double-digit price increase in the second quarter in the midst of heavier promotional activity by competitors distorted our relative pricing and caused us to lose share. We continue to see a higher-than-normal level of discounting activity in the marketplace, and given competitive dynamics, it's likely that we continue in the near future.

During our last earnings call, we spoke of the remedial strategies we were putting in place to recover share in China, including increased promotional pricing activity and heightened focus on trade execution. I'm very satisfied to report that these strategies appear to be working as anticipated. And by third quarter end, we had recovered 2 full share points from our midyear lows. We are very pleased with that improvement, and we expect to deliver further gains as we close out 2012. I would like to add that despite some temporary promotional activity, we have sustained the price increase in the mid- to high single digits in China.

The exact pace of further share recovery is naturally difficult to predict. Share will fluctuate from months to months, depending on competitive dynamics. And we will obviously want to see share gains sustained over some months before declaring success, but we are satisfied with our most recent progress.

Despite improvements during the quarter, our average market share in China remained flat between the second and third quarters. But with the improvements we've made during the third quarter, we are confident that our average share will be higher in the fourth quarter. We also remain optimistic about our business in China. An increasing number of babies are still being born into middle class families, and market dynamics will return to normal. And we believe that long-term market share growth will ultimately be driven by product innovation and strong brand equity rather than temporary price activity.

To conclude my comments on China, based on the appeal of our recently launched product upgrade and improving market share, we expect the fourth quarter to see better sales growth than the quarter just completed.

Turning now to the rest of the Asia/Latin America segment. Outside of China/Hong Kong, we delivered double-digit constant-dollar sales growth during the third quarter, with strong performance across Southeast Asia, including the key markets of the Philippines and Vietnam.

Organic growth in Latin America was above levels seen over the last 5 years and the highest in the segment. Our March 2012 acquisition in Argentina added further fuel to our expansion in the region. Other highlights from our Latin American business include strong share gains in Mexico since the beginning of the year based on recent innovation, continued market share growth in infant formula in Brazil and further strengthening of our market share in Colombia.

Wrapping up the discussion on Asia/Latin America, we expect 2012 annual sales growth of the segment to run in the low double digits on a constant-dollar sales basis.

Turning now to the North America/Europe segment, we reported a sales decline of 4% on a constant-dollar basis. Volumes were down by 7% but offset by price improvements of 3%. Europe was a significant contributor to the volume decline.

In the third quarter of 2011, we saw some inventory reloading as we began to operate a new distribution model. Compounding this effect, challenging economic conditions across Europe have caused some governments to tighten reimbursement parameters for our specialty products, forcing the category to shrink in select markets.

You will recall that the majority of our sales in Europe are from widely-reimbursed Nutramigen brand. Over the past few years, our European business has been challenged for both growth and profitability. Through 2012, we are taking steps to refocus our Western European business around our competitively superior, market-leading allergy franchise, Nutramigen. Cow's milk allergy is on the rise globally and in Europe, and once reshaped, we believe we can grow our European business profitably in this segment. As a result, we are in the process of reorganizing our European operations and incurred a specified item charge in the third quarter. This expense is excluded from our non-GAAP results.

The U.S. accounted for the balance of the volume decline, driven by the residual impact from the unfounded media scare in December of 2011. We estimate that the impact peaked around July, when the affected cohorts of babies reached the age of maximum consumption. Recent share data indicate the impact is tailing off as expected as we move into the fourth quarter. Our U.S. market share recovery remains on track. In our last call, we noted that our share amongst newborns and 3-month olds had already recovered from the media event. Market share reported by Nielsen is now beginning to reflect these improving trends.

Our share recovery reaffirms the inherent strength of our U.S. organization and our executional ability. It has been helped by the introduction earlier this year of a strengthened lineup of liquid product offerings spanning the age range from prematurity to toddlerhood. Where introduced, we are seeing incremental share improvements in the liquid segment, where we have historically been relatively weak.

As previously discussed, the U.S. market remains under pressure from declining birth and lower consumption. We, however, retained the view that the market is set to rebound as the economy improves over time.

On a full year basis, we expect North America/Europe segment sales to be down in the mid-single digits on a constant-dollar basis. In summary, we made good progress in improving our share position in the U.S. and China during the third quarter, while continuing to deliver rapid growth in our other emerging markets.

While we are targeting further reductions in China distributor inventories in the fourth quarter, we will continue to invest in demand generation across geographies to drive longer-term growth for our business.

With that, let me now turn over to Pete, who will provide you with further financial highlights. Pete?

Peter G. Leemputte

Thanks, Kasper, and good morning, everyone. My comments will focus on our non-GAAP results. Kasper highlighted constant-dollar sales trends, but let me begin by discussing the impact of foreign exchange on sales.

The dollar was stronger on average against many Latin American and Asian currencies in the third quarter of 2012 versus 2011 and, therefore, reduced sales by about 2%. For the full year, currency will reduce sales by 1% if current exchange rates are maintained. As Steve highlighted, EPS of $0.71 per share was below the $0.78 we reported in the third quarter of 2011. The single biggest driver of lower earnings accounting for the full $0.07 decline was related to the impact of foreign exchange on dollar-denominated balances in our manufacturing operations outside of the U.S., most notably our plant in The Netherlands. In the third quarter, currency movements generated $0.02 per share in balance sheet remeasurement losses. Note that this impact was not specifically included in our prior guidance. In contrast, we saw $0.05 of balance sheet remeasurement gains in the third quarter of last year.

As always, there were a number of other puts and takes that affected the third quarter EPS comparison to 2011, including the following. Third quarter gross margin was down on a reported basis from 61.6% last year to 61.2%. Excluding the impact of foreign exchange, this cost us about $0.02 in lower earnings. The decline is completely attributed to the North America/Europe segment, where we faced higher dairy costs in the prior year. Also, lower production volumes in the U.S. continued to drive unfavorable fixed cost absorption. I'll have more to say in gross margins in a minute.

Constant-dollar advertising and promotion spending increased by 9%, reducing earnings by $0.04 per share, in support of new product launches not only in China but also in a number of other important markets.

We delivered a $0.02 reduction in general and administrative spending from lower incentive compensation accruals and productivity initiatives. We have been more aggressive in driving G&A productivity in light of slower sales growth. Offsetting this benefit, however, was an additional $0.02 increase in pension settlement expenses in the third quarter. These are triggered when cumulative lump sum payments exceed annual pension expense. The trigger was seen in the second quarter of 2012 compared to the fourth quarter in 2011, due in part to the low interest rate environment, which obviously drives higher lump sum payouts.

Finally, we realized a $0.06 per share benefit arising from 2 prior year tax items. First, we reduced our 2011 tax provision to reflect the September filing of our final U.S. federal income tax return. Second, we made significant progress in our cash repatriation planning, and have concluded that more of our historical earnings can be kept offshore. Note that the $0.06 from these 2 items is completely attributed to prior year's results and, therefore, will not recur in the future. Also, they had not been included in our July earnings guidance.

Absent the 2011 tax impacts, we continue to expect our full year tax rate will run between 26% and 27%, consistent with our guidance in our last conference call and our year-to-date effective tax rate of 26.2%. That's down significantly from 28.5% in 2011. And note that we believe a rate between 26% and 27% will be sustained in 2013.

Turning to our latest full year guidance, we now expect constant-dollar sales to grow between 6% and 7% compared to 8% to 9% in our last conference call. Asia/Latin America is now expected to see constant-dollar sales growth in the low double digits, with the North America/Europe segment expected to be down in the mid-single digits.

As I mentioned earlier, currency impacts will reduce reported growth by about 1% versus the prior year. Please note that the 2012 trend in China's quarterly sales will impact our 2013 comparisons. Our market share was highest in the first quarter of 2012, down in the second and third quarters on average, and we expect to see solid fourth quarter improvement, with much of the recovery already delivered.

In addition, the reduced share led to an increased in distributors' inventories during the first half of 2012 and conversely, a correction through lower sales in the second half of the year. As a result, we expect our first half comparisons in 2013 will be more difficult than the second half.

We expect gross margins for the current year to average about 62%. That's down about 50 basis points from our last call and reflects the impact of both lower sales in China, which carry relatively high margin, and the initial impact from unfavorable fixed cost absorption from lower production in plants serving China.

Note that the fixed cost absorption issue will continue into 2013 since we'll be manufacturing products throughout the fourth quarter that carries a higher overhead burden from lower production rates. These products will be carried in inventory through year end and will not be sold until early next year.

Our long-term target of gross margin remains at 63% for the company. As we move through the distributor inventory reductions and see further share gains in China, sales will stabilize at a higher level and production rates will increase correspondingly. And remember that we also temporarily reduced production rates in the U.S. this year as we carried higher internal inventories due to the temporary share loss from the December media issue.

Productivity remains an important lever for us to meet our gross margin target, and we have the pricing power to offset inflationary trends in emerging markets. In both the third quarter and year-to-date, we achieved a global price increase of 6%. On a full year basis, operating expenses, measured as a percentage of sales, remains around 38.8%. Our earnings guidance of $3.02 to $3.07 per share for 2012 tightens and lowers the range from $3.04 to $3.14 that we detailed last quarter. The lower sales growth for the year is obviously the key factor at work along with a lower gross margin, partially offset by lower expenses, predominantly for general and administrative spending. Also, the $0.04 benefit from reduction in prior year's tax accruals, net of the third quarter balance sheet remeasurement loss, was not included in our prior guidance.

Our cash balance at the end of September was $958 million, up $171 million from June. The increase was attributed to a $155 million temporary drawdown on a revolving credit facility due to cash needs in part related to the ultimate retirement of debt associated with our Argentine acquisition and our investment in the new Asia spray dryer. The incremental borrowing will be paid off over the next several quarters.

Capital spending year-to-date is $73 million but is expected to reach about $175 million for the full year, lower than our prior guidance of $200 million as fourth quarter spending ramps up on the Asia spray dryer. Depreciation and amortization expense is estimated at about $75 million for the year.

During our prior earnings call, I mentioned that we might be opportunistic around the timing of our share buybacks. In our 10-Q that will be issued today, you'll see that we repurchased 676,000 shares of stock in the third quarter, consuming $49 million in cash. That's more than we repurchased in total during the prior 2 quarters, and it's evidence of our belief in the longer-term growth opportunities for Mead Johnson. Our strong cash flow allows us to invest heavily in our business while returning capital to shareholders through both dividends and the share repurchase program.

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

Stephen W. Golsby

Thank you, Pete. While we face some operational challenges in the short term, our financial estimates for the year would still deliver 6% to 7% revenue growth and record earnings in a difficult global economic environment. We are confident in our ability to overcome these challenges successfully and expeditiously, taking all necessary actions and already seeing significant progress.

Success is never a straight line. We retain an unwavering belief in the long-term sustainable and profitable growth of Mead Johnson and in our business model, our strategies and our people.

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

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Ken Goldman with JPMorgan.

Kenneth Goldman - JP Morgan Chase & Co, Research Division

So can we talk about the U.S. a little bit? I think it's right to assume, and correct me if I'm wrong, that the U.S. was down meaningfully, too, despite a -- it looks like an easier comparison. So I'm curious, if that is correct, what happened here to drive such a sudden change. And I was a little surprised to see you blaming the Cronobacter scare a little bit. You hadn't mentioned it for a while. I thought that was behind you, especially since you're now talking about market share gains in the U.S. So if you could just talk about that a little bit and add some color, that would be helpful.

Peter Kasper Jakobsen

Ken, this is Kasper. Thanks very much for the question. It's an excellent question. I do believe that we have taken this group and other groups through the impact of the Cronobacter scare that we had previously. But let me just remind you that we said at the outset that the impact from this would be greatest in the third quarter, when the affected cohorts would reach the age of 6 to 9 months, which is the age of peak consumption for infants. So sort of simply put, most of our market share is driven by infants that are between 6 and 9 months of age, and therefore, it follows from that, that to some degree, to date, sales are substantially driven by actions and events that really unfolded 6 to 9 months ago.

Kenneth Goldman - JP Morgan Chase & Co, Research Division

So you expected, going into this quarter, to see volumes down to this degree?

Peter Kasper Jakobsen

We were certainly expecting that our market share would come under pressure. We also know that there are other factors at play. Notably, this is the last quarter we are out of the Catalina couponing project, I guess you can call it, as we now come back into this program in the fourth quarter, which sort of, historically, has helped our market shares as well as we go into the fourth quarter.

Kenneth Goldman - JP Morgan Chase & Co, Research Division

Okay. I'm just a little confused because you did lower your -- I think you lowered your guidance for the top line for U.S./Europe today from down low single digits to mid-single digits and now just down mid-single digits. So something changed. I'm just curious if you could -- what it was. Was the category worse than you thought? Just help us understand a little bit what's driving your guidance change there.

Peter G. Leemputte

Sure. This is Pete, Ken. Frankly, I think the -- Kasper talked about in Europe how the government reimbursement for specialty projects has come under pressure due to budget constraints in many markets, and that's been a little bit tougher than what we had expected. And remember, 1 point of share for North America/Europe is probably the equivalent of something under $10 million, so the level of accuracy, I think, that we have can be quite tough. As Kasper said, too, the market share in the U.S. continues to increase. We're seeing that where we want to see it. We're exiting the quarter with higher share, and we feel comfortable there. We're making good progress.

Operator

Your next question comes from the line of Ed Aaron with RBC Capital Markets.

Edward Aaron - RBC Capital Markets, LLC, Research Division

It sounds like in China, there was more of a surprise on your end from the -- on the distributor de-loading side than on the consumption side. But it would kind of seem that the appropriate level of inventories is directly tied to customer demands. So I'm just trying to reconcile those 2 things. Can you provide some color there? And then also, if, perhaps, you can quantify what the full year impact of the inventory reductions will be on sales, that would be helpful, too.

Peter G. Leemputte

Yes, let me take that last question first. And we don't want to give you a specific number here. The majority of our reduction in our sales growth for the year is attributed to distributor inventory reductions that we intend to take in the fourth quarter. And once we get beyond that, you're not going to see it. But I think it was mentioned during the comments by Steve and Kasper. We did see a slightly higher share decline in the second quarter than what we had estimated. You may recall in our last conference call, we said we estimated it between 1% and 1.5%. That came in a little bit higher than the top end of that range. And while it's not very big in terms of kind of a share differential, when you look at a market the size of China, it has some impact on sales overall. But if you say that we're slightly over 1.5%, that represents roughly 10% of the total share points that we have in China proper, and for a $1 billion-plus business, that's $25 million. So that is a big component of what -- of the distributor numbers for the full year. Layered on top of that, as we've discussed, for the food and even baby store channels, we have seen lower growth. I mentioned in our last call that it was running in the mid-20s last year. It's been cut roughly in half, and that results -- it could result in an extra week or 2 weeks of inventory sitting in retailers that ultimately will be reflected in distributor shipments. So that's kind of a second point there. And then I think, as Kasper said, as we went through a very thorough review in light of what was going on, we identified some additional opportunities for inventory reductions on the part of our distributors to improve their efficiencies. So it's the combination of all those, but it's meaningful dollars. In terms of your first question, when you sit back and look at the increase in distributor inventory, you're right in pointing out 2 things. That's driven by, first of all, the actual higher level of dollars that are there, and then there's the impact of the fact that you also will have a change in -- a reduction, as we saw in the second quarter, and some improvement in the third quarter for higher sales per day at retail. Remember, distributor inventory has 2 factors: what we sell in and then what is sold out ultimately by consumers. And both affect it. But when we look at the increase that we had, 70% of that increase came from the higher dollar value of the inventory that was out there. 30% or even a little bit less was related to the daily sales rates. So the vast majority of what we see is really coming from that factor, not in improvement in the retail sales, if you will, at the end of the third quarter.

Operator

Your next question comes from the line of Diane Geisler with CLSA.

Diane Geissler - Credit Agricole Securities (USA) Inc., Research Division

I just wanted to ask on China. I've had a lot of discussions with clients over the last few weeks, particularly with regard to all the messaging that was done during September about inventory levels, et cetera, and just the feedback I've gotten is sort of everybody expected Mead Johnson to have sort of like the best intelligence on infant formula in China. And there's been a lot of questions about why would you institute a double-digit price increase back in May, June, when it looked like the category was getting promotional and it looked like inventories were a little bit higher than what they should have been. And also a lot of questions about -- I thought distributor inventory levels were kept at a minimum anyway. I mean, my understanding was that they were 5, 10, 15 days of inventory in the channel at any given time. So can you talk about sort of how far out of whack they had gotten before you made the determination that you needed to do something about curtailing the level of inventory within the channel?

Peter Kasper Jakobsen

Diane, this is Kasper. Thanks for the question. Let me firstly talk about the price increase that we announced into the trade in China in April. So you will recognize that having announced the price increase in April, this was prior to the sort of increased promotional activity hardening up in the category in China. I think we are very humble about the fact that we clearly got that price increase or the magnitude of it wrong. We mistimed, at the very least. And I'm not going to try and defend that. I think we recognized that. We've taken actions to realign our pricing to make sure we stay with what we call our strategic pricing relativities in the market. And, as I just mentioned, we are happy with the progress that we've seen since we've done that, with us regaining well over half of the share we lost between the beginning of the year and midyear. So that's maybe addressing your point on price. Let me talk a little bit about inventories. You're quite right that we pride ourselves on our commitment to maintaining inventories at appropriate levels at all times. And when and if we discover that inventory levels have gotten out of whack with that philosophy, we are absolutely determined to take prompt action to bring them back in line, and that sometimes includes giving unpopular messages, I guess. But inventory, as you correctly say, is always relative to what your demand is, your retailer demand. So it was less about -- what we've seen was less about us increasing inventory than it was about the fact that when our demand dropped through the second quarter towards midyear, a fixed amount of inventory that was sitting in our system effectively came to represent a higher-than-appropriate amount of forward cover for our distributors. That obviously affects them and it affects their profitability and it just affects the general efficiency of the entire supply chain. And therefore, we are taking the necessary steps to address that promptly. So I hope you feel that gives you some kind of clarity on the issue.

Diane Geissler - Credit Agricole Securities (USA) Inc., Research Division

Well, I just -- I'm curious because I think the $55 million that Pete referenced in the second quarter earnings call, and now you've taken down your total sales guidance by 2 percentage points, if I'm not mistaken, which would suggest another, call it, $75 million, most of which you said is related to China, although you do have some commentary about North America/Europe being weaker than anticipated. So that suggests, all in, that the China business sort of was originally sort of overbooked by about $125 million. Am I looking -- in sales, which would be 12% to 15% of your sales based in China. Am I looking at that incorrectly or...

Peter Kasper Jakobsen

I think just 2 quick points. First of all, keep in mind that the market share loss in the second quarter, more than half of that came through in the last month of June. And you don't respond -- you can't make corrections that quickly. Second of all, with regard to -- your math is right about what's the reduction in sales for the company. It's about $70 million. It's not a $70 million reduction -- increase in further inventories. And if you recall, too, the $55 million was a big number, but it was driven by -- we weren't going to all get it in the third quarter. The only other thing I would point out is that we're taking our guidance back to where we had it in January, $3 to $3.10. And certainly, the numbers have come down from lower sales growth than we anticipated earlier in the year with other offsets, but we're in pretty good shape, we think, coming out of this year.

Operator

Your next question comes from the line of Jason English with Goldman Sachs.

Jason English - Goldman Sachs Group Inc., Research Division

I guess I'll turn my attention to Europe really quick. That was a surprise to me in regards to the reimbursement change. When did that reimbursement change happen?

Peter Kasper Jakobsen

It's been a topic that has been sort of evolving and, indeed, continues to evolve, as you are probably aware and can well imagine. Many of the European governments are undergoing a constant review of their expenditures and are, hence, looking for ways to constrain expenditure on healthcare-related reimbursements. So this is a topic that is in constant evolution, and we are, indeed, in several countries, in sort of continuous discussion with the governments on reimbursement levels. Poland would be an excellent example of that. So I would say it's a constantly evolving topic.

Jason English - Goldman Sachs Group Inc., Research Division

But in terms of timing, this is the first time you talked about it. Is it fair to assume that this is a challenge that's going to persist for, at least, the next 3 quarters until you cycle this?

Peter Kasper Jakobsen

I think it's fair to say that this pressure is going to remain in Europe for some time, but we believe that we've digested most of the pressure within the third quarter.

Jason English - Goldman Sachs Group Inc., Research Division

But from a year-on-year perspective, it's still -- am I misinterpreting it, or should we expect year-on-year pressure in Europe for the next few quarters? And related to that, is it right to assume that Europe is around 10% of aggregate North America/Europe segments? And then how big was it down this quarter?

Stephen W. Golsby

I think you're maybe becoming overly focused on the reimbursement change, and I just want to draw your attention back to the fact that a larger impact was from the change in our distribution model in the base year, which, obviously, we are lapping now, so that's not going to be with us in the next quarter.

Jason English - Goldman Sachs Group Inc., Research Division

Okay. So Europe gets better from here, most likely.

Operator

Your next question comes from the line of Tim Ramey with D.A. Davidson.

Timothy S. Ramey - D.A. Davidson & Co., Research Division

On the increase in DHA in the Chinese product line, how does that stack up versus most of the market? I know you said you spend a lot more on advertising and promotion. Is that messaging effective with consumers right now? And where is it at relative to the U.S. levels of DHA in the product?

Peter Kasper Jakobsen

Yes, I mean, most of the change occurred in our children -- in the level of DHA in our children's products, so that's a much larger component of our business in our emerging markets than it is in the U.S. And we raised the level significantly. And I believe that on previous calls, we've alluded to the fact that this is a global innovation that we have launched in several other markets, including Thailand and Hong Kong, where we've seen it be very successful. So we're very confident that the message is resonating with consumers, including consumers in China, I may add. And we feel very good about the change, and we feel good about the underlying value that, that's adding to our brand equity.

Timothy S. Ramey - D.A. Davidson & Co., Research Division

And relative to the rest of the market for children's growing-up drinks?

Peter Kasper Jakobsen

We would be at the highest level of DHA in the marketplace now, if that's what you mean.

Operator

Your next question comes from the line of Victoria Collin with Atlantic Equities.

Victoria Watson Collin - Atlantic Equities LLP

I wonder if you could talk a little bit about the promotional activity that you mentioned in China and Mead's position in terms of taking up promotional activity yourselves, whether this relates to the premium category, where you currently exist, or where you feel that there's any need as well to move into the super premium or mass -- if you are seeing heightened promotion in your particular category in general. And then I wonder as well if you could talk a little bit about the growth rates for the market, if you wouldn't mind. I think last quarter, you mentioned that Chinese growth rates had slowed a little bit maybe to 7.5%. Could you quantify what the changes you've seen in the last quarter equate to relative to that number and also how you see -- whether some of this is the one-off impacts of regime change or whether this is a more structural shift that we're seeing in the Chinese consumer?

Peter Kasper Jakobsen

Yes, we don't believe that there's a structural change taking place in the marketplace. We are still seeing the premium category as growing, and therefore, we believe that we are in the right segment in the market. We'll continue to change in that direction. We previously said, in relation to the merits of entering super premium, that we feel that unless we can bring true signs to that segment that justifies charging the consumer double the price, we do not believe it's consistent with our values to enter that segment. We are sticking with that view and remain concerned that any growth in that segment may not be sustainable unless it's underpinned by science. In relation to the category growth, we've spoken to you about that before. We remain very excited about the growth prospects in China. We think the growth prospects are very healthy, but there's little doubt that the Chinese economy has slowed somewhat, even though, I guess, the latest economic data out of China is, perhaps, somewhat more encouraging. And with that, the category growth versus what it was, say, a year or 18 months ago has slowed somewhat, but I should say that it still remains pretty strong.

Operator

Your next question comes from the line of Bryan Spillane with Bank of America.

Bryan D. Spillane - BofA Merrill Lynch, Research Division

Just one follow-up and one question, just -- and a follow-up in terms of the commentary on price promotion in China. I just want to make sure I understood it correctly. At this point, you're at a price point where you believe you've struck the right promotional balance in terms of restoring market share. You're not implying that you might have to promote for some more. Is that correct?

Peter Kasper Jakobsen

That's correct.

Bryan D. Spillane - BofA Merrill Lynch, Research Division

Okay. And then second, just for Pete. As I've just gone through the press release and listening to the commentary, I just want to make sure I'm capturing some of the kind of the one-off headwinds going into next year. I guess we're lapping what will be a lower tax rate, will be lapping higher compensation expenses, I guess some overhead absorption, the effect of having higher-cost product gets pulled into next year, the spray dryer expense. And then I guess also in this quarter, we have the gain on sale of non-core intangibles, which I'm not sure how big that was. But have I captured, at least, all of some of the unusual items that will affect the first half and maybe part of next year as we try to model '13?

Peter G. Leemputte

Yes, I think you have. Let me just first point out that that gain on the sale of some intangible assets was not included in our non-GAAP earnings. So if you're focused on that, that's not going to be an issue. We are going to see, as I mentioned, lower growth in the first half of the year, higher in the second half. You will see a $0.04 to $0.05 impact from startup expenses associated with the spray dryer, which is temporary, and that will dissipate significantly in 2014. There will be some carryover impact from lower production rates in the fourth quarter for China. It isn't huge, though. I wouldn't get overly focused on that in terms of a big impact on our overall earnings.

Operator

Your next question will come from the line of Amit Sharma with BMO Capital Markets.

Amit Sharma - BMO Capital Markets U.S.

I just want to focus on dairy environment. I understand that you have a 7-month lag, but dairy prices are continuing to rise since summer both here and in Oceania as well. So as we look into '13, given that pricing would probably be moderate, if anything, should that be a concern on the gross margin line?

Peter G. Leemputte

Well, first of all, remember, as I said in the last call, we're going to go into 2013 seeing the benefit of the reduction in dairy costs this year, while your point is spot on with regard to dairy costs up in the last 3 months in North America/Europe and some in New Zealand. Everything we're hearing is for the Asia market. New Zealand season is looking good, so I wouldn't draw a conclusion that that's necessarily going to continue throughout the rest of the year. It will put probably a little bit of pressure on gross margins in the second quarter versus the first, but it's too early to draw a conclusion that that's going to be in the second half.

Amit Sharma - BMO Capital Markets U.S.

And just as follow-up to earlier discussion, the price increase in China, is that only in Mainland China or is it in Hong Kong as well?

Peter Kasper Jakobsen

That's only in Mainland China. And I, perhaps, was guilty when Bryan asked the question. I should be clear that obviously, pricing is a dynamic thing because we operate in a competitive environment. So it's hard to anticipate how our competitors will behave over the coming quarter or 2. But we are very happy with the pricing relativities that we have established as we came out of this last quarter that we've just reported. And assuming a static environment, we've not looked to make changes to that.

Operator

Your next question comes from the line of Robert Moskow with Credit Suisse.

Robert Moskow - Crédit Suisse AG, Research Division

Yet another follow-up question on China. About the promotional environment, you said that the category maybe is around 7% or 8%, but my understanding is that there's really no volume in that number. Is it your view that the promotional activity will remain aggressive like this as long as volume is weak? And do you think that, that -- in your history of being in this category, is that when -- volume starts to return, is that when the promotional spending kind of normalizes?

Peter Kasper Jakobsen

Rob, this is Kasper. I think our experience is that this particular sort of competitive dynamic is less related to volume growth in the market than it is related to, perhaps, pressures on individual companies taking particular actions. And a number of companies are undergoing change or are facing different pressures in different parts of the world, so it's a competitive environment. Everybody clearly wants to gain share and certainly defend their market share in China. We do believe that over the next 1 or 2 quarters, this market ought to return to sort of more of the historical dynamics, where pricing is less of a -- is much less of a factor. And ultimately, innovation and product improvement and brand equity will be enhanced, really, by other actions and by equity building initiatives rather than pricing activity. I don't want to be sitting here trying to anticipate or give the impression that I can anticipate with accuracy what my competitors will do in China. We will clearly defend our share, and we feel good about where we are. We feel good about the prospects for China.

Robert Moskow - Crédit Suisse AG, Research Division

And if I can ask a follow-up on the comment that market share was up. I think I heard 200 basis points from the midpoint in the quarter as you exited this quarter.

Peter Kasper Jakobsen

What I said was that from the beginning of the year to our low around midyear, we lost approximately 3.5 share points. By the time we exited the third quarter, we had recovered just over 2 full share points of that, so just over 200 basis points of that.

Robert Moskow - Crédit Suisse AG, Research Division

Okay. So you've recovered about 2/3 of what you lost.

Peter Kasper Jakobsen

That's the right way to think about it. And we recovered that gradually as we went through the third quarter.

Operator

Your last question comes from the line of David Driscoll with Citi Research.

David Driscoll - Citigroup Inc, Research Division

One, I just -- again, I know there's a lot of questions on China, just maybe 2 for me. The first one is, Steve, over the years -- Kasper, over the years, I've never heard you guys talk this much about China and the promotional environment. I'm very used to, over the years, understanding that the Chinese consumer was really focused on the product itself, and they were very much willing to pay almost any price that you would ask. And we've seen in the data, I think, very consistent numbers. This year, it feels like there's a change. It feels like the promotional activity from some of the competitors really got a response from the consumer. And I suppose, very directly, the question is, are we hitting such high levels on the price point to the consumer such that we've gotten to some kind of maximum? Do you have any thoughts on that?

Stephen W. Golsby

David, let me have a go at that. There are a number of factors. Firstly, as I mentioned and Kasper detailed, the timing of our double-digit price increase and the timing of promotional activity, particularly from 2 of our largest international competitors, resulted in an unprecedented pricing gap between our product and market and theirs. Kasper was suitably humble, I think, about the execution of that price increase, but, as I mentioned, it was intended to cover 2 years of cost inflation given that we haven't taken an increase in 2011. I wouldn't name our competitors, but one of them is involved in a strategic transaction that made it attractive to them to be price-promoting aggressively and driving revenues. And another was planning their own product upgrade and price increase, and we're looking to move inventories through the retail channel at the same time. So I think there were a number of factors. And then, of course, as you know better than me, there is some slowdown in the Chinese economy and some resultant impact on confidence, which -- there's no pure science here, but there's greater elasticity in the children's category, in particular. The Europe environment is weak. The North American environment is weak. China has been the biggest prize for a long time. That is never more true than it is now. But I do think, as Kasper said, that normality will return in the near future. And then ultimately, it will be our science, our quality and our brand equity that will win out. And then I understand the disappointment in our short-term results, but we're very pleased with the share momentum that we're seeing now, and we will exit this year with industry-leading low levels of inventory right across the system. The business will exit this year in terrific health.

David Driscoll - Citigroup Inc, Research Division

I'll just sneak one last question in, and I think it's reasonably critical, is the distributor inventory. So if in the third quarter, you're ending below industry norms, I don't think I understand why there needs to be further reductions into the fourth quarter. Is there some nice piece of logic here as to why?

Stephen W. Golsby

Yes, we weren't trying to be cute with our words. Kasper was speaking very accurately. But our business model and our view of how much inventory our distributors should carry, particularly since they pay cash in advance, is different from our competitors both local and international. We pride ourselves in having a very high standard, and we could allow that to lapse right now in order to report improved results, and we will not let that happen.

So thank you all very much for attending today, and I look forward to speaking to you again soon. Thank you, operator.

Operator

Thank you, sir. Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a great day.

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