OPINION: You can pack and repack the parachute as many times as you like, but at some point you have to trust it’s packed right – and jump.
Right now, dairy giant Fonterra’s ears are pinned back and its cheeks are wobbling in the blast of its high altitude leap into China, but already some folk are sucking their teeth and thinking «I wonder if they checked the slider grommets?».
This is a big deal for Fonterra. Its purchase of a 20 per cent stake in Chinese company Beingmate Baby and Child, announced last week, will cost more than $700 million.
The deal, valuing Beingmate at $3.5 billion, is part of a wider relationship which involves the Chinese company marketing Fonterra’s Anmum infant formula brand in China and buying half of Fonterra’s processing plant at Darnum, southeast of Melbourne.
After getting the money from Beingmate for Darnum, Fonterra’s net outlay will be about $615m.
Even for an elephant like Fonterra that’s a big chunk of change.
It’s probably fair to describe the move by chief executive Theo Spierings and his management team as bold, but Chalkie reckons it also relies on some heroic assumptions.
In its explanation of the Beingmate deal, Fonterra reported that the Chinese market for infant formula was worth $18b now and would be worth $33b by 2017 – a virtual doubling in three years.
Really?
Before going over the numbers, let’s remember that infant formula is, in a nutritional sense, unnecessary for most families. The World Health Organisation advocates that babies be exclusively breast fed for the first six months and has drafted a code of practice governing the marketing of breast milk substitutes.
Among its provisions, this code bans advertising or promotion of infant formula to the public and the distribution of samples to expectant mothers.
In the headlong rush to profit from the apparent Chinese thirst for infant formula, Chalkie wonders whether much thought has been given to the potential backlash.
Those with long memories may recall campaigners in the United States and Europe advocating a boycott against Nestle in the 1970s and 80s after it was accused of aggressively marketing infant formula in the Third World.
It’s hard to say how seriously this sort of thing is taken in China, but presumably dairy companies can’t bank on boosting infant formula sales through any kind of public marketing campaign.
Back to the numbers, according to the CIA Factbook, China’s population is about 1.34 billion people and its 2014 birth rate is expected to be about 12.17 per 1000. That translates to about 16.5 million babies a year. Making some assumptions, say a 900-gram tin retails for about $45 in China (about double the New Zealand price) and a baby gets through 50 tins a year, that would mean a year’s supply would cost $2250.
An $18b market would supply enough formula for about 8 million babies – half of all infants born this year in China. A $33b market would supply about 15 million babies, or about 90 per cent of this year’s crop.
It’s possible the dairy industry could sell that much, but Chalkie reckons it is looking at a remarkable degree of market penetration in what is still a poor country.
Fonterra argues that it considers the formula market to cover ages 0 to 3 years old, not just 0 to 1, which makes the numbers more plausible. Then there is the relaxation of China’s one-child policy, which some see as the trigger for an explosive growth in the birth rate.
However, local analysts see a limited effect.
When the policy change was announced last November, Bloomberg quoted Hong Kong analyst Jessie Guo saying it would boost momentum in the baby formula market, a bit.
«The impact on fundamentals are likely to be seen only in 2015. This policy will only result in 6 per cent additional newborns. The benefit should be moderate.» Meanwhile, the price premium on infant formula could ease as production ramps up to meet demand. China has already fined several companies, including Fonterra, for alleged price fixing in baby formula and prices have fallen by 10 to 20 per cent as a result.
The question here is whether Beingmate is worth $3.5b and whether a 20 per cent stake will deliver $700m worth of benefits to Fonterra.
No doubt the Kiwi co-op has put in a phenomenal amount of due diligence, because the Beingmate deal naturally conjures up the spectre of the last time it bought into a Chinese company, which could scarcely have been a bigger disaster.
In December 2005 Fonterra paid $160m or so for 43 per cent of dairy company Sanlu after more than two years of negotiations.
The outcome was a complete write-off because corrupt farmers in China put melamine into Sanlu’s milk supplies and poisoned children.
Lessons have been learned. This time Fonterra is not allowing its brands to be manufactured under licence in China.
Instead, Beingmate will import Anmum from Darnum and elsewhere in Fonterra’s empire, while sourcing supplies from the likes of Kerry Group in Ireland and Hochdorf in Switzerland.
Beingmate will also make formula at its own factory, where production is about 40,000 tonnes a year.
In 2013 Beingmate had revenue of $1.18b and earnings before interest, tax, depreciation and amortisation of $191m, according to Fonterra.
Net profit was about $140m, according to figures from the Shenzen Stock Exchange.
Chalkie reckons that gives Beingmate a price to earnings ratio of about 25, which implies a firm belief in the market growth figures.
As a Fonterra spokesman told Chalkie: «Historical data put sales at $5b in 2008, equating to more than 250 per cent growth over the past five to six years to reach $18b in 2013 (McKinsey Global Institute, Euromonitor Passport). This came during a time of minimal growth in population. Given the relaxing of the one child policy in China, $33b by 2018 is a conservative figure.»
OK then. So Fonterra has checked its slider grommets.
It better had. The purchase is being funded from Fonterra’s existing cash and debt facilities.
Standard and Poor’s downgraded the co-op’s credit rating late last week and analysts at Craigs Investment Partners see Fonterra’s balance sheet as limiting its international expansion.
With just a 20 per cent stake, «Fonterra has neither control over the direction of Beingmate or over its cash flows and it doesn’t have the capital to make an investment that would give it that,» they said.
Fonterra’s leap is looking even bolder than Chalkie thought – Spierings and his team must be experiencing some adrenaline right now.
Source: Stuff