Earlier this year, I was intrigued by an article in the Wall Street Journal that discussed rising Chinese demand for milk powder for use as a feedstock in dairy products ranging from ice cream to infant formula. But the infant formula angle was especially compelling, since this consumer staple presumably has recession-resistant properties.
Although one might assume that during lean times mothers can simply opt for breastfeeding in lieu of formula, China’s burgeoning middle class means that mothers often return to work shortly after having children. In fact, only about 30 percent of Chinese mothers breastfeed exclusively six months after giving birth. Beyond that, many Chinese believe that infant formula offers superior nutrition.
However, memories of the mainland’s 2008 scandal involving milk powder tainted with the toxic chemical melamine have not faded. These faulty products reportedly caused six deaths and sickened about 300,000 people. As a result, many skeptical consumers continue to look for milk powder sourced overseas, and that’s spurred a dramatic rise in imports.
According to the market research firm Euromonitor, the $12.4 billion Chinese infant formula market is expected to be a key driver of global formula sales. That number is projected to jump to $25 billion by 2017, as more and more Chinese women enter the workforce.
Even though China’s “one child” policy has actually forced its birth rate slightly lower than that of the US, China’s middle class is forecast to reach 700 million people by 2020 from roughly 300 million today. And as wealth trickles down, some Chinese can afford to pay the fines associated with this policy and therefore have more than one child. In the meantime, this policy has also led to what is colorfully described as the “Little Emperor Syndrome,” where families spend whatever it takes to ensure the best possible life for their sole offspring.
In particular, consumers are willing to pay a premium for milk powder imported from New Zealand. The Kiwi nation is the world’s top dairy exporter, and its proximity to China makes it well situated to accommodate this demand. Indeed, New Zealand dairies sold nearly 380,000 tons of milk powder to the Middle Kingdom in 2011, a 10 percent increase from the prior year.
But in researching a pure play on this trend, I hit a partial dead end. At the time, Fonterra, New Zealand’s largest dairy cooperative, remained privately held, though there was talk of an initial public offering (IPO). On the global dairy front, Fonterra is a juggernaut: Its farms put out nearly 22 million tonnes of milk products a year, making it the largest milk producer in the world. And it exports roughly half the world’s supply of milk powder.
On Nov. 30, Fonterra finally went public, though with an unusual structure. To preserve the relative independence of the cooperative’s 10,500 member farmers, the IPO involved two different sets of shares: Fonterra Co-Operative Group, Ltd. (NZX: FCG) and Fonterra Shareholder’s Fund (NZX: FSF, ASX: FSF).
The former shares can only be traded among members of the cooperative, while the latter is a unit trust available to the investing public. But units of the Fonterra Shareholder’s Fund only confer economic rights to the cooperative’s financial performance, without any corresponding voting rights.
Additionally, the offering was limited to just 6 percent of the cooperative’s total equity, or NZD525 million, with concentrated shareholders capped at owning 15 percent of shares outstanding. However, Fonterra is legally permitted to issue shares accounting for as much as 25 percent of its total equity, though there are no plans for follow-on offerings at present.
Pent-up demand for shares in Fonterra coupled with the aforementioned limitations caused shares to soar as high as 22 percent from the NZD5.50 offer price during the initial day of trading. The unit trust recently traded near NZD6.81, which remains 22.5 percent above the level at which it began trading.
The cooperative generated NZD19.8 billion in annual revenue through the end of July, and while it may appear undervalued compared to global peers such as Danone (OTC: DANOY), analysts point out that its profitability and margins lag these industry giants. That’s because Fonterra is still largely a supplier of raw milk and lacks a wide array of higher-margin branded products.Prior to the IPO, Morningstar estimated fair value for the units at NZD5.50, but recommended investors only consider buying a stake if units fall to NZD4.95 or below.
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