Description

Feihe is the market leader in China’s infant formula market. The company has reversed a decade of market shift towards international/imported infant formula almost entirely on its own through brilliant execution in every respect of the business, whether marketing, distribution, production quality and capabilities and inventory and pricing management. The company’s market of share of the Chinese IMF market has increased from 4.5% in 2017 to ~19% today, beating the likes of Nestle, Danone, Reckitt, Abbott and a whole host of domestic players.  The company’s target is to increase its market share to 30% by 2023 with a sales target of RMB35bn, representing a 25% CAGR over the next 3 years. This will be achieved by

Ø  Further concentration of the Chinese IMF market (top 5 IMF companies in China have combined share of 51% vs 80-90% in most other markets)

Ø  Continued premiumisation of the market, especially in lower-tier cities where Feihe’s distribution capabilities are a major competitive advantage. The super-premium segment is 2/3 of Feihe’s revenue

Ø  Market share gains in Tier 1 cities where Feihe’s penetration is still relatively low (the company entered Beijing in 2017 and already has 16% share. It is now expanding into Shanghai and Shenzhen)

Ø  Further market shift from the indirect channel (HK imported) to the direct channel (locally manufactured). The government targets 60% of milk formula to be produced with locally sourced milk

Ø  Continued regulatory tightening driving out smaller local players (following the 2015 and 2018 regulatory changes the number of domestic players shrank from >2k to <500. New registration requirements will come into effect from January 2023 that will further drive this consolidation of the market)

Ø  Growth in stage 3-4 milk (2 years and older) and adults milk is accelerating. Feihe is relatively more exposed to stage 3-4 with c.50% of sales in the category

Background on Feihe’s success:

The Chinese IMF market went through some dramatic changes over the past decade+. Following the melamine scandal in 2008 Chinese consumers became very wary of domestic brands leading to major market shift towards imported formula from overseas manufacturers. The share of domestic players declined form c.70% pre-2008 to just over 40% in 2014 with overseas players share rising to 55-60%. At the same time the market saw strong growth with a brief/short lived acceleration in 2017-18 post the relaxation of the single child policy in 2016. This coincided with 2 simultaneous factors that set the foundation of Feihe’s meteoric rise. First the government introduced a series of more rigid food safety and regulatory capacity policies which laid the foundation for restoring trust in domestically produced formula. Second, Feihe found a unique and powerful marketing message to differentiate itself from international peers that resonated strongly with local consumers: “More suitable for Chinese babies”. It aims at offering what consumers believe foreign brands might lack, namely offering products that meet the specific physique of Chinese babies. The fact that Feihe was untainted by the melamine scandal certainly helped it in building credibility for this message. The successful marketing message was bolstered with strong media campaigns and celebrity endorsements.

Alongside the successful marketing strategy the company spent significant capital in R&D and developing its distribution capabilities. Some highlights:

• R&D investments to enable close resemblance to the breast milk of Chinese mothers through studies of a large Chinese breast milk database it built from scratch, partnerships with renowned international and domestic research institutes and building an infant formula supply chain innovation centre with China’s National Dairy Science and Technology Innovation Alliance
• Building a distribution channel of 119k k retail points of sale (including ~90% of all mother and baby stores) compared to <40k for most competitors
• Large-scale offline customer education sessions: in 2018 Feihe hosted >300k offline events. In 2019 this jumped to 500k, in 2020 700k and this year it plans to top 1 million events. This is >10x the nearest competitor.
• Very tight inventory management  through direct distribution capabilities, cutting out the middlemen and planning its manufacturing footprint in a highly efficient manner leading to negative working capital and just 60 inventory days (vs ~165 at local peers)
• Vertical integration: Last September Feihe announced the acquisition of YST, its largest fresh milk supplier accounting for >80% of its milk procurement

Source of the opportunity

Feihe share have declined 35% from their peak in January, c.30% since mid-May due to several simultaneous overhangs:

·         Chinese birth rates: while the overall rate of new births in China has been in low-single digit annual decline, during 2020, due to covid, births dropped 15% y/y. This has led many to downgrade their long-term forecasts of birth rate declines

·         Feihe’s chairman was quoted as saying that covid vaccinations will have a further negative impact on birth rates as prospective parents need to wait 6 months post vaccination before planning pregnancy. This quote was taken out of context. He merely said that some people think they need to do that even though the government guidelines clearly state that the vaccines have no implications for pregnancy

·         Milk prices: the price of skimmed milk is up significantly from last year leading to margin pressure concerns

·         New government policy: in a major new initiative to fix China’s major demographic cliff, last month the Chinese government announced it will allow couples to have up to 3 children (vs 2 previously) and it is exploring supportive measures to promote fertility including lowering of educational costs offering additional tax and housing support, developing affordable childcare services, protecting the legal interests of working women, and clamping down on "dowries". Some fear the government will force a reduction in the price of formula

·         Competitive fears: Feihe’s massive success has not gone unnoticed. Over the past year, Nestle and Danone have launched their own domestically produced premium brand to try to play in this market

As a result of this Feihe’s shares have derated to their lowest P/E since going public 2 years ago, now selling for 14x P/E and 9x EBITDA on 2022 consensus estimates. The shares previously traded as high as 25x forward P/E.

However, the above overhangs are actually mostly positives and data so far YTD points to the aforementioned consensus expectations being too low. The company has launched a $200m buyback in June to take advantage of the share price weakness.

·         Covid birth rate decline: rather than extrapolating the decline, one could argue there should be a catch-up that could lead to 2022 being an above average year for births. In fact YTD the IMF market is +7% vs expectations of a decline

·         Chairman comments: as said, out of context, and even if true would be a short-term issue. Market growth of +7% YTD also points to this not being an issue

·         Milk prices: Feihe is now almost fully integrated with milk sourcing so the raw material pressure is limited+its gross margins are >70% so the impact of this is limited anyway

·         New child birth promotion policies: the reason people are sceptical that it will lead to a glut of pregnancies is that the 2016 relaxation to allow 2 child children only had a temporary effect and was followed by a steep decline. However, the temporary effect was still a positive and this isn’t priced into 2022-2023 estimates and more importantly, with the new policy the government is looking to tackle the key barriers to people wanting to build larger families such as the cost of education and housing. With the right incentives things could change very quickly and the government is highly motivated to do so now. The policies announced last month followed vocal calls from the PBOC about the demographic challenges and the impact on pensions, labour markets and productivity. It argued for full liberalisation of birth policies and structural reforms.

Will they regulate formula pricing? It is unlikely for 2 reasons:

1.       infant formula accounts for about c.20% of the total cost of raising a child in China, with the other 80% being healthcare, education and housing. The latter is the main cause of concern among young Chinese couples/parents and is the area where the government is expected to step in and provide incentives

2.       Consumers in China have a wide choice of pricing in the formula market. Despite this, premium segments continue to outperform the rest of the category, showing that consumers are driving premiumisation in the category, not companies raising prices

• Finally on competition, Feihe’s market share gains are targeted at gaining share primarily from players exiting the market as it consolidates rather than against Nestle and Danone. The fact that they are now trying to emulate Feihe only further substantiates the case for how well the company is executing

If the company can achieve its growth targets for 2023 it should earn c.HK$1.45/share in EPS. Putting this on a mere 20x P/E which is arguably low for a consumer staples company with these attributes in terms of growth and quality, yields a stock price of HK$29 in 2 years, 75% above the current price….and there is actually upside to this should the government succeed in reversing the birth rate decline.

Conversely, at current valuations, the stock isn’t pricing in any growth so downside should be limited if things don’t improve on the marco birth rate front.

Catalyst

• Continued market share gains
• Stabilisation/imporvements in China birth rate