Podcast: China M&A Outlook and Dairy Product Acquisitions

A shrinking infant formula market and slowing birth rate

In this episode, we look at the M&A outlook and challenges for dairy products in China — specifically the shrinking infant formula market — in part due to a slowing birth rate in the country. Joining Dealcast host Julie-Anna Needham is Ling Yang, Mergermarket’s china editor, and Stephanie Hanna, who is DealReporter’s deputy editor for Asia Pacific discussing their insights on the M&A outlook in China. Dealcast is presented by Mergermarket and SS&C Intralinks.

In this episode, you'll learn hear about:

• The current market for infant milk in China — it’s facing a few challenges.
• How China's new child three-child policy will affect domestic brand
• Private equity's involvement in the sector

Transcript

[MUSIC PLAYING] JULIE-ANNA NEEDHAM: Welcome to Dealcast, the weekly M&A podcast, presented to you by Mergermarket and SS&C Intralinks. I'm Julia-Anna Needham. In this episode, we're looking at the M&A outlook and challenges for dairy products in China — in part prompted by a slowing birthrate in the country.

Joining me are Mergermarket's China editor Ling Yang, and Stephanie Hanna, who is Dealreporter's deputy editor for Asia Pacific. Hi, Lin. Hi, Stephanie.

STEPHANIE HANNA: Hi, Julie-Anna.

LING YANG: Hi, Julie-Anna.

JULIE-ANNA NEEDHAM: Thanks for joining me today. So, let's start by looking at the current market for infant milk in China — it’s facing a few challenges. Can you give us an overview of that market, and outline some of those issues that are specific to the Chinese market?

LING YANG: Sure, Julianna. So overall, the Chinese infant formula market is shrinking due to China's decline in birth rate as we all know. And the retail sales volume in China's infant milk from the market began to decline in 2019. And it's expected to decrease at CAGR of negative 4.1 percent for the next five years. So that's data from Frost & Sullivan.

And so, the low birth rates and increased domestic competition as well as the ongoing restrictions on cross-border trade activity between Hong Kong and mainland China amid COVID. So these are all the reasons for the sales decline of many foreign brands in China.

And as we know, the foreign formula brands thrived for several years after tainted milk scandal in 2008. However, government — the Chinese government — has done a lot to improve the overall quality of the industry, including how they implemented the restriction requirements in 2019. And that dramatically reduced the number of brands on the market. And that helped to reshape the industry.

And also, at the same time, investment by domestic players in premium brands and special formulations are helping lots of domestic brands to overcome safety concerns. So the local brands’ market share has increased to about 60 percent in recent years, from only just 30 percent in 2013. So that's according to Euromonitor.

And so basically, that's how the dynamics of the foreign brands are operating in China and the challenges that they're facing right now. But having said that, China’s market is very big, which accounted for about 50 percent of the global market. And we do see a lot of competition still ongoing. And also brands are competing with each other in the different segment of the products.

STEPHANIE HANNA: I guess, I would just add to that, that as a result of the latest census figures, China changed it's — you may know that China had a one-child policy until about 2016, when it was relaxed to a two-child limit. But as a result of the latest census figures, this was changed again to a three-child limit.

So, in theory, that would be a positive for the infant formula producers here. But the widely held view here is also that a policy change alone isn't going to reverse that population trend. For many reasons, people are reluctant to have multiple children in China. The main reason being that it's quite expensive to raise kids, especially in the cities.

So, if that policy change is followed by other policy changes such as reducing the cost of education and other sort of expenses associated with raising children, then that could be like a long-term sort of driver of the growth of the infant formula manufacturers.

JULIE-ANNA NEEDHAM: Great, thank you both. So, Ling, looking at Reckitt Benckiser sale of its infant formula and child nutrition subsidiary in China, can you run through the details of that deal, please?

LING YANG: Sure. So Reckitt Benckiser is a British consumer goods company. And it disclosed the strategic review of the Chinese infant child nutrition unit in its 2020 financial result announcement in February. And earlier this month — so RB announced that Chinese private equity firm Primavera acquired the business for USD 2.2 billion U.S. dollars.

And interestingly, the deal was announced just four days after the government announced the relaxation of three-child policy. And then you sent many baby-product-related stocks to share price to surge.

And Mergermarket has been following this sale closely. And there were many big PE names — in the mix. Including Carlyle, Baine and CITIC Capital — that's Chan's state-owned private equity firm. And strategics — domestic names like Ealey and New Hope and Junlebao. And what we heard is that the private equity from Primaveracame in quite late in the process in April. But it just took them about two months to sign the deal.

And the PE owner was — they have quite extensive presence in the sector. And some notable portfolios, including Yum brands and China-based dairy products Junlebao, which we reported that is also in the race for this infant formula business meet Johnson brand in greater China.

And apparently this is the big bite for Primavera as they certainly have a very strong confidence in growing this brand in China with a more localized strategy to tap the unreached low-tier cities. As I think for the new child policy that we just relaxed earlier this month. This will boost birth rates for the lower-tier cities, especially for the third-tier to fourth-tier cities.

And that's where all those foreign brands are having difficulty to penetrate that market. So we think that with the investment of Primavera, they will probably help this brand to go deeper. To be more localized and to tap, really reach that kind of localized the market.

And we know that Primavera invested in Alibaba, Ant Group and ByteDance so the online to offline strategy could be further explored and there also there is integration opportunity between Junlebao — the existing portfolio of Primavera — and Mead Johnson as well.

So because Junlebao is more present in lower-tier cities and trying to go upscale, yet all the firm brands like Mead Johnson, they are really looking to penetrate the provincial cities to gain more market share. So I think that's quite an interesting investment they made, because for the former owner, they really aren't capable of taking that brand really deeper to the local market.

JULIE-ANNA NEEDHAM: And you said that Primavera came in quite late in the process. Did they know, or was it widely expected, that China's policy on the number of children you could have was going to change?

LING YANG: Well, even though the policies were expected, still I think they wouldn't know the exact timing of that announcement. And the deal was — and I think the decision to have big investment in the formula business really comes from the top executive from this firm from Primavera. And they really had a lot of interest in this sector, long before, and they kind of examined the sector for a long time.

I wouldn't say that is because of the — they knew it's going to come out this kind of announcement. So they made investment — but I think it's more of a thorough decision for the industry for a long time. At least for a couple of years, I think.

JULIE-ANNA NEEDHAM: Great. Thanks, Ling. And Stephanie, looking at A2 Milk, can we start off by looking at the company and the current challenges it is facing? Because it had a bit of a fall from grace, hasn't it?

STEPHANIE HANNA: Yeah, that's right. So just as background — A2 Milk is a company that was established in New Zealand, but listed in New Zealand and Australia. And it produces various dairy products, including infant formula. And I guess it differentiates itself by using this A2 protein from cows. And the company claims that, that particular protein is easier to digest than the A1 protein.

So they've had a really stellar run up until about a year ago when travel restrictions kicked in. In the last 9 to 12 months, they've announced four earnings downgrades. So the travel restrictions have impacted their digo sales, which means that their cross-border sales channel — and digo just refers to people outside of China buying products on behalf of customers who are inside China.

That particular sales channel has been disrupted. And for the company, about half of its earnings come from China and the broader Asian region. So the company is in a position now where it has an excess supply of stock. And it's trying to rebalance its inventory. So that will involve a write down of about 100 million New Zealand dollars’ worth of stock.

And the company has also acknowledged that the birth rate is slowing in China. So, this obviously raises questions about its longer-term strategy. And then on top of that, the CEO of the Asia-Pacific division said he intends to step down, and the company may be the target of a class-action suit from shareholders.

So, there was a media report saying that a law firm is investigating claims by shareholders that the A2 board may have not been completely honest about the extent of its struggles. So as far as I know, no lawsuit has been filed yet. But I imagine that's also on the board's mind.

JULIE-ANNA NEEDHAM: Well, so lots of challenges on different fronts. How can you see getting out of the situation, do you expect to see asset disposals or even potentially a takeover of the whole company?

STEPHANIE HANNA: Well, I think the immediate plan is to get that level of inventory right, and perhaps change its approach to sales and distribution. But you know its shares have come off about 70 percent in the last year or so, and that does make us wonder whether it is vulnerable to a takeover, because I mean despite its struggles, analysts say that the company still has a decent brand and its balance sheet is in okay shape.

So, the Reckitt Benckiser sale attracted numerous bidders. From the Mergermarket reports, it seemed to be quite competitive. So, it's possible that the unsuccessful suitors from that auction may turn their attention to A2 Milk, assuming that they still believe in the fundamentals of the infant formula industry in China.

JULIE-ANNA NEEDHAM: And I guess it was good news to A2, given their exposure to the Chinese market that the three-child policy is being introduced.

STEPHANIE HANNA: Yeah, its shares have — its shares have definitely risen on the back of that news. So it is like a boost for the company's valuation in the short term. But whether that policy change will be followed by an increase in the population, that remains to be seen.

JULIE-ANNA NEEDHAM: Yeah, I'm guessing it's going to take quite a few years before that becomes obvious. And looking at the wider infant formula market in China, what are the corporate you expecting to see there, and who are the other key players?

STEPHANIE HANNA: Look, I would say in terms of foreign players, they are slowly leaving the Chinese market. As Ling alluded to earlier, it's just it's a real struggle for foreign players to establish a position here in light of the preference for local brands now. So, you've seen Danone sell its stake in a Chinese dairy company recently. A New Zealand player, Fonterra also got out of the China market.

Nestlé is still very much here. And they signaled last year that the Chinese infant formula place — sorry the Chinese infant formula market — is very key to them. And they're in a pretty solid position to make acquisitions. I know they have a lot of segments that they operate in around the world. But they have flagged the Chinese formula sector as one to watch. So, I wouldn't be surprised if they were to make some kind of move in the next 12 to 18 months.

JULIE-ANNA NEEDHAM: Great. And Ling, who are the domestic players? And what kind of corporate activity do you expect to see from them?

LING YANG: Yeah, so to add Stephanie on that, Nestlé reviewed that its annual review that sales of the infant formula declined in China as well. And also disclosed the infant formula sales in 2020 decreased 41 percent as well. But they see a lot more growth in Southeast Asian countries. But the obvious decline from China market — greater China market.

So really, the challenges are real for foreign brands that used to be very predominant in China market. And we see some of the rise of the local brand names, including Yili(伊利), Mengniu Dairy(蒙牛), Biostime (合生元) , Feihe(飞鹤), and Ausnutria(澳优)  . Especially, , Feihe and also Ausnutria],  are the two brands that are likely to benefit the most from the relaxation of three child policy because of their strong presence in the lower tier cities.

And we expect the South could grow — and we could see that reflecting and their share price increase actually. So I think there's interesting market to watch.

Absolutely, thank you both very much.

JULIE-ANNA NEEDHAM: That was major market China Editor Ling Yang, and Stephanie Hanna, who is DealReporter's deputy editor for Asia Pacific. Thank you for listening to this week's episode of Dealcast, presented by Mergermarket and SS&C Intralinks. Please rate, review and follow the podcast.

You can find us on Apple podcast, Spotify, or look out for your Mergermarket news alert. For more information, check out our show notes. Join us next week for another episode.