China's One-Child Policy Ended -- Shouldn't Baby Formula Sales Be Surging?

Image source: Getty.

November 15 marked the one year anniversary of the Chinese government's announcement that it was ending its decades-long one-child policy. When the announcement came that starting Jan.1 2016millions of families would be able to have two children, baby formula stocks surged on the news. A year later, that bet doesn't look to have played out as those early movers thought.

Only slight evidence that birth rate is rising

When the communist leadership of China first implemented the one child policy, it was following the economic crisis and great famine the country faced in the 1960s and 1970s. The one-child policy, while not applying to every family, dropped China's fertility rate from an estimated 6 births per woman at the time of the policy implementation, to barely over 1 birth per woman in 2015. The recent easing of the one child policy was as a result of the country's aging workforce and China's fear that it might lose its competitive edge in the next few decades.

Some analysts warned that attempting to alter a culture that has been ingrained for decades may be harder than it seems, and that the impact of this policy change will be negligible in the short-term. Early evidence suggests that there has been a modest increase in births so far. According to AsiaOne, the number of second children born grew about 6.9% for the first half of 2016 compared to full year 2015.

Infant formula companies in China have yet to feel the gains

Despite what does look like a small uptick in birth rate so far, the performance of the top companies selling infant formula in China such asNestl S.A.(NASDAQOTH:NSRGY),Groupe Danone(NASDAQOTH:DANOY), andMead Johnson Nutrition(NYSE:MJN)doesn't inspire much confidence. The largest of this group by market share is Nestle, which makes various brands of infant formula. During the most recent earnings, management did say that their premium Illuma brand saw double digit organic growth in China, but the company's nutrition segment which includes infant formula products, still struggled with sales up less than 1% year over year.

Image source: Mead Johnson

Things look similar for Mead Johnson, which is focused almost solely on infant formula, such as its Enfamil brand,and gets nearly half of its sales from Asia. Total sales in Asia declined 3% year over year, and while growth in China was called out due to pricing increases, overall volume for the segment still dropped year over year.

The most disappointing of these three is Danone, which reported slower than expected sales growth of just 2% year over year in the third quarter. Danone actually singled-out issues with its Chinese infant formula business for part of that. For the quarter, total sales in the "early life nutrition" segment rose 1.7%, but volume fell 0.04% year over year. The reason for this decline is not just that demand hasn't grown as expected. Danone had been benefiting from online sales of imported baby foods through third parties and China's renewed regulation of this activity has hampered sales. In the earnings release, management said that the company is combating this byincreasing its direct distribution through specialized stores and direct e-commerce offerings.

Does this mean that this bet was wrong?

Do these companies' recent disappointing sales numbers mean that this change in policy was oversold? Perhaps, but it's still early.The one-child policy officially ended just nine months before most of the financial periods above ended, so it may take some time to see a significant increase in these companies' sales.

While the volatile regulatory market in China seems to have hurt Danone recently, there are some recent regulations that could benefit these companies in the years to come. The China Food and Drug Administration (CFDA) released new rules to crack down on false advertising and low-quality ingredients following some recent infant formula scandals. These new rules state that companies must; register each of its products with the CFDA, produce no more than nine formulas under up to three brands, clarify where the ingredients were sourced, and not suggest that its products could treat diseases or enhance intelligence. These rules should benefit the big name international brands that have standardized safety practices and establishedreputations.

This bet on growing Chinese demand has not worked out yet for these companies, which is reflected in the lower stock prices from the post-announcement surges. However, this is likely a market trend that is going to take years to play out, and one that patient investors could still very much gain from.

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