Glenboden M & A Originations

American Dairy trumps Emerald as infant formula deal of choice in China

Priority Rating priority rating 4
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Origination Status proprietary origination, July 2009
Asset American Dairy Inc (USA), leading infant /ageing formula and milk powder producer in China
Buyer candidates include Danone, Nestle, Wyeth, Mead Johnson
Seller group's CEO (majority), two US investment funds, free float on NYSE
Buyer Rationale fast-growing platform in high-potential Chinese IMF /milk formula market
Seller Rationale strategic partner for expensive nationwide expansion, QC programme, product knowhow
NBs AD was founded in 1962, making it 20 years older than its smaller independent rival, Emerald Dairy
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American Dairy has uncanny similarities with another high -potential infant milk formula player in China, Emerald, in terms of product profile, strategy, US listing and shareholder structure. We compare the two according to key M&A parameters; AD appears both more attractive through its size, and more vulnerable because of its indebtedness.

The Chinese infant milk formula market is growing by 20% per annum; AD’s near tenfold growth in sales revenue since 2003 suggest it’s outperforming that market, especially compared with state-owned majors. The group is however burdened by high selling costs, and is heavily indebted (see chart).

AD needs to raise equity capital, to reduce debt, and to meet both its ambitious nationwide distribution plans, and its aim of providing top quality control from the field to the finished product. The time may be ripe therefore for a multinational IMF player to make a bid for that public company, and keep it super-premium.

AD and Emerald have strong strategic similarities ...

Both groups are focused on infant milk formula, and other milk powders, which in both cases constitute 80 - 90% of total sales value. Both have listings in the US, the former on NYSE and the latter on the OBB market; both have their CEOs as the majority shareholders. Both are expanding their distribution furiously, and both have selling costs as high as 25% of sales revenue.

However the key difference, between AD and Emerald, is the latter is at a more advanced stage in its evolution, and has a far bigger scale. Given that even AD has less that 10% share of the fragmented Chinese IMF market; these are very important criteria for a major buyer.

... but AD is a bigger and more advanced player than Emerald ...AD has been operating in China for much longer than Emerald, and has six processing facilities, not just the two that Emerald has. Its annual output already reaches over 400k t. per annum, whereas Emerald in investing heavily in capex, to achieve 30k p.a. output by 2011. If these figures are accurate, then AD has inherited huge over-capacity, whereas Emerald is building something more state-of-the-art. Stranger things have happened in the dairy business; better to have the land-grab under your belt.

American Dairy has higher sales ...AD had turnover in 2008 of just under US$ 200 mln, while Emerald booked over US$ 40 mln; hence the huge sales /capacity mismatch that needs explaining, when both are mostly producing milk formulas and powder, and when the volume /value difference is much more in line. A question of inherited capacity of lower-value stuff.

... and wider and more vertical-sales distribution ...Turning to distribution, AD has a much bigger footprint. It's grown in six months, from end 2008, to reaching 80k retail outlets from 50k at the start; to 1.500 salesmen from 1.000 - the goal being 100k outlets by y/e 2009, nationwide, including the south and west of China (formerly weak spots for AD).

By comparison, Emerald has as many as 800 salesmen, but reaches only 6.000 retail points so far, in 20 provinces. To reach more first-tier retail points, in big cities, they have to achieve the drop-rate scale of AD; that's a key facet of what's famously known as 'critical mass'.

AD is also ahead in the investment curve ...In addition, there are fundamental differences in the respective investment cycles. AD's aim, predictably, is to convert more raw milk powder into value-added formulas. Hence the focus on products for non -infants with health issues; the investment in the cold chain and in freshness; it works on 25 QA process points, and on superior breeds of Holstein cows to give higher milk yields.

Emerald, in contrast, is in the middle of trebling capex to US$ 35, to create new capacity by 2011; it's only after that they'll face the full QA and supply-chain problems that AD is dealing with now. Look to the relevant Glenboden lead, to see how they might fund that.

... meaning it's more focused on quality from field to table ...AD has passed its investment hump, seeing capex down from US$ 100 mln in 2007 to US$ 30 mln in 2008, as its profile changes from lumpier production sites to higher bang-for-buck milk breeding and distribution activities. Sure, this brings more challenges, but less risk - you just have to manage farmers and salesforces better. Easy eh ?

... but AD has higher debt and other questionable liabilities ... At the same time, however, AD needs a new investor, to take them to the next level in scale and traction - as evidenced by their biological assets, property and leases tucked away as 'other payables'; plus discontinued activities with old partners all just waiting to fully crystallise.

… providing a window for a strategic buyer ...So there could be an opportunity now, for a multinational major in infant nutrition, like Nestle, Danone, Heinz, Wyatt or Mead Johnson, to enter into negotiations with AD's principal shareholders. These are its CEO, Leng You-Bin, who owns over 50% of its outstanding shares; a further 20% are owned by two investors in the US, and the rest is free floating on the NYSE exchange in the US.

... but valuation's a drag thanks to a lower EBITDA margin trendAD's EBITDA fell hard by over 50% in 2008/7, because of the increased distribution and supply chain costs that it's incurring. For that reason, we have to give it a mid-size player discount in terms of its potential valuation, which anyway isn't bad.

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THIS LEAD'S VALUATION
Size (€ mln) 500
Sector Infant nutrition
Asset Quality China leader independent premium
Seller small plc
Buyer large plc
P/S 3,5
P/Ebitda 20,0
Type value estimate
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