Glenboden M & A Originations

Private equity targets frantic Chinese infant formula market

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Origination Status investor announcements of minority stakes, September 2009
Asset American Dairy Inc (USA), Yashili Group (China), leading infant formula producers in China
Buyer Sequoia Capital (American Dairy), Carlyle Group (Yashili), US private equity firms
Seller founders and public shareholders of American Dairy and Yashili
Buyer Rationale entry into fast -growing Chinese IMF market, exit opportunities
Seller Rationale obtain capital and knowhow for expansion, exit partners
NBs in both cases investments were by capital injection
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In mid 2009, Glenboden hailed Emerald and, moreover, American Dairy as exciting companies in the burgeoning Chinese infant milk formula market. Since then, two global expansion capital players, Sequoia and Carlyle, announced minority equity investments in, respectively, American Dairy and Yashili. We compare four key independents in China, and identify exit opportunities in that market.

Yashili the least transparent and most riskyLittle is known about Yashili, as it's a private company, while its competitors covered by this origination, AD, Emerald and Synutra, are all public companies listed in the US (respectively on the NYSE, OBB and NASDAQ exchanges).

What we can say about Yashili is that, given its requirement for enhanced R&D and quality control capabilities, which Carlyle's capital is supposed to bring, and given that its growth is focused on second- and third-tier cities in China, it's likely to be more weighted in the mainstream and discount, rather than premium, segments of the IMF market.

Given these factors, and that Carlyle is to control less than 20% of the company's equity, then this looks like a relatively high risk investment.

American Dairy is outgrowing its market ...Sequoia's 10% stake in American Dairy looks like a safe bet, by comparison. With the Chinese IMF market growing at 20-30% p.a., AD’s tenfold growth in sales since 2003 suggest it’s growing at twice the rate of the overall market.

.... and is well positioned for 'land-grab' going forward ...Other positives are that, with FY2008 turnover of nearly US$ 200 mln, H1 2009 turnover of over US$ 150 mln, and a market share of about 10%, AD is one of the biggest players in the fragmented Chinese IMF market; we estimate it's no.3, behind Beingmate and Synutra.

Also, its 'footprint' in both production and distribution terms is substantial. As we pointed out in our previous lead on AD, the group is quite well placed to 'land -grab' as the market matures. It manages six processors in several provinces, with 400k t. total output p.a. Its sales reach is 80k retail stores, through 1.500 salesmen, covering most of China, and is growing fast.

... and its net debt and profitability has improved sharply ....AD's EBITDA margin in H1 2009 has more than trebled, compared with H1 2008, to exceed 20%; this is reflected in a net debt ratio which is now less than x1,0.

.... suggesting new equity can be allocated to qualitative improvementsAs with Carlyle's investment in Yashili, Sequoia's US$ 60 mln capital injection into AD could be used to improve quality control and other 'soft' functions like R&D. The group is past its capex 'hump', of US$ 130 mln in 2007 -8, so it doesn't need much more cash in that area.

AD deal provides a valuation benchmark for China IMFThe valuation we've estimated (see right column) is taken from Sequoia's investment in AD (2009F). The discrepancy between the high P/S and low P /EBITDA suggests that AD's current EBITDA margin, of well over 20%, is not deemed to be sustainable.

Synutra is now under greater pressure...Another major independent player in China's IMF market, Synutra International, is now under pressure as AD's sales and profitability levels start to catch up with it. Synutra also has a private equity investor, Warburg Pincus, with a 9% stake.

... after its strong fundamentals were wrecked by melamine...Having grown in line with its peers in 2004 -8, Synutra suffered a 15% drop in revenue in FY 2009, totally out of sync with the market, because of a melamine contamination scandal that caused a 15% drop in sales, product recalls and inventory write -downs; the effect on the group's operating result was a loss of over US$ 125 mln in 2009 (y/e 31.03.09).

... but the company could bounce back to pre -2008 performance levelsIf Synutra is able to quickly overcome the impact of the melamine scare, then its healthy fundamentals and near 20% EBITDA margin, as illustrated by its 2008 results (see chart above) will come back to the fore.

Synutra is still bigger than AD, with over US$ 300 mln in sales even in 2009, and 8 production facilities.

It also appears to have an efficient sales system, with selling costs around 10% of sales in regular years; in addition, A&P absorbs over 20% of the cost structure.

This makes it look like a 'western' foods business, with an ability to 'premiumise' its portfolio through marketing spend. Its pursuer, AD, is only now replicating this business model.

Emerald Dairy is now looking relatively weak ...Glenboden had earlier extolled the virtues of the small, young and highly -focused Emerald; however its stellar growth rate ground to a halt in H1 2009, remaining at an annualised US$ 40 mln in turnover.

This may mean that the Chinese IMF market is now closed to new entrants. Emerald is not only an 'arriviste', but its output is tiny, at 10k t. p.a.; also it only reaches about 10k retail points so far.

That sales reach is in spite of having 800 salesmen. That's a much worse outlets per SR ratio than at AD or Synutra; it suggests that Emerald has overinvested in this area, and/or has a price point constraint or other issues with its distributors.

These demerits are reflected in an EBITDA margin at Emerald of well under 10% in H1 2009; well below its peers.

... and needs a breakthrough or a niche approach ...Emerald may therefore find it hard to find a major private equity investor, as its three peers in this origination have done.

Possibly its salvation will be through some breakthrough product innovation, or in reducing distribution costs and focusing purely on the most premium segments in the biggest cities in China. Its efforts to get the first organic certification in China may hold the key.

.... in order to attract the capital it needsEmerald plans to treble its production capacity, by 2011. That will require about US$ 25 mln in new equity and/or debt capital. So, providing the group's strategy is right, there's an opportunity there for another private equity firm.

Exit opportunities to strategic investors will arise ...Finishing on the note of exit opportunities; many strategic investors already have a presence in the Chinese IMF and/or age-related nutrition sector. They include Abbot Laboratories, Mead Johnson, Danone (Numico), Nestle and Wyeth.

... as the independents matureOnce the independents, with their private equity backers, have straightened out quality control and product formula issues, and have fully invested in capex terms and distribution networks, and once the spectre of melamine has faded, then the consolidation game will hot up in China.

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THIS LEAD'S VALUATION
Size (€ mln) 500
Sector infant milk formula
Asset Quality China no.3 branded
Seller mid-cap plc
Buyer private equity
P/S 2,0
P/Ebitda 10,0
Type enterprise value minority stake
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