AVCJ Awards 2020: Exit of the Year - Small Cap: China Feihe

Twenty-two Chinese dairy companies were caught up in the 2008 melamine scandal, whereby chemicals were used to artificially boost the protein levels in infant milk formula. Thousands of children were hospitalized and six died. China Feihe was not among the offenders.

Five years on, public confidence in domestic infant formula was still relatively low, but Morgan Stanley Private Equity Asia (MSPEA) was comfortable enough to take part in a $147 million take-private alongside Feihe’s chairman. It was convinced by the then US-listed company’s product safety and quality credentials.

“Feihe produces its formula from fresh milk rather than powdered milk. While it is a more complicated process, the firm has more control over quality,” says Chin Chou, CEO of MSPEA. “Feihe has worked very closely with a company that operates seven dairy farms in northern China. And today they’ve combined some of these businesses. Within 24 hours of milk leaving the cow, it goes through a two-hour process to be turned into infant formula.”

China’s dairy industry was already benefiting from macro tailwinds, but a focus on premiumization – combined with operational improvements that ensured safety and efficiency – delivered an additional growth driver to Feihe. The company re-listed in Hong Kong in November 2019 with a market capitalization of HK$67 billion ($8.6 billion). As of January 8, it was worth HK$185 billion and trading at a 177% premium to the IPO price.

MSPEA invested $30 million in the company through the take-private. During the 12 months ended September 2020, it completed two sell-downs, generating proceeds of $1.1 billion (a third came later in the year). The private equity firm also sold $230 million in shares prior to the IPO and has received $169 million in dividends, putting realized proceeds at $1.5 billion.

Its remaining 12.34% position – as of September 2020 – was worth $2.6 billion. This translated into an overall return, realized and unrealized, of 138x. It rises to 148x based on Feihe’s January 8 closing price.

Booming market

China is the world’s single largest consumer of infant milk formula, accounting for approximately 50% global share. Euromonitor International estimates the market will be worth $32 billion by 2023. MSPEA first invested in the space in 2002, so it was familiar with the growth story as part of a broader family spending play.

“As incomes grow in China, a disproportionate amount of that income is directed to the child. So, we made investments in dairy, diapers, maternity care centers and kindergartens. We’ve owned four diaper businesses throughout our history,” says Chou.

The private equity firm hired an operating partner to work on the Feihe investment and immediately set about delivering some quick wins in operational improvement to win the trust of management. The quality oversight system was upgraded, supply chains were re-engineered to make more efficient use of time and resources, and costs were pared. MSPEA also helped the company recruit and integrate executives with multinational experience.

Feihe now has a vertically integrated set-up, with 25 quality control procedures comprising more than 300 checkpoints from feed inspection through product delivery.

The company ranks first among its domestic peers in terms of retail sales, with a 15.2% market share as of May 2020, up from 9.5% at the start of 2019, according to The Nielsen Corporation. Feihe’s super-premium Astrobaby product series accounts for 60% of overall revenue. Astrobaby soared 73% year-on-year in the first half of 2020.

Moving Feihe into the premium space was always part of MSPEA’s strategy. “Those products today represent more than 40% of the infant milk formula market. When we invested, they were less than 15%. Positioning the company’s products for that trend towards premiumization and ensuring quality in terms of products is very important,” says Chou.

Frost & Sullivan expects the high-end infant milk formula segment to be worth RMB199.8 billion ($31 billion) by 2023. Its share of overall sales will be 58.3%, up from 37.9% in 2018.

Getting noticed

MSPEA’s brand positioning efforts stretched to distribution. “We found that channels were changing from grocery stores and typical sort of mass commodity retailers to more specialized mother and baby stores, where the environment was more positive and conducive for selling premium products,” says Chin.

Feihe has a network of 1,900 offline distributors with more than 119,000 retail points of sale. Recognizing the significance of the maternity store channel, it has established partnerships with Kidswant, Aiyingdao and Babemax Shanghai.

In 2012, the year before MSPEA invested, Feihe’s revenue and net profit were $267.8 million and $21.2 million, respectively. For the 12 months ended December 2019, revenue reached RMB13.7 billion ($2.1 billion), a year-on-year increase of 32%, and net profit rose from RMB2.24 billion to RMB3.93 billion. In the first half of 2020, revenue and net profit jumped 48% and 57%, respectively, despite disruptions caused by COVID-19.

Considering the contributors to MSPEA’s return, China emphasizes the importance of multiple arbitrage as well as performance improvement.

“When we went in and led the take-private in 2013, the P/E [price-to-earnings] ratio we paid was approximately 5x, and we valued the company at approximately $150 million,” he explains. “While profit has increased by more than 25x, today the stock trades at approximately 20x earnings. We got to the 100x return from the profit increase and the P/E expansion.”

Pictured: Chin Chou of Morgan Stanley Private Equity Asia talks to AVCJ's Tim Burroughs

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• Topics
• Greater China
• Open market
• IPO
• Consumer
• China
• Morgan Stanley Private Equity Asia
• AVCJ Awards