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Abbott Labs’ (NYSE:ABT) Chinese baby formula business faced two small setbacks last week. First, the company was fined around 77 million Yuan ($12.63 million) for allegedly collaborating with several competitors to fix the prices of its baby formula products in the country. Second, the healthcare giant was asked by China’s national quality watchdog to recall two batches of its infant baby formula products due to concerns that they might contain bacteria that cause food poisoning.  
We however think that both these events are unlikely to have a material impact on the company’s performance. The $12.63 million fine levied on Abbott is less than 0.1% of its 2012 revenue and signals an end to the company’s anti-trust problems in China. Additionally, we think it was a prudent move by Abbott to recall two of its baby formula products as it preempts any loss of reputation that the company would have to otherwise bear had infants fallen sick.
We believe that the future of the company’s baby formula business in China is bright because of the high affinity for globally renowned brands among Chinese parents.
The Penalty Signals An End To Abbott’s Anti-trust Troubles In China
In 2008, China faced a major milk scandal in which adulterated milk powder caused 53,000 infants to fall sick, out of which around 13,000 babies had to be hospitalized.  Since then, Chinese parents have shown a strong affinity towards trusted brands from multinationals like Abbott, Danone, Mead Johnson and Nestle. (Read more about the Chinese milk scandal here) To get a sense of how strong this demand is consider the fact that smuggling foreign baby formula from Hong Kong is at present a booming business in China. In fact, Hong Kong authorities have had to crack down on this illegal activity by slapping violators with “fines of up to $6,500 and two years in prison,” according to the New York Times.  (see: China’s Parents Crave Illegally Imported Baby Formula)
To check the high prices of foreign labeled baby formula, which is an essential commodity for a large populace in China, Chinese regulators started investigating the pricing practices of several multinational baby formula producers around four months ago. In response, Abbott and other multinational baby powder manufacturers such as Mead Johnson, Nestle and Danone slashed their baby formula prices by 4%-20% last month.
Now, as a final step of the investigation, these companies have been fined a total of around $110 million for their pricing practices.  While the total amount seems huge (it is reported to be the largest anti-trust penalty ever levied in China), it is small compared to the sales of any of these players. Further, we believe that once these multinationals have paid the fines, the worst will be behind them and they can once again focus on capturing the large and fast growing Chinese baby formula market.
Abbott Is Likely To Gain Additional Market Share In China
The preference of Chinese parents for global baby formula brands stems from quality concerns in locally manufactured products. Therefore, it is unlikely that allegations of price fixing will induce consumers to stop buying global brands. On the contrary, it is likely that the recent price cuts implemented by Abbott, Mead Johnson, Nestle and Danone will make their products affordable to a larger section of the Chinese population. If this happens, more Chinese households might replace the local brands they currently use with renowned names like Similac (a product from Abbott), thereby boosting sales and market share of multinational players at the expense of domestic manufacturers. (see: How Abbott Could Gain From Cutting Formula Prices In China)
The Product Recall Does Not Signal A Fault In Abbott’s Manufacturing Processes
In the second case, the Chinese quality watchdog asked Abbott and Danone to recall some of their baby formula products from Chinese markets due to doubts that it may contain bacteria that cause food poisoning. Both these players were using either ingredients or production lines of Fonterra, New Zealand’s premier milk powder manufacturer, which recently announced that some of its products were found to have been infected with botulism causing bacteria. 
The recall was “voluntary” and it remains to be proved that the products of Abbott or Danone were actually contaminated. We believe that quality is a major touch point forABT, the sensitive Chinese market, and the two companies effectively managed the tough situation by agreeing to recall their products as a precautionary measure. Had a case of botulism been detected due to their products, the two companies would have suffered an irreparable damage to their brands and would have forever alienated Chinese consumers.
While it remains to be seen if Abbott’s sales will be impacted due to the botulism scare, we can be sure that the company’s top line will not be significantly affected even if its baby formula sales dip in the short term. According to Euromonitor, Abbott accounted for just 3% of the $12.69 billion total infant formula sales in China last year. That means the company generated only about $380 million, or less than 2% of its total revenue from the Chinese baby powder market in 2012. Notes:
- China fines milk powder makers $110 million for price fixing, Reuters, August 7, 2013 [↩]
- China Asks Abbott to Recall Some Formula Products, WSJ, August 5, 2013 [↩]
- China milk scandal: 53,000 children ill from tainted powder, The Telegraph, September 22, 2008 [↩]
- Chinese Search for Infant Formula Goes Global, NYT, July 25, 2013 [↩]
- China Fines Mead to Danone Joint $109 Million in Probe, Bloomberg, August 7, 2013 [↩]
- Fonterra Tainted Items Add to Woes of Consumers in China, Bloomberg, August 6, 2013 [↩]
- Abbott Cuts Baby Formula Prices in China, Wall Street Journal, July 9, 2013 [↩]