Baby Formula Shortage Tests Outlook for Manufacturers

Baby formula, as a category, is conducive to competitive advantages. Parents are often reluctant to experiment with unfamiliar brands, opting instead for products that are known to work well for their babies. This creates brand loyalty and pricing power for established players. In the United States, beyond these universal factors, federal policy has contributed to significant market consolidation. Here, three players—Abbott Laboratories ABT, Reckitt Benckiser RBGLY, and Nestle NSRGY—control around 90% of the market. Lately, baby formula has been in short supply, initially because of supply chain disruptions, which were worsened by product safety and quality concerns around Abbott’s baby formula. Now, the challenge is determining what changes, if any, will be made to federal policy and regulation to prevent similar crises in the future.

How Three Companies Came to Dominate the Market

The current U.S. formula market structure could be attributed to a variety of factors: stringent U.S. Food and Drug Administration regulations regarding nutritional values, product testing, and labeling; high import tariffs; and the sole-contracting setup of the U.S. Department of Agriculture’s Special Supplemental Nutrition Program for Women, Infants, and Children. The WIC program was designed to assist low-income families in providing adequate nutrition to children up to the age of five, with most of the federal support going to infant formula and directly benefiting around half of all babies born in the U.S. In order to secure large discounts from manufacturers and provide baby formula to all eligible families, the program awards an exclusive contract to a manufacturer in each state, which has historically translated into a near-monopoly for the manufacturer in that state. While profits are meager for products that are bought through WIC vouchers, manufacturers are able to compensate with full profit margins from non-WIC sales. The steep discounts required to win state contracts have discouraged more players from participating, and the number of competitors taking part in bids has not exceeded three for more than two decades.

All these factors have served to discourage both domestic and foreign players from entering the market over the last few decades. In 2021, the U.S. imported only 1.5% of its estimated domestic demand for infant formula.

Baby Formula Shortages Could Alter Industry Structure

Baby formula shortages started amid pandemic-related supply chain disruptions and were exacerbated by the temporary shutdown in February of the Abbott plant in Sturgis, Michigan, following reports of bacterial contamination and voluntary product recalls. Although the direct link hasn’t been proved between the bacteria found at the Abbott plant and the bacteria causing the illness of the babies, the dramatic formula shortages caused by the supply shock revealed the vulnerabilities of the market structure. That could spur changes in regulation.

To that end, multiple regulatory options could be explored. The FDA has taken steps to cut the red tape in order to ensure additional supply through imports, measures which could be maintained even after the shortage is resolved. The U.S. government could also alter the WIC program. For example, it could move away from the sole-provider contract setup, which would have significant implications for the structure of the market. While this would have the benefit of reducing the reliance on a single supplier for a certain state, it would also significantly increase the cost of the program for the government, as manufacturers wouldn’t be incentivized to offer the same depth of discount. A balancing act would be required between securing diversified supply sources and managing the increased costs of the program.

Impact on Competitive Advantage and Growth Prospects

All three major U.S. infant formula manufacturers—narrow-moat Abbott, wide-moat Reckitt, and wide-moat Nestle—have diversified product portfolios and are therefore not overly reliant on the infant formula segment for the robustness of their economic moats. But it’s possible that regulatory changes in the wake of the infant formula shortage could alter the market structure and therefore dent their competitive advantages over time.

1. Abbott Laboratories

2. Reckitt Benckiser

3. Nestle

We believe the most likely outcome will be a relaxation of trade and regulatory barriers in order to allow for more importation of baby formula, which could gradually increase competition in the segment. This, and the long-term structural decline in birthrates in the U.S., is likely to put pressure on the growth rates that can be achieved by the largest players, especially Abbott and Reckitt which account for roughly 80% of the market. We estimate top-line growth for the infant nutrition segments of Abbott and Reckitt to average 2% per year after supply normalizes, constituting a drag on the faster growth that the two players aim to achieve from their other business segments. For Nestle, the U.S. infant formula segment accounts for less than 1% of group sales, so we expect the impact on its overall business to be negligible.

The baby formula shortage has also affected Reckitt’s near-term transformation plans. Before the crisis, Reckitt started taking steps to dispose of its infant nutrition segment, which it acquired from Mead Johnson in 2017. Years of failed attempts to turn the business around, which culminated with exiting Mead Johnson’s second-largest market, China, in 2021, have translated into a diminished contribution from the segment to growth and profits. An exit from the remaining predominantly U.S. business would allow management to shift focus and investment to the faster-growing hygiene and consumer health segments.

However, given the current market environment, Reckitt will face the reluctance of potential investors to enter the infant-formula segment, which is now perceived as higher risk. Any deal will also encounter increased scrutiny from the U.S. Department of Justice’s antitrust unit. The latter concern follows a letter from a group of senior U.S. politicians arguing that a sale by Reckitt of the infant formula business to a private equity buyer (the most likely scenario) could lead to further market disruption and consolidation, as well as potentially weaker management of quality and safety risks, and would not be in the best interest of consumers.

Baby Formula Shortage Shows Necessity of Safeguarding Competitive Advantage

The full implications of the baby formula crisis are still to unfold, but one thing is clear: Supplying essential, highly specialized, and complex consumer products such as baby formula might be a great source of competitive advantage for established players, but the risks involved are proportionate. Companies may be beneficiaries of strong market positions as a result of their track record and expertise. But they still need to safeguard their competitive advantage and their all-important reputation through strong product quality and safety programs, taking all the necessary steps to ensure their adequate enforcement.