China Mengniu Dairy Co. Ltd.

Transcription

1 China Mengniu Dairy Co. Ltd. Takeaways from Mengniu visits in Beijing and impact of new government measures We believe the latest government measures aimed at tightening dairy product supervision will help Mengniu to gain share from smaller players as it already has upstream investments and quality tracking systems in place. We recently visited Mengniu s production plant in Beijing and met Mengniu's head of sales and Mengniu s largest distributor in China. Main takeaways from our visit are i) Mengniu's sales momentum has accelerated in recent months, in particular for higher margin products; ii) distribution reach is getting stronger with c10% addition to distributors this year. Upstream investment now mandatory: According to a statement posted on the central government website on 21 June, China now requires baby formula powder producers to build and control their own farms. Mengniu already satisfies the latest requirement (our recent note The consolidator highlights Mengniu upstream investments) and has no plans for further upstream investments, according to management. Yashili is already building a dairy processing plant in New Zealand. Real-time tracking system: Xinhua news agency reported on 19 June that the government is looking to introduce a real-time tracking system for baby formula. Mengniu management notes that the company is well placed to comply with regulations, as the company already has tracking systems in place to monitor quality from source of milk to point of sale. Bridge loan financing: According to management, the company has secured a 1 year bridge loan financing (RMB9bn) at ~1.6% to finance Yashili acquisition. In the longer term, we expect the company to borrow at a higher range of 3% to 5%. If Mengniu secures a 3% rate, we expect a +15.6% impact to 2014 earnings from Yashili acquisition. Higher margin product sales momentum strong. Our meetings with Mengniu s head of sales and largest distributor supports our view that Mengniu's sales momentum has accelerated in recent months, in particular for higher margin products. China Mengniu Dairy Co. Ltd. (Reuters: 2319.HK, Bloomberg: 2319 HK) Rmb in mn, year-end Dec FY11A FY12A FY13E FY14E FY15E Revenue (Rmb mn) 37,388 36,080 41,615 48,777 56,612 Net Profit (Rmb mn) 1,589 1,257 1,557 2,094 2,611 EPS (Rmb) Recurring EPS (Rmb) DPS (Rmb) Revenue growth (%) 23.5% (3.5%) 15.3% 17.2% 16.1% Net Profit growth (%) 28.4% (20.9%) 23.8% 34.5% 24.6% Recurring profit growth 28.4% (20.9%) 23.8% 34.5% 24.6% EPS growth (%) 26.3% (20.9%) 23.8% 34.5% 24.6% ROE 15.0% 10.5% 11.9% 14.3% 15.8% ROA 8.5% 6.2% 7.2% 8.7% 9.6% P/E (x) P/BV (x) EV/EBITDA (x) Dividend Yield 1.0% 0.8% 0.9% 1.3% 1.6% Source: Company data, Bloomberg, J.P. Morgan estimates. Overweight 2319.HK, 2319 HK Price: HK$25.90 Price Target: HK$30.50 China Consumer Ebru Sener Kurumlu AC Shen Li, CFA (852) shen.w.li@jpmorgan.com Henry Tan (852) henry.wd.tan@jpmorgan.com J.P. Morgan Securities (Asia Pacific) Limited Price Performance HK$ Jun-12 Sep-12 Dec-12 Mar-13 Jun HK share price (HK$) MSCI-Cnx (rebased) YTD 1m 3m 12m Abs 15.9% -1.5% 23.3% 28.2% Rel 33.9% 12.7% 37.8% 29.4% Company Data Shares O/S (mn) 1,768 Market Cap (Rmb mn) 36,274 Market Cap ($ mn) 5,903 Price (HK$) Date Of Price 25 Jun 13 Free Float(%) 80.0% 3M - Avg daily volume (mn) M - Avg daily value (HK$ mn) 3M - Avg daily value ($ mn) 22.3 MSCI-Cnx Exchange Rate 7.76 Fiscal Year End Dec See page 9 for analyst certification and important disclosures, including non-us analyst disclosures. J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

2 Company Description P&L sensitivity metrics for FY13E EBIT EPS impact (%) impact (%) Mengniu is a leading dairy producer in ASP assumption China. Its major products include liquid Impact of a 0.5% increase 5.9% 5.3% milk product and ice cream. In 2008, it Raw milk cost assumption ranked No.1 in the sectors of liquid milk, Impact of a 1% increase -9.3% -8.3% yogurt and ice cream in China dairy Selling expense as % of sales assumption industry. Impact of a 0.5% increase -11% -9.9% Source: J.P. Morgan estimates Revenue Breakdown Price target and valuation analysis Ice cream 9% Other products 1% Our Jun-14 price target of HK$30.5 is based on 0.9x PEG, a discount to the 1x we use for other China consumer staples to reflect higher system risk for the dairy industry, with a two-year ( ) EPS CAGR of c26%. We are using PEG in order to capture earnings growth prospects. Source: Company. Liquid milk 90% EPS J.P. Morgan vs consensus J.P. Morgan Consensus FY13E FY14E FY15E Source: Bloomberg, J.P. Morgan estimates Target PEG E EPS CAGR 26% Implied Jun-14 target PE (x) 23.4 Jun-14 EPS (CNY) 1 Target price (HK$) 30.5 Key risks to our price target are higher-than-expected A&P spending, shortage of raw milk supply in China and slower momentum in Mengniu s high-end products. Peer comparison valuations Company Ticker Rating PT Price Mkt Cap P/E P/B (HK$) (HK$) (USD mn) E 2013E 2014E China Food sector China Mengniu Dairy 2319 HK OW , Tingyi 322 HK UW , Want Want 151 HK N , Tsingtao Brewery 168 HK UW , Uni-president China 220 HK N , Sector average Source: Bloomberg, J.P. Morgan estimates. Share prices are as of close of 25 Jun,

3 Government tightens supervision over baby formula Upstream investments now mandatory for baby formula producers According to a statement posted on the central government website on 21 June 2013, China now requires baby formula powder producers to build and control their own dairy farms. The statement further stated that powder producers need to: 1) set up an electronic data record system of the entire production and sales process; 2) Create a food safety management division and assign specially-trained safety staff. The government will also implement strict approval for new or expanding baby formula projects. Our talks with industry contacts and Mengniu s management indicate that this move is targeted at local firms who do not operate farms or factories but instead have their products produced at contract manufacturing facilities overseas. We note that CCTV has run stories regarding concerns on the safety of formula milk imported by these firms. We also note that in early June, Premier Li Keqiang spoke about improving the monitoring of the quality of imported milk powder in an address to the state council. Mengniu already satisfies the latest requirement, according to the management. As mentioned in our recent note The consolidator, Mengniu has invested in a series of upstream initiatives with self-built large scale ranches. Yashili is already building a processing plant in New Zealand. Mengniu states that there are no plans for further upstream investments this point in time. Real-time tracking system for baby formulae Xinhua news agency published an article (citing the Ministry of Industry and Information Technology) on 19 June 2013 stating that China is looking to introduce a real-time tracking system for baby formula this year. This relates to the supervision of the sale of infant formula on the Internet. Milk producers, transporters or collection stations that failed to meet safety standards will be banned and violators of safety laws strictly punished. Mengniu management states that if this law is passed, the company is well placed to comply with regulations, as the company already has tracking systems in place to monitor quality from source of milk to point of sales. It believes smaller players will not have the financial resources to meet this requirement. Bride loan financing secured at low interest rates According to management, the company has secured a 1 year bridge loan financing (RMB9bn) from HSBC and SCB at ~1.6% to finance Yashili acquisition. In the longer term, we expect the company to borrow at a higher range of 3% to 5%. If Mengniu secures a 3% rate, we expect a +15.6% impact to 2014 earnings from 3

4 Yashili acquisition. In the table below, we provide a sensitivity analysis on the impact of the funding cost on earnings. Table 1: Sensitivity Analysis on impact of funding costs on earnings Funding cost Yashili acquisition s impact on Mengniu's 2014 Earnings 1.6% 21.6% 2.0% 19.9% 2.5% 17.7% 3.0% 15.6% 5.0% 7.1% Source: J.P. Morgan estimates. Mengniu s market visit detailed meeting notes We visited Mengniu s production plant in Beijing, spoke with the Head of Sales, and visited Mengniu's largest distributor in China. Main takeaways from our visit are i) Mengniu's sales momentum has accelerated in recent months, in particular for higher margin products; and ii) distribution reach is getting stronger with c10% addition to distributors this year. Detailed notes are available below: Plant visit We visited Mengniu s Beijing production plant. This was located on the outskirts of the city centre, and about two hours away from the farm according to management (which was further away from city centre), and two hours away from the city centre. After milk is collected from the farmers and transported to the production plants, it will have to pass through a detection tank which is configured to inspect if the milk meets quality (e.g. fat, protein) and safety standards (e.g. microbe count, somatic count). After the milk passes the inspection tests, it will be stored in tanks or silos along different phases of the milk processing line - these inter processing tanks are automated into the processing line. Within the milk manufacturing line, there are two key processes: (1) Sterilization to reduce bacteria organisms; and (2) dehydrating + filtration to reduce water content and fat particles. In this process, we note centralized IT systems which will constantly monitor the quality and safety standards of the milk. Once the product manufacturing process is finished, the milk passes to the filling and packaging process. Standard processes produce milk with a shelf life of ~15 days, whilst aseptic processing produces milk with a shelf life ~30 to ~90 days. 60% of the packaging machines are supplied by Tetra Pak (machines churn 40k packets of milk every hour) and 20% of the packaging machines are supplied by Greatview (machines churn 20k packets of milk every hour). According to management, although Tetra Pak has the most productive machines by a stretch, Mengniu uses other suppliers to diversify their supplier dependence. Mengniu believes that the quality of their milk was higher than competitors. Mengniu highlights that the most notable difference between their milk and the 4

5 competitor milk was that Mengniu s liquid milk feels clear when consumers drink it, and competitor s milk still contain some small particles ( fat golubes ) which can be tasted by consumer. We note that the R&D department is also located within the plant premises. We did not see any Arla products manufactured in the plant. According to management, Mengniu currently imports Arla products to sell locally, as Arla products are not produced domestically. There are no plans in the near future to produce Arla products locally. Meeting with Head of Sales We met with Mengniu's head of sales, Mr. Gao. In the meeting the company indicated that sales grew mid teens in 2013 YTD, and shared that growth accelerated in April and May Mr. Gao believes this is because consumer confidence in dairy products have returned in the last two months. Management indicates that Mengniu has been the biggest beneficiary of this restoration in confidence and that the company has further gained market share of +2ppt to close to 25% in 1Q13 (up from around 23% in 2012). The company shared the following commentaries at a product level: "Star brands" have been driving this growth in 2013 YTD: You Yi C, Milk Deluxe, Latte are all growing at decent double digit levels. "Backbone" products have also achieved decent growth in 2013 YTD: Suan Suan Ru is growing at mid to high single digit growth. The company continued to emphasize that they will focus on higher margin products going forward. The minimum GPM for new product launches is 30%. Mr Gao indicates that since the 5 year strategic plan was implemented in end-12, the organization has been operating more efficiently. Mr Gao believes that this plan is the most concrete and detailed plan to date for Mengniu and there is huge buy-in from around the organization. Mengniu has already enjoyed quick wins in cost savings in 2013 YTD as a result of the deployment of the strategic plan. In particular, the integration of the sales and marketing resources for various product categories, lower SKUs and brands has resulted in marketing expenses (as a % of sales) to decrease. The company has a target to increase number of POS by 30% to 500k in 2013, and indicates this is well on track. The company utilizes mainly distributors for sales (~80% of total) currently and is looking to move towards more direct sales (~remaining 20%). The company estimates that the benefits of having more control over point of sales/ inventory levels would yield savings. This would outweigh the costs of deploying more direct sales resources. 5

6 The company has 3k distributors currently, and is looking to increase that by a net ~10% this year. At the same time, it is looking to drop smaller distributors who are under-performing - this adjustment will be a gradual one according to the company. The company continues to emphasize that food safety remains high on management's agenda and that they are working with regulators continuously on boosting industry standards. Arla products have been on sale for ~6 months now on a relatively small scale. Arla products sold in China include pure milk, milk powder, butter and cheese. Danone currently has operations in Shanghai, Beijing and Guangzhou and will be leveraging on Mengniu's nationwide distribution reach to extend their sales into other parts of China. Meeting with Mengniu's largest distributor We met CEO of Mengniu's largest distributor in China. The CEO is also chairman of a customer/ distributor committee set up by Mengniu and is invited to Mengniu's management meetings. The distributor is based in Beijing, and has been an exclusive distributor of Mengniu's products for 14 years. The company employs 1k employees and focuses on liquid normal temperature milk. The CEO highlighted that sales have significantly recovered in 2013 YTD, growing low teens (vs. flat in 2012). In particular, he noted that the Modern Dairy and Danone transactions have provided a notable momentum to growth. Subsequent to the announcements in early/ mid May, sales were up 5% relative to Mar/Apr 13. He believes that this is recognition from consumers on Megniu's efforts on ensuring food safety. He believes the safety concerns on milk quality were valid for milk powder but over-played by the media on other dairy categories. As a result, he believes the "worst is over" and forecasts mid teens growth for FY2013. The distributor also shared that high end premium milk continued to grow faster than other categories. The distributor highlights that there were a few notable differences in distribution strategy/ structure between Mengniu and main competitors that provides Mengniu with a significant competitive advantage: Mengniu has the lowest turnover days in the nation. The distributor's inventory turnover days were 12x (compared to 21x for Mengniu and 39x for Yili). Mengniu's scale advantages result in lower distribution costs. As volumes were higher, Mengniu incurs lower distribution costs per unit This scale advantage also allows Mengniu to fulfill higher % of orders compared to their competitors. According to the distributor, Mengniu fulfills very high % of sales orders, compared with much lower levels by competitors. As orders for 6

7 competitors were usually in lower volumes, competitors would typically consolidate two/ three orders in one delivery, to save transportation and logistics costs which can be very significant. This causes a delay in delivery response time, and results in competitors being unable to fulfill orders. As a result, Mengniu's scale advantage allows them to pay lower concessionaire rates and get allocated more shelf space. Mengniu's distributors also have to manage their own costs, while some of the competitors distributors costs are borne centrally by the brand and hence higher distribution costs. 7

8 China Mengniu Dairy Co. Ltd.: Summary of Financials Income Statement Cash flow statement Rmb in millions, year end Dec FY11 FY12 FY13E FY14E FY15E Rmb in millions, year end Dec FY11 FY12 FY13E FY14E FY15E Revenues 37,388 36,080 41,615 48,777 56,612 PBT 2,061 1,685 2,099 2,909 3,677 % change Y/Y 23.5% (3.5%) 15.3% 17.2% 16.1% Depr. & amortization 864 1,009 1,193 1,333 1,434 Gross Profit 9,592 9,055 10,605 12,766 15,092 Change in working capital 38 (68) % change Y/Y 23.2% (5.6%) 17.1% 20.4% 18.2% Tax & Other (442) (627) (428) (587) (802) Gross margin 25.7% 25.1% 25.5% 26.2% 26.7% Cash flow from operations 2,520 1,999 2,950 3,751 4,418 Other operating income EBITDA 2,760 2,503 3,081 3,892 4,692 Capex (2,484) (2,658) (2,350) (2,300) (2,000) % change Y/Y 27.3% (9.3%) 23.1% 26.3% 20.6% Sale of assets EBITDA Margin 7.4% 6.9% 7.4% 8.0% 8.3% Acquisition of subsidiaries/intangibles (17) (153) (2,512) 0 0 EBIT 1,896 1,494 1,888 2,559 3,258 Other 856 (429) % change Y/Y 30.3% (21.2%) 26.3% 35.5% 27.3% Cash flow from investing (1,645) (3,239) (4,749) (2,178) (1,823) EBIT Margin 5.1% 4.1% 4.5% 5.2% 5.8% Net Interest Equity raised/(repaid) Share of JVs Debt raised/(repaid) (450) (287) Other non operating income Dividends paid (331) (421) (275) (342) (460) Earnings before tax 2,061 1,685 2,099 2,909 3,677 Other 22 (35) % change Y/Y 34.0% (18.2%) 24.6% 38.6% 26.4% Cash flow from financing (238) (731) (275) 208 (460) Tax (276) (245) (315) (465) (625) as % of EBT 13.4% 14.6% 15.0% 16.0% 17.0% FX gain/(loss) (52) (2) Minorities (195) (182) (227) (349) (442) Net change in cash 585 (1,974) (2,074) 1,781 2,135 Net income (reported) 1,589 1,257 1,557 2,094 2,611 Ending cash 4,360 2, ,650 4,236 % change Y/Y 28.4% (20.9%) 23.8% 34.5% 24.6% DPS Recurring Net Income 1,589 1,257 1,557 2,094 2,611 % change Y/Y 28.4% (20.9%) 23.8% 34.5% 24.6% EPS (reported) % change Y/Y 26.3% (20.9%) 23.8% 34.5% 24.6% Recurring EPS % change Y/Y 26.3% (20.9%) 23.8% 34.5% 24.6% Balance sheet Ratio Analysis Rmb in millions, year end Dec FY11 FY12 FY13E FY14E FY15E Rmb in millions, year end Dec FY11 FY12 FY13E FY14E FY15E Cash and cash equivalents 6,523 5,778 3,704 4,935 7,070 Gross margin 25.7% 25.1% 25.5% 26.2% 26.7% Accounts receivable ,021 1,157 EBITDA margin 7.4% 6.9% 7.4% 8.0% 8.3% Inventories 1,685 1,420 1,629 1,892 2,181 Operating Margin 5.1% 4.1% 4.5% 5.2% 5.8% Others 1,342 1,521 1,722 1,982 2,267 Net margin 4.3% 3.5% 3.7% 4.3% 4.6% Current assets 10,387 9,521 7,953 9,831 12,675 Recurring net profit margin 4.3% 3.5% 3.7% 4.3% 4.6% Goodwill Sales growth 23.5% (3.5%) 15.3% 17.2% 16.1% Intangible assets Net profit growth 28.4% (20.9%) 23.8% 34.5% 24.6% Long term investments Recurring net profit growth 28.4% (20.9%) 23.8% 34.5% 24.6% Net fixed assets 7,694 8,489 9,660 10,642 11,223 EPS growth 26.3% (20.9%) 23.8% 34.5% 24.6% Other assets 1,261 1,743 1,728 1,713 1,698 Total Assets 20,202 20,539 22,640 25,485 28,895 Interest coverage (x) Net debt to equity (48.7%) (39.6%) (21.3%) (26.0%) (33.6%) Liabilities Sales/assets Short-term loans Assets/equity 176.7% 170.4% 165.0% 164.8% 164.3% Trade & other payables 3,685 3,679 4,030 4,471 4,956 ROE 15.0% 10.5% 11.9% 14.3% 15.8% Others 2,885 2,703 2,944 3,246 3,578 ROCE 14.5% 10.1% 11.7% 14.1% 15.8% Total current liabilities 7,226 6,981 7,573 8,315 9,133 Long-term debt Others Total Liabilities 8,153 7,919 8,511 9,254 10,072 Minorities ,205 1,647 Shareholders' equity 11,471 12,443 13,725 15,477 17,628 BVPS Source: Company reports and J.P. Morgan estimates. 8

9 Analyst Certification: The research analyst(s) denoted by an AC on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an AC on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst's compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report. Important Disclosures Client: J.P. Morgan currently has, or had within the past 12 months, the following company(ies) as clients: China Mengniu Dairy Co. Ltd.. Company-Specific Disclosures: Important disclosures, including price charts, are available for compendium reports and all J.P. Morgan covered companies by visiting calling , or ing with your request. J.P. Morgan s Strategy, Technical, and Quantitative Research teams may screen companies not covered by J.P. Morgan. For important disclosures for these companies, please call or research.disclosure.inquiries@jpmorgan.com. China Mengniu Dairy Co. Ltd. (2319.HK, 2319 HK) Price Chart Price(HK$) Oct 06 Jul 07 Apr 08 Jan 09 OW HK$23 UW HK$14.5 Oct 09 Jul 10 Apr 11 OW HK$24 OW HK$25 OW HK$33 OW HK$26 UW HK$18 UW HK$3.8 UW HK$8.1 OW HK$32 OW HK$30 OW HK$26OW HK$30 OW HK$35 OW HK$27 OW HK$28 OW HK$24 OW HK$3 Source: Bloomberg and J.P. Morgan; price data adjusted for stock splits and dividends. Initiated coverage Apr 10, Jan 12 Oct 12 Jul 13 Date Rating Share Price (HK$) 10-Apr-08 UW Sep-08 UW Apr-09 UW Jun-09 UW Sep-09 OW Dec-09 OW Apr-10 OW Sep-10 OW May-11 OW Aug-11 OW Oct-11 OW Jan-12 OW Feb-12 OW Mar-12 OW Jul-12 OW Aug-12 OW Dec-12 OW Jun-13 OW Price Target (HK$) The chart(s) show J.P. Morgan's continuing coverage of the stocks; the current analysts may or may not have covered it over the entire period. J.P. Morgan ratings or designations: OW = Overweight, N= Neutral, UW = Underweight, NR = Not Rated Explanation of Equity Research Ratings, Designations and Analyst(s) Coverage Universe: J.P. Morgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analyst s (or the analyst s team s) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analyst s (or the analyst s team s) coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks in the analyst s (or the analyst s team s) coverage universe.] Not Rated (NR): J.P. Morgan has removed the rating and, if applicable, the price target, for this stock because of either a lack of a sufficient fundamental basis or for legal, regulatory or policy reasons. The previous rating and, if applicable, the price target, no longer should be relied upon. An NR designation is not a recommendation or a rating. In our Asia (ex-australia) and U.K. small- and mid-cap equity research, each stock s expected total return is compared to the expected total return of a benchmark country market index, not to those analysts coverage universe. If it does not appear in the Important Disclosures section of this report, the certifying analyst s coverage universe can be found on J.P. Morgan s research website, Coverage Universe: Sener, Kurumlu Ebru: Ajisen China Holdings Ltd (0538.HK), Belle International Holdings Ltd. (1880.HK), Cafe de Coral Holdings Ltd (0341.HK), China Foods Ltd (0506.HK), China Mengniu Dairy Co. Ltd. (2319.HK), China Resources Enterprise (0291.HK), Chow Tai Fook Jewellery Company Ltd. (1929.HK), Dairy Farm International Holdings Limited (DAIR.SI), Esprit Holdings 9

10 (0330.HK), Golden Eagle Retail Group Ltd (3308.HK), Hengan International Group Ltd (1044.HK), L'Occitane International SA (0973.HK), Li & Fung (0494.HK), Lifestyle International Holdings (1212.HK), New World Department Stores Ltd (0825.HK), Parkson Retail Group Ltd (3368.HK), Prada S.P.A (1913.HK), Sa Sa International Holdings Limited (0178.HK), Thai Beverage Public Company Ltd. (TBEV.SI), Tibet 5100 Water Resources Holdings Ltd (1115.HK), Tingyi (Cayman Islands) Holding Corp (0322.HK), Tsingtao Brewery - A ( SS), Tsingtao Brewery - H (0168.HK), Uni-President China Holdings Ltd (0220.HK), Want Want China Holdings Ltd (0151.HK) J.P. Morgan Equity Research Ratings Distribution, as of March 30, 2013 Overweight (buy) Neutral (hold) Underweight (sell) J.P. Morgan Global Equity Research Coverage 43% 44% 13% IB clients* 54% 47% 38% JPMS Equity Research Coverage 42% 50% 9% IB clients* 74% 64% 57% *Percentage of investment banking clients in each rating category. 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Clients should contact analysts and execute transactions through a J.P. Morgan subsidiary or affiliate in their home jurisdiction unless governing law permits otherwise. "Other Disclosures" last revised May 4, Copyright 2013 JPMorgan Chase & Co. All rights reserved. This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of J.P. Morgan. #$J&098$#*P 11

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