Mengniu (2319 HK) Accumulate (initiation) Target price: HK$ Benefiting from declining raw milk prices; initiate at Accumulate

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1 Equity Research Consumer Staples Mengniu (2319 HK) Accumulate (initiation) Target price: HK$45.6 Benefiting from declining raw milk prices; initiate at Accumulate A volume-driven dairy leader Mengniu, which manufactures and distributes dairy products in China along with its subsidiaries, is the second largest dairy company in China with a 24% liquid milk market share. It has an asset-light model as it does not operate directly in dairy farming which requires considerable investment in farm construction and cow raising. As a downstream player, Mengniu s NPM ranges between 4-6%, with its earnings mainly driven by volume growth. Alex Fan, CFA SFC CE No. ADJ672 alexfan@gfgroup.com.hk YangKe SFC CE No. BEZ121 yangke@gfgroup.com.hk GF Securities (Hong Kong)Brokerage Limited 29-3/F, Li Po Chun Chambers 189 Des Voeux Road Central Hong Kong Stock performance Long-term outlook positive China s dairy industry has grown substantially over the past 15 years, with dairy product sales volume growing at a CAGR of 26.49%. Mengniu has been an industry leader with revenue growth higher than industry average for the most part of the past decade. Although sector expansion has slowed down, we still have a positive outlook on the industry, one main reason being that per capita milk consumption in China is much lower than levels in developed countries. We expect the domestic dairy industry to maintain steady growth in the long run as Chinese residents disposable income increases. Mengniu, in particular, is making great efforts to increase its market share and improve its operational efficiency. Ambitious cooperation with Danone Danone has a 2% stake in its JV with Mengniu, which focuses on low-temp products including yogurt and lactic acid fungus beverage. Danone has also acquired a 25% stake in Yashili through an HK$4.39bn private placement. Mengniu has introduced Danone into the picture to leverage on the latter s management team to help pull Yashili out of its current difficulties. Danone s infant milk formula business ranked No.1 in mainland China by revenue in 214. In fact, it has been a consistent pattern for Danone to expand its presence in China through M&A with a strategic focus on maintaining the highest market shares for its different products. In view of this pattern, we expect to see aggressive growth in the Mengniu-Danone JV as well as Yashili. Controlling shareholder with fully integrated value chain to provide support COFCO, which is controlled by the central government, is Mengniu s biggest shareholder with a 31.62% stake. COFCO operates businesses along a fully integrated value chain covering grain distribution, agricultural product processing, breeding and slaughtering, branded consumer goods manufacturing and distribution, property development, financial services and e-commerce. Mengniu benefits from its connection with COFCO in terms of forage and packaging materials supply, cash management and COFCO s e-commerce platform. Growth driven by declining costs and synergy; initiate at Accumulate We expect Mengniu to see annual earnings growth of 2-29% during The stock is trading at 21.1x 215E P/E, or 2.5x 215E P/B. Although its share price has rebounded 27% YTD, we believe the company will continue to benefit from declining raw milk prices in 215. In addition, the market has yet to fully factor in the synergy of its cooperation with Danone and its equity investments in CMD and Yashili. We initiate coverage of the stock at Accumulate, with a target price of HK$45.6, equivalent to 23.5x 215E P/E (its historical average P/E level). Source: Wind Risks Increasing raw milk prices, tougher competition downstream, food safety issues, and stronger-than-expected impact of imported products. Key data May 4 close (HK$) 4.7 Share in issue (m) 1,96 Major shareholder COFCO (31.62%) Market cap (HK$ bn) M avg.vol. (m) W high/low (HK$) 51./27. Source: Wind Stock valuation Turnover Net profit EPS EPS YoY P/E BPS P/B ROE Net gearing (Rmb m) (Rmb m) (Rmb) (%) (Rmb) (%) (%) ,357 1, ,49 2, E 58,189 3, E 68,933 3, E 83,28 4, Note: Calculated based on diluted shares.

2 Business model An FMCG company with a balanced asset structure Mengniu, which manufactures and distributes dairy products in China along with its subsidiaries, is the second largest dairy company in China. Currently 86%of its revenue comes from the liquid milk segment, which includes UHT (ultra-heat treated) milk, milk beverage and yogurt. As a downstream player which makes less investment in forage production and dairy farming, it has a relatively balanced asset structure. Non-current assets account for around 5% of the company s total assets, while most of its investment is in plants and equipment for its production across the country. Raw milk cost (representing COGS) accounts for the biggest share of total cost at 7%, followed by selling and distribution expenses which account for 24%, as the company s revenue is primarily driven by its distribution network and distributor incentive mechanism. Figure 1: Dairy industry value chain Forage production Dairy farming Dairy product manufacturing End market sales Source: GF Securities (HK) Volume-driven growth Due to its low NPM and ASP, quick turnover and a rising market share are crucial for the company s success. Mengniu has set up an efficient sales system with its distributors, which has contributed significantly to its expansion over the past ten years. Thanks to this system, distributors have helped to reduce Mengniu s funding pressure and provided regional logistics services. Furthermore, a performance-based mechanism has motivated distributors to work hard for higher sales growth. 94% of milk supply coming from ranches and large-scale farms In order to maintain a relatively asset-light model, Mengniu previously purchased raw milk from small-scale farms scattered across China. However, following the dairy crisis in 28, the industry has attached greater importance to raw milk sources given concerns about milk quality. As a result, nearly every leading dairy company has increased investment in farm development. Mengniu is the controlling shareholder of CMD (1117 HK, Underperform), the largest dairy farming company in China by herd size. In addition, Mengniu also has equity interests in some of its other suppliers such as YST (1431 HK, Hold) and Shengmu (1432 HK, NR). Figure 2:214 revenue breakdown Figure 3: Liquid milk revenue breakdown in 214 Ice cream 5% Milk formula 8% Others 1% Yogurt 17% Liquid milk 86% Milk beverage 28% UHT milk 55% Page 2

3 Figure 4:Annual revenue breakdown by product (Rmb ) Figure 5: Annual revenue breakdown by product (%) 6,, 5,, 4,, 3,, 2,, 1,, Liquid milk Ice cream Milk formula Others 1% 95% 9% 85% 8% 75% 7% 65% 6% 55% 5% Liquid milk Ice cream Milk formula Others Figure 6: Cost breakdown Figure 7: COGS and S&D as % of sales 1% 9% 8% 7% 6% 5% 4% 3% 2% 1% % COGS S&D expenses Administrative expenses 85% 8% 75% 7% 65% 6% 55% 5% 45% 77.73% 14.41% 77.71% 13.81% 77.9% 14.65% 77.47% 15.49% 8.43% 18.55% 73.35% 18.1% 74.27% 17.94% 74.34% 17.91% 75.14% 73.2% 69.16% 21.11% 17.29% 18.84% COGS/sales S&D expenses/sales (RHS) 4% 35% 3% 25% 2% 15% 1% Figure 8: 214 asset breakdown Figure 9: Revenue and net profit growth (YoY) 6% 1% Prepayments, deposits and others 4% Trade and bills receivables 3% Deferred tax assets 1% Cash and bank balances 19% Inventories 1% Financial assets 12% PPE and construction in progress 24% Intangible assets 16% Investment in associates 8% Investment in properties and land 3% 5% 4% 3% 2% 1% % -1% -2% -3% -4% Revenue (YoY) Net profit (YoY, RHS) 5% % -5% -1% -15% -2% -25% Page 3

4 Figure 1: Current and non-current assets (Rmb m) Figure 11: Current and non-current assets (%) Figure 12: Plant map Page 4

5 Industry overview Supply and demand Great potential driven by rising demand China s dairy industry has grown substantially over the past 15 years, as dairy product sales volume increased from 779, tonnes in 2 to 26,432, tonnes in 214, with a CAGR of 26.49%. That said, per capita liquid milk consumption in the country was just 15.9kg in 212, which was relatively low compared with the amount for developed countries, meaning considerable growth potential for domestic dairy companies. In addition, urban residents spent more on dairy products than rural residents as a result of their income difference. The difference also presents new opportunities for dairy companies as the disposable income of residents in underdeveloped regions is set to increase in the long term. Figure 13: Dairy product sales volume in China (tonnes) Figure 14: Per capita liquid milk consumption (kg, 212) 3,, 25,, 2,, 15,, 1,, 5,, Sources: Dairy Association of China, Wind, GF Securities (HK) Figure 15: Urban residents spending on dairy products Figure 16: Urban vs. rural dairy consumption % % 19.3% 18.12% 17.91% % 8.36% 6.15% 6.98% 4.72% % 1.19% 35.% 3.% 25.% 2.% 15.% 1.% 5.%.% Urban residents' spending on dairy products (Rmb/person) YoY (RHS) Annual dairy consumption by urban residents (kg/person) Annual dairy consumption by rural residents (kg/person) Sources: Dairy Association of China, Wind, GF Securities (HK) Industry concentration high with competitor number declining Only a relatively small number of the 6 plus dairy companies in China are capable of large-scale production. The top three among them, namely Yili (6887 SH), Mengniu (2319 HK, Accumulate) and Bright Dairy (6597 SH), represent a combined market share of 6%. In addition, the number of competitors in the industry has been declining since the dairy crisis in 28. We believe smaller players not seeing economies of scale and strong profitability will be pushed out of the market. Page 5

6 Figure 17: Chinese liquid milk market breakdown (214) Figure 18: Number of dairy companies in China Others 4% Mengniu 27% % 1.73% 2.72% 2.65% % 1.39% % -2.37% % 1% 5% % -5% -1% Bright dairy 1% Yili 23% % % -2% Number of dairy companies in China YoY (RHS) Entry barriers Stricter government policy for milk source control Strict requirements regarding the source of raw milk supply have been put in place following the melamine contamination crisis in 28. In general, companies processing and manufacturing dairy products are required to have stable and controllable raw milk supply. For newly developed dairy manufacturing projects, at least 4% of raw milk is required to come from self-owned supply bases, whereas for rebuilt or expanded projects, the requirement is raised to75%. For infant milk formula companies, at least 5%of raw milk supply should come from self-owned sources. Difficulty in obtaining stable raw milk supply 76% of raw milk in China is produced in the northern part of the country, which consumes only 25% of dairy products in the country. Most dairy farms in northern China have signed long-term contracts with Yili or Mengniu, the industry s top two players, while regional dairy companies typically operate self-owned farms or purchase raw milk from local farmers. The ability to obtain a stable supply of high-quality raw milk is crucial for new entrants as dairy farming has a long production cycle and requires a large amount of capital expenditure. A dairy farm with 1, cows requires initial investment of ~Rmb4m, which does not include operating costs related to forage, labor and so on. Brand recognition and nationwide sales networks The market share of a consumer company largely hinges upon its brand influence and sales channels. Yili and Mengniu have worked hard over the years to set up their own sales networks across the country, and have maintained continued input in advertising and marketing relying on their strong profitability. In contrast, it is very difficult for new entrants to achieve success given their lack of economies of scale and low NPM. Sector expansion has decelerated from the previous double-digit growth to single-digit growth nowadays (in terms of sector revenue) amid increased competition from lower-priced overseas products. In addition, regional companies are also having difficulty expanding their business nationwide due to the challenge of maintaining stable milk sources as well as the longterm efforts required by brand building. Competition landscape Dairy farms bargaining power weakening due to declining raw milk prices As raw milk prices rose 6% from 29 to 213, high profitability upstream led to increased investment in dairy farms. Large-scale farms are able to produce higher-quality milk at a lower cost compared with small or family farms, while downstream brand owners such as Mengniu can earn a higher profit margin from premium products. As such, the industry began to boom in 29 with a rise in ASP driven by tight supply. This upward trend was reversed in early 214 when milk production dropped off due to the drought in New Zealand and China in 213, which led to a sharp increase in milk ASP. In view of the milk shortage, most downstream companies strengthened milk powder purchases from overseas, which were used to produce milk beverage. Afterwards, as dairy companies tried to destock the large amount of milk powder inventory accumulated during this process, they lowered raw milk purchases from domestic farms in 214.Separately, dairy farms primarily sell their products to a wholesale customer base which mainly consists of several major downstream dairy companies. Downstream players tend to have stronger bargaining power over Page 6

7 Jan-9 May-9 Sep-9 Jan-1 May-1 Sep-1 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14 Sep-14 Jan-15 Company report upstream players given their large purchasing volumes. In addition, the fact that milk quality among major large-scale dairy farms is nearly undifferentiated means the cost for buyers to switch between suppliers is low. As more competitors crowd into the upstream market and as capacity increases, raw milk prices are likely to decline further until a supply-demand equilibrium can be reached. During the ongoing price decline, small-scale farms without economies of scale might be pushed out of the market. Figure 19: National average raw milk price in China (Rmb/kg) Figure 2: Raw milk production in China ,, 37,5, 37,, 36,5, 36,, 35,5, 35,, 34,5, 34,, 2.24% 2.4% 1.55%.86% -.98% -5.67% 5.48% Raw milk production in China (tonnes) 8.% 6.% 4.% 2.%.% -2.% -4.% -6.% -8.% YoY growth (%, RHS) Sources: Ministry of Agriculture, Wind, GF Securities (HK) Figure 21: Monthly cow imports to China (head) Figure 22: Annual cow imports to China(head) 4, 25, 11.68% 12% 35, 3, 2, 215,45 1% 8% 25, 15, 6% 2, 15, 1, 5, 1, 5, 128,249 12, % 4% 2% % -2% Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec % Imported cows YoY growth Sources: Dairy Association of China, China Customs, GF Securities (HK) Figure 23: Chinese liquid milk market breakdown (214) Figure 24: Major raw milk producers client base breakdown (214) 1% 9% Others 4% Bright dairy 1% Mengniu 27% Yili 23% 8% 7% 6% 5% 4% 3% 2% 1% % CMD HSD YST Shengmu Self use Others Feihe Bright Dairy Yili Mengniu Page 7

8 Company report Retail customers with limited bargaining power The downstream dairy market is highly concentrated with the top three players taking a combined 6% share of the liquid milk market. The small number of downstream dairy companies with national presence means that these companies have stronger bargaining power over their customers who are mostly retail consumers. Therefore, market leaders with an extensive distribution network are currently ahead of peers given the increasing number of suppliers and a large customer base spread across the country. This is also the reason why many raw milk producers are trying to develop their own downstream business. New entrants from upstream Mengniu has indicated that it is sourcing raw milk from more than 1, suppliers, whereas dairy farming companies listed in HK typically have no more than ten key customers. An increasing number of raw milk producers have started to develop their own downstream operations amid the raw milk ASP slump. UHT milk produced by CMD (1117 HK, Underperform) and Shengmu (1432 HK, NR) are now available under their own brands in supermarkets, competing alongside Mengniu though the latter has been the biggest customer of both producers for many years. Direct competition from upstream companies is taking market shares away from downstream brand owners. More importantly, the founders of both CMD and Shengmu previously served at Mengniu for a long period of time. Mr. Deng Jiuqiang, founder of CMD, worked at Mengniu for eleven years before going into dairy farming in 25, while Shengmu, now the biggest organic raw milk producer in China, was first established with Mengniu s investment. Shengmu s CEO previously served for eight years at Mengniu which contributed 58% of Shengmu s revenue in 213. This means it is not particularly difficult for these competitors from upstream to set up marketing networks and build their own brands on a national level. Furthermore, the New Hope Group, which is the largest forage producer in China, has set up a national dairy company through a series of M&A of regional dairy companies. This company has a competitive edge in low-temperature products such as Yogurt and fresh milk, and is said to be preparing for a listing. Increasing threat from imported products Dairy products from the EU and Australia/New Zealand have a cost advantage over Chinese products. In addition, imported liquid milk is also competing directly with domestic premium UHT products such as Mengniu s Delux. Data from Chinese customs indicates that liquid milk imported by China rose 68.85%to 328,923 tonnes in 214, with the top three exporters, Germany, New Zealand and Australia, collectively accounting for 69% of the total imported amount. Although the current import volume represents less than 1% of total milk production in China, its rapid growth has come to the attention of domestic dairy companies. Figure 25: Milk powder import volume and ASP Figure 26: Milk powder import volume (tonnes) 18, 16, 14, 12, 1, 8, 6, 4, 2, Imported milk powder (tonnes) ASP of imported milk powder (RHS, US$/tonne) 6, 5, 4, 3, 2, 1, 18, 16, 14, 12, 1, 8, 6, 4, 2, Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Sources: Dairy Association of China, Wind, GF Securities (HK) Page 8

9 Company report Figure 27: Milk powder import volume and YoY growth Figure 28: Liquid milk import volume and ASP 1,, 9, 8, 7, 6, 5, 4, 3, 2, 1, % 67.11% 8.58% 27.47% 49.8% 8.11% 16% 14% 12% 1% 8% 6% 4% 2% 4, 35, 3, 25, 2, 15, 1, 5, 3, 2,5 2, 1,5 1, % Imported liquid milk (tonnes) Imported milk powder (tonnes) YoY (RHS) ASP of imported liquid milk (RHS, US$/tonne) Sources: Dairy Association of China, Wind, GF Securities (HK) Figure 29: Liquid milk import volume (tonnes) Figure 3: Liquid milk import volume and YoY growth 4, 35, 35, 3, 151.6% % 16% 14% 3, 25, 2, 15, 1, , 2, 15, 1, 5, 72.52% 19.11% 91.56% 68.85% 12% 1% 8% 6% 4% 2% 5, Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Imported liquid milk (tonnes) YoY (RHS) % Sources: Dairy Association of China, China Customs, GF Securities (HK) Figure 31: Milk powder imports breakdown by country Figure 32: Milk powder imports breakdown by country (214) 1% 9% 8% 7% 6% 5% 4% 3% 2% 1% % Others Australia New Zealand US Singapore Netherlands Ireland France Denmark Australia 3% Denmark 2% Others 6% New Zealand 74% France 4% Ireland Netherlands 3% 1% Singapore US 3% 4% Sources: Dairy Association of China, China Customs, GF Securities (HK) Page 9

10 Figure 33: Imported liquid milk breakdown by country Figure 34: Imported liquid milk breakdown by country (214) 1% 9% 8% 7% 6% 5% 4% 3% Others New Zealand Australia Switzerland Austria Netherlands France New Zealand 21% Others 15% Korea 8% England 2% Germany 32% 2% Germany 1% % UK Korea Netherlands 1% Australia 16% Switzerland % France 4% Austria 1% Sources: Dairy Association of China, China Customs, GF Securities (HK) Company outlook Long-term outlook positive despite short-term slowdown China s dairy industry has grown substantially over the past 15 years, as dairy product sales volume increased from 779, tonnes in 2 to 26,432, tonnes in 214, with a CAGR of 26.49%. Mengniu has been an industry leader with revenue growth higher than industry average for the most part of the past decade. Although sector expansion has slowed down from the previous double-digit revenue growth to single-digit growth, we still have a positive outlook on the industry, one main reason being that per capita milk consumption in China is much lower than levels in developed countries. We expect the domestic dairy industry to maintain steady growth in the long run as Chinese residents disposable income increases. Mengniu, in particular, is making great efforts to increase its market share and improve its operational efficiency. Strategic control of upstream players Mengniu has strengthened efforts to secure milk sources by making equity investment in upstream players so that it can maintain a solid partnership with suppliers without having to make considerable capex investment in dairy farming (which typically involves an asset-heavy operating model). According to Mengniu, 94% of its milk supply comes from ranches and large-scale farms. Mengniu buys milk from all four HK-listed dairy farming companies and has equity interests in three of them. Figure 35: Equity interests in upstream players held by Mengniu (as of Apr 215) Company Ticker Core business Stake CMD 1117 HK Raw milk production 27.92% Fuyuan not listed Raw milk production 43.% YST 1431 HK Raw milk production 4.43% Shengmu 1432 HK Raw milk production 4.% New growth in premium UHT milk, UHT yogurt and low-temp products Mengniu s premium UHT brand, Delux, takes a 55% share of the UHT milk market in China. It has maintained a No.1 ranking position for many years, although having suffered a slight loss of market share recently due to fierce competition. Mengniu now has OEM producers in New Zealand and Denmark to produce UHT milk under the Delux brand. Delux, which is produced with milk sourced from overseas, mainly targets high-end customers desiring high quality products. In addition, this brand has helped alleviate the impact of competition from imported UHT milk. Following Bright Dairy, which was the first to develop a UHT yoghurt, Mengniu and Yili have also started to offer this product in view of its strong growth. We believe Mengniu will see its UHT yogurt outperform its other products in terms of sales growth given its extensive sales network across the country. Separately, Mengniu is running its low-temp product business mainly through its JV with Danone. Unlike competitors such as Bright Dairy (6597 SH), Huishan (6863 HK) and CMD (1117 HK, Underperform), Mengniu has not stepped up efforts in the pasteurized milk space which requires the relevant dairy farms to be located near the targeted market. This has resulted from Mengniu s failed experiment with this product in China s most developed Yangtze River Delta which has the Page 1

11 highest level of pasteurized milk consumption in the country. Mengniu ran into strong competition from regional market dominator Bright Dairy and suffered financial losses, with the main difficulties lying in the product s short storage period and inventory management issues due to the higher capex required by cold chain logistics development. As a result, Mengniu has turned to Danone for the expansion of its low-temp business. Expansion through horizontal M&A Horizontal M&A of downstream peers is an efficient way to increase market share which also produces a complementary effect between different businesses. Mengniu has acquired a controlling stake in Yashili given its own weakness in the infant milk formula business compared with major opponent Yili. Amid the ongoing slowdown in the baby formula sector, Mengniu has brought Danone in as Yashili s second largest shareholder and thus made Danone its own strategic and financial partner, given that Danone s baby formula business ranked No.1 in 214 by total sales. Separately, Junlebao, a regional dairy company, achieved considerable growth in its baby formula business in 214 by selling products at low prices through the online channel which helped reduce sales costs significantly. Figure 36: Equity interests in downstream players (as of Mar 215) Company Ticker Core business Stake Time of investment Yashili 123 HK IMF producer 68.5% 213 Junlebao not listed Diary company 51.% 211 Youzhiyou not listed Diary company 1.% 27 Cooperation with Arla Arla Foods is a global dairy company based in Denmark. As it offers guaranteed returns for dairy farms, it avoids an aggressive expansion approach which often involves a high level of risks. Arla has a 5.35% stake in Mengniu, and cooperates with the latter in dairy farm operations and sells products through Mengniu s channels. Danone to be increasingly ambitious with Mengniu JV Danone has a 2% stake in its JV with Mengniu. Cooperation between the two companies focuses on low-temp products including yogurt and lactic acid fungus beverage. The JV, which operates 13 factories across China, is Mengniu s only platform for low-temp products. It is worth noting that Danone cooperated with Bright Dairy during , providing guidance for the latter in terms of brand building and product design. Despite the 15-year partnership, Danone was not able to control Bright Dairy which is a stateowned company controlled by the Shanghai government. In addition, Danone was not satisfied with Bright Dairy s relatively slow pace of growth. As such, Danone ended its partnership with Bright Dairy and made an investment in Mengniu. In fact, it has been a consistent pattern for Danone to expand its presence in China through M&A with a strategic focus on maintaining the highest market shares for its different products. In view of this pattern, we expect to see aggressive growth in the Mengniu-Danone JV. Things to improve for Yashili with Danone assistance Yashili posted an earnings decline of 4% YoY in 214, the year following Mengniu s acquisition. In Oct 214, Danone acquired a 25% stake in Yashili through a HK$4.39bn private placement. Danone s infant milk formula business ranked No.1 in mainland China by revenue in 214. It has tapped into the online shopping channel which is popular among Chinese consumers nowadays, and has seen an increase in its market share. In addition, its experience in international brand operation is also highly valuable. We expect the expertise of Danone s management team to help Yashili get out of its current business difficulties. Controlling shareholder with fully integrated value chain COFCO Group has in total a 16.35% stake in Mengniu, but has a 31.62% voting right as a result of the company s shareholding structure. COFCO is the biggest supplier of agricultural and food products and services in China, and is controlled by the central government with the State-owned Assets Supervision and Administration Commission (SASAC) as its majority shareholder. Five of its subsidiaries are listed in Hong Kong with another three listed in mainland China. COFCO operates businesses along a fully integrated value chain covering grain distribution, agricultural product processing, breeding and slaughtering, branded consumer goods manufacturing and distribution, property development, financial services and e-commerce. The CEO of COFCO, Ning Gaoning, previously served 17 years at China Resources, another SASAC-controlled company. China Resources developed into a conglomerate through a series of M&A during his tenure, and the same developmental pattern has been copied over to COFCO. In particular, Mengniu started its M&A with CMD and Yashili after COFCO became its controlling shareholder. We find it Page 11

12 meaningful to view Mengniu within COFCO s business network. COFCO supplies forage for CMD, while both Mengniu and Yashili purchase financial products from COFCO Trust. In addition, COFCO Packaging (96 HK, NR) provides packaging materials for Mengniu, while Mengniu s products are available on COFCO s e-commerce platform Womai. We believe Mengniu is likely to have access to more resources relying on COFCO s support, especially when compared with its major competitors Yili and Bright Dairy, both of which are owned by local governments. Figure 37: Listed companies in the COFCO family (as of Mar 215) Company Ticker Business China Foods 56 HK Production, distribution and trading of consumer food, beverage and others China Agi Industries 66 HK Agribusiness and food processing Mengniu Dairy 2319 HK Dairy COFCO Packaging 96 HK Consumer goods packaging Joy City Property 27 HK Commercial property development COFCO Tunhe 6737 CH Processing and production of sugar and tomatoes COFCO Real Estate 31 CH Residential property development CFOCO Biochemical 93 CH Biotechnology in agri-food processing Figure 38: Mengniu s shareholder structure(as of Mar 215) Figure 39: Shareholder structure(as of Mar 215) COFCO 16.35% Arla 5.35% Public sharholders 68.38% Daonoe 9.92% Financial analysis Profit margin widening on upstream price slumps Mengniu reported revenue and net profit of Rmb5,49m and Rmb2,69m in 214, representing YoY growth of 15.44% and 44.5%. GPM rose 386bps to 3.84%. Strong earnings were mainly driven by lower raw milk cost, which accounted for 7-8% of total costs. The industry top three have all seen their profit margin on the rise, with Yili achieving the highest NPM of 8.67% in 214. Page 12

13 Figure 4: Mengniu s annual revenue Figure 41: Mengniu s annual net profit 6, 5, 4, 3, 2, 1, 5.6% 5.8% 31.22% 23.53% 17.72% 11.95% 7.73% -3.71% 2.44% 15.44% % 5% 4% 3% 2% 1% % -1% 3, 2,5 2, 1,5 1, , 41.68% 55.94% 1% 27.98% 11.13% 31.61% 25.7% 44.5% 5% % % -5% -1% % -15% % % -25% Revenue (Rmb m) YoY (RHS) Net profit (Rmb m) YoY (RHS) Figure 42: Mengniu s GPM and NPM An asset-light model with more equity investment within industry chain Properties, plants and equipment account for 27% of Mengniu s total assets, a percentage that is lower than the other two of the top three players. Yili and Bright Dairy own a larger amount of fixed assets upstream, while Mengniu tend to secure its milk supply sources through equity investment in upstream players. Downstream, Mengniu has acquired stakes in Yashili as a way of expanding its infant milk formula business, an area in which Mengniu has long been outperformed by Yili. As it borrowed more funds to finance secondary market stake acquisitions in 213, Mengniu saw its total liabilities increase % YoY to Rmb22,328m during the year with its debt-to-asset ratio jumping from 37.73% in 212 to 55.35% in 213.As a result, the company s financial cost surged %YoYin 214. Top three player comparison The top three companies did not differentiate significantly from each other in terms of revenue back in 24. However, things started to change when Yili and Mengniu began to expand their business on a national basis, while Bright Dairy remained focused on its regional operations in Shanghai. The top two companies began to compete head-to-head with each other in 26. However, Mengniu fell behind due to its flavacin scandal in 211, while the members of its management team sequentially left the company following COFCO s takeover. Yili has demonstrated stronger revenue and net profit growth than Mengniu since 212 with its profit margins now higher than the other two companies. Noticeably in terms of asset structure, Mengniu s PPE accounts for 27% of total assets, which is the lowest percentage among downstream players, reflecting its asset-light strategy. That said, Mengniu s equity investment in CMD for milk supply and that in Yashili for infant milk formula business development have driven its gearing ratio higher. In terms of operational efficiency, Mengniu has outperformed Bright Dairy while slightly underperforming Yili. During the ongoing inventory destocking cycle, Mengniu has posted the slowest progress among the top three as it turned raw milk into dry powder in 2H14for longer storage periods, whereas Yili and Bright Dairy accelerated inventory depletion. We expect Yili, Mengniu and Bright Dairy to finish destocking in 2Q15, 1Q16 and 2Q15 respectively. Mengniu s inventory turnover days increased by 58% YoY in 214. Page 13

14 Figure 43: Revenue comparison (Rmb m) Figure 44: YoY revenue growth comparison Figure 45: Net profit comparison (Rmb m) Figure 46: YoY net profit growth comparison Figure 47: NPM comparison Figure 48:Yili s revenue breakdown (214) Page 14

15 Figure 49: Mengniu s revenue breakdown (214) Figure 5: Bright Dairy s revenue breakdown (214) Figure 51: Yili s asset structure(214) Figure 52: Bright Dairy s asset structure(214) Figure 53: Mengniu s asset structure (214) Figure 54: Comparison of debt-to-asset ratio Page 15

16 Figure 55: Asset turnover comparison Figure 56: Yili s ROE breakdown Figure 57: Mengniu s ROE breakdown Figure 58: Bright Dairy s ROE breakdown Figure 59: ROE comparison Figure 6: Net cash flow comparison Page 16

17 Figure 61: Inventory turnover days Figure 62: Receivables turnover days Figure 63: Operating cycle (days) Figure 64: Destocking estimates Yili Mengniu Bright Dairy Normal level (Rmb m) 2, ,562. 1, Oversupply (Rmb m) 1, , Inventory consumption last quarter Oversupply depletion quarters Expected destocking completion 2Q15 1Q16 2Q15 Figure 65: Yili s inventory Figure 66: Bright Dairy s inventory Page 17

18 Figure 67: Mengniu s inventory Figure 68: Top five company inventory growth (HoH in 1H14) Valuation We expect Mengniu to see annual earnings growth of 2-29% during The stock is trading at 21.1x 215E P/E, or 2.5x 215E P/B. Although its share price has rebounded 27% YTD, we believe the company will continue to benefit from declining raw milk prices in 215. In addition, the market has yet to fully factor in the synergy of its cooperation with Danone and its equity investments in CMD and Yashili. We initiate coverage of the stock at Accumulate, with a target price of HK$45.6, equivalent to 23.5x 215E P/E (its historical average P/E level). Risks Increasing raw milk prices, tougher competition downstream, food safety issues, and stronger-than-expected impact of imported products. Figure 69: P/E comparison (Jan 1, 211 to Apr 29, 215) Figure 7: P/E comparison (Jan 1, 212 to May 4, 215) Yili Mengniu Bright Dairy Max Min Historical average Current Sources: Company data, Wind, GF Securities (HK) Figure 71: Market value comparison (Rmb) Figure 72: Key assumptions E 216E 217E Liquid milk (Rmb m) 38,184,45 43,36, 5,417,832 6,363,5 73,823,14 YoY change (%) 17.19% 12.71% 17.15% 19.73% 22.3% Ice cream (Rmb m) 3,63,919 2,716, 2,99,253 3,157,658 3,481,196 YoY change (%) -4.21% % 7.12% 8.54% 1.25% Milk formula (Rmb m) 2,216,8 3,961, 4,475,93 4,968,282 5,465,111 YoY change (%) N/A 78.74% 13.% 11.% 1.% Others (Rmb m) 296,52 336, 386,4 444,36 511,14 YoY change (%) % 13.31% 15.% 15.% 15.% Total sales (Rmb m) 43,76,924 5,49, 58,189,416 68,933,351 83,28,425 YoY change (%) 19.64% 14.37% 16.26% 18.46% 2.81% GPM (%) 26.98% 3.84% 31.64% 3.3% 28.96% NPM (%) 4.29% 5.38% 5.96% 6.39% 6.36% S&D cost/rev (%) 18.84% 21.11% 21.49% 2.1% 18.9% Admin cost/rev (%) 3.7% 3.88% 3.78% 3.26% 3.3% Sources: Company data, Wind, GF Securities (HK) Page 18

19 Figure 73: Peer comparison Dairy companies Infant formula companies Company Ticker 214 revenue Market cap* 214 net profit Share price** NPM ROE P/E Historical P/B P/S P/CF Sources: Company data, Wind, GF Securities (HK) Note: * As of May 4 close. **May 4 close. (Rmb m) (Rmb m) (Rmb m) (Rmb) (%) (%) (214) average P/E (214) (214) (214) Yili 6887 CH 54, ,14 4, Mengniu 2319 HK 5,49 63,832 2, Bright Dairy 6597 CH 2,385 24, Sanyuan 6429 CH 4,581 16, N/A Yantang 2732 CH 919 4, Beingmate 257 CH 4,589 2, Yashili 123 HK 2,816 1, Biostime 1112 HK 4,732 17, Page 19

20 Figure 74: Financial statements Income Statement Balance Sheet Year end Dec 31 (Rmb m) E 216E 217E Year end Dec 31 (Rmb m) E 216E 217E Revenue 43,357 5,49 58,189 68,933 83,28 PPE and related 11,687 12,852 15,47 17,67 2,94 COGS (31,66) (34,616) (39,779) (48,233) (59,165) Intangible assets 7,37 7,458 7,458 7,458 7,458 Gross profit 11,697 15,434 18,41 2,7 24,115 Investment in associates 2,843 3,841 3,841 3,841 3,841 Other income and gains Deferred tax assets S&D expenses (8,168) (1,564) (12,57) (13,795) (15,74) Biological assets Administrative expenses (1,66) (1,941) (2,197) (2,248) (2,745) Financial assets 1,989 2,58 2,143 2,143 2,143 Other expenses (36) (713) (419) (361) (49) Non-current assets 24,18 26,748 28,794 31,417 34,651 Profit from operating activities 1,852 2,665 3,582 4,627 5,552 Inventories 2,577 4,342 1,942 2,651 2,983 Interest income Trade and bills receivables 754 1,148 1,294 1,599 1,896 Finance costs (16) (34) (374) (393) (399) Prepayments, deposits and oth 3,47 1,829 2,14 2,14 2,14 P&L from associates and a JV Cash and bank balances 7,12 4,65 5,694 5,694 5,694 Profit before tax 2,25 3,15 3,989 5,74 6,13 Financial assets 2,841 8,355 8,355 8,355 8,355 Income tax (367) (459) (532) (677) (814) Current assets 16,321 2,324 19,39 2,44 21,33 Profit from continuing operations 1,838 2,691 3,458 4,398 5,289 Tradepayable and others 9,116 9,546 9,461 13,586 14,685 Discontinued operations 24 () Borrowings 8,757 4,483 2,96 2,283 1,97 Profit for the year 1,862 2,691 3,466 4,46 5,298 Deferred income Owners of the company 1,631 2,351 3,28 3,85 4,628 Income tax payable Non-controlling interests Current Liabilities 18,63 14,351 12,577 16,114 16,883 Borrowings 3,899 7,81 9,326 9,925 1,166 Long term payables Cash Flow Statement Deferred income Year end Dec 31 (Rmb m) E 216E 217E Deferred tax liabilities Profit before tax 2,229 3,15 3,998 5,83 6,111 Non-current Liabilities 4,265 8,237 9,831 1,332 1,749 Interest income (359) (548) (458) (458) (454) Issued capital Finance costs Share award scheme (394) (489) (442) (442) (442) D&A 1,198 1,321 1,589 1,864 2,198 Other reserves 1,628 14,963 14,15 11,44 11,7 P&L from assets (46) (27) Retained earnings 4,94 6,819 8,79 11,14 13,85 Changes in working capital 517 (478) Non-controlling intersts 2,65 3,3 3,161 3,112 3,44 Interest and tax paid (414) (889) (91) (1,3) (1,149) Equity 18,11 24,493 25,775 25,374 28,51 Others (57) 21 (14) (129) (154) Financial Ratios CFO 3,227 3,8 4,617 5,839 7,76 Year end Dec 31 (Rmb m) E 216E 217E CAPEX (13,586) (3,554) (3,24) (3,644) (4,231) ROE(%) Others (1,683) (2,862) (2,823) (2,823) (2,823) ROA(%) CFI (15,269) (6,415) (6,27) (6,467) (7,54) EBITDA margin (%) Changes inbank loans 1,711 2,536 8,59 7,99 7,195 EBIT margin (%) Dividends paid (479) (491) (892) (1,133) (1,363) Interest cover (x) Share changes 835 (322) Net gearing ratio (%) Others 1,17 1,896 Debt/asset ratio (%) CFF 12,237 3,619 7,27 6,5 5,872 Current ratio (x) Net CF ,797 5,377 5,894 Quick ratio (x) Beginning cash 2,918 3,355 3,67 9,373 14,719 Inventory turnover days FX effects 148 (31) (31) (31) (31) Receivables turnover days End cash 3,26 3,67 9,373 14,719 2,583 Payable turnover days Cash conversion cycle days (48.37) (51.77) (47.51) (59.99) (6.86) Page 2

21 Rating definitions Benchmark: Hong Kong Hang Seng Index Time horizon: 12 months Company ratings Buy Stock expected to outperform benchmark by more than 15% Accumulate Stock expected to outperform benchmark by more than 5% but not more than 15% Hold Expected stock relative performance ranges between -5% and 5% Underperform Stock expected to underperform benchmark by more than 5% Sector ratings Positive Sector expected to outperform benchmark by more than 1% Neutral Expected sector relative performance ranges between -1% and 1% Cautious Sector expected to underperform benchmark by more than 1% Analyst Certification The research analyst(s) primarily responsible for the content of this research report, in whole or in part, certifies that with respect to the company or relevant securities that the analyst(s) covered in this report: (1) all of the views expressed accurately reflect his or her personal views on the company or relevant securities mentioned herein; and (2) no part of his or her remuneration was, is, or will be, directly or indirectly, in connection with his or her specific recommendations or views expressed in this research report. 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