Equity Research Consumer staples China Modern Dairy (1117 HK) Underperform (Downgraded) Target price: HK$2.75 ASP outlook worsens on China Mengniu settlement price cut Milk powder inventory destocking to take some time Many companies hoarded significant amounts of milk powder to avoid rising costs and raw material shortages following 4Q13 s surging raw milk prices, and we have seen a substantial rise in inventory at leading dairy companies from their interim reports. Companies have been trying to reduce liquid raw milk purchases as a result of falling milk powder prices and weaker consumer demand, and sales promotions have been rolled out for products made from milk powder such as modified milk and reconstituted milk. According to dairy companies, inventory destocking will take some 3-6 months. Indeed, China Mengniu wrote down Rmb261m from its inventory in 1H14, up from Rmb286, in 1H13. Alex Fan, CFA SFC CE No. ADJ672 alexfan@gfgroup.com.hk +852 3719 147 GF Securities (Hong Kong) Brokerage Limited 29-3/F, Li Po Chun Chambers 189 Des Voeux Road Central Hong Kong Stock performance 4. 35. 3. 25. 2. 15. 1. 5.. (5.) (1.) % return (15.) Jan- Jan-14 Apr-14 Jul-14 Sep-14 HSI Index China Modern Dairy Whole milk powder price reaching new low as demand declines Chinese customs data show that 58% of imported dairy products in 4M14 were from New Zealand. There has been a decrease in imported dairy products in terms of both volume and price this year, indicating weak demand from dairy companies. The Fonterra auction index was down 7.3% on Oct 1 214, with whole milk powder averaging US$2,442/tonne across all contracts, a 1% decline from the last auction. ASP decline Data from the Ministry of Agriculture indicated that raw milk prices remain in consolidation, with prices down from a peak of Rmb4.27/kg in Jan to Rmb3.91/kg in Sep. At the same time, the price of beef has risen in recent months, encouraging farmers to cut losses by killing cows. According to China Modern Dairy s (CMD) management, the latest settlement price for premium raw milk for China Mengniu, its largest client and shareholder, was Rmb4.9/kg in Sep, lower than the average contract price of Rmb5.14/kg in 1H14. Assuming that the new price took effect from Sep, its 214 ASP should come in at Rmb5.6/kg, 1.6% lower than 1H14. Feeding costs on the rise Some alfalfa imports failed transgenetic tests in Aug, leading to a supply shortage, while corn prices have risen 16% since the beginning of the year. Given that feeding costs account for 78% of CMD s dairy farming costs, of which about 4% is spent on corn, we expect feeding cost pressure to emerge in 2H14. We expect to see margin pressure as a result. Earnings forecasts lowered; downgrade from Buy to Underperform With raw milk prices likely to remain relatively weak over the next six months, and given rising farming cost pressure, we have lowered our ASP forecast for 214/15/16 from Rmb5.1/kg, Rmb5.25/kg and Rmb5.41/kg to Rmb5.6/kg, Rmb4.9/kg and Rmb5./kg, respectively. We also lower our corresponding GPM forecasts from 37.7%, 38.4% and 38.8% to 36.6%, 35.% and 35.9% respectively. As a result, we have lowered our earnings forecasts by 9%, 28% and 26%, respectively for 214/15/16. We lower our target price from HK$4.88 to HK$2.75, based on our estimated DCF value and 11x 215 forecast P/E. We downgrade the stock from Buy to Underperform. Risks include a more rapid and betterthan-expected ASP rebound. Source: Bloomberg Key data Oct 1 close (HK$) 3.36 Shares in issue (m) 4827 Major shareholder Mengniu (27.9%) Market cap (HK$ bn) 16.2 3M avg. vol. (m) 21.5 52W high/low (HK$) 3.5/ 4.39 Source: Bloomberg Stock valuation Turnover Net profit EPS EPS YoY P/E BPS P/B ROE (RMB m) (RMB m) (RMB) (%) (RMB) (%) 212 2,35 49.85 n.a. 31.2 1.1 2.4 n.a. 213 3,289 481.1 17 26.6 1.2 2.2 8.6 214E 5,21 935.194 94 13.7 1.4 1.9 15. 215E 5,988 952.198 2 13.4 1.5 1.7 13.5 216E 7,125 1,216.252 28 1.5 1.7 1.5 15.3 Sources: Company data, GF Securities (HK) Note: Calculated based on diluted shares.
ASP risk drags on Milk powder inventory destocking to take some time Many companies hoarded significant amounts of milk powder to avoid rising costs and raw material shortages following 4Q13 s surging raw milk prices milk powder has a much longer storage life than raw milk. We have seen a substantial rise in inventory at leading dairy companies from thieir interim reports, including Yili (6887 CH), China Mengniu (2319 HK), Bright Dairy (6597 CH), Sanyuan (6429 CH) and Huishan (6863 HK). Companies have been trying to reduce liquid raw milk purchases as a result of falling milk powder prices and weaker consumer demand, and sales promotions have been rolled out for products made from milk powder such as modified milk and reconstituted milk. According to dairy companies, inventory destocking will take some 3-6 months. Indeed, China Mengniu wrote down Rmb261m from its inventory in 1H14, up from Rmb286, in 1H13. Figure 1: Inventory growth (1H14 vs 213) 12.% 1.% 8.% 6.% 4.% 2.%.% Yili Mengniu Bright Dairy Sanyuan Huishan Inventory Growth Rate Sources: Company data, GF Securities Figure 2: Retail sales promotions Sources: GF Securities Whole milk powder price reaching new low as demand declines Chinese customs data show that 58% of imported dairy products in 4M14 were from New Zealand. There has been a decrease in imported dairy products in terms of both volume and price this year, indicating weak demand from dairy companies. The Fonterra auction index was down 7.3% on Oct 1 214, with whole milk powder averaging US$2,442/tonne across all contracts, a 1% decline from the last auction. Page 2
21311W 21314W 21323W 21332W 21341W 21344W 21353W 21372W 21371W 21374W 21383W 21392W 21311W 21314W 213113W 213122W 21411W 21414W 21423W 21432W 21441W 21444W 21453W 21462W 21471W 21474W 21483W 21492W 3-Nov-9 2-Mar-1 6-Jul-1 6-Oct-1 1-Dec-1 1-Feb-11 5-Apr-11 1-Jun-11 2-Aug-11 4-Oct-11 6-Dec-11 1-Feb-12 3-Apr-12 5-Jun-12 1-Aug-12 2-Oct-12 4-Dec-12 5-Feb-13 2-Apr-13 4-Jun-13 6-Aug-13 1-Oct-13 3-Dec-13 4-Feb-14 1-Apr-14 3-Jun-14 5-Aug-14 1-Oct-14 US $/tonne 28-1 28-6 28-11 29-4 29-9 21-2 21-7 21-12 211-5 211-1 212-3 212-8 213-1 213-6 213-11 214-4 Company report Figure 3: Dairy product imports Figure 4: Milk powder imports 25, 2, 15, 1, 5, Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Dairy products imported (tonnes) Dairy products imported (US$m) (RHS) 12 1 8 6 4 2 18, 16, 14, 12, 1, 8, 6, 4, 2, Milk powder imported (tonnes) Sources: Ministry of Agriculture, Wind, GF Securities Figure 5: Fonterra Auction published on Oct 1, 214 Figure 6: Fonterra weighted average auction price 7, Changes in Price Indices Contract 1 Contract 2 Contract 3 Contract 4 Contract 5 Contract 6 Nov-14 Dec-14 Jan-14 Feb-14 Mar-14 Apr-14 All contracts Anhydrous Milk Fat n.a -8.3% -1.7% -2.8% -2.1% -2.5% -5.% Butter n.a -.6% -8.1% 11.9% 15.% n.a -6.6% Butter Milk Powder (BMP) n.a 15.% -7.2% -7.5% n.a n.a -11.3% Cheddar (Ched) n.a -.8% -.7% -2.1% n.a n.a -1.2% Rennet Casein (RenCas) n.a -.8% -1.7% -2.5% n.a n.a -1.4% Skim Milk Powder (SMP) -4.4% -2.8% -4.1% -.6% 2.5% -5.8% -2.7% Whole Milk Powder (WMP) 1.9% -9.9% 1.7% 1.1% -9.7% -3.5% -1.% All Products (Trade-Weighted) -4.4% -6.9% -8.1% -7.2% -7.2% -3.8% -7.3% 6,5 6, 5,5 5, 4,5 4, 3,5 3, 2,5 2, WMP SMP AMF Sources: Ministry of Agriculture, Wind, GF Securities Sources: GDT platform Price consolidation continues Data from the Ministry of Agriculture indicated that raw milk prices remain in consolidation, with prices down from a peak of Rmb4.27/kg in Jan to Rmb3.91/kg in Sep. CMD s management indicated that some farmers have begun to throw away milk and have even killed cows. At the same time, the price of beef has risen in recent months, encouraging farmers to cut losses by killing cows. Figure 7: Raw milk price 4.5 4.3 4.1 3.9 3.7 3.5 3.3 3.1 2.9 Raw milk price (Rmb/kg) Sources: Ministry of Agriculture, GF Securities ASP decline According to CMD s management, the latest settlement price for premium raw milk for China Mengniu, its largest client and shareholder, was Rmb4.9/kg in Sep, lower than the average Page 3
contract price of Rmb5.14/kg in 1H14. Assuming that the new price took effect from Sep, its 214 ASP should come in at Rmb5.6/kg, 1.6% lower than 1H14. Figure 8: Raw milk ASP of CMD 6 2.% 5 15.% 4 1.% 3 5.% 2.% 1-5.% 212 213 1H14 Sep 214-1.% Raw milk price (Rmb/kg) ASP growth rate (RHS) Sources: Company data, GF Securities Feeding cost is rising According to CMD, some alfalfa imports failed transgenetic tests in Aug, leading to a supply shortage, while corn prices have risen 16% since the beginning of the year. Given that feeding costs account for 78% of CMD s dairy farming costs, of which about 4% is spent on corn, we expect feeding cost pressure to emerge in 2H14. We expect to see margin pressure as a result. Figure 9: Domestic corn price Figure 1: Breakdown of dairy farming cost of CMD 2.8 2.7 2.6 2.5 2.4 2.3 2.2 2.1 2% 6% 5% 9% 78% Feeding costs Labor costs Utilities Depreciation Other farm costs Domestic corn price (Rmb/kg) Sources: Ministry of Agriculture, Company data, GF Securities Earnings forecasts lowered; downgrade from Buy to Underperform With raw milk prices likely to remain relatively weak over the next six months, and given rising farming cost pressure, we have lowered our ASP forecast for 214/15/16 from Rmb5.1/kg, Rmb5.25/kg and Rmb5.41/kg to Rmb5.6/kg, Rmb4.9/kg and Rmb5./kg, respectively. We also lower our corresponding GPM forecasts from 37.7%, 38.4% and 38.8% to 36.6%, 35.% and 35.9% respectively. As a result, we have lowered our earnings forecasts by 9%, 28% and 26%, respectively for 214/15/16. We lower our target price from HK$4.88 to HK$2.75, based on our estimated DCF value and 11x 215 forecast P/E. We downgrade the stock from Buy to Underperform. Page 4
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