China Mengniu Dairy Co. Ltd

China Mengniu Dairy Company Limited and its subsidiaries manufacture and distribute dairy products and ice cream in the People’s Republic of China (PRC). Mengniu was founded in 1999 and currently it is listed on the Hong Kong Stock Exchange. The company’s sources of revenue are from the sales of its products under the Mengniu brand, which includes liquid milk, ice cream, milk formula and other products. The liquid milk segment includes UHT Milk, Milk Beverages and Yoghurt.

STOCK INFORMATION

Ticker symbol: 2319.HK
Market Cap: RMB54.55B (As at 14 Oct 2015)
Market Price/Share: HKD 14.74 (As at 14 Oct 2015)
Industry: Consumer staples

THE BUSINESS

China Mengniu could be split into upstream and downstream segments. The upstream companies are involved in raising the biological asses and selling the unprocessed raw milk to the downstream companies. In the case of China Mengniu, it has 7,747 cows. Currently, Mengniu also has 28% equity interest in China Modern Dairy Holdings Ltd, which is a pure dairy upstream company and the largest dairy farming company and raw milk producer in China. In 2014, Mengniu actually contributed 60% of Modern Dairy’s sales. This is not only to ensure that Mengniu has a stable supply of raw milk, but also to control the quality and safety of the raw material Mengniu will be using.

On the other hand, downstream companies are involved in processing the raw milk supplied by the upstream companies and distribute to the consumers and Mengniu is one of the leading downstream players in the China dairy market. Mengniu produces and distributes a wide range of dairy products which includes:

• Ultra-high temperature (UHT) milk (RMB 43,0361 million l 47.4% of FY 2014 revenue)
• Milk Beverages (RMB 11,920.6 million l 23.8% of FY 2014 revenue)
• Yoghurt (RMB 7,413.9 million l 14.8% of FY 2014 revenue)

In the case of downstream companies in China, most of them are producing shelf stable milk products with longer shelf life, like UHT milk and UHT yoghurts. UHT milk products has typically unrefrigerated shelf life of 6 to 9 months as compared to fresh milk which has a shorter shelf life of  1-2 weeks and requires to be refrigerated. Majority of dairy products in China are UHT products because due to the undeveloped China’s cold chain distribution. With the low milk consumption per capita in China as compared to Japan and South Korea and the current favorable low cost of raw milk, it would depend on Mengniu’s corporate strategy whether will it be possible to secure more market share in the competitive market.

Being a dairy giant in China, Mengniu’s brand was ranked 21^st in the BrandZ Top 100 Most Valuable Chinese Brand 2014 and was also ranked the 14^th on the “2014 Global Dairy Top 20”. Mengniu’s products such as Milk Deluxe (Premium UHT milk) and Yoyi C received awards such as “2014 Leading Brands that Influence China” and “Welcome Favorite Brand” respectively. Having the second largest market share in the drinking milk products segment, Mengniu is 1% away from Inner Mongolia Yili. If you wish to gain exposure to China’s dairy growth, Mengniu could be one of the counters you can consider.

KEY OPPORTUNITES

1. Strategic Partnerships

Yoghurt
Mengniu Dairy Co is the market leader in the China’s yoghurt sector by market share. Just in 2014 Mengniu experienced a 26.8% revenue growth from the sales of yoghurt, exceeding the market growth of 23.2%. Its market share also has been gradually growing for the past few years, currently it is commanding 19% of the market share. Mengniu has been marketing and innovating its yoghurt products and it has been proven successful in capturing market share. In addition, with the joint venture with Danone group, Mengniu aims to boost the consumers’ confidence in its products amidst the food quality scandals in China by leveraging on Danone’s brand and also Danone’s quality control standards. Mengniu’s market share has room for growth as Mengniu continually innovate and tap on the growth in this sector.

Milk formula
It has experienced an impressive 81.92% growth from 2013 to 2014. Knowing that it is not easy to win PRC consumers in this sector, Mengniu formed partnership with Danone Group to leverage on Danone’s brand and also expertise in the infant milk formula. Having control in its raw material supplier also enable Mengniu to ensure its quality and safety of its products. By adhering to Danone’s product safety standards and having strong control in its supply, Mengniu hopes to become the trusted brand for dairy products.

2. Distribution

Since China is such a large country, the consumer tastes and preferences vary across the various regions, due to the differences in their culture background and wealth. The 160 Regional Business Units (RBUs) have helped Mengniu to provide a comprehensive range of services to more than 3,000 distributors in third- and fourth-tier cities. The RBUs have the flexibility to respond to the respective regions’ needs more promptly such that it allows Mengniu to refine their allocation of resources and not missed out on the growth opportunities. However, Yili and Mengniu distribution network coverage are comparable, while, Bright Dairy has a smaller distribution network.

Mengniu also has been aggressively expanding its presence in the e-commerce business through closer cooperation with mobile and internet platforms, such as Tmall.com, Yhd.com and JD.COM and involved in the coordination of the distribution of its products. This enable Mengniu to further reach out to consumers through online channels which is gaining traction.

3. Legit Shareholders

Danone and Arla Foods have 9.9% and 5.3% equity interest in Mengniu Dairy. Danone and Arla Foods are vested in Mengniu’s performance and we could see that they have formed alliances and are currently sharing expertise. Currently, Mengniu could leverage on Danone’s expertise on infant milk formula and also Arla Foods’ expertise in cheese and butter. With the strong collaboration between these parties and the strong international brand names, Mengniu will not lose out in the China Dairy industry.

KEY RISKS

1. More overseas competition –imports of high end products

Due to the loss of confidence after the notorious 2008 Milk scandals, many still distrust the local dairy brand and would prefer imported infant milk formula. The top 3 milk formula brands by market share in China are all from overseas. These products are able to command on average 30% to 90% premium over the same products overseas. Companies like Mead Johnson and Biostime’s EBIT margins are more than double as compared to Mengniu’s. Indeed, imported infant milk formula is a threat to Mengniu in the milk formula (7.9% of Mengniu’s revenue) . However, Mengniu has been ramping up its effort in expanding into the milk formula sector by working hand-in-hand with Danone. Recently, Danone has 25% interest in Yashili (Mengniu has 68.02% equity interest in Yashili), which will align Danone and Mengniu’s interest in the milk formula sector.

On the other hand, overseas branded UHT milk (e.g. Devondale, Anchor, Meadow Fresh) has also successfully entered the Chinese market. This increases the competition in the market and most of the competitors have comparable price/ml, which means Mengniu has to improve its other aspect of business such as its brand equity, distribution channel and innovative products to gain more market share in the market.

2. Switch in Consumer Preference

As consumers in China are seeking more fresh food and more consumers actually would switch from UHT milk to fresh milk (Seen to be a more nutritious alternative) which will be a threat to Mengniu, since Mengniu derives almost half of its revenue from UHT milk.

However, a mitigating factor is the current state of China’s cold-chain distribution. Given that China’s cold-chain distribution is not well developed coupled with the low raw milk prices, upstream companies may not have sufficient capital to carry out any actions to establish their fresh milk products. However, once the raw milk prices stabilizes, upstream companies could possibly expand their business to sell their fresh milk to consumers directly and they also could utilize e-commerce as a distribution channel to distribute its shorter shelf-life products.

3. Valuation

In general, most of these established consumer staples brands will not be trading at less than 20x PE. Hence, when such companies are trading at levels below 20x PE, it might be worthwhile to find out why. One’s valuation may vary from another since different people will factor in different conditions, hence, investors are advised to spend a considerable amount of time in this segment.

It is notable that China Mengniu has generally been trading above a P/E ratio of 20x for the most part of its history. It is currently trading at 18x trailing earnings.

LISTED PEERS

1. Inner Mongolia Yili Industrial Group Co Ltd
2. Bright Dairy & Food Co Ltd
3. China Huishan Dairy Holdings

TOP SHAREHOLDERS

1. China State-Owned Assets Supervision & Admn Commision (31.5%)
2. First State Investments (Hong Kong) Ltd (5.43%)
3. Genesis Investment Management LLP (2.20%)

Note: Danone S.A and its subsidiaries became Mengniu’s 2^nd largest strategic shareholder in March 2014 with 9.9%

Financials

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We will only provide you with information relevant to value investing. You can unsubscribe at any time. Your contact details will be safeguarded The information provided is for general information purposes only and is not intended to be any investment or financial advice. All views and opinions articulated in the article were expressed in Jessie’s personal capacity and do not in any way represent those of his/her employer and other related entities. Chan Chean does not own any companies mentioned.

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