dairy/ china china dairy sector - oriental patron dairy sector - fresh.pdf · equity research china...

Tue, 06 Nov 2012

Equi ty Research China Dairy Sector Dairy/ China

Fresh!

We initiate coverage on the China Dairy sector (3 companies) with positive

outlook and the market size will expect to be double over the next 8-10 years,

implying overall volume growth rate with a high single digit and continuous

product mix toward value-added categories. We recommend China Modern

Dairy (1117 HK, BUY) as our top pick for its fast expansion pace and organic

growth from constant raw milk yield improvement. We also favor Biostime

International (1112 HK, BUY) and seeing it as a niche fast-moving premium

baby product player in China. Its unique Mama100 membership platform

promoted strong consumer loyalty and led to a rising cross selling. As lack of

positive catalysts in short-term and lower-than-expected recovery progress, we

rate Mengniu (2319 HK, HOLD) with neutral.

Upstream: raw milk

Our preference is based on i) strong demand from downstream dairy operators

for high quality raw milk; ii) undergoing industry consolidation and expansion in

standardized large-scale dairy farms pushed by government and targeting to

reach~48mn tons of production in 2013E with a 15% CAGR over 2011-2013E; iii)

supportive government policies, like exemptions on agricultural tax, VAT and

income tax. Raw milk price is projected to trend up moderately due to more

sourcing from large-scale farms which charge premium price and supporting from

increasing feed costs.

Downstream: Liquid milk

Liquid milk accounts for 80% of total dairy industry and is dominated by domestic

brands. The top three players, Mengniu, Yili (600887 CH, NR) and Bright Dairy

(600597 CH, NR) have an aggregate market share of about 68%. High-end liquid

milk sales growth will outpace that of mid-to-low-end driven by consumers’ trade

up after 2008 melamine scandal. Lactic acid drinks, baby and toddler milk and

flavored milk are expected to record the fastest growth rates in 2011-2014E

among liquid milk segment.

Downstream: infant formula

We believe this sub-sector will be fueled by i) the 4th baby boom; ii) atypical

consumer behavior among customs of relatively low price sensitivity; and iii)

Relaxation of China’s one-child policy. In our conservative case projection, we

expect the Chinese infant formula market to grow at a CAGR of 9% between

2012-2020E assuming no change in one-child policy application, and that of 13%

in the scenario with relaxation of one-child policy and outpace the whole dairy

market in China.

Tracy Sun

Analyst

+852 2135 0214

[email protected]

Sector Report

Exhibit1: Recommendat ions summary Company Stock code Rating Closed Price Target Price Upside (%)

China Modern Dairy 1117 BUY 2.02 2.64 +31%

Biostime 1112 BUY 19.98 24.60 +23%

Mengniu 2319 HOLD 23.50 24.20 +3%

Closing price as at 5 November 2012

Source: Bloomberg, OP Research

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Table of Contents

What are our recommendations? ................................................................................................................. 3

Cast a glance at the China Dairy Industry .................................................................................................... 5

Major players in this markets........................................................................................................................ 7

Upstream: raw milk, the key of dairy industry ............................................................................................... 8

Downstream: Liquid milk, biggest category .................................................................................................12

Downstream: Infant formula, attractive growth prospect ..............................................................................14

China Modern Dairy (1117 HK) – Enjoy the taste of High Growth ................................................................19

Investment thesis .............................................................................................................................20

Financial analysis .............................................................................................................................28

Key risks...........................................................................................................................................30

Valuation ..........................................................................................................................................31

Financial Summary - China Modern Dairy (1117 HK) ........................................................................35

Biostime International (1112 HK) - A premium story .....................................................................................36


Robust 1H12 results .........................................................................................................................43

Earning forecast ...............................................................................................................................44

Valuation ..........................................................................................................................................46

Key risks...........................................................................................................................................48

Financial Summary - Biostime (1112 HK) .........................................................................................51

Mengniu Dairy (2319 HK) - No surprise ......................................................................................................52


Earnings forecast .............................................................................................................................58

Key risks...........................................................................................................................................59

Valuation ..........................................................................................................................................60

Financial Summary - Mengniu Dairy (2319 HK) ................................................................................63

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What are our recommendations?

China Modern Dairy (1117 HK) – Enjoy the taste of High Growth (BUY)

TP: HK$2.64

We forecast CMD could enjoy the net profit growth at a CAGR of 34% for

FY12-FY15E. Key earnings drivers should come from i) top line growth boosted

by strong demand from downstream dairy operators for high quality raw milk as

well as 10-year take off agreement with Mengniu to secure the long-term sales

volume growth and premium selling price; ii) operating leverage generates from

its modernization and scale operation; iii) supportive government policies (i.e.

exemption on certain tax and subsidies) for the modernization of dairy farming.

Its advanced breeding, feeding and herd management techniques enable CMD to

produce the high-quality raw milk with a high double digit premium over the

industry average price. CMD targets the milk yield per milkable cow is at about

9.0 tons/annum in FY15E and 9.4 in FY17E, ultimately up to 10 tons/annum,

driven by increasing proportion of mature cows and genetic improvement.

Based on a blending DCF/PEG model, we estimate a fair value of HK$2.64 per

share, which implies 30.7% potential upside. We give a BUY rating.

Biostime International (1112 HK) - A premium story (BUY) TP:

HK$24.60

We project that Biostime could enjoy the net profit growth at a CAGR of 24% for

2011-2014E. Key earnings drivers come from top line growth boosted by infant

formula segment and consequent SG&A/sales ratio decline.

As a player in premium market, Biostime was able to achieve superior margin

over its peer average at 20% over the past five years. All its products are sourcing

from overseas to guarantee quality and safety. Its real time and effective channel

management can monitor distributors’ inventory and sales level, resulting in the

account receivables turnover days at 1 day. Its Mama 100 membership platform

promoted strong consumer loyalty, leading to a rising cross selling and saving the

expense of selling and distribution each year.

Our TP is based on a blending SOTP/DCF model, we estimate a fair value of

HK$24.60 per share, which implies undemanding 2013E PE of 14.5x and

suggests 23.1% potential upside.

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Mengniu Dairy (2319 HK) - No surprise (HOLD) TP: HK$24.20

We forecast Mengniu net profit to grow at a CAGR of 10.8% for FY11-FY14E and

revenue to rise from RMB37.4bn in FY11 to RMB49.13bn in FY14E, equating to a

CAGR of 10% and led by a 7% CAGR in sales volume and a 3% CAGR of APS

hike.

It appears to us that Mengniu’s high growth era is behind us. Its brand value and

consumer loyalty are undermined after the melamine crisis in 2008 and M1

scandal in 2011. Although the new strategies initiated by new management team

can pave the way for long-term earnings growth, near-term headwind from

internal restructuring is visibility. We like Mengniu’s prudent cost control and

outstanding operating efficiency combined with continuing product mix shift

towards high-value added categories, however, all above are fully reflected in

current valuation, with 21x PE in 2013. We found the Bloomberg-consensus EPS

forecast has been revised down since December 2011 and even speed up after

Mengniu’s interim results, partly due to their concerns about recovery pace and

disappointing result of 1H12. The market bearish mood also reflected our

downside risk cautions.

Based on a blending DCF/PER model, we estimate a fair value of HK$24.20 per

share, which implies 2013E PE of 19.0x and suggests 2.98% potential upside.

We give a HOLD rating.

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Cast a glance at the China Dairy Industry

Looking back, China dairy industry has growth at a rapid pace in both a

demand and supply perspective driven by continued rising rate of urbanization

and increasing disposable incomes. According to China Dairy Associate, per

capita consumption of major dairy products has increased from 2.7kg per capita

in 2000 to 16.2kg per capita in 2011, a CAGR of 17.8%.

Exhibit 2: Major dairy products per capita consumption in China, 1990-2011

Source: CEIC, OP Research

A structural problem of human being

While the CAGR was impressive, per capita consumption in China falls further

behind other developed countries and remains only one-third of developed

countries globally. We believe the major reason of consumption per capita is a

structural problem due to high prevalence of lactose intolerance of Chinese

people. Lactose intolerance individuals have insufficient level of lactase to digest

lactose, a sugar in milk. It is estimated that 75% of adults worldwide show some

decrease in lactase activity during adulthood. The frequency of decreased

lactase activity ranges from 5% in northern Europe and more than 90% in some

Asian countries. It appears to us that high prevalence of lactose intolerance is the

key bottleneck for liquid milk market growth, while high quality and value added

milk products supply (i.e. yogurt, low lactose milk, low fat milk) is like an antidote

to the genetic composition of Chinese people. The situation of Japanese can

provide us with some guidance on where China’s dairy industry will go. The per

capita of Japanese is more than double of Chinese, and studies show its level of

lactose intolerance is not significantly different in China.

1.7 1.9 1.9 1.8 1.8 1.92.6 2.8 2.6 3.0 2.7

3.6

4.9

7.3 7.7

11.3

13.3

14.6

13.112.713.5

16.2

0

2

4

6

8

10

12

14

16

18

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

(kg)

1990-2000: 4.7% CAGR2000-2011: 17.8% CAGR

Melamine incident impacted the consumer confidence

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Exhibit 3: Per capita consumption of dairy product (kg/year)

Source: China Dairy Yearbook, OP Research

Outlook

According to Euromonitor, China dairy industry is estimated to grow at a CAGR of

9% in 2011-2015E. We observed an 81% correlation between the Chinese dairy

market growth and the Chinese GDP per capita growth in 1998-2011. Thus, we

conclude that as a country becomes more developed, the people tend to beef up

dairy product intake as a part of their protein needs. Thanks to the product mix

shift to high-value-added categories, a 10% CAGR growth of China dairy industry

over the next 5 years is achievable.

119

107

9289

83

44 44

35

16

Holland Australia Canada EU USA Korea Argentina Japan China

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Major players in this markets

Exhibit 4: comparison of key operating statistics for domestic dairy players listing in HK markets

Upstream: Raw milk Downstream Liquid Milk/Milk Beverage Downstream Milk Powder

Company China Modern Dairy Mengniu Dairy Yili Bright Dairy Biostime Yashili Feihe Beingmate

Logo

Year Established 2005 1999 1993 1952 1999 1983 1962 1999

Products Raw milk

Liquid Milk/

Ice Cream/

Others

Liquid Milk/

Ice Cream/

Others

Liquid Milk/

Others

Infant formula/

Probiotic

Supplements/

Others

Infant formula/

Nutrition products/

Others

Infant

formula/Nutrition

products/others

Infant

formula/Others

Brands Modern Farming Mengniu Yili Bright Biostime

BM Care

Yashil

Scient Feihe, Firmus Beingmate

Milk sources n.a. Domestic Domestic Mainly Domestic Imported Imported Domestic Mainly

Domestic

Major milk source locations n.a. Inner Mongolia Inner Mongolia Shanghai Europe New Zealand Heilongjiang Heilongjiang

Production Base Anhui/Heibei Mainly Inner Mongolia Mainly Inner Mongolia Shanghai Guangdong

Guangdong

Shanxi

Heilongjiang

Heilongjiang Hangzhou

Source: Company data, OP Research

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Upstream: raw milk, the key of dairy industry

Impressive growth

Raw milk as the key raw material for the dairy industry, has grown dramatically in

the past 20 years, with total production up to 36.6mn tons in 2011 from 4mn tons

in 1986, representing a CAGR of 11%. China’s primary raw milk production

regions are located between the latitudes of 35 degree and 48 degree in Northern

China where the climate is temperate with a high level of sunshine, and the

environment is more conductive to dairy farming and provides higher quality feed.

Inner Mongolia and Heilongjiang total accounted for 40% of China raw milk

production in 2010, followed by Hebei and Shandong at 12% and 7%,

respectively. Dairy industry giants Mengniu and Yili both are mainly sourcing the

raw milk from Inner Mongolia.

Exhibit 5: Raw milk production in China, 1989-2011


Exhibit 6: Raw milk production by region, 2010


0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

1989-2011: 11% CAGR2000-2007: 23% CAGR

(th tons)

Beijing2%

Hebei12%

Shanxi2%

Inner mongolia25%

Helongjiang15%Shandong

7%

Shaanxi4%

Xinjiang4%

Others29%

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Price

The profitability of dairy industry was quite sensitive to the price change of raw

milk, as it accounted for 60%-70% of COGS of the liquid milk, 80% that of milk

powder. There are several factors impacting the price of raw milk, including the

quality of the milk as measured by metrics such as protein and fat content, and

the price of feed. These factors in turn are affected by changes in the prices of

commodities such as corn and soybean meal.

As shown in Exhibit 7, raw milk price declined significantly since 2008 after

melamine incident. During that period, several farms slaughtered or sold their

cows, which led to relatively small herd size in China. As a result, as demand

started to recover in later of 2009, the supply of milk was not able to meet the

rising demand driven from downstream manufacturers and the price of raw milk

grew almost whole year of 2010 and back to relatively stable in 2011 and 2012.

We expect the raw milk price to trend up moderately due to i) milk production per

cow has been going up; ii) increasing feed costs (corn and soybean price have

climbed up around 1.7% and 11.7% YTD, to Rmb2.4/kg and Rmb3.3/kg,

respectively); and iii) more raw milk sourcing from large-scale farms and ranches

which provide higher quality but charge premium price.

Exhibit 7: China raw milk price, 2008-2012

Source: sn110.com, OP Research

2.0

2.2

2.4

2.6

2.8

3.0

3.2

3.4

Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12

(RMB/kg)

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Policy support

Generally speaking, China’s dairy farming market is still in an early stage and

highly fragmented, as only approximately 7% of dairy herds in China were reared

by large-scale dairy farms which own more than 1,000 cows in 2008 vs.46.9% in

the US. There is great potential for industry consolidation.

After the melamine milk scandal in 2008, the government pushed for

modernization and expansion in standardized large-scale dairy farms as well as

consolidation of the upstream dairy industry. The government has set a target to

reach~48mn tons of cow milk production and 15mn heads of dairy cows in 2013,

which represents 15%/2.1% CAGRs, according to the National Dairy Industry

Development Guideline (2009-2013) . The government has adopted both national

and regional policies to encourage the development of large scale farms by i)

issuing new set of policies to governing the dairy industry; ii) subsidies for

purchasing quality dairy cows from oversea; iii) allowing large-scale operators to

lease agriculture or forestry land; iv) exemptions on agricultural tax, VAT and

income tax.

Those industry’s early movers and large-scale dairy farms, like China Modern

Dairy (1117HK, BUY) will directly be benefited from the industry consolidation

pushed by government, in our view.

Exhibit 8: Milk supply market share by dairy farm size

Source: China Dairy Yearbook, OP Research

1-4 cows25%

5-19 cows32%

20-99 cows18%

100-1000 cows18%

>1000 cows

7%

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Milk yield

According to the China Dairy association, the industry average milk yield per cow

in China was 4.8 tons /annum and is one of lowest among major consumption

countries. The large-scale farms are 7.0 tons /annum. We believe the milk yield

per cow in China is going to catch up with that of US given the constant upgrading

techniques and accelerating expansion in standardized large-scale dairy farms.

Exhibit 9: Milk yield by country, 2006-2011

Source: China Dairy Association, OP Research

2

3

4

5

6

7

8

9

10

11

2006 2007 2008 2009 2010 2011

US Japan UK Australia China

(Tons/head/year)

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Downstream: Liquid milk, biggest category

Liquid milk is composed of UHT milk, milk beverage, and yogurt, accounting for

largest portion of total dairy consumption (~80% in 2011).

Still the domestic brands’ market

After the melamine incident in 2008, unlike in the infant formula market, the

domestic brands recovered quickly in liquid milk market, where the foreign brands

were restricted by high transportation costs and have not successfully involved.

The domestic brands still dominate the liquid milk market in terms of sales. The

top three giants Mengniu, Yili and Bright Dairy with aggregate market share of

about 68% in China liquid milk market in 2011.

Shift to premium

We appreciate that the customers’ propensity to upgrade for high-end products

after 2008 melamine scandal. The market share of liquid milk priced above

RMB10/litre was ~24.7% in 2009 from 3.9% in 2005, according to China dairy

yearbook. The rapid consumption growth in the past years was mainly driven by

ASP increment and product mix improvement, in our view. We believe the

high-end liquid milk sales growth will outpace that of mid-to-low-end. Mengniu

(2319 HK, BUY), with 28% of revenue generated from high-end products, is one

of big beneficiaries of this trend.

Industry output slowdown?

Some investors may concern the slowing down of industry sales in 1H12. We

have to admit the domestic production volumes for liquid milk firstly recorded

negative figures for Jul and Aug since 2009. We believe the weak supply is partly

due to i) the hike feeding cost eroded profitability of smaller farms and force them

out of the industry; ii) a series of food safety incidents. However, we positively

detect that industry output rebounded to 13.1% yoy in Sep, according to Dairy

Association of China. We believe that resilience output is largely contributed from

the premium products as customer’s trade up.

Exhibit 10: Liquid milk production volume yoy % growth


(40)

(20)

0

20

40

60

Feb-08 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10 Feb-11 Aug-11 Feb-12 Aug-12

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Value-added categories likely cut a figure

As we mentioned before that high prevalence of lactose intolerance is the key

bottleneck for liquid milk market growth, while high quality and value added milk

products supply (i.e. yogurt, low lactose milk, low fat milk) is like an antidote to the

genetic composition of Chinese people. Thus the products, like yogurt, flavored

milk and lactic Acid milk, will grow faster in our point of view.

According to Tetra Pak (the world’s leading food processing and packaging

solutions and suppliers with a 70.2% market share in China), China’s liquid dairy

product consumption is forecasted to rise by round 10.2% (CAGR) in 2011-2014E.

Lactic acid drinks, baby and toddler milk and flavored milk are expected to record

the fastest growth rates in 2011-2014E. Lactic acid drinks is expected to notch up

the highest growth rate, a CAGR of 11.9%, followed by baby and toddler milk with

a CAGR of 9.0%. Flavored milk is expected to record a CAGR of 4.8%. White

milk sales, the biggest category by volume, are expected to post a CAGR of 1.6%

in 2011-2014E.

Exhibit 11: Liquid dairy product sub categories growth

Source: Tetra Pak 2011, OP Research

1.3%

4.5%

9.5%

12.5%

4.5%

3.1%

1.9%

3.2%

2.7%

-0.6%

-5% 0% 5% 10% 15%

white Milk

Flavored Milk

Baby&Toddler Milk

Lactic Acid Drinks

Traditional Cultured Milk

Drinking Yoghurt

Liquid Cream

Sweetened Condensed Milk

Buttermilk

Evaporated Milk2008-2011 CAGR

1.6%

4.8%

9.0%

11.9%

4.1%

4.7%

1.4%

2.6%

4.5%

1.0%

0% 4% 8% 12% 16%

white Milk

Flavored Milk

Baby&Toddler Milk

Lactic Acid Drinks

Traditional Cultured Milk

Drinking Yoghurt

Liquid Cream

Sweetened Condensed Milk

Buttermilk

Evaporated Milk2011-2014E CAGR

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Downstream: Infant formula, attractive growth prospect

Infant formula market of China experienced a 19% CAGR in the past 10 years,

supported by the urbanization of the Chinese population, the development of the

middle class and the increasing participation of women in the workforce.

Euromonitor forecasts the average market growth of 17% in 2010-2015 and

outpace the whole dairy market of China.

Atypical consumer behavior: low bargaining power among

consumers

The market for infant products is unique: parents are the buyers and the infants

are the consumers, thus the key decision maker is the buyer, not the consumer.

Quality, nutritional value and brand are the three most important considerations

when parents choose products for their children. A market survey conducted by

sina.com (SINA US, NR) indicated that 99% and 95% of parents care most about

quality and nutritional value of infant formula, while 89% also take into account

the brand. Unlike the other consumer goods, price is not a major consideration for

83% of the respondents. That means the bargaining power of consumers in the

infant formula market is relatively low, and we expect that the industry’s margins

are likely to remain solid or even improve.

Exhibit 12: Consumer considerations in purchase of infant formula, 2009

Source: Sina.com, OP Research

99%95%

89%

82%

75%

13%

3%

Quality Nutritional value

Brand Great taste Convenient to feed

Price Others

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Growth by ASP hike, Foreign brands charge premium

The per capita consumption of infant formula climbed up by 18% in 2011 yoy,

largely driven by ASP increment. The ASP for domestic brand infant formula has

climbed up by 6.8% YTD, followed by foreign brand at 3.6%. As shown in Exhibit

13, its price no matter foreign or domestic kept low single-digit mom growth since

June 2009.

Exhibit 13: Milk powder ASP mom growth by category, 2009- 2011


The 2008 melamine scandal led to a shift in market shares from local to foreign

brands and foreign brands are structurally more expensive than the domestic

producers at a 25%-35% premium as their perceived higher quality. We believe

improving awareness of food safety and high brand loyalty, in addition with

relatively low price sensitivity, are the key driving forces for sustainable upside

trend. Any growth in the high-end milk market will continue to be seized by foreign

brands due to better brand perceptions and quality raw milk source. Biostime,

Nestle (NESN VX, NR) and Mead Johnson (MJN US, NR) are all the likely

winners, in our view.

Exhibit 14: Milk powder Price by category and Price Premium, 2009- 2011


-1%

0%

1%

2%

Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12

Domestic Brand Infant Formula Foreign Brand Infant Formula

100

150

200

250

May-09 Feb-10 Nov-10 Aug-11 May-12

Adult Milk Powder Foreign Brand Infant Formula

(RMB/kg)

42

46

50

54

May-09 Nov-09 May-10 Nov-10 May-11 Nov-11 May-12

(RMB/kg)

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The 4th baby boom is happening in the PRC

According to a National Population Development Strategy report, women born

during the third baby boom (1982-1992) have entered their most active

childbearing years (20 to 29 years old). We forecast 2012E-2020E the number of

annual births in the range from 17 to 18.5mn (see Exhibit 15).

Exhibit 15: Birth rate, 1949 - 2011


Relaxation of China’s one-child policy

After thirty-three years enforcement of the one-child policy, China’s birth rate has

gradually slowed down to around 1.19% in 2011 from 4.34% in 1963 (see

Exhibit15 gray line). Not only has the one-child policy led to a significant decline

in the population growth but it has also impacted by the pyramid of age structure

and the country sex ratio in less desirable ways. The ageing of the population,

4-2-1 family phenomenon and economic sluggish have led several experts to

consider abandonment the one-child policy. The Chinese authorities have taken a

cautious approach, launched several pilot programs and enforce new rules in

different provinces.

In the case of Chinese government could allow all couples to have two children in

2013 and 50% of women in most active childbearing years choose to have the

second child, we project 2012E-2020E number of annual births will increase to

22mn to 23mn based on our model.

0

5

10

15

20

25

30

35

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

1949 1952 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

Annual Birth (LHR) Birth rate (RHS)

(%) (mn)2010-2020 The 4th

Baby Boom

1952-1957 The 1st

Baby

1962-1970 The 2nd

Baby

1982-1992The 3th

Baby Boom

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Case study: China baby formula market

Without projecting the relaxation of China’s one-child policy, as shown in Exhibit

16, our rough calculation reveals that the infant formula market can reach

Rmb95bn in 2015 based on the assumptions of :1) low-single digit growth of ASP;

2) gradually increase in penetration rate; 3) the average consumption volume per

children under three years ago is 2-3.5 cans per month. One-child policy

relaxation’s assumption will further bring approximately Rmb28bn increment in

2015E to RMB123bn. On our conservative case projection, Chinese infant

formula market is to grow at a CAGR of 9% between 2012-2020E assuming no

change in one-child policy application, and that of 13% in the scenario with

relaxation of one-child policy.

Exhibit 16: China infant formula sales forecast-Scenario 1: One-child policy

2012E 2013E 2014E 2015E

Age (years) 1 2 3 1 2 3 1 2 3 1 2 3

Population 18 16 16 18 18 16 17 18 18 17 17 18

No. of cans consumption per month 3.50 2.50 2.00 3.50 2.50 2.00 3.50 2.50 2.00 3.50 2.50 2.00

Average ASP 144 144 144 153 153 153 162 162 162 170 170 170

Duration of consumption (months) 6 12 12 6 12 12 6 12 12 6 12 12

Penetration rate 35% 35% 35% 38% 38% 38% 41% 41% 41% 43% 43% 43%

Infant formula market value (mn) 63,095 76,150 88,854 95,263

Source: OP Research

Exhibit 17: China infant formula sales forecast-Scenario 2: Two-Children policy

2012E 2013E 2014E 2015E

Age (years) 1 2 3 1 2 3 1 2 3 1 2 3

Population 18 16 16 23 18 16 22 23 18 22 22 23

No. of cans consumption per month 3.50 2.50 2.00 3.50 2.50 2.00 3.50 2.50 2.00 3.50 2.50 2.00

Average ASP 144 144 144 153 153 153 162 162 162 170 170 170

Duration of consumption (months) 6 12 12 6 12 12 6 12 12 6 12 12

Penetration rate 35% 35% 35% 38% 38% 38% 41% 41% 41% 43% 43% 43%

Infant formula market value (mn) 63,095 82,669 106,716 123,842

Source: OP Research

Exhibit 18: China Infant formula sales forecast, 2012E- 2020E

Source: OP Research

50,000

70,000

90,000

110,000

130,000

150,000

170,000

2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E

Two-child policy One-child policy

(RMB mn)

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Exhibit 19: Infant formula retail price of major brands in China market

Source: Walmart , Taobao.com, Watsons, OP Research

0

100

200

300

400

500

600

700

(RMB/900g)

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China Modern Dairy (1117 HK) – Enjoy the taste of High Growth

We see strong total revenue growth prospects ahead; total revenue could maintain a CAGR of 42% from FY12-FY15E.

CMD will continue benefits from the policy of exemption on agricultural tax.

The company’s cash can catch up with CAPEX and generate positive free cash flow in FY14.

China modern dairy (CMD) is largest large-scale modern farm operator in China,

with 20 scalable farms and 159,347 dairy cows. Its duplicable business model

speeds up its expansion pace and target to 27 by FY15E with 240,000 cows. Its

high capital intensive and long-term pay-back business model creates a high

entry barrier for new rivals.

The advanced breeding, feeding and herd management techniques enable CMD

to produce the high-quality raw milk. And the price commands a high double digit

premium over the industry average level. To ensure the quality of raw milk, CMD’s

farms are strategically located closed to downstream milk processing plants.

CMD targets the milk yield per milkable cow is at about 9.0 tons/annum in FY15E

and 9.4 in FY17E, ultimately up to 10 tons/annum, driven by increasing proportion

of mature cows and genetic improvement. Continuing improvement in milk yield

will further boost the production volume growth, in our view. Thanks to its

economies of scale, cash cost of raw milk per ton declined by 7.24% in FY12

despite of surging commodities’ price.

A 10-year off-take agreement with Mengniu is mutually beneficial for both parties,

in our view. Sales to Mengniu accounted for 96.4% of its total sales in FY12, and

represented 12% of Mengniu’s raw milk demand.

Initial BUY. We forecast CMD could enjoy the net profit growth at a CAGR of 34%

for FY12-FY15E. Based on a blending DCF/PEG model, we estimate a fair value

of HK$2.64 per share, which implies 30.7% potential upside. We give a BUY

rating.

Initial Coverage

BUY

Close price: HK$2.02

Target Price: HK$2.64 (+30.7%)

Key Data

HKEx code 1117

12 Months High (HK$) 2.45

12 Month Low (HK$) 1.51

3M Avg Dail Vol. (mn) 3.33

Issue Share (mn) 4,800.00

Market Cap (HK$mn) 9,696.00

Fiscal Year 06/2012

Major shareholder (s) Advanced Dairy (24.01%)

Source: Company data, Bloomberg, OP Research Closing price are as of 5/11/2012

Price Chart

1mth 3mth 6mth

Absolute % 0.0 -4.3 -0.5

Rel. MSCI CHINA % -7.1 -13.8 -6.0

PE

Company Profi le Established in 2005, China modern dairy is

the largest modernized dairy farm operator

in China. It operated 20 scalable farms in

China with 159,347 dairy cows. Two more

new farms are under construction, planning

to reach a total of 27 by FY15E. Its milk

yield of 8.09 against the industry average of

4.8. Sales to Mengniu accounted for

96.4% of its total sales in FY12, and

represented 12% of Mengniu’s raw milk

demand.

Exhibit 20: Forecast and Valuation Year to Jun (RMB mn) FY10A FY11A FY12A FY13E FY14E

Revenue 590 1,113 1,678 2,685 3,832

Growth (%) 77% 89% 51% 60% 43%

Net Profit 107 225 398 541 732

Growth (%) 152% 109% 77% 36% 35%

Diluted EPS (RMB) 0.025 0.052 0.082 0.112 0.151

EPS growth (%) n.a. 103% 60% 36% 35%

Change to previous EPS (%) n.a. n.a. n.a. n.a. n.a.

Consensus EPS (RMB)

0.119 0.164

ROE (%) 7.5 4.8 7.9 9.7 11.5

P/E (x) 64.7 31.9 20.0 14.7 10.9

P/B (x) 4.8 1.5 1.6 1.4 1.3

Yield (%) 0.0 0.0 0.0 0.0 0.7

DPS (HK$) 0.000 0.000 0.000 0.000 0.015


0.0

0.5

1.0

1.5

2.0

2.5

3.0

Nov/11 Feb/12 May/12 Aug/12

HK$1117 HK MSCI CHINA

0

10

20

30

40

50

60

Jan/11 Jul/11 Jan/12 Jul/12

Forward P/E Ratio

+1std.

avg.

-1std.

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Investment thesis

The largest dairy farming company

As China largest large-scale modern farm operator, China modern dairy (CMD)

established in 2005 and has been recognized by the China Dairy Association as

the best-in-class dairy farm operator in China. It operated 20 scalable farms in

China with 159,347 dairy cows. Two more new farms are under construction,

planning to reach a total of 27 by FY15. According to the China Dairy yearbook,

the number of milkable cows was 14.4mn in 2011.By milkable cow size, China

Modern Dairy’s market share was only ~1%, despite its position the largest dairy

farm operator in China.

Exhibit 21: The top-four largest dairy farms in China

Company No. of farms No. of Dairy Cows No. of Milkable Cows

China Modern Dairy 20 159,347 70,793

Beijing Sanyuan Luhe Dairy Farming 25 45,000 23,000

Huishan 50 109,000 45,000

Shanghai Dairy Group 18 37,000 19,000


Standardized farm, speed up its expansion pace

CMD’s dairy farms are designed and constructed using a modern and scientific

layout to maximize yield and productivity, making the farms easily duplicable and

scalable to speed up its expansion pace. Thanks to its duplicable business model,

the number of farms of CMD has surged to 20 in FY12 from 3 in FY08, while the

number of cows is rapidly increasing from 24,358 in FY08 to 159,347 in FY12, a

CAGR of 60%. In FY13E, CMD plans to complete the construction of two farms

located in Bengbu farms (Anhui province), and targets to 27 by FY15E with

240,000 cows in total.

Exhibit 22: Number of cows and farms, FY08-FY12


14,964 20,427 26,607

46,267

70,793

9,394

23,532

45,584

61,309

88,554

3

6

11

16

20

0

5

10

15

20

25

10,000

50,000

90,000

130,000

170,000

FY08 FY09 FY10 FY11 FY12

No. of Milkable cows No. of Heifers and calves No. of farms

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Exhibit 23: Layout of CMD’s standard dairy farm design


High entry barrier from capital intensive

Building up a large scale-farms is quite capital intensive, with around RMB300mn

capital expenditure comprising of RMB180mn for fixed asset investment and

RMB120mn for purchase 6000 heifers (RMB20,000/head). As the production of

raw milk will not commence in the first 2 years, thus a single farm will generate

positive free cash flow till third year based on our model. High capital investment

requirement and long-term pay-back time create a high entry barrier for new

rivals.

Exhibit 24: Free cash flow of a single large-scale farm


-400

-300

-200

-100

0

100

200

300

Year1 year2 Year3 Year4 Year5 Year6 Year7 Year8 Year9 Year10 Year11

Payback

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Raw milk provider, premium quality oriented

Frequent quality scandals that happened in the past years have make consumers

more willing to pay for high-quality and health dairy products. Modern and

scientific practices and advanced breeding, feeding and herd management

techniques enable CMD to produce the high-quality and safe raw milk. Somatic

cell Count and Microbe Count are two of the major indicators used to determine

milk quality. As shown in Exhibit40, the quality of CMD’s raw milk is significantly

higher than China and EU standard, and higher than China’s other large scale

farms. Meanwhile, CMD’s protein and fat content of raw milk are 3.1% and 3.7%,

richer than China’s industry standards which are 2.8% and 3.1%, respectively.

Exhibit 25: Milk quality ratios comparison

China Modern

Dairy

Other large scale

farms in China

China

Standard

EU

Standard

Microbe Count <50k/ml N/A <=2,000k/ml <=100k/ml

Somatic Cell Count <300k/ml 592k/ml N/A <=400k/ml

Note: Generally a lower somatic cell count indicates better animal health, while a lower microbe plate count indicates improved sanitation.

Source: China Dairy Statistical Summary 2010

Unlike the individual farmers and small scale farms, CMD’s farms are strategically

located closed to downstream milk processing plants (1-3 hours transportation

time) and directly deliver to milk processor after the raw milk produced. This

“one-stop” procedure shortens the transportation process and reduces the risk of

contamination and product tampering, thus secures the quality of raw milk.

Exhibit 26: The pipeline of raw milk delivery


High quality combined with consumer’s low price sensitivity enables CMD to

charge a high double digit premium over the industry average price. We expect

the ASP hike 1% in FY13E-15E supporting by rising feed cost, in line with the

management guidance. Based on our sensitivity analysis, every 1% increase in

raw milk price could boost by 3.6% in net profit in FY13E (see exhibit 33).

Individual

farmers

Milk collation

stations

Intermediated

stationsTraders Agents Truck drivers Producers

China Modern

DairyProducers

VS.

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Exhibit 27: Raw milk price(RMB/kg), 2008-2012

Source: sn110.com, Company data, OP Research

Higher milk yield

According to the China Dairy association, the industry average milk yield per cow

in China was 4.8 tons /annum and the average milk yield per cow for large-scale

farms was 7.0 tons/annum. Thanks to the continuous importing high quality

heifers and scientific breeding and feeding herd management, CMD’s average

milk yield per milkable cow achieved 8.09 tons/annum and the mature farms

average was 9.0 tons/annum in FY12. CMD targets the milk yield per milkable

cow is 9.0 tons/annum in FY15E and 9.4 in 2017E, ultimately up to 10

tons/annum, in the view of management. This is mainly driven by:

Heifers become milkable cows and increasing proportion of mature cows

(4-5 years old) with higher milk yield. According to the management, the

average age of CMD’s cows was around 3.5 years.

Genetic improvement and advanced herd upgrade the milk yield in the

subsequent lactation period. CMD imported its first generation Holstein

dairy heifers (>8tons/annum milk yield) from New Zealand and Australia,

and imported semen from high-quality bulls (born by the milkable cow with

15 tons/annum milk yield) from several international suppliers, to improve

the yield of the next few generations and ultimately to 10 tons/annum.

Continuing improvement in milk yield will further boost the production volume

growth, in our point of view.

2.0

2.5

3.0

3.5

4.0

4.5

2008 2009 2010 2011 2012

Industry average China Modern Dairy

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Exhibit 28: Economics of a Dairy Farm: Milk yield


Exhibit 29: Average milk yield (tons/head/year), FY2008-FY2012


3

4

5

6

7

8

9

10

1 4

Breeding –

No Milk

Produced

Rapid Yield

Improvement

–Cows

Maturing

Gradual Yield

Improvement –

Improvements in

Herd Quality,

Feed Mix etc.

Year

Milk Y

ield

(to

ns/a

nn

um

)

6.10

6.90

7.30 7.56

8.09

9.00

9.40

4.0

6.0

8.0

10.0

2008 2009 2010 2011 2012 2015E 2017E

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Scale operation bring cost efficiency

The milk quality and yield are primarily determined by the nutritional composition

of the feed. Feed cost, as the largest and fixed expense, account for 88.3% of

farm operating expense in FY12. The cash cost of raw milk per ton declined by

7.24% from RMB3,190 in FY10 to RMB2,959 in FY12 despite of surging

commodities’ price, indicating CMD’s constant improvement in milk yield and

reduction on feed transportation.

Cost advantages also came from CMD’s economies of scale and market leading

position as well as good relationships with the upstream suppliers, which lower

the purchase price for feed but can still guarantee the quality. CMD’s feeding

includes concentrates and forages. Concentrates, representing 60% of total feed

consumption, consist of corn, soybean meal, beer pulp and cotton meal; forages,

accounting for 40% of total feed consumption, consist of corn silage, sheep grass

and alfalfa. In order to ensure and improve the quality of raw milk, CMD

purchases concentrates from large national supplier, like Jilin COFCO (accounts

for 10% of concentrates), and sources forages from local farmers. CMD also plan

to improve the labor efficiency, the long-term target ratio of 60:1 dairy cows to

employees in the coming 5 years from 30:1 in FY2010.

Exhibit 30: Cash cost of raw milk per ton (RMB), FY2010-FY2012


We do not expect the cash cost of raw milk per ton to rise substantially over the

next three years, as i) CMD optimizes of the feed mix and uses cheaper

substitutes with a similar content; ii) the major raw material price of corn and

soybean (accounting for 36% of total feed cost) declined from the peak since mid

of 2012 and downward trend will continue, in our point of view. We estimate 5%

increment of the blended feed cost price in line with the trend of inflation. Our

sensitivity analysis reveals that CMD’s earnings are not highly affected by feed

cost fluctuations, and every 1% hike in feed costs price would lead to a 2.7% drop

in net profit (see exhibit 33).

3,190

2,841

2,959

2010 2011 2012

Cash cost= Farm operating

expense + labor cost

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Exhibit 31: Feed cost constructure


Exhibit 32: Raw material price, 2011-2012


10-year agreement, strategic partnership with Mengniu

In October 2008, CMD entered into a 10-year off-take agreement with Mengniu.

Under the agreement, both parties shall discuss annual procurement volume of

raw milk 3 months prior to each calendar year and mengniu is required to

purchase all raw milk production of CMD in the upcoming calendar year if the

parities fail to reach an agreed amount. This agreement also allows CMD to sell

up 30% of daily raw milk production to third parties, except for Inner Mongolia Yili

(600887 CH, NR) and Bright dairy (600597 CH, NR). The pricing of the raw milk

sold to Mengniu is determined by a formula, base price plus upward adjustment.

Base price refers to the price of Mengniu buys raw milk from other mid-to

large-scale dairy farms or, if no relevant comparison, use other comparable dairy

farms in nearby regions with adjustments. The upward adjustment depends on

certain quality standards.

Corn30%

Soybean meal6%

Alfalfa20%

Others 44%

2,000

2,500

3,000

3,500

4,000

4,500

Jan-09 Oct-09 Jul-10 Apr-11 Jan-12 Oct-12

(Soybean Meal (RMB/Ton))

1.0

1.5

2.0

2.5

3.0

Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12

(Corn (RMB/KG))

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CMD’s strategic partnership with Mengniu is mutually beneficial for both parties,

in our view. Long-term partnership ensures CMD’s strong demand from market

leading player. For Mengniu, CMD’s high quality raw milk can reduce consumer’s

concerns about its product safety, especially for high-end products, i.e. deluxe

milk.

From FY08 to FY12, sales to Mengniu accounted for 98.9%, 99.6%, 97.6%, 97.4%

and 96.4% of CMD’s total sales, respectively. So far, CMD’s supply represented

12% of Mengniu’s raw milk demand from 10% in FY11.

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Financial analysis

We forecast CMD could enjoy the net profit growth at a CAGR of 33% for

FY12-FY15E, corresponding to net profit of RMB541mn (or RMB0.11/share) for

2013E, RMB732mn (or RMB0.15/share) for 2014E, and RMB956mn (or

RMB0.20/share) for 2015E.

Key earnings drivers should come from i) top line growth boosted by strong

demand from downstream dairy operators for high quality raw milk as well as

10-year take off agreement with Mengniu to secure the long-term sales volume

growth and premium selling price; ii) operating leverage generates from its

modernization and scale operation; and iii) government policies supporting (i.e.

exemption on certain tax and subsidies) for the modernization of dairy farming.

We see strong total revenue growth prospects ahead, and total revenue could

maintain a CAGR of 42% from FY12-FY15E, driven by i) a 35% CAGR in raw milk

sales volume (led by a 5% CAGR in improvement of milk yield and the rest

generate from the increment of milkable cows; ii) a 1% CAGR of raw milk selling

price, tracking on the trend of feed price and strong consumption of high quality

milk products; iii) contribution from own brand products and selling excess cows

which are project to happen in FY15E on our model.

Our base case’s assumptions are 1% hike of ASP and 5% increase of feed cost.

The sensitivity analysis reveals that our net profit is not quite sensitive to the

change of feed cost and ASP. Assuming no change in feed cost, we estimate that

1% increase in ASP would boost the FY13E net profit by 3.6%. On the cost side,

we estimate that 1% increase in feed costs would drag down the net profit by 2.7%

in net profit of FY13E. We conclude CMD can improve its net profit margin if they

can adjust ASP in-line with change of feed cost.

Exhibit 33: Sensitivie Analysis of net profit change to change of Feed cost (%) and change of ASP (%)

Change of Feed cost (%)

2.3 3.0% 4.0% 5.0% 6.0% 7.0%

Change of ASP (%)

-1.0% -2.0% -4.6% -7.3% -9.9% -12.6%

0.0% 1.7% -1.0% -3.6% -6.3% -8.9%

1.0% 5.3% 2.7% 0.0% -2.7% -5.3%

2.0% 8.9% 6.3% 3.6% 1.0% -1.7%

3.0% 12.6% 9.9% 7.3% 4.6% 2.0%

4.0% 16.2% 13.6% 10.9% 8.2% 5.6%

Source: OP Research

The management expects the gain arising from changes in fair value less costs to

sell of dairy cows will decline to RMB70mn and RMB50mn in FY13/14E as fair

value changes will decrease with herd maturation. Meanwhile the cow

import-related government grants will slowdown as cow imports will cease. These

two items will drop down CMD’s operating profit margin and net profit margin in

FY13/14E.

We group the farm operating expenses, staff cost, depreciations and other

expenses as the operating expenses. The EBIT margin (excluding the non-cash

fair value of biological assets) is forecasted to be 19.4%, 19.5% and 19.6% in

FY13E, FY14E and FY15E, respectively, largely due to i) its economies of scale

further drop down the farm operating expenses, especially the cash cost of raw

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milk per ton (commodity price increase is largely hedged by higher milk yield); ii)

staff cost ratio drops to 7.0% in FY13E, 6.9% in FY14E and 6.8% in FY15E on

operating leverage; iii) depreciation ratio accounts for 3.7%-5.3% of sales for

FY13E to FY15E.

Exhibit 34: Operating expense breakdown , FY13E


Income tax rate=0%

The Chinese government has implemented a plenty of policies to support the

development of large-scale dairy farms, including exemptions on agricultural tax,

VAT and income tax. The management expects CMD will continue benefits from

this tax policy, thus we expect the income tax expense to be equal to zero in our

model.

CAPEX

CMD is still in the stage of high growth, and large capital investment is required.

In FY13, CMD plans to complete the construction of two farms located in Bengbu

farms (Anhui province), and targets to have 180,000 cows from 159,347 in FY12,

11,000 of net increment would be imported. The management expects to be

self-sufficient in the supply of heifers by FY14E. We believe it is

achievable. Based on 15% organic cattle growth and 180,000 cows target base,

CMD can transfer excess heifers from mature farms to meet 6,000 cows per new

farm’s requirement. The excess cows could be sold to other dairy farms as

CMD’s another mid-term revenue contributor. By FY15E, CMD targets to lift up

the number of cows to 240,000 by expanding the size and utilization rate of the

existing farms, and the total number of farms will reach 27. The management

indicated that the capital expenditure (CAPEX) for building a large-scale dairy

farm with 10,000 dairy cows comprises is approximately RMB300mn, comprising

of RMB180mn for fixed asset investment and RMB120mn for purchase of heifers.

We forecast the annual CAPEX of RMB1.2bn, RMB0.9bn, and RMB0.8bn, for

FY13-FY15E, respectively. We believe the company’s cash can catch up with

CAPEX and generate positive free cash flow in FY14E, in line with management

guidance.

Feed costs

Other farm operating expenses

Employee benefits expense

Depreciation

Other expenses

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Key risks

Line-up of famous brand, but strong reliance on this single customer.

Based on the 10 year off-take agreement, over 95% of CMD’s revenue is

contributed by its largest customer, Mengniu Dairy. CMD only has the

flexibility of selling no more than 30% of raw milk to other dairy processors

(excluding Yili and Bright Dairy) and directly to end-customers, which could

potentially hinder CMD’s ability to expand the customer base. The

management expects the sales to Mengniu will continue to represent a large

portion of its annual sales of milk produced in the future. CMD is directly

subjected to Mengniu’s operating risks.

Significantly reliance on one product, raw milk. Over 95% of revenue is

generated from raw milk. The management also anticipates the production of

raw milk will continue to be CMD’s primary business. Its sales volume is

highly dependent on and sensitive to fluctuation in raw milk production

volume and pricing.

Feed cost inflation. Feed cost accounted for 60.4% of total sales, and 88.3%

of total farm operating expense in FY12. Like most agricultural products, the

cost and supply of feed are largely subjected to market condition, which may

be affected by adverse weather conditions, various plant diseases, pests and

other acts of nature. The company may be unable to obtain sufficient

quantities of feed or purchase with high cost in unfavorable environment,

which will erode the margin.

Outbreak of any major diseases among cows The quality and healthy of

the dairy cows the important factors in production of raw milk. Any major

outbreak of any illness and disease (such as foot and mouth disease, bovine

tuberculosis) among cows could significantly impact on the raw milk

production capacity and volume. The company carries insurance to hedge

the losses related to cow diseases, will receive government compensation in

the event of an outbreak of a disease. However, it might be not sufficient to

cover all of the losses, including damage of the brand value and relation with

the upstream players.

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Valuation

DCF Model

Given its cash flow-generative business nature and no direct listed peers for

comparison, we use DCF-based methodology to derive the 12-month target price

of HK$2.62for CMD. We use cost of equity of 10.2%, based on the assumptions

are:i) risk free rate of 3%; ii) market risk premium of 9%; iii) beta of 0.8 to reflect

its stock’s volatility relative to the Hang Seng Index; iv) 2% terminal growth rate

from 2023 onward, in line with our long-term growth assumption for China

consumer players.

We also conduct sensitivity analysis to quantify how target price changes in

different scenarios of cost of equity and terminal growth rate.

Exhibit 35: Sensitivity analysis of target price to Cost of Equity and Terminal growth rate assumption

Perpetual growth rate (%)

2.3 1.0% 1.5% 2.0% 2.5% 3.0%

Cost of Equity (%)

9.2% 2.84 2.98 3.14 3.33 3.55

9.7% 2.60 2.73 2.87 3.02 3.21

10.2% 2.40 2.50 2.62 2.76 2.91

10.7% 2.21 2.31 2.41 2.52 2.65

11.2% 2.05 2.13 2.22 2.31 2.42

11.7% 1.90 1.97 2.04 2.13 2.22

Source: OP Research

PEG Model

We also derive our 12-month target price of HK$2.67 from a PEG-based

methodology. The FY13 P/E multiple is 0.6x, based on a 25% discount to the

China dairy sector average on back of its unique business risk of strong reliance

on its single customer and high sensitivity to major diseases among cows.

Based on a blending DCF/PEG model, we estimate a fair value of HK$2.64 per

share, which implies 30.7% potential upside. We give a BUY rating.

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Appendix

Company information

As of 30 June 2012, CMD operated 20 farms across China with 159,347 dairy

cows (70,793 milkable cows) producing 431,394 tonnes of raw milk annually. The

farms are located in the provinces of Anhui, Shandong, Hebei, Sichuan, Shaanxi,

Inner Mongolia, Heilongjiang, and Hubei. All of farms have a designed capacity of

10,000 dairy cows each and are strategically located within approximately 200

kilometers from Mengniu processing factories to ensure the quality and reduce

transportation expense.

Exhibit 36: China Modern Dairy farms distribution (As of 30 June 2012)


Shangzhi Farm

Tongliao Farm

Saibei Farm, I, II & III

Chabei Farm, I, II & III)

Wenshang Farm

Bengbu Farm III& IV

Maanshan Farm

Hengsheng Farm

Helingeer Farm

Baoji Farm I

Baoji Farm II

Hongya Farm

Bengbu Farm I&II

Feidong Farm I&II

TongshanFarm

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Exhibit 37: Sales volume of raw milk, FY08-FY12


Exhibit 38: Shareholding Structure

#Jinmu owned by Ms.Gao Lina, Mr Sun yugang and other management


55,888

96,306

158,081

288,620

431,394

0

100,000

200,000

300,000

400,000

500,000

FY08 FY09 FY10 FY11 FY12

(tonne)

Yinmu15%

Xinmu15%

Advanced Dairy company

24%

Cystal Dairy Holdings (CDH)

8%

Jinmu5%

Public Shareholders

33%

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Management profile

Mr. WOLHARDT Julian Juul (39) - Chairman, non-executive Director

He is currently a partner of KKR Asia Limited focusing on private equity

transactions in the Greater China region. He has been actively involved in

advising on investments Yageo Corporation (2327 TT), Tianrui Group Cement

Company limited and International Far Eastern Leasing Company limited since

he joined KKR Asia limited in 2006. Before joining KKR Asia limited, Mr. Wolhardt

was with Morgan Stanley Private Equity from 1998 to 2006. He is also a

non-executive director of Mengniu.

Mr. Deng Jiuqiang (61) - Founder, Executive director

He has more than 10 years experience in dairy industry and 15 years of

experience in dairy-related industries in China. He joined the Group in December

2006 and was appointed as an executive Director of the Company on 14

November 2008. Mr. Deng was a co-founder and former vice chairman of inner

Mongolia Mengniu Dairy (Group) Company Limited, a subsidiary of Mengniu from

August 1999 to May 2008. He has ceased to hold any positions with Mengniu

since May 2008. Mr. Deng was also the founder of Inner Mongolia Jiuqiang

Machinery Company Limited and has been its chairman since 1999.

Ms. Gao Lina (55) - Executive Director, CEO

Ms. Gao is one of the founders of the Group and has significant experience in

cross-border trading, resource integration and administrative management. Prior

to joining the Group, Ms. Gao was the general manager of Taian Foreign General

Trade Corporation between October 1993 to June 2005.

Mr. Han Chunlin (40) - Executive Director, COO

Mr. Han has more than 15 years of experience in food and beverage industry in

China and join the Group in September 2008. Mr. Han worked as the marketing

vice general manager of Nowara Shinnosuke (Fujian) Food industry Company

from February 2006 to July 2008. From January 1999 to September 2004, he

served at the liquid milk Department of Mengniu as marketing manager. Prior to

that, Mr Han was a branch-plant manager at Milk Powder Department of Inner

Mongolia Yili Industrial Group Company Limited from July 1994 to January 1999.

Company Milestone

Exhibit 39: China modern dairy milestone

2005-09 Commenced business under the name of “leading farming”

2006 First farm became operational in Maanshan, Anhui province.

2007-2008 New dairy farms in Hebei and Shandong provinces commenced operation

2008-07 Modern Farm was incorporated and acquired all the business and assets of Leading farming for RMB202mn

2008-11 First round of Equity Financing for purchases of heifers and as general working capital

2008-12 Second round of Equity Financing for purchase of heifers

2008-12 Acquisition of Helingeer Modern Farm in Inner Mongolia

2009-03 and 2009-06 Third and fourth rounds of Equity Financings for construction of dairy farms in Feidong

2009-2010 New dairy farms in Sichuan, Shanxi, Hubei, and Henglongjiang provinces commenced operation

2010-11 Listed on the Main Board of The Stock Exchange of Hong Kong Limited


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Financial Summary - China Modern Dairy (1117 HK) Year to Jun FY10A FY11A FY12A FY13E FY14E

Year to Jun FY10A FY11A FY12A FY13E FY14E

Income Statement (RMB mn)

Ratios

Turnover 590 1,113 1,678 2,685 3,832

Gross margin (%) 25.8 34.4 31.5 32.3 32.2

YoY% 77% 89% 51% 60% 43%

Operating margin (%) 23.3 27.2 28.5 22.4 20.6

COGS (438) (730) (1,149) (1,819) (2,597)

Net margin (%) 18.2 20.2 23.8 20.2 19.1

Gross profit 152 383 529 866 1,235

Payout ratio (%) 0.0 0.0 0.0 0.0 0.0

Gross margin 25.8% 34.4% 31.5% 32.3% 32.2%

Effective tax (%) (0.1) (0.0) (0.0) 0.0 0.0

Other income 65 102 117 81 59

Total debt/equity (%) 85.3 32.6 51.1 53.4 49.5

Gain arising from changes in

fair value less costs to sell of

dairy cows

61 56 131 70 50

Net debt/equity (%) 67.8 10.7 40.9 42.1 35.2

Operating profit 137 303 479 601 789

Current ratio (x) 0.7 2.1 0.7 0.7 0.8

Operating margin 23.3% 27.2% 28.5% 22.4% 20.6%

Quick ratio (x) 0.5 1.8 0.6 0.6 0.6

Finance costs (30) (59) (71) (52) (46)

Inventory T/O (days) 88 82 69 79 79

Profit after financing costs 107 244 407 550 743

AR T/O (days) 25 24 26 25 25

Associated companies & JVs 0 0 0 0 0

AP T/O (days) 71 51 63 57 57

Pre-tax profit 107 244 407 550 743

Cash conversion cycle (days) 41 55 32 47 47

Tax (0) (0) (0) 0 0 Minority interests 0 (19) (9) (8) (11)

EBIT margin (%) 23.3 27.2 28.5 22.4 20.6

Net profit 107 225 398 541 732

Pre-tax/EBIT (x) 0.8 0.8 0.9 0.9 0.9

YoY% 151.6% 109.2% 77.4% 35.8% 35.2%

Net profit/pre-tax (x) 1.0 0.9 1.0 1.0 1.0

Net margin 18.2% 20.2% 23.8% 20.2% 19.1%

Asset turnover (x) 0.1 0.2 0.2 0.3 0.3

EBITDA 181 370 574 743 953

Assets/equity (x) 2.9 1.5 1.7 1.8 1.8

EBITDA margin 30.8% 33.3% 34.2% 27.7% 24.9%

Return on equity (%) 7.5 4.8 7.9 9.7 11.5

EPS (RMB) 0.025 0.052 0.082 0.112 0.151 YoY% n.a. 102.8% 59.6% 35.8% 35.2%


DPS (RMB) 0.000 0.000 0.000 0.000 0.012

Balance Sheet (RMB mn)

Fixed assets 1,578 2,221 2,965 3,410 3,793


Intangible assets & goodwill 365 373 378 379 381

Cash Flow (RMB mn)


EBITDA 181 370 574 743 953

Long-term investments 0 0 0 0 0

Chg in working cap 3 10 121 203 121

Other non-current assets 1,756 2,653 4,195 4,791 5,138

Others (95) (129) (224) (169) (144)

Non-current assets 3,699 5,247 7,553 8,595 9,327

Operating cash 89 252 471 777 931 Interests paid 30 59 71 52 46

Inventories 139 213 264 271 576

Tax (0) (0) (0) 0 0

AR 77 137 181 309 390

Net cash from operations 119 311 542 829 977

Prepayments & deposits 36 287 134 134 134

Other current assets 1 1 2 2 2

Capex (1,207) (1,440) (2,169) (1,119) (852)

Cash 251 1,022 518 633 907

Investments (46) (5) (14) 0 0

Current assets 505 1,660 1,099 1,349 2,010

Dividends received 0 0 0 0 0 Sales of assets 0 0 0 0 0

AP 352 483 821 1,160 1,667

Interests received 3 10 17 11 15

Tax 0 0 0 0 0

Others 69 (224) 179 40 38

Accruals & other payables 0 0 0 0 0

Investing cash (1,181) (1,659) (1,987) (1,067) (798)

Bank loans & leases 385 304 664 732 801

FCF (1,062) (1,349) (1,444) (238) 178

CB & othe debts 0 0 0 0 0

Issue of shares 0 903 0 0 0

Other current liabilities 5 5 16 16 16

Buy-back 0 0 0 0 0

Current liabilities 742 792 1,501 1,908 2,484

Minority interests 1 0 3 0 0 Net change in bank loans 633 298 1,068 404 142

Bank loans & leases 840 1,219 1,927 2,263 2,336

Others (55) 918 (129) (52) (46)


Financing cash 579 2,119 941 352 96

Deferred tax & others 52 174 91 91 91

MI 1,133 55 66 74 86

Net change in cash (483) 771 (503) 114 275

Non-current liabilities 2,025 1,447 2,084 2,428 2,513

Exchange rate or other Adj 0 0 0 0 0 Opening cash 734 251 1,022 518 633

Total net assets 1,437 4,668 5,066 5,608 6,340

Closing cash 251 1,022 518 633 907

Shareholder's equity 1,437 4,668 5,066 5,608 6,340

CFPS (RMB) 0.059 0.234 0.107 0.130 0.187

Share capital 0 413 413 413 413

Reserves 1,436 4,255 4,653 5,195 5,927

BVPS (RMB) 0.34 1.07 1.04 1.16 1.31

Total debts 1,225 1,523 2,591 2,995 3,137

Net cash/(debts) (974) (501) (2,073) (2,362) (2,230)

Source: Company, OP Research

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Biostime International (1112 HK) - A premium story

The total revenue could maintain a CAGR of 31% from 2011-2014E

the blended gross profit margin further erode to 65.1%, 64.7% and 64.4% in 2012E- 2014E, largely due to the product mix changes

Selling & distribution expense ratio is projected to decline to around 32% in 2012E-2015E, driven by the effective cross selling marketing.

As a player in premium market, Biostime international (Biostime) is a provider

of premium pediatric nutritional and baby products in China, with 85% market

share in children probiotic supplement and 44% in that of supreme infant formula

market. Biostime was able to achieve superior margin over its peer average at 20%

over the past five years. As the fast growing segment, Infant formula has replaced

the probiotic supplement and become the largest revenue contributor, accounting

for over 80% of total revenue. All its products are sourcing from overseas to

guarantee quality and safety.

Its real time and effective channel management can monitor distributors’

inventory and sales level, leading to the account receivables turnover days at 1

day, while its POS machines can track sales information and consumer purchase

behavior. Its Mama 100 membership platform promoted strong consumer

loyalty, resulting in a rising cross selling and saving the expense of selling and

distribution each year. We believe Biostime can better grasp the market trend to

better prepare the orders through this effective channel management and Mama

100 membership.

Initial BUY with undemanding valuation We forecast Biostime could enjoy the

net profit growth at a CAGR of 24% for 2011-2014E. Key earnings drivers come

from top line growth boosted by infant formula segment and consequent

SG&A/sales ratio decline driven by effective cross selling marketing strategy. Our

TP is based on a blending SOTP/DCF model, we estimate a fair value of

HK$24.60 per share, which implies undemanding 2013E PE of 14.5x and

suggests 23.1% potential upside.

Initial Coverage

BUY



Key Data

HKEx code 1112




Issue Share (mn) 602.29


Fiscal Year 12/2011

Major shareholder (s) Biostime Pharm. (74.7%)


Price Chart

1mth 3mth 6mth

Absolute % 3.3 8.9 -5.1

Rel. MSCI CHINA % -3.8 -0.6 -10.6

PE

Company Profi le Biostime international holdings Ltd. provides

pediatric nutrition and baby care products.

Their products include probiotic supplement

for children, infant formulas, dried baby food,

and nutritional supplements. The products

under the brand names “Biostime” and

“BMcare”.

Exhibit 40: Forecast and Valuation Year to Dec (RMB mn) FY10A FY11A FY12E FY13E FY14E

Revenue 1,234 2,189 3,078 4,024 4,924

Growth (%) 121% 77% 41% 31% 22%

Net Profit 266 527 644 824 1,000

Growth (%) 145% 98% 22% 28% 21%

Diluted EPS (RMB) 0.580 0.864 1.054 1.347 1.636

EPS growth (%) 142% 49% 22% 28% 21%


Consensus EPS (RMB)

1.100 1.385 1.650

ROE (%) 16.0 26.7 27.7 27.4 26.5

P/E (x) 27.9 18.7 15.3 12.0 9.9

P/B (x) 4.5 5.0 4.2 3.3 2.6

Yield (%) 1.4 3.8 2.7 3.4 4.1

DPS (HK$) 0.273 0.761 0.529 0.676 0.821


0.0

5.0

10.0

15.0

20.0

25.0



0

5

10

15

20

25

Feb/11 Aug/11 Feb/12 Aug/12

Forward P/E Ratio

+1std.

avg.

-1std.

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Investment thesis

A player in premium market

Biostime international (Biostime), founded in 1999 and listed in 2010, is a

provider of premium pediatric nutritional and baby products in China. With 85%

market share in children probiotic supplement market, Biostime leveraged its

solid market position and started to expand its business to baby formula in July

2008 and baby care products in 1H10. Its blended gross profit margin is higher

than the peers approximately by 20%.

Exhibit 41: Gross profit margin comparison, 2007-2011


Infant formulas, the main catalyst

According to Nielson, Biostime has become the No.1 infant formula player in the

supreme tier segment (over Rmb300/can) with a market share of 44% in 1H11(vs.

32% in 1H10). In high-tier segment (RMB 200-300/can), Biostime have 7.4%

market share and ranked 6th

in 1H11. Infant formula, as the fast growing segment,

has replaced the probiotic supplement and became the largest revenue

contributor, accounting for 80.3% of total revenue with 65% gross profit margin in

1H12.

30%

40%

50%

60%

70%

80%

90%

2007 2008 2009 2010 2011

Biostime Yashili Feihe Beingmate

Tue, 06 Nov 2012

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Exhibit 42: Infant formula industry in China in 1H11

Source: AC Nelson, OP Research

Under the 4-2-1 phenomenon, today’s China parents, especially the generation

born in 1980s, who exhibit relatively lower price sensitivity and higher value

awareness are willing to spend on premium products for their children. This

consumption preference shift was more visible in infant formula, especially after

the scandal happened on late 2008. As such, we estimate Biostime to maintain

fast growth momentum for revenue with 31% CAGR in 2012-2015E driven by i)

the 4th baby boom and potential one-child policy relaxation; ii) the effect from

“dragon baby” concept; iii) launching stage 4 infant formula by the year end of

2012.

Probiotic supplement, traditional and dominate the market

As Biostime’s traditional product, probiotic supplement was firstly launched in

China in 2001 and contributed approximately 12.6% of total revenue with 76.4%

gross profit margin in 1H12. According to Euromonitor, Biostime has a 85%

market share in children’s probiotic supplement sector in China in 2009. The

company soured probiotic from Lallemand, a leading bacteria producer in France,

and packed products in Guangzhou plant which has an annual capacity of 103mn

sachets with 84% utilization rate.

The revenue generated from probiotic supplements grew at a CAGR of 9% in

2008-2011. We expect the Biostime to maintain a relatively stable growth and

register a 7% CAGR of revenue in 2012-2015E driving from rising custom base of

mama 100 active members and conversion rate of member points.

Nestle1%

Wyeth9%

Beingmate19%

Ausnutria25%

Biostime44%

Others2%

Supreme tier

Mead Johnson,

27%

Dumex, 13%

Abbott, 11%

Wyeth, 11%

Beingmate, 10%

Biostime, 7%

Others, 21%

High tier

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Real time and effective channel management

Biostime’s products are sold through 87 nationwide sales offices to connect the

371 regional distributors, which further place the products to 8,321 VIP baby

specialty stores (69.7% of products sold in 1H12), 3,336 supermarkets (23.1% of

products sold in 1H12) and 601 pharmacies with Mama 100 Member zone.

Biostime plans to further expand its distribution channels, aiming to cover 10,000

VIP baby specialty stores, 800 pharmacies with Mama100 Member’s Zones, and

4,000 supermarkets by the end of 2012.

All the end retailers have to sign contracts with Biostime and regional distributors

are only responsible for logistics and can only delivery products to the contractual

retail outlets. The company also requires the regional distributors to settle the

payment before delivering products, resulting in the account receivables turnover

days at 1 day in 1H12. Its real-time logistics management system can monitor

distributors’ inventory and sales level, while its POS machines, installed in their

retail outlets, can track sales information and consumer purchase behavior. We

believe Biostime can better grasp the market trend to better prepare the orders

through this effective channel management.

Exhibit 43: Channel management model


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Exhibit 44: Multi-channel distribution network


Mama100 membership, a real VIP platform

Biostime’s Mama 100 membership system consists of membership point

accumulation program, nursing consultancy, and sharing information via

mama100.com website. It has approximately 1.18mn active members as June 30

of 2012, contributing 87.8% of total revenue (vs. 81% in 1H11). The active

member registered a CAGR 105% from 2007 to 2011; and the management

expects the figure will reach 1.5mn till 2014, representing a CAGR 22% for

2011-2014E. The same store membership points have successfully recorded

high double digit growth (~29% to ~40%) for the mature store which has

cooperated with Biostime over 2 years. Through this unique system, Bisotime

have already promoted strong consumer loyalty and better understood

consumers’ needs to enhance customer services, in our point of view.

Exhibit 45: Number of Active number, 2007-2014E


We are positive to aware the per cent of selling and distribution expense of sales

declined by 3.1% in 1H12, especially the promotional & advertising expenses

(15.7% in 1H12 vs. 19.6% in 1H11). It appears to us this downward trend of

operating expense was an evidence of effective marketing from Mama100

Nationwide sales office (87)

Regional distributors (371)

Specialty

storesSupermarkets Pharmacies

VIP Baby

stores

General

pharmacies

Pharmacy

stores with

Mama 100

Member

Zone

Rapid growth of Stores No.

Jun 30,

2011

Jun 30,

2012

Sep 30,

2012

2012

Target

VIP Baby Specialty stores 4,399 8,321 9,343 10,000

Supermarkets 2,126 3,336 3,849 4,000

Pharmacies with Mama100 Member Zone 389 601 640 800

46,373 93,171

214,452

322,225

465,536

685,458

825,230

1,179,732

1,500,000

0

400,000

800,000

1,200,000

1,600,000

Dec-07 Dec-08 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dce-14

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membership. Mama100 membership platform successful led to a rising cross

selling and average expense per active member, thus reducing its spending on

traditional media to build brand awareness.

Exhibit 46: Cross selling rate, 2011-2012


Mother

formulas

Infant

formulas

Baby

cereals

Probio-tic

sachet

Baby

diapers

Mother

formulas

2.08% 2.06% 2.29% 2.30%

Infant

formulas

24.11% 15.84% 15.11% 10.02%

Baby

cereals

15.28% 12.73% 11.49% 13.85%

Probio-tic

sachet

13.85% 13.76% 16.15% 12.61%

Baby

diapers

8.29% 5.95% 7.89% 6.20%

A

B

Cross selling rate (end of Jun, 2011)

Mother

formulas

Infant

formulas

Baby

cereals

Probio-tic

sachet

Baby

diapers

Mother

formulas

2.25% 3.02% 2.59% 3.23%

Infant

formulas

26.53% 18.16% 13.90% 13.18%

Baby

cereals

12.85% 11.06% 10.02% 14.64%

Probio-tic

sachet

16.26% 15.91% 20.41% 18.25%

Baby

diapers

7.64% 5.03% 8.05% 5.41%

A

B

Cross selling rate (end of Jun, 2012)

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Sourcing from overseas to guarantee quality

Supplier of infant formula: Laiterie de Montaigu, Isigny Sainte Mere, and Alra

Food

Laiterie de Montaigu, a French dairy company established in 1932, sources milk

from Appellation d’Origine Contreolee (AOC) Charentes-Poitou. Montaigu

produces the formulas based on Biostime’s formula profiles and applies a

patented full-formulation spray drying technique to optimize the nutritional quality.

The products supplied with original packing. Biostime is by far the biggest client of

Montaigu (~80% of its capacity), purchasing 10,000-12,000 tons of infant formula

each year for supreme series.

Isigny Sainte Mere, as the second infant formula supplier of Biostime, also

sources milk from AOC. Like Montaigu, Isigny Saite Mere will produce based on

Biostime’s formula and apply spray drying technique. Biostime will purchase

5,000-6,000 tons of infant formula from Isigny Sainte Mere per year.

Biostime signed 10-year financing and supply JV development agreement with

Arla Food and introduced Arla Food as its third infant formula supplier in June

2012. Arla Food is a global dairy company and also entered a strategic

cooperation with China Mengniu (2319.HK, Hold). Based on the agreement, Arla

Foods borrowed HKD108mn loans from Bisotime for capacity expansion, and

repay the loan by delivering infant formula starting from 2013 (cap to 20,000 tons

per year) combining with financing interest (~2%). According to the management,

Arla Foods is expected to supply thousands of tons infant formula in 2013E for

stage 4 formula, cap to 20,000 tons in 2015E. The management also articulated

that the amount of infant formula supplied by Arla will be more than 20,000 tons

after 2015E depending on their future strategy plan.

Supplier of probiotic supplements: Lallemand

Lallemand is a privately-held Canadian company, established at the end of the

19th century, specializing in the development, production, and marketing of

yeasts and bacteria. Biostime started business with Lallemand since 2000,

importing probiotic powder from Lallemand and packing in its Guangzhou

GMP-certified plants.

Supplier of dried baby food: Diana Naturals and Kerry Ingredients & Flavors

Biostime imported vegetable and fruit natural extracts in powder from Diana

Naturals, a worldwide natural ingredients supplier with sales of more than

US$150mn. Rice, oat and multi-grain cereal with original packing are imported

from Kerry Ingredients, which produces over 15,000 ingredients, flavors and

integrated solutions. Both Kerry and Diana manufacture and supply products

base on Biostime’s specification.

Supplier of baby care: Sarbec and First Quality

Biostime import toiletry products made by Sarbec (a French cosmetic company

established in 1972) with original packing since 2009. These toiletry products are

based on Biostime’s design and formulas. First Quality, a US consumer paper

product supplier operating over 20 years, provides Bisotime baby diapers with

original packing since 2009.

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Robust 1H12 results

Revenue surged 57% yoy to RMB1,363mn in 1H12, mainly driven by strong

growth in infant formula, which represented 80.3% of total revenue. Excluding

nutrition supplements contribution (launched on Sep 2011), the top-line

climbed up by 55.2% yoy. Probiotic supplement only registered 3% yoy

growth in 1H12, the proportion has decrease to 12% from 18.4% in 1H11.

Gross profit margin shrank 2.4% to 65.6%, largely due to the rising

proportion of infant formula (vs. 73.4% in 1H11), also partly due to the

purchasing price of infant formula and labor cost hike.

EBIT margin expanded 0.3ppt to 25.8%, reflecting i) 3.1% contracted in

selling and distribution expense driven by effective cross selling marketing ; ii)

0.1ppt decline in administrative expenses.

Net profit margin contracted 2.4% to 20.1% due in part to the higher

effective tax rate with lower foreign exchange gain. The company still

maintains high pay-out ratio policy, and declared 40% for 1H12.

Its solid balance sheet was underpinned by RMB 1.382mn of net cash as

June of 2012, with 1 day account receivables turnover days and 126 days for

that of inventory. High ROA (28.4%) and ROE (20.3%) also approved its

strong profitability.

Exhibit 47: Interim results of 1H12

1H11 1H12 yoy%

Revenue 867,550 1,362,742 57%

Probiotic supplements 159,296 164,461 3%

Infant formulas 636,550 1,094,732 72%

Dried Baby food products 53,631 54,361 1%

Baby care products 18,073 32,760 81%

Nutrition supplements

16,428 n.a.

Cost of sales (277,856) (469,146) 69%

Gross profit 589,694 893,596 52%

Other income and gains 29,736 21,633 -27%

Selling and distribution costs (330,045) (475,382) 44%

Administrative expense (32,813) (49,825) 52%

Other expenses (6,879) (16,958) 147%

EBIT 221,132 351,861 59%

Finance costs

(175) n.a.

PBT 249,693 372,889 49%

Income tax expense (54,067) (98,963) 83%

Net profit 195,626 273,926 40%

Key ratios 1H11 1H12 difference %

Margins %

Gross profit 68.0% 65.6% -2.4%

EBIT 25.5% 25.8% 0.3%

Net profit 22.5% 20.1% -2.4%

Turnover days

Accounts receivable 1 1 0

Inventory 86 126 40

Accounts payable 47 38 -9

Profitability

ROA 18.9% 20.6% 1.7%

ROE 22.4% 28.4% 6.0%


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Earning forecast

We forecast Biostime could enjoy the net profit growth at a CAGR of 24% for

2011-2014E, corresponding to net profit of RMB644mn (or RMB1.05/share) for

2012E, RMB824mn (or RMB1.35/share) for 2013E, and RMB1,000mn (or

RMB1.64/share) for 2014E. Key earnings drivers should come from top line

growth boosted by infant formula segment and consequent SG&A/sales ratio

decline driven by effective cross selling marketing strategy.

The total revenue could maintain a CAGR of 31% from 2011-2014E. Key driving

forces include: i) robust revenue growth in infant formula segment, which will

register a CAGR of 36% in 2011-2014E, accounting for 84% of total sales in

2013E; ii) continual launching new products each year to enrich its product

portfolio; iii) dramatically rising in the number of active members; iv) expansion of

distribution network in VIP baby specialty stores, pharmacies with Mama100

Member’s Zones, and supermarkets.

We expect the proportion of probiotic supplements will further decline to 11.3%,

9.6% and 8.3% of the total sales for 2012E, 2013E and 2014E although the

management will redistribute the resource to rejuvenate this traditional segment.

The declining contribution in sales was mainly caused by a rising proportion of

revenue from the sales of infant formula.

Exhibit 48: Revenue forecast, 2011-2014E


We expect the blended gross profit margin to erode to 65.1%, 64.7% and 64.4%

in 2012E, 2013E and 2014E, respectively, largely due to i) the product mix

changes, especially the high-end infant formula (GPM: ~62%) rising faster than

the supreme series (GPM: ~68%); ii) higher conversation rate of member points

pull the probiotic supplements’ GPM down to 75-76% in 2012e-2014e; iii) modest

purchasing price hike without ASP upsides adjustment. Base on our sensitivity

analysis, every 0.5% decrease in the sales proportion of probiotic supplements

could lead to 0.1% drop in blended GPM in FY13E.

We expect the EBIT margins to be stable at 27%-27.7% in 2012-2014E. The

ratio of selling & distribution expense/sales is projected to decline to around 32%

0

1,000

2,000

3,000

4,000

5,000

6,000

2011 2012E 2013E 2014E

Probiotic supplements Infant formulas Dried Baby food products

Baby care products Nutrition supplements

(RMB mn)

Tue, 06 Nov 2012

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in 2012-2014E, driven by the effective cross selling marketing.

Exhibit 49: Gross profit margin, 2011-2014E


30%

40%

50%

60%

70%

80%

90%

2011 2012E 2013E 2014E

Probiotic supplements Infant formulas

Dried Baby food products Baby care products

Nutrition supplements Blended GP margin%

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Valuation

Sum-of-the-parts Model

We derive our 12-month price target of HK$23.58 from a sum-of-the-parts based

methodology, given Biostime diversified portfolio. Our valuation entitles 5.00x

targeted 2013 EV/EBIT for the company’s probiotic supplements segment, 4.98x

targeted 2013 EV/EBIT for the infant formulas business, 6.93x/4.85x/5x for dried

baby food products, baby care products and nutrition supplements, respectively.

The peers for infant formula projected in our valuation are Yashili (1230 HK, NR),

Beingmate international (002570 CH, NR), Feihe international (ADY US, NR),

Nestle Danone (BN FP, NR) and Mead Johnson. Given Biostime oversea

sourcing and domestic customer base business model, we think using both

foreign and domestic players is a comparable approach to forecast its infant

formula business.

Chr Hansen (CHR DC, NR) was used as our probiotic supplements’ competitor,

and we applied a 30% discount of this segment multiple as we think Biostime’s

probiotic supplements products lack awareness global brand name and low

single digit growth in 2012-2014E, in our view.

Exhibit 50: Sum-of-the-parts Model

EV/EBIT Projected Multiple EBIT(RMB mn) EV

Probiotic supplements 5.00 271 1,354

Infant formulas 4.98 1,945 9,679

Dried Baby food products 6.93 61 426

Baby care products 4.85 22 105

Nutrition supplements 5.00 31 157

Total

2,330 11,721

Plus: Net cash

1,791

Less: MI

0

Outstanding share('000'000)

612

Share price (RMB)

19.17

Share price (HK$)

23.58

Notes: The peers of dried baby food and baby care products peers are Kerry group (KYGA LN) and (JNJ US), with 40% discount of multiple.


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DCF Model

Given its cash flow-generative business nature and strong earnings growths, we

also use DCF-based methodology to derive the 12-month target price of

HK$25.60 for Biostime. The assumptions are: i) risk free rate of 3%, based on the

annual yield on China’s 10-year government bond; ii) market risk premium of 9%;

iii) beta of 1.2 higher than the China dairy sector average to reflect its stock’s

volatility relative to the Hang Seng Index (China dairy sector beta: 1.05) and its

business model; iv) cost of equity 13.8%; v) 2% terminal growth rate, in line with

our long-term growth assumption for China consumer players.




Perpetual growth rate (%)

2.3 1.0% 1.5% 2.0% 2.5% 3.0%

Cost of Equity (%)

11.8% 28.9 29.5 30.1 30.8 31.6

12.8% 26.7 27.2 27.7 28.2 28.8

13.8% 24.9 25.3 25.6 26.0 26.5

14.8% 23.3 23.6 23.9 24.2 24.6

15.8% 22.0 22.2 22.5 22.7 23.0

16.8% 20.8 21.0 21.2 21.4 21.6

Source: OP Research

Based on a blending SOTP/DCF model, we estimate a fair value of HK$24.60 per

share, which implies undemanding 2013E PE of 14.5x and suggests 23.1%

potential upside. We give a BUY rating.

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Key risks

Food safety issue

The major concern of food and beverage sector is safety and quality issues,

especially infant food. Any news, no matter real or suspected, regardless of

Biostime or the competitors, related to product’s safety and quality will spread

quickly across the whole industry and result in sales weakness or cost relate to

inventory write-off.

Strong reliance on suppliers

In order to secure the quality and safety, all of Biostime’s raw materials are

sourcing from oversea. Infant formula, representing 80% of total revenue, is

original packaged from its three suppliers. Its top 5 suppliers accounted over 90%

of total procurement in 1H12. Although Bisotime has established stable and

longer relationship with the upstream suppliers, any disruption will cause supply

issue. As a result, Biostime’s business is heavily dependent on its suppliers.

High competition

We believe the competitive landscape of milk powder is more severe than that of

liquid milk and most other dairy products due to the large number of suppliers.

The foreign players, like Dumex, Mead Johnson, and Wyeth, have dominative

positions in the premium market and the per cent of market shares are continually

rising. Biostime needs to keep innovation to differentiate itself from the other

competitors in such steep environment.

Regulation risk

Infant formula industry is subject to extensive laws and regulations promulgated

by the State Council, the Ministry of Health, the State Food and Drug

Administration, and other national and local regulatory authorities in China.

Regulatory changes could potentially bring negative impact on Biostime’s sales.

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Appendix

Company profile

Biostime, founded in 1999 and listed in 2010, is a provider of premium pediatric

nutritional and baby care products in China. Its product portfolio include infant

formula, probiotic supplements, dry baby food, baby care products and nutrition

supplements, under the brands with “Biostime” and “BM Care”.

Exhibit 52: Revenue breakdown by products, in 1H12


Exhibit 53: Shareholding Structure

Biostime Pharmaceuticals (China)limited is owned as to 28.15% by Mr. Luo Fei, 26% by Mr. WuXiong, 19.55% by Mr. Luo Yun, 11.9% by Mr. Chen Fufang, 10% by Dr. Zhang Wenhui and 4.40% by Ms. Kong qingjuan.


Probiotic supplements

12%

Infant formulas80%

Dried Baby food products

4%

Baby care products

3%

Nutrition supplements

1%

Biostime Pharmaceuticals

75%

Public shareholders

25%

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Management profile

Mr. Luo Fei (47) - Founder, Chairman and CEO

He is primarily responsible for overall strategies, planning and business

development. He is also a director of Biostime Guangzhou, Biostime Health and

BMcare Baby. He has approximately 18 years of experience in the industry of

products of biotechnology. In August 1999, he established Biostime Guangzhou.

Dr. Patrice Malard (57) - Chief Scientific Officer

He is primarily responsible for providing technical support and advice to the

research and development of its products. He was the scientific consultant of

Biostime Guangzhou from Mar 2008 to Sep 2010. He joined Biostime in October

2010 and has approximately 20 years of experience in the nutrition products

industry.

Ms. Kong Qingjuan (49) - Executive Director, COO

She is primarily responsible for the overall procurement, logistics, production, as

well as internal compliance and control. She has over 16 years of experience in

the industry of products of biotechnology and joined the company in 2000.

Milestone

Exhibit 54: Biostime milestone

1999 Establishment of Biostime Inc., Guangzhou

2000-08 Launch of the Biostime™ brand.

2002-05 Commencement of strategic cooperation with Lallemand to develop Biostime™

branded probiotic supplements in the PRC.

2003-01 Launch of Biostime™ branded probiotic supplement products in China

2006-03 Construction of production facilities in Guangzhou.

2007-09 Launch of dried baby food products series and of the Mama100 web portal

2008-05 Accreditation of GMP certification for production facilities in Guangzhou

2009-05 Launch of baby cereal products

2010-05 Launch of BMcare™ branded baby care products

2010-12 Listed on the Main Board of The Stock Exchange of Hong Kong Limited

2011-09 Launching of BIOSTIME™ branded DHA and microencapsulated milk calcium products


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Financial Summary - Biostime (1112 HK) Year to Dec FY10A FY11A FY12E FY13E FY14E

Year to Dec FY10A FY11A FY12E FY13E FY14E


Ratios

Probiotic supplements 304 332 349 387 410

Gross margin (%) 71.1 66.5 65.1 64.7 64.4

Infant formulas 794 1,685 2,527 3,411 4,264


Dried Baby food products 98 97 112 123 135

Net margin (%) 21.5 24.1 20.9 20.5 20.3

Baby care products 38 48 54 57 59

Selling & dist'n exp/Sales (%) (36.4) (32.4) (32.1) (32.2) (32.1)

Nutrition supplements 0 27 37 46 56

Admin exp/Sales (%) (7.1) (3.7) (3.8) (3.9) (3.9)

Turnover 1,234 2,189 3,078 4,024 4,924

Payout ratio (%) 38.2 70.6 40.0 40.0 40.0

YoY% 121% 77% 41% 31% 22%

Effective tax (%) (20.5) (26.1) (25.5) (26.0) (26.0)

COGS (356) (733) (1,074) (1,421) (1,753)


Gross profit 877 1,456 2,004 2,603 3,171

Net debt (Cash)/equity (%) (104.1) (91.7) (76.9) (76.9) (79.6)

Gross margin 71.1% 66.5% 65.1% 64.7% 64.4%

Current ratio (x) 7.9 5.2 4.6 4.8 5.1

Other income 4 72 16 24 26

Quick ratio (x) 7.4 4.5 3.9 4.0 4.3

Selling & distribution (449) (709) (988) (1,296) (1,578)


Admin (88) (82) (117) (155) (190)

AR T/O (days) 1 1 1 1 1

Other opex (10) (23) (46) (60) (74)

AP T/O (days) 54 33 33 33 33

Total opex (547) (814) (1,151) (1,511) (1,842)

Cash conversion cycle (days) 43 69 84 84 84

Operating profit 334 714 868 1,116 1,355 Operating margin 27.1% 32.6% 28.2% 27.7% 27.5%

EBIT margin (%) 27.1 32.6 28.2 27.7 27.5

Finance costs 0 0 (3) (3) (3)

Pre-tax/EBIT (x) 1.0 1.0 1.0 1.0 1.0

Profit after financing costs 334 714 865 1,113 1,352



Asset turnover (x) 0.6 0.9 1.1 1.1 1.1

Pre-tax profit 334 714 865 1,113 1,352

Assets/equity (x) 1.1 1.2 1.3 1.2 1.2

Tax (68) (187) (221) (289) (351)

Return on equity (%) 16.0 26.7 27.7 27.4 26.5

Minority interests 0 0 0 0 0 Net profit 266 527 644 824 1,000


YoY% 145.3% 98.5% 22.2% 27.9% 21.4%


Net margin 21.5% 24.1% 20.9% 20.5% 20.3%

Fixed assets 31 59 87 139 232

EBITDA 337 655 871 1,121 1,379


EBITDA margin 27.3% 29.9% 28.3% 27.9% 28.0%


EPS (RMB) 0.580 0.864 1.054 1.347 1.636


YoY% 141.7% 48.9% 22.0% 27.9% 21.4%

Other non-current assets 7 227 238 253 270

DPS (RMB) 0.222 0.618 0.430 0.550 0.668

Non-current assets 40 288 435 501 612


Inventories 106 297 382 517 592

Cash Flow (RMB mn)

AR 5 10 11 16 17

EBITDA 337 655 871 1,121 1,379

Prepayments & deposits 23 29 43 123 126

Chg in working cap 75 (72) 28 (92) 38

Other current assets 0 0 172 172 172

Others 13 56 6 7 8

Cash 1,728 1,814 1,872 2,393 3,089

Operating cash 425 639 904 1,037 1,425

Current assets 1,862 2,150 2,480 3,221 3,996

Interests paid 0 0 3 3 3 Tax (44) (123) (303) (289) (351)

AP 66 67 128 130 188

Net cash from operations 381 516 604 750 1,076

Tax 28 83 0 0 0

Accruals & other payables 142 265 332 458 517

Capex (18) (39) (55) (93) (158)


Investments 0 (484) (280) 0 0


Dividends received 0 0 0 0 0


Sales of assets 0 0 0 0 0

Current liabilities 236 415 541 670 786

Interests received 1 2 14 5 11 Others 8 (9) (10) 7 1


Investing cash (9) (529) (331) (82) (146)


FCF 372 (13) 273 669 930


Issue of shares 1,413 21 0 0 0

MI 0 0 0 0 0

Buy-back 0 0 0 0 0

Non-current liabilities 6 45 45 45 45

Minority interests 0 0 0 0 0 Dividends paid (146) (180) (293) (145) (231)

Total net assets 1,660 1,978 2,328 3,007 3,777

Net change in bank loans (1) 0 82 0 0 Others (36) (10) (3) (3) (3)


Financing cash 1,231 (169) (215) (148) (234)

Share capital 5 5 5 5 5

Reserves 1,655 1,972 2,323 3,002 3,772

Net change in cash 1,603 (182) 58 520 696 Exchange rate or other Adj (8) (56) 0 0 0

BVPS (RMB) 3.63 3.24 3.81 4.92 6.18

Opening cash 134 1,728 1,490 1,549 2,069 Closing cash 1,728 1,490 1,549 2,069 2,766

Total debts 0 0 82 82 82

CFPS (RMB) 3.778 2.441 2.533 3.384 4.522


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Mengniu Dairy (2319 HK) - No surprise

Revenue is projected to grow at a CAGR of 10% in 2011-2014E and led by a 7% CAGR in sales volume and a 3% CAGR of APS hike

GPM inches down 0.1% in FY12E and improves to 26.4% and 26.7% in FY13/14E by product mix improvement and raw milk price modest hike

OPM trims 0.2% in FY12E and rises by 30/30bps in FY13/14E due to Mengniu’s prudent cost control

The product mix improvement is Mengniu’s core strategy to maintain a healthy

profit growth. Premium products (GPM higher than 28%) represent around 28%

of the total revenue in 1H12. We believe continuous product mix shift towards

high-margin items will likely be accelerated as Mengniu has started to cut down

its low-margin products, thus the proportion of high-end products is expected to

rise by 2ppt-3ppt in the next few years.

Mengniu’s earning is highly vulnerable to raw milk price (45% of COGS) volatility.

We do not expect the raw milk price to increase significantly over the next three

years, as it sourced 84% of its raw milk from large-scale dairy farms and ranches

which charge relative stable price. It strengthens its procurement capacities and

saves cost of packaging (24% of COGS) by signing long-term contracts with

major suppliers and the tie up with COFCO.

It appears to us that Mengniu’s high growth era is behind us. Its brand value

and consumer loyalty are undermined after experiencing the melamine crisis in

2008 and M1 scandal in 2011. Although the new strategies initiated by new

management team can pave the way for long-term earnings growth, near-term

headwind from internal restructuring is visibility. We like Mengniu’s prudent cost

control and outstanding operating efficiency combined with continuing product

mix shift towards high-value added categories, however, all above are reflected in

current valuation, with 21x PE in 2013E. It strategically alliances with Arla

Food to generate RMB3bn sales from milk powder by 2015, and we classify it as

mid-to-long term catalyst.

Initial HOLD. We forecast Mengniu net profit growth at a CAGR of 11.2% for

FY11-FY14E. Based on a blending DCF/PER model, we estimate a fair value of

HK$24.20 per share, which implies 2013E PE of 19.0 x and suggests 2.98%

potential upside.

Initial Coverage

HOLD



Key Data

HKEx code 2319




Issue Share (mn) 1,768.07


Fiscal Year 12/2011

Major shareholder (s) COFCO (28.06%)


Price Chart

1mth 3mth 6mth

Absolute % 1.7 2.6 -0.6

Rel. MSCI CHINA % -5.4 -6.9 -6.1

PE

Company Profi le Established in 1999, China Mengniu Dairy

(Mengniu) is one of the leading dairy-product

manufactures in China. It manufactures and

distributes dairy products in China primarily

under its core Mengniu brand. Its product

portfolio includes UHT milk, milk beverages

and yogurt, ice cream and milk powder.

Exhibit 55: Forecast and Valuation Year to Dec (RMB mn) FY10A FY11A FY12E FY13E FY14E

Revenue 30,265 37,388 39,764 44,343 49,133

Growth (%) 18% 24% 6% 12% 11%

Net Profit 1,237 1,589 1,504 1,841 2,161

Growth (%) 11% 28% -5% 22% 17%

Diluted EPS (RMB) 0.711 0.905 0.851 1.042 1.223

EPS growth (%) 5% 27% -6% 22% 17%


Consensus EPS (RMB)

0.848 1.077 1.274

ROE (%) 12.7 13.9 11.7 12.7 13.2

P/E (x) 26.8 21.1 22.4 18.3 15.6

P/B (x) 3.2 2.9 2.6 2.3 2.1

Yield (%) 0.9 1.0 1.0 1.2 1.4

DPS (HK$) 0.2 0.2 0.2 0.3 0.3


0.0

5.0

10.0

15.0

20.0

25.0

30.0



0

5

10

15

20

25

30

35

40

Dec/08 Sep/09 Jun/10 Mar/11 Dec/11 Sep/12

Forward P/E Ratio

+1std.

avg.

-1std.

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Investment thesis

From plain to high-end

We reveal the customers’ propensity to upgrade for premium products after 2008

melamine scandal. The product mix improvement is Mengniu’s core strategy to

maintain a healthy profit growth, in our view. Besides hike ASP of exiting pillar

products, Mengniu continually optimizes its product portfolio by rolling out new

high premium products and targets different customer groups. Its premium

ultra-high temperature (UHT) milk brand Milk Deluxe caters to high income

consumer, for instance, commands more than double retail price of the

mid-to-low-end UHT pure milk series. Gross profit margin for high-end UHT

products such as Milk Deluxe, Future Star Milk (targets at children) and Xin Yang

Dao low-lactose Milk (tailor makes for white collar) are approximately

30%/35%/28% vs 20% for the mid-to low-end categories.

In 1H12, high-end products with gross profit margin higher than 28% represent

around 28% of the total revenue, increased by 5ppt yoy. This mix upgrade was

mainly due to high margin milk products that were less affected by the flavacin M1

incident in December 2012, growing up 14% yoy vs negative growth of lower

margin products. Continuing product mix shift towards high-margin items will

likely be faster as Mengniu has started to cut down its low-margin products (i.e.

gross margins below 20%) and focused on optimizing the product mix, thus the

proportion of high-end products is expected to rise by 2ppt-3ppt per year to

30%/33% in FY13/FY14, in our view.

Exhibit 56: High-end product proportion, FY09-1H12


15% 19% 23%28%

85% 81% 77%72%

FY09 1H10 1H11 1H12

High-end product Mid-to-low end product

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Raw material price, STABLE

Raw milk is an important ingredient for Mengniu, accounting for 46% of COGS

based on our estimates. Thus Mengniu’s earning is highly vulnerable to raw milk

price volatility. We estimate that every 1 % hike in raw milk ASP will drop down

FY13E net profit by around 6.5%, other things being equal. The raw milk price

bottomed out dramatically in 2010 mainly due to i) rising cow feeding costs,

especially the corn price rose by 15% yoy; ii) milk supply shortage caused by

over-killing in cows after the melamine incident. We do not expect the raw milk

price to increase significantly over the next three years, as it strategically

cooperates with large-scale dairy farms and ranches, and the supply contracts

with them are usually long term and the price relatively stable. The company

currently sources c.84% of its raw milk from large-scale dairy farms and ranches,

targeting to 100% by 2015E. We also reveal that the cow feeding cost pressure

for famers has eased and the downward trend will continue in 2013.

Another major raw material cost is packaging, accounting for 24% of total COGS.

We expect the price of packaging materials to be stable in FY13, because

Mengniu has long-term contracts with its major suppliers (i.e. Tetra Pak, SIG

Combibloc and Greatview Aseptic). The tie up with COFCO could also help to

strengthen Mengniu’s raw material procurement capabilities and save cost of raw

material like sugar and packaging materials.

Exhibit 57: Raw material price

Source: sn110.com, alibaba.com, OP Research

SOE background: Like or not like?

Following the placement of a 20% stake to COFCO and Hopu on Jul 6, 2009,

COFCO is now the group’s largest shareholder with more than 28% of the

company stake after further acquiring 8% from the founders in July 2011. With a

state-owned enterprise (SOE) background, we caution about Mengniu’s future

earnings growth as SOEs do not have a successful track record of running

efficient operations and profitability is not their first priority but top-line growth.

Over the long term, we see positive synergies from this alliance. Mengniu has

started to leverage COFCO’s resources, such as i) sharing sales network to

12,000

12,500

13,000

13,500

14,000

14,500

15,000

15,500

Nov-11 Feb-12 May-12 Aug-12

(RMB/ton)

PET

2.0

2.2

2.4

2.6

2.8

3.0

3.2

3.4

Jan-08 Oct-08 Jul-09 Apr-10 Jan-11 Oct-11 Jul-12

(RMB/kg)

Raw milk

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expand its footprint; ii) using COFCO’s network to source its raw materials; iii)

detecting the potential overseas partners based on COFCO’s platform. New

CEO’s solid experience in the beverage industry (more than 10 years at

Coca-Cola) and new mission and strategy for Mengniu are also in our favorable

list.

Quality control goes first

The group is now targeting to build a system to fully control of the entire industry

chain from upstream to retail, instead of separated quality control divisions as in

the past. However, it is a time-consuming process and operating expense

intensive project for Mengniu to build system and organization restructure, in our

view.

Currently, the company sources 84% of its raw milk from large-scale dairy farms,

and targets to 100% by 2015E. The management indicated that it would invest a

total of RMB3bn-3.5bn in upstream dairy farms to build six self-owned large scale

farms with 10k cows each(RMB2bn) and make minority investment (10-20%

stakes 1-1.5bn) in cattle ranches in 2012-2015E. It is also on track to achieve

1.5k tons of raw milk per day by 2015E. Sourcing high quality milk from

large-scale dairy farms will enable the company to roll out more premium

products and drive up the blended gross profit margin further.

Apple-to-apple comparison

We like Mengniu and mark it as the leader in China dairy industry as the reasons

of:

Mengniu has been the largest dairy-products supplier in China since 2007

with 26.1% and 22.9% market share in liquid milk and yogurt products as

June 30 of 2012, in terms of revenue. Its revenue registered at a CAGR of

21% from 2009-2011 after the melamine crisis in 2008. As the first Chinese

diary company among the world’s top-20, Mengniu was ranked 16th among

global dairy companies in 2010, up from 19th in 2009.

Exhibit 58: Market share of liquid milk and yogurt product in China, June 30 of 2012


Mengniu26%

Yili22%

Wahaha13%

Bright dairy

8%

Want want5%

Others26%

Liquid milk product market share as June 30of 2012

Mengniu23%

junlebao8%

Bright dairy22%

Yili 18%

sanyuan 3%

weiquan4%

others23%

Yogurt product market share as June 30 of 2012

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After comparing with its closest peers Yili (600887 CH, NR) and Bright Dairy

(600597 CH, NR), we found Mengniu’s revenue were largely generated

from liquid milk and has around 6% gap with Yili in milk powder segment.

Co-operation with Arla and launching more milk powder products under

Mengniu own brands and Arla’s brands will narrow the gap in the coming

years, in our view.

Mengniu recorded the lowest gross profit margin while highest EBIT margin,

due in part to different accounting principles adopted by these three

companies for listing in different stock market. Thus we think it is

meaningless to use EBIT margin or gross profit margin as standards to

compare their profitability. Mengniu delivered the lowest SG&A expense

ratio versus Yili and Bright Dairy, reflecting its prudent cost control and

outstanding operating efficiency in this industry.

Mengniu’s best-in-breed inventory management ability is demonstrated by

its low inventory turnover days of 19 days versus Yili’s 41 day and Bright

Dairy’s 44 days.

The solid balance sheet is underpinned by RMB5.8 of net cash at FY11 with

48% net-cash-to-equity ratio, versus Yili’s 12% and Bright Dairy’s -27 %.

Exhibit 59: Comparisions between Mengniu, Yili and Bright Dairy, 2011

(RMB mn) Mengniu (2319 HK) Yili (600887 CH) Bright Dairy (600597 CH)

Revenue 37,388 37,218 11,725

Revenue mix

Liquid milk 90% 72% n.a.

Milk powder 9% 15% n.a.

Others 1% 12% n.a.

Margin %

Gross profit 25.7 28.8 32.9

EBIT 4.6 3.9 2.1

Net profit 4.3 4.9 2

Operating expense ( as % of total revenue)

Selling and distribution expense 17.90% 19.50% 27.50%

Administrative expense 2.97% 5.26% 3.01%

Working capital

A/R days 7 3 33

A/P days 30 54 53

Inventory days 19 41 44

Cash Conversion Cycle -4 -10 24

Balance sheet

Cash 4,360 3,921 1,114

Net Cash 5,838 779 -754

Net Cash/Equity (%) 48 12 -27


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In the general cases, Mengniu products charge slightly higher retail price

than its major competitors based on our channel check in Guangdong and

Zhejiang province. For instance, the retail price of Mengniu premium

product Deluxe is RMB2.27 per 100ml, higher than that of Yili’s comparative

product Satine by 6.6% and Bright Dairy’s U+ by 7.6%. It appears to us that

Mengniu has stronger bargain power to pass through the rising cost to

consumers.

Exhibit 60: Retail price comparisons

Retail price Series Average price (RMB/100ml)

Mengniu Plain UHT 1.1

Deluxe 2.27

Future Star 2.03

Xinyangdao 1.72

Yili Plain UHT 1

Satine 2.13

QQ Star 2.3

Low Lactose 1.72

Bright Dairy Plain UHT 1.2

U+ 2.11

DuDu 2.17

Source: Walmart, Taobao.com, Lianhua supermarket, OP Research

Strategically alliance with Arla

Arla is the No. 5 dairy producer in Europe and No.7 in the world. Arla will assist

Mengniu in the following areas: i) product innovation; 2) food safety management;

4) knowledge exchange; and 5) long-term supplier of milk powder to Mengniu.

Mengniu aims to generate RMB3bn sales from milk powder of both own brand

and Arla’s brand by 2015. We are conservative about ability of the Arla alliance to

improve product quality management in the near term, and milk powder segment

expansion should be classified as Mengniu’s mid-to-long term catalyst, in our

view.

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Earnings forecast

The dairy industry in China is expected to grow 9% CAGR over 2011-2014E,

according to Euromonitor, and Mengniu’s pace will be faster at 10-12%, in the

view of management. We think the sales target is undemanding as Mengniu’s

niche market positioning and sourcing raw milk from large scale farms to roll out

high quality premium products to secure its top-line growth.

We forecast Mengniu’s revenue to rise from RMB37.4bn in FY11 to RMB49.13bn

in FY14E, equating to a CAGR of 10% and led by a 7% CAGR in sales volume

and a 3% CAGR of APS hike. Liquid milk is still the major revenue-growth driver

over the next three years, in our calculation.

Exhibit 61: Revenue forecast, 2012E-2014E

Sales (RMB mn) FY12E FY13E FY14E

Liquid milk 35,324 39,392 43,519

yoy % 4.8% 11.5% 10.5%

Ice-cream 3,922 4,324 4,903

yoy % 20% 10% 13%

Other dairy 518 627 711

yoy % 21% 21% 13%

Total sales 39,764 44,343 49,133

yoy % 6.4% 11.5% 10.8%


Gross profit margin: we project gross profit margin inched down 0.1% in FY12

to 25.6% from 25.7% in FY11 as bigger discount to distributors to recover sales

after the safety incident. We forecast the gross profit margin to remain relatively

flattish and improve by 80/30bps in FY13E/14E to 26.4% and 26.7% on the back

of i) continuing product mix shift towards high-margin items; ii) cost saving from

the tie up with COFCO; iii) modest hike of raw milk price due to rising proportion

of sourcing from large scale farms which charge premium price for high quality

raw milk.

Operating profit margin: we expect the operating profit margin will trim 0.2% to

4.9% in FY12 from 5.1% in FY11 due to extra A&P expense to revive sales. We

estimate that the operating profit margin rose by 30/30bps in FY13E/14E to

5.2%/5.5%, factoring in i) Mengniu’s prudent cost control and outstanding

operating efficiency; ii) upside risk for opex in building a system to fully control of

the entire industry chain from upstream to retail; iii) manageable share option

expense (the management expects a share option expense of

RMB210mn/150mn in FY12E/13E).

We forecast Mengniu net profit to rise at a CAGR of 10.8% for FY11-FY14E,

corresponding to net profit of RMB1,504mn (or RMB0.85/share) for 2012E,

RMB1,841mn (or RMB1.04/share) for 2014E, and RMB2,161mn (or

RMB1.22/share) for 2015E.

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Key risks

Food safety issues

Any national food safety issues could negatively impact the consumer’s

confidence for Mengniu’s products and further lead to slowdown the growth of

sales volume and inventory write-offs, like melamine incident in 2008 and M1

scandal in 2011. Bigger discount for distributors to recover the sales will bring

upside risk of operating expense.

Slowing the growth of liquid milk consumption

Approximately 87% of revenue is generated from liquid milk. We anticipate the

production of liquid milk will continue to be Mengniu’s primary business. Its sales

growth is highly dependent on and sensitive to market demand for liquid milk. The

industry output has first recorded negative growth (-8.4%) in July 2012 since

2009, on back of food safety incidents and hiking feeding cost to drive smaller

farmers out of the business. While the industry rebounded quickly in Sep 2012.

Mengniu possesses the highest market share (26.1%) in the liquid market; China

liquid milk industry slowdown does not a good single for Mengniu, in our view.

Rising raw material price

With raw milk and packing total accounting for 70% of Mengniu’s cost of goods

sold, thus Mengniu’s earnings are highly affected by price of these two major raw

materials. Thus, in the event that cost increases are not passed through to

consumers, Mengniu’s earnings will be undermined. Based on our sensitivity

analysis, every 1% increase in raw milk price could lead to a 6.3% decline of net

profit in FY12, all else equal.

Outbreak of any major diseases among cows may disruption of raw

milk supply

84% of Mengniu’s raw milk are sourcing from large scale farms, and thus

maintains relatively stable and sufficient supply. Any major outbreak of any illness

and disease among cows could lead to shortage of raw milk supply and directly

hurt the sales growth.

Tue, 06 Nov 2012

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Valuation

It appears to us that Mengniu’s high growth era is behind us. Its brand value and

consumer loyalty are undermined after experienced the melamine crisis in 2008

and M1 scandal in 2011. Although the new strategies initiated by new

management team can pave the way for long-term earnings growth, near-term

headwind from internal restructuring is visible. We like Mengniu’s prudent cost

control and outstanding operating efficiency combined with continuing product

mix shift towards high-value added categories, however, all above are fully

reflected in current valuation, with 21x PE in 2013. We found the

Bloomberg-consensus EPS forecast has been revised down since December

2011 and this trend even speeded up after Mengniu’s interim results, partly due to

their concerns about its recovery pace and disappointing result of 1H12. The

market relative bearish mood reflected our downside risk concerns.

Exhibit 62: Earning revisions


DCF Model

Given its cash flow-generative business nature and long-term development

company, we use DCF-based methodology to derive the 12-month target price of

HK$23.40 for Mengniu. We use cost of equity of 12%, based on the assumptions

are: i) risk free rate of 3%, based on the annual yield on China’s 10-year

government bond; ii) market risk premium of 9%; iii) beta of 1.03 to factor in the

stock’s volatility relative to the Hang Seng Index; iv) 2% terminal growth rate from

2022 onward, in line with our long-term growth assumption for China consumer

plays.

0.6

0.8

1

1.2

1.4

1.6

1.8

Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12

FY12 FY13

(RMB)

Tue, 06 Nov 2012

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FCFE Sensitive Analysis Perpetual growth rate (%)

23.4 1.0% 1.5% 2.0% 2.5% 3.0%

Cost of Equity (%)

11.3% 24.4 24.9 25.4 26.0 26.7

11.8% 23.5 23.9 24.4 24.9 25.5

12.3% 22.6 23.0 23.4 23.9 24.4

12.8% 21.9 22.2 22.6 23.0 23.4

13.3% 21.2 21.5 21.8 22.1 22.5

13.8% 20.5 20.8 21.1 21.4 21.7

Source: OP Research

PER model

We also derive our 12-month target price of HK$25.00 from a PER based

methodology. The 2013E P/E multiple is 19.5x, based on a 20% discount to the

staple large cap average (24.5x for FY13E) on back of i) Mengniu modest

earnings growth for FY11-FY14E; ii) relatively low dividend yield 0.8% versus 1.6%

for industry average; iii) high sensitivity to food safety incident.

Exhibit 64: Peer group valuation comparison @ Nov 5, 2012

Company Ticker Price Mkt cap (US$ mn) PER FY1 (x) PER FY2 (x) 3-Yr EPS Cagr (%) Div yld FY1 (%) P/B FY1 (x)

China Mengniu Dairy* 2319 HK 23.50 5,361 23.4 19.0 10.8 0.8 2.6

Tingyi Hldg Co 322 HK 22.50 16,237 33.4 27.1 21.0 1.3 6.57

Want Want China 151 HK 11.22 19,150 35.3 28.4 24.4 1.6 11.96

China Res Enterp 291 HK 27.00 8,363 25.4 22.7 6.5 1.7 1.69

Tsingtao Brew-H 168 HK 43.00 7,173 25.4 21.8 12.9 0.7 3.62

China Foods 506 HK 7.86 2,836 23.7 19.2 29.6 1.3 2.95

Uni-President 220 HK 9.86 4,579 32.0 26.8 60.1 0.3 3.75

*OP estimate


Based on a blending DCF/PER model, we estimate a fair value of HK$24.20 per

share, which implies 2013E PE of 19.0x and suggests 2.98% potential upside.

We give a HOLD rating.

Tue, 06 Nov 2012

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Appendix

Company information

In 1999, Mr Niu Gensheng along with nine other founders, including the former

CEO Mr YANG Wenjun established Mengniu. Mengniu is the largest dairy

product manufacturer in China, with MENGNIU as the core brand. Its product

portfolio includes liquid milk (such as UHT milk, milk beverage, and yogurt)

accounting for 86.8% of total revenue, ice cream and other dairy products (i.e.

milk powder and cheese).

The company was listed in HKEx in Jun 2004. In Jul 2009, COFCO and Hopu

investment became joint controlling shareholder with a 20.0% stake. Then on July

2011, COFCO acquired 8% from the founders and becomes the largest

shareholder. Ms. Sun Yiping, appointed as the new CEO of Mengniu on 12 April

2012, meanwhile the former CEO Mr. YANG Wenjun resigned on 30 July 2012.

Exhibit 65: Revenue mix and Capacity


5.575.76

6.5

7.05

7.39

4.0

5.0

6.0

7.0

8.0

2008 2009 2010 2011 1H2012

(mn ton)

UHT Milk52%

Milk beverage

22%

Yogurt13%

Ice Cream12%

Other dairy products

1%

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Financial Summary - Mengniu Dairy (2319 HK) Year to Dec FY10A FY11A FY12E FY13E FY14E



Ratios

Liquid Milk 26,872 33,701 35,324 39,392 43,519

Gross margin (%) 25.7 25.7 25.6 26.4 26.7

Ice Cream 3,112 3,259 3,922 4,324 4,903


Other Dairy Products 282 428 518 627 711

Net margin (%) 4.1 4.3 3.8 4.2 4.4

Turnover 30,265 37,388 39,764 44,343 49,133

Selling & dist'n exp/Sales (%) (17.9) (17.9) (18.3) (18.7) (18.7)

YoY% 18% 24% 6% 12% 11%

Admin exp/Sales (%) (3.4) (3.0) (2.5) (2.5) (2.5)

COGS (22,479) (27,796) (29,602) (32,656) (36,037)

Payout ratio (%) 22.5 22.0 22.0 22.0 22.0

Gross profit 7,786 9,592 10,162 11,687 13,097

Effective tax (%) (9.6) (12.4) (15.0) (16.0) (17.0)

Gross margin 25.7% 25.7% 25.6% 26.4% 26.7%


Other income 193 296 123 137 151

Net debt(Cash)/equity (%) (30.1) (32.3) (34.8) (41.4) (46.9)

Selling & distribution (5,429) (6,695) (7,284) (8,300) (9,203)

Current ratio (x) 1.5 1.4 1.5 1.6 1.6

Admin (1,036) (1,110) (989) (1,125) (1,222)

Quick ratio (x) 1.4 1.2 1.3 1.4 1.4

Other opex (60) (187) (80) (89) (98)


Total opex (6,525) (7,992) (8,352) (9,513) (10,523)

AR T/O (days) 7 7 7 7 7

Operating profit (EBIT) 1,455 1,896 1,932 2,311 2,725

AP T/O (days) 36 35 34 33 33

Operating margin 4.8% 5.1% 4.9% 5.2% 5.5%

Cash conversion cycle (days) (13) (10) (5) (5) (7)

Interest income 88 173 148 179 220 Finance costs (45) (61) (79) (79) (79)

EBIT margin (%) 4.8 5.1 4.9 5.2 5.5

Profit after financing costs 1,498 2,009 2,001 2,411 2,866

Pre-tax/EBIT (x) 1.1 1.1 1.0 1.1 1.1



Pre-tax profit 1,538 2,061 2,001 2,466 2,924

Asset turnover (x) 1.7 1.9 1.8 1.8 1.8

Tax (182) (276) (330) (420) (523)

Assets/equity (x) 1.8 1.8 1.7 1.7 1.7

Minority interests (119) (195) (167) (205) (240)

Return on equity (%) 12.7 13.9 11.7 12.7 13.2

Net profit 1,237 1,589 1,504 1,841 2,161 YoY% 10.9% 28.4% -5.4% 22.4% 17.4%


Net margin 4.1% 4.3% 3.8% 4.2% 4.4%


EBITDA 2,168 2,760 2,920 3,412 3,952

Fixed assets 6,400 8,279 9,040 9,884 10,808

EBITDA margin 7.2% 7.4% 7.3% 7.7% 8.0%


EPS (RMB) 0.711 0.905 0.851 1.042 1.223


YoY% 4.6% 27.3% -6.0% 22.4% 17.4%


DPS (RMB) 0.170 0.199 0.187 0.229 0.269

Other non-current assets 153 137 137 137 137

Non-current assets 7,642 9,815 10,568 11,459 12,436

Year to Dec FY10A FY11A FY12E FY13E FY14E Cash Flow (RMB mn)

Inventories 1,176 1,685 1,849 1,900 1,943

EBITDA 2,168 2,760 2,920 3,412 3,952

AR 575 836 791 858 951

Chg in working cap 153 7 551 554 530

Prepayments & deposits 1,215 1,342 1,609 1,725 1,884

Others 305 (4) 134 83 67

Other current assets 2,923 2,163 2,163 2,163 2,163

Operating cash 2,626 2,763 3,605 4,049 4,550

Cash 3,775 4,360 5,319 6,853 8,550

Interests paid (39) (46) (79) (79) (79)

Current assets 9,664 10,387 11,732 13,500 15,491

Tax (102) (196) (330) (420) (523) Net cash from operations 2,485 2,520 3,196 3,551 3,949

AP 3,548 3,685 3,793 4,230 4,687

Tax 43 103 103 103 103

Capex (1,136) (2,381) (1,739) (1,939) (2,149)

Accruals & other payables 1,941 2,763 3,036 3,385 3,751

Investments (416) (223) (558) 0 0


Dividends received 13 11 0 0 0

CB & othe debts 140 119 119 119 119

Interests received 82 168 148 179 220


Others (748) 780 67 75 83

Current liabilities 6,238 7,226 7,802 8,589 9,412

Investing cash (2,204) (1,645) (2,082) (1,685) (1,846) FCF 281 875 1,114 1,865 2,102


Issue of shares 13 521 0 0 0


Buy-back 0 0 0 0 0


Minority interests 0 0 0 0 0

MI 459 578 745 949 1,190

Dividends paid (273) (331) (350) (331) (405)

Non-current liabilities 1,309 1,505 1,672 1,877 2,117

Net change in bank loans (130) (280) 195 0 0 Others (6) (148) 0 0 0

Total net assets 9,758 11,471 12,826 14,494 16,399

Financing cash (396) (238) (155) (331) (405)


Net change in cash (115) 637 959 1,534 1,697

Share capital 2,229 3,255 4,409 5,920 7,675

Exchange rate or other Adj (96) (52) 0 0 0

Reserves 7,529 8,216 8,417 8,574 8,724

Opening cash 3,987 3,775 4,360 5,319 6,853 Closing cash 3,775 4,360 5,319 6,853 8,550

BVPS (RMB) 5.96 6.53 7.26 8.20 9.28

CFPS (RMB) 2.306 2.482 3.009 3.877 4.837

Total debts 841 657 851 851 851

Net cash/(debts) 2,934 3,703 4,468 6,002 7,699


Tue, 06 Nov 2012

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Exhibit 66: Peer Group Comparison

Company Ticker Price

Mkt

cap

(US$m)

3-mth

avg t/o

(US$m)

PER

Hist (x)

PER

FY1 (x)

PER

FY2 (x)

EPS

FY1

YoY%

EPS

FY2

YoY%

3-Yr EPS

Cagr (%)

PEG

(x)

Div yld

Hist (%)

Div yld

FY1 (%)

P/B

Hist

(x)

P/B

FY1

(x)

EV/

Ebitda

Hist

EV/

Ebitda

Cur Yr

Net

gearing

Hist (%)

Gross

margin

Hist (%)

Net

margin

Hist (%)

ROE

Hist

(%)

ROE

FY1 (%)

Sh px

1-mth %

Sh px

3-mth %

Upstream liquid milk:

China Modern Dai 1117 HK 2.02 1,251 0.9 19.6 13.7 9.9 43.4 37.8 35.4 0.39 N/A 0.0 1.54 1.37 23.1 13.2 40.4 N/A 23.8 8.2 11.0 0.0 (3.3)

Downstream liquid milk

Inner Mong Yil-A 600887 CH 21.94 5,616 26.3 19.4 20.0 14.9 (2.7) 34.1 15.4 1.30 1.1 1.0 5.02 4.27 16.2 10.9 0.0 28.8 4.9 27.8 22.3 3.0 18.1

Bright Dairy-A 600597 CH 9.01 1,767 2.9 39.2 35.6 28.3 10.0 25.7 19.2 1.85 1.7 N/A 2.80 N/A 19.5 N/A 26.6 32.9 2.0 9.5 37.4 5.8 0.2

Downstream milk power

Biostime Interna 1112 HK 19.98 1,553 1.7 18.3 14.1 11.1 26.0 31.1 24.5 0.58 4.2 3.0 5.03 4.28 12.4 9.2 0.0 66.5 24.1 32.9 30.5 3.3 12.5

Yashili Internat 1230 HK 1.91 868 1.0 17.7 11.4 10.1 55.2 13.3 22.5 0.51 3.6 4.1 1.42 1.33 7.0 4.5 0.0 52.0 10.4 10.0 10.8 27.3 60.5

Feihe Internatio ADY US 6.35 126 0.7 8.2 4.7 4.3 76.0 9.6 N/A N/A N/A N/A 0.67 N/A 10.2 N/A 29.6 38.3 (0.4) 2.2 15.0 (6.6) (9.3)

Zhejiang Being-A 002570 CH 21.96 1,498 25.1 20.7 18.6 15.0 11.6 24.1 18.5 1.00 3.2 1.6 2.94 2.59 11.9 9.3 0.0 63.6 9.3 20.7 14.4 2.9 5.9

Sector average

20.5 16.9 13.4 31.3 25.1 22.6 0.9 2.8 1.9 2.8 2.8 14.3 9.4 13.8 47.0 10.6 15.9 20.2 5.1 12.1

Food and Beverage

Tingyi Hldg Co 322 HK 22.50 16,237 16.1 38.7 33.4 27.1 15.8 23.0 21.0 1.59 1.3 2.0 7.73 6.57 19.2 14.3 24.5 26.5 5.3 21.4 21.2 (4.3) 18.5

Want Want China 151 HK 11.22 19,150 14.9 45.7 35.3 28.4 29.3 24.4 24.4 1.45 1.6 1.7 13.92 11.96 31.8 23.8 0.0 34.8 14.2 39.0 37.2 12.8 19.7

Uni-President 220 HK 9.86 4,579 5.0 91.6 32.0 26.8 187.2 19.3 60.1 0.53 0.3 0.8 3.92 3.75 38.6 16.6 10.7 29.2 1.8 9.2 12.0 7.1 36.2

China Res Enterp 291 HK 27.00 8,363 10.7 22.9 25.4 22.7 (9.2) N/A 6.5 3.88 1.7 1.9 1.65 1.69 10.6 8.6 0.0 24.8 2.6 9.8 6.4 3.4 27.1

Tsingtao Brew-H 168 HK 43.00 7,173 8.1 26.9 25.4 21.8 6.1 16.4 12.9 1.97 0.7 0.8 3.77 3.62 13.6 12.1 0.0 36.5 8.2 15.0 15.5 (2.5) (2.9)

China Yurun Food 1068 HK 5.74 1,350 12.0 5.8 46.7 9.6 (87.8) 393.4 1.3 35.97 N/A 1.7 0.65 0.63 5.8 13.7 5.9 8.6 5.6 1.9 1.5 (1.4) (6.5)

China Huiyuan 1886 HK 2.43 463 0.2 9.3 23.9 19.0 (61.0) 25.6 (27.5) N/A N/A 1.2 0.55 0.57 17.7 16.9 55.8 26.9 8.1 6.0 2.0 3.4 1.7

China Foods Ltd 506 HK 7.86 2,836 2.9 34.0 23.7 19.2 43.6 23.2 29.6 0.80 1.3 1.5 3.13 2.95 16.2 13.5 0.0 23.8 2.3 12.1 12.6 (8.9) 7.7

China Mengniu Da 2319 HK 23.50 5,361 10.0 20.9 22.1 17.4 (5.5) 27.2 12.6 1.74 1.0 1.0 2.81 2.64 10.9 9.9 0.0 25.7 4.3 12.9 12.8 1.7 4.4

Sector average

32.9 29.8 21.3 13.2 69.1 15.7 6.0 1.1 1.4 4.2 3.8 18.3 14.4 10.8 26.3 5.8 14.1 13.5 1.3 11.8

* Outliners and "N/A" entries are in red and excl. from the calculation of averages


Tue, 06 Nov 2012

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http://www.oriental-patron.com.hk/opsl/dl_count.php?id=1100&type=company&pdf_path=/upload/File/Brilliance%20China%20(1114)%201H12%20Results%20Review%20-%20NR.pdf






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Rating and Related Definitions

Buy (B) We expect this stock outperform the relevant benchmark greater than 15% over the next 12 months. Hold (H) We expect this stock to perform in line with the relevant benchmark over the next 12 months. Sell (S) We expect this stock to underperform the relevant benchmark greater than 15% over the next 12 month. Relevant Benchmark Represents the stock closing price as at the date quoted in this report.

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