Company description

Founded in 1999, China Mengniu Dairy (Mengniu) has evolved to become China’s second largest dairy product manufacturer, with MENGNIU as its core brand. Mengniu has been active in merger & acquisition to expand its market share and presence along the value chain of dairy products. In May 2013, Mengniu acquired 26.9% equity interest of China Modern Dairy (1117 HK), a leading upstream dairy farm operator. Mengniu later increased its stake in CMD to 60.77% in 2017. In June 2013, Mengniu acquired an infant formula power maker. Yashili (1230 HK). Mengniu also has a strategic cooperation with Danone (a French food-products corporation), Arla Foods(the largest producer of dairy products in Scandinavia based in Denmark), and WhiteWaves Food (an American packaged food and beverage company) to distribute quality dairy products. 

Mengniu’s diversified products range includes liquid milk products (such as UHT milk, milk beverages and yogurt), ice cream, milk formula and other dairy products (such as cheese). As of 31 December 2017, the Group’s annual production capacity reached 9.22 million tons. 

Investment thesis

Mengniu has a clear road map to regain market leadership . Management targets to drive 60% of sales growth by volume and 40% in increase average selling price (ASP) through product upgrade. Near term, it also looks to re-invest 80% of its gross margin expansion in brand building. Despite the aggressive promotion by Yili, Mengniu remained disciplined in discounting and stay focused in branding and products innovation. We expect margin to further expand with optimizing product mix and operating leverage. Its 61%-owned China Modern Dairy (CMD) and 51%-owned Yashili are on track to turn profitable in 2018.

Investment summary

  • More optimistic sales growth outlook. Mengniu’s revenue growth accelerated slightly to +17% y/y in 1H18 (2H17: +16%), which comprised of 7% volume growth and ~10% hike in average selling price (ASP) through product upgrade and reduced discount. Strength was noted across segments, where sales of liquid milk +14% (2H17: +14%), ice cream products +13% (2H17: +11%) and milk powder +65% (2H17: +51%). Continuous products innovation and increasing brand awareness likely to sustain the momentum. Management lifted its full year sales guidance to mid-teens growth (from low-teens). 
  • Disciplined discounting despite aggressive peers’ promotion. Gross margin expanded significantly by 3.6ppt y/y to 39.2% due to the product upgrade and mix tilting towards higher margin product (e.g. yogurt) Despite peers’ aggressive promotion in 2Q, Mengniu is also disciplined in discounting. The front – loaded marketing expense on World Cup sponsorship (CNY800mn in 1H18, 2.3% of sales) boosted selling expense to 28.9% of sales (1H17: 24.2%) and resulted in operating margin drop by 50bps y/y to 5.6%. A&P expense should normalise from 12% of sales in 1H18 but stayed above historical 9% to catch up with the peers (~12%) and improve brand prominence. 
  • Optimistic 2H outlook, buy on dip. We reiterate our positive view on Mengniu. Most of its business drag (CMD and Yashili) have turned around and started to contribute to earnings. Its normalised selling expenses, new products pipeline and increasing brand prominence will serve Mengniu well in going forward.
  • Stronger-than-expected sales growth 
  • Good consumer feedback from new product launches 
  • Margin expansion from better-than-expected operating efficiencies 
  • Successful turnaround of Yashili and CMD