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Please refer to page 48 for important disclosures and analyst certification, or on our website

www.macquarie.com/research/disclosures.

17 January 2019 Greater China

EQUITIES

Inside

Global dairy valuation table 2

Upstream: demand to ougrow supply; raw milk

price up 5% YoY 3

Downstream: prisoner’s dilemma, so easing

competition will be mild 8

IMF: Turning cautious as one child

policy relaxation benefit is winding down 16

China Modern Dairy (1117 HK) 22

Want Want China (151 HK) 28

Yili (A-Share) (600887 CH) 32

China Mengniu Dairy Company (2319 HK) 37

Bright Dairy (A-Share) (600597 CH) 42

Health & Happiness (H&H) (1112 HK) 45

Yashili International (1230 HK) 49

Analysts

Macquarie Capital Limited

Linda Huang, CFA +852 3922 4068

[email protected]

Sunny Chow +852 3922 3768

[email protected]

Cici Yu +86 21 2412 9078

[email protected]

China Dairy Industry

Upstream sector on the ascendant

Key points

 5% raw milk price rise expected as demand outgrows supply in upstream.

 Prisoner’s dilemma in downstream, so competition is unlikely to ease much.

 Cautious on IMF as bonus from One-child Policy relaxation winding down.

China’s dairy industry faces significant changes in upstream demand and supply

in 2019. We expect upstream raw milk price to rise 5% in the year, the biggest

rise since 2013. Downstream dairy companies’ GPMs will inevitably come under

pressure, causing price competition to ease. We prefer upstream dairy

companies and are selective on downstream names. Our top picks are CMD,

Want Want and Yili. We reiterate Underperform on Mengniu and Neutral on H&H

and Yashili.

Upstream: demand to outgrow supply; raw milk price to rise 5%

Raw milk prices in China have long remained soft, but we expect the dynamics to

shift in favour of upstream dairies this year. We estimate China’s raw milk price

will rise 5% as milk supply tightens due to a lower milkable cow count and rising

feed cost. Overall, we expect to see a slight shortage in milk supply in 2019.

Downstream: prisoner’s dilemma, rivalry will ease but not much

Higher raw-milk prices will directly translate to gross margin pressure for

downstream companies in 2019. Our sensitivity analysis shows that every 1%

increase in raw milk prices will take 30bps each off Yili’s and Mengniu’s GPM,

and 20bps off Bright Dairy’s. This means operating profit downside of 3.8%, 6.2%

and 4.6%, respectively. This should ease price competition, but not by much, as

both Yili and Mengniu are in a prisoner’s dilemma—the market share gap is only

mid-single-digit, not wide enough for both to make much difference.

IMF: growth rate to moderate from 14% in 2018 to 6% in 2019

Growth in sales of infant milk formula (IMF) will be modest, we believe, as the

effect of the lifting of the one-child policy has faded, and the number of births is

likely to fall with the decline in the number of women of childbearing age and low

fertility desire. Meanwhile, we believe international brands will continue to

outperform, as customers are increasingly demanding high standards of food

safety and quality, regardless of income. We project industry growth will

moderate from 14% in 2018 to 6% in 2019.

Recommendations

China Modern Dairy (OP, TP HK$1.34): Direct beneficiary of milk price rise.

Want Want (OP, TP HK$7.70): Key beneficiary of competition easing. We

estimate net profit growth acceleration to 19.4% in FY20E with 16x PER.

Yili (OP, TP Rmb27.10): Better capacity to control A&P with cheap valuation of

22x 2019E PER.

Mengniu (UP, TP HK$16): GPM is likely to fall from the historical high in 1H18.

Valuation expensive at 32x 2019E PER.

H&H (N, TP HK$44.30): ANC to continue to outperform BNC as BNC faces

industry moderation.

Bright Dairy (N, TP Rmb8): Regional play that still lags behind Yili and Mengniu.

Yashili (OP, TP HK$1.97): Earnings turnaround boosted by factory disposal.

Macquarie Research China Dairy Industry

17 January 2019 2

Global dairy valuation table

Fig 1 Global dairy valuation table

Company

Code

Price

Rating

TSR

Mkt Cap

P/E(X)

P/B(X)

ROE (%)

EPS Growth (%)

PEG

Div yield (%)

EV/EBITDA

(lcy/sh)

(%)

US$m

2018E

2019E

2018E

2019E

2018E

2019E

2018E

2019E

2018E

2019E

2018E

2019E

Global dairy product producers

Nestle

NESN SW

83.62

259,291

21.6

19.9

4.2

4.1

20.7

21.4

8.9

8.5

2.4

3.0

3.2

15.2

14.2

Danone

BN FP

62.26

48,678

17.5

16.2

2.5

2.3

14.4

15.1

3.8

8.1

2.0

3.1

3.4

12.3

11.6

Kraft Foods

KHC US

46.91

52,230

13.0

12.6

0.9

0.8

6.3

6.4

1.0

2.9

4.4

5.4

5.5

12.1

11.8

Fonterra

FSF NZ

4.71

5.00

5,186

19.9

15.1

1.2

5.7

7.9

-48.2

31.3

0.5

2.1

3.1

9.8

8.6

Yakult

2267 JP

7280.00

11,631

35.3

30.4

3.4

3.1

9.8

10.6

25.0

16.1

0.5

0.6

18.8

17.8

Parmalat

PLT IM

2.85

6,024

39.0

29.6

1.6

1.4

0.0

31.5

0.9

0.6

0.8

Vina Milk

VNM VN

134900.00

10,130

25.7

24.1

9.0

8.3

39.1

38.7

-8.5

6.6

3.7

3.2

3.4

18.4

16.9

Meiji Foods

2269 JP

8810.00

11,717

20.9

18.5

2.6

2.4

13.7

13.5

0.0

12.9

1.4

1.3

1.5

10.1

9.9

Dean Foods

DF US

4.65

425

54.7

0.7

-3.7

1.8

7.4

5.6

7.0

5.7

Dairy Crest

DCG LN

446.20

540

12.3

12.6

3.0

2.5

38.4

18.5

2.8

-2.2

-5.7

0.1

10.2

9.9

Morinaga Milk

2264 JP

3195.00

1,435

10.5

159.0

1.0

0.9

10.2

7.5

20.3

-93.4

-1.7

1.9

1.6

6.0

6.2

A2 Milk Company

A2M AU

11.21

6,001

43.4

30.9

18.1

10.5

54.8

38.0

40.7

0.8

0.0

0.3

30.5

22.1

Global dairy product producers average

23.6

35.3

4.0

3.2

19.0

16.3

0.5

5.7

0.9

2.4

13.7

12.2

Chinese dairy processors

Yili

600887 CH

24.10

27.10

15%

21,936

25.3

22.9

5.4

5.0

22.2

22.6

-2.7

10.3

2.2

2.1

2.3

14.8

13.7

Mengniu

2319 HK

25.40

16.00

-36%

12,770

33.2

32.3

3.5

3.2

10.9

10.3

25.3

3.0

10.9

0.7

23.0

21.6

Bright Dairy

600597 CH

8.51

Neutral

8.00

-5%

1,534

19.9

18.0

1.8

1.7

9.5

10.0

-22.4

10.8

1.7

1.4

1.6

6.1

5.7

Want Want

151 HK

6.27

7.70

25%

9,936

19.5

16.3

4.4

3.8

23.1

24.9

7.7

18.2

0.9

2.5

3.1

11.3

9.8

Guangxi Royal

002329 CH

3.54

442

1.1

Yantang

002732 CH

16.75

390

17.8

14.4

0.7

Chinese dairy processors average

19.9

18.1

2.8

2.6

16.5

-1.3

8.8

3.8

1.6

1.5

13.8

13.1

Chinese dairy farmers

CMD

1117 HK

0.73

1.34

84%

578

4.9

4.3

0.6

11.4

13.3

80.4

15.4

0.3

0.0

5.8

5.6

YuanShengTai

1431 HK

0.17

Huishan

6863 HK

0.42

722

Xinjiang Western

300106 CH

5.72

178

Shengmu

1432 HK

0.34

280

5.7

0.5

8.8

5.7

Chinese dairy farmers average

4.9

5.0

0.5

11.4

11.0

80.4

15.4

0.3

0.0

5.8

5.6

Infant milk formula (IMF)

H&H

1112 HK

43.35

Neutral

44.30

3,547

22.2

17.7

4.5

3.6

22.6

15.2

25.1

0.7

0.0

10.3

8.5

Yashili

1230 HK

1.32

1.97

49%

799

111.8

38.8

1.0

0.9

2.5

0.0

61.0

19.8

Beingmate

002570 CH

5.21

796

Chinese IMF average

67.0

28.3

2.7

2.3

11.8

12.5

15.2

25.1

0.7

0.0

35.7

14.2

Note: For Want Want, 2018E is FY19E (Mar, 2018-Mar, 2019) and 2019E is FY20E (Mar, 2019-Mar, 2020).

Source: Company data, Bloomberg, Macquarie Research, January 2019; prices as of 15 January 2019

Macquarie Research China Dairy Industry

17 January 2019 3

Upstream: demand to outgrow supply; raw milk price

up 5% YoY

China’s raw milk price on the mend

China’s raw milk price remained soft in 1H18 with price down 4% HoH but the trend began to

reverse starting in August with latest price (as of 2

January 2019) rising 7% HoH and 2% YoY to

Rmb3.60/kg. Meanwhile, overall milk production growth has peaked in April 2018 and even dipped

into negative territory in September and October 2018. That being said, we expect China’s overall

raw milk supply to maintain positive growth albeit at a slower rate in 2019 as improving milk yield

and imported milk powder will somewhat alleviate the supply challenge. Looking ahead, we expect

to see a moderate raw milk price recovery driven by tighter milk supply on the back of lower

milkable cow herd size and rising feed cost. Our proprietary China upstream supply and demand

model projects a 1% YoY supply growth with slight shortage in 2019.

Fig 2 China raw milk price began to rise since Aug 2018

Fig 3 China’s overall milk production has been slowing

down

Source: Ministry of Agriculture, Macquarie Research, January 2019

Source: NBS, Macquarie Research, January 2019

Driver #1: Lower milkable cow herd size

After China’s raw milk price peaked out in 2014 in the last cycle, China’s upstream dairy industry

went through a period of high culling rates and smaller farmers exiting the industry amid sluggish

milk prices. Given that it takes three years before a milkable cow can begin to produce milk, there’s

usually a lagging effect on milk production after high culling rates. Evidently, China’s total milkable

cow count began to decline in 2016 and decline slightly widened to -6.0% YoY in 2017. Meanwhile,

China’s average milk yield continue to improve as it is below other developed countries that have

>10 tons/ cow/ year. Net-net, we expect to see tighter raw milk supply driven by lower milkable

cows but partially offset by the average milk yield improvement.

2.0

2.2

2.4

2.6

2.8

3.0

3.2

3.4

3.6

3.8

4.0

4.2

4.4

4.6

Jan-12

Jul-12

Jan-13

Jul-13

Jan-14

Jul-14

Jan-15

Jul-15

Jan-16

Jul-16

Jan-17

Jul-17

Jan-18

Jul-18

Jan-19

(Rmb/kg)

Macquarie Research China Dairy Industry

17 January 2019 4

Fig 4 China’s milkable cow count began to contract in 2016

Fig 5 China’s average milk yield still far below global

average despite continuous improvement

Source: China Dairy Yearbook, Macquarie Research, January 2019

Driver #2: rising feed cost

Feed cost is the predominant expense item for raw milk production cost and the ideal mix between

forage and coarse fodder is roughly 50/50 but the exact mix differs for each dairy farm. All three

key types of feed prices, i.e. alfalfa, corn and soybean, have trended upwards in 2018. Based on

the Dec 2018 prices, there is no sign of prices moderating for both alfalfa and corn. Meanwhile,

soybean prices have showed growth moderation from Nov 2018 onwards.

Overall, we expect feed cost will continue to rise for the following reasons:

 U.S- China trade war. This has led to a 25% tariff on U.S imported alfalfa and soybeans.

Potential upside could be improved U.S-China relations.

 China corn supply side reform. This has resulted in lower supply and subsequently

higher corn prices.

Fig 6 Feed cost accounts for over 70% of raw milk

production cost

Fig 7 Alfalfa prices continue to trend up

Source: Company data, Macquarie Research, January 2019. Note: based

on CMD’s 1H18 FS

Source: Ministry of Agriculture, Macquarie Research, January 2019

-10%

-5%

10%

15%

20%

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

(m herds)

Milkable cow YoY % (RHS)

-2%

10%

12%

14%

16%

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

(ton/head/yr)

Average milk yield YoY % (RHS)

Feed

75%

Labor

Utilities

Depreciation

Others

-25%

-20%

-15%

-10%

-5%

10%

15%

20%

25%

100

150

200

250

300

350

400

Mar-12

Jun-12

Sep-12

Dec-12

Mar-13

Jun-13

Sep-13

Dec-13

Mar-14

Jun-14

Sep-14

Dec-14

Mar-15

Jun-15

Sep-15

Dec-15

Mar-16

Jun-16

Sep-16

Dec-16

Mar-17

Jun-17

Sep-17

Dec-17

Mar-18

Jun-18

Sep-18

Dec-18

(US$/ton)

International alfafa price YoY % (RHS)

Macquarie Research China Dairy Industry

17 January 2019 5

Fig 8 Similarly, corn prices are also on an upward trend

Fig 9 Meanwhile, soybean price growth has begun to

moderate since Nov 2018

Source: Ministry of Agriculture, Macquarie Research, January 2019

Imported milk powder to see moderate growth in the near term

China’s imported milk powder volume has not returned to its 2014 peak despite two years of

double-digit YoY growth in 2016-17. Moreover, 9M18 has seen further slowdown to only 4% YoY.

On the other hand, imported liquid milk recorded even softer growth with 9M18 volume only flattish

YoY, down from +7% in 2017.

Imported milk powder has proven to be a popular alternative for downstream dairy companies

whenever the price gap widens between domestic and overseas prices. That being said, we

expect the price gap to slightly narrow in 2019 with the anticipation of a moderate domestic raw

milk price increase and mid-single-digit to low-double-digit growth for WMP price in 2019.

Fig 10 Imported milk powder volume grew 4% YoY in 9M18

Fig 11 Meanwhile, imported liquid milk volume only stayed

flattish in 9M18

Source: Dairy Association of China, Macquarie Research, January 2019

China raw milk price still trades at a premium over Fonterra

Based on the most recent auction held by GDT on 15 January 2019, WMP price edged up 2.7%

WoW but declined 7.7% YoY to US$2,777/MT. Meanwhile, China’s raw milk price edged up 2.0%

YoY to Rmb3.60/kg per most recent data on 26 December 2018. This implies that the China raw

milk price is currently trading at 17% premium to Fonterra’s WMP price.

-30%

-25%

-20%

-15%

-10%

-5%

10%

15%

20%

25%

500

1,000

1,500

2,000

2,500

3,000

Mar-12

Jun-12

Sep-12

Dec-12

Mar-13

Jun-13

Sep-13

Dec-13

Mar-14

Jun-14

Sep-14

Dec-14

Mar-15

Jun-15

Sep-15

Dec-15

Mar-16

Jun-16

Sep-16

Dec-16

Mar-17

Jun-17

Sep-17

Dec-17

Mar-18

Jun-18

Sep-18

Dec-18

(Rmb/ton)

Corn price YoY % (RHS)

-40%

-30%

-20%

-10%

10%

20%

30%

40%

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

Mar-12

Jun-12

Sep-12

Dec-12

Mar-13

Jun-13

Sep-13

Dec-13

Mar-14

Jun-14

Sep-14

Dec-14

Mar-15

Jun-15

Sep-15

Dec-15

Mar-16

Jun-16

Sep-16

Dec-16

Mar-17

Jun-17

Sep-17

Dec-17

Mar-18

Jun-18

Sep-18

Dec-18

(Rmb/ton)

Soybean price YoY % (RHS)

-100%

-50%

50%

100%

150%

200%

100

200

300

400

500

600

700

800

900

1,000

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

9M18

(k ton)

Imported milk powder YoY % (RHS)

20%

40%

60%

80%

100%

120%

140%

160%

100

200

300

400

500

600

700

800

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

9M18

(k ton)

Imported liquid milk YoY % (RHS)

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