China Mengniu Dairy: Opportunities And Challenges Coexist

Summary

• China Mengniu's 1Q2020 financial performance is likely to have taken a hit from the coronavirus pandemic, which is expected to change the behavior of both competitors and consumers.
• China Mengniu expects a recovery in the second half of the year, and it is guiding for double-digit growth in revenue and an improvement in operating profit margin for 2H2020.
• In the medium to long term, the positive impact of increased health consciousness and premiumization is partially offset by declining birth rates and stiffer competition.
• China Mengniu trades at 27.1 times consensus forward next twelve months' P/E, and it offers a consensus forward FY2020 dividend yield of 0.9%.
• Looking for more stock ideas like this one? Get them exclusively at Asia Value & Moat Stocks. Get started today »

Elevator Pitch

I maintain a "Neutral" rating on Hong Kong-listed Chinese dairy company China Mengniu Dairy Co., Ltd. (OTCPK:CIADF) (OTCPK:CIADY) [2319:HK].

China Mengniu's 1Q2020 financial performance is likely to have taken a hit from the coronavirus pandemic, which is expected to change the behavior of both competitors and consumers. But China Mengniu expects a recovery in the second half of the year, and it is guiding for double-digit growth in revenue and an improvement in operating profit margin for 2H2020.

In the medium-to-long term, the positive impact of increased health consciousness and premiumization on the Chinese dairy market is partially offset by declining birth rates and stiffer competition. In other words, opportunities and challenges coexist, which explains my "Neutral" rating on China Mengniu.

This is an update of my prior article on China Mengniu published on December 23, 2019. China Mengniu's share price has declined by -17% from HK$31.65 as of December 19, 2019, to HK$26.30 as of May 4, 2020, since my last update. China Mengniu trades at 27.1 times consensus forward next twelve months' P/E versus its historical five-year and 10-year mean consensus forward next twelve months' P/E multiples of 21.6 times and 21.9 times respectively. The stock also offers a consensus forward FY2020 dividend yield of 0.9%.

Readers are advised to trade in China Mengniu shares listed on the Hong Kong Stock Exchange with the ticker 2319:HK where average daily trading value for the past three months exceeds $40 million and market capitalization is above $13 billion. Investors can invest in key Asian stock markets either using U.S. brokers with international coverage such as Interactive Brokers, Fidelity, Charles Schwab, or local brokers operating in their respective domestic markets.

Impact Of Coronavirus Pandemic

On March 25, 2020, China Mengniu released an update on the impact of the coronavirus pandemic on its business. In the update, China Mengniu highlighted that its revenue in February and March 2020 was negatively affected by disruptions to manufacturing and logistics operations. The company also incurred higher expenses over the same period as a result of an increase in marketing expenses with the aim of clearing excess inventories and other costs relating to pandemic control and prevention.

As a Hong Kong-listed company, China Mengniu reports its financial results on a semi-annual basis. But the 1Q2020 results for Inner Mongolia Yili Industrial [600887:CH], China's market leader in the drinking milk products market, offers potential insights into China Mengniu's financial performance in the past quarter; China Mengniu is the second-largest drinking milk products company in China after Inner Mongolia Yili Industrial. Bloomberg reported on April 28, 2020, that Inner Mongolia Yili Industrial's revenue and earnings in 1Q2020 decreased by -11% YoY and -50% YoY to RMB20.5 billion and RMB1.14 billion respectively.

At the company's FY2019 earnings call on March 26, 2020, China Mengniu provided more details on how the coronavirus pandemic has impacted the company's business operations in 1Q2020. Apart from lower revenue and higher costs resulting from the coronavirus pandemic as highlighted above, China Mengniu also offered low-interest or interest-free loans to the company's raw milk suppliers to help them tide through this difficult period. This is critical to ensure that China Mengniu's raw milk supply is not disrupted going forward, as local media Yicai Global reported on April 22, 2020, that many liquid milk suppliers in China either saw their profits plunge in 1Q2020 or suffered from losses last quarter.

More importantly, the coronavirus pandemic is expected to change the behavior of both competitors and consumers.

In the short term, price competition is a key risk for China Mengniu and the liquid milk products industry in China. China Mengniu noted at its FY2019 earnings call on March 26, 2020, that "discounts might be higher than the normal level" up to April 2020 at the very least, as industry players are stuck with excess inventories due to lower-than-expected sales during the Chinese New Year period. However, the company added at the recent earnings call that "once the inventory level goes back to a normal level, I don't think that within the channels, we will be seeing price wars or discounts being offered anymore." China Mengniu expects product discounts to normalize by 2H2020.

In the medium-to-long term, the coronavirus pandemic could potentially accelerate the pace of industry consolidation, which benefits China Mengniu Dairy. An April 22, 2020, article published by Yicai Global found that 237 of the 561 milk producers surveyed in China were loss-making in 2M2020, compared with just 127 which suffered from losses in 2M2019. Sub-scale milk producers that are less well-capitalized could potentially go out of business as a result of the coronavirus pandemic. According to Euromonitor research, China Mengniu and Inner Mongolia Yili Industrial have in aggregate approximately 40% market share in China's drinking milk products market.

There is also a significant change in consumer purchasing patterns and sales channel as a result of the coronavirus pandemic. China Mengniu disclosed at the company's FY2019 earnings call on March 26, 2020, that sales from e-commerce platforms and O2O (Online-to-Offline) home delivery grew by more than 50% and over two times respectively. China Mengniu's O2O home delivery service named as Tianxianpei "allows residents to order fresh milk and yogurt products on Tmall (e-commerce platform) and pick them up in refrigerators near their residences" with a presence in "600 neighborhoods in more than 20 major cities in China", according to a November 20, 2019, article published by digital media publication KrASIA.

Notably, a new sales channel, which China Mengniu refers to as "community household group buying", contributed approximately 10% of the company's revenue in 1Q2020. The company estimated that it created around 90,000 community groups on social networking platforms such as WeChat during the coronavirus pandemic, and group purchases from these community groups on social networking platforms grew rapidly in the past few months. This form of community-based selling helps to build China Mengniu's brand and could potentially increase customer stickiness in the long run.

FY2020 Guidance

While the coronavirus pandemic is likely to have had a negative impact on China Mengniu's 1Q2020 results, the outlook for full-year FY2020 is not as bad as feared.

China Mengniu announced on March 25, 2020, that "all production bases of the Group in China have resumed normal production and supply to the market except for the factories in Wuhan which are still gradually recovering from the Outbreak." At the company's FY2019 results briefing on March 26, 2020, China Mengniu noted that "our market recovery, our work resumption rate is also the highest in the industry."

Looking ahead, China Mengniu is guiding for a "slight decline" in 1H2020 revenue and a "double-digit growth" in revenue for 2H2020. The company also expects a YoY improvement in operating profit margin for 2H2020. Market consensus expects China Mengniu's revenue to decline by -5.6% YoY from RMB79,030 million in FY2019 to RMB74,580 million in FY2020, and for the company's EBITDA margin to decrease from 9.4% to 8.0% over the same period.

Opportunities And Challenges Coexist In The Medium To Long Term

In the medium to long term, opportunities and challenges co-exist for China Mengniu.

In terms of opportunities, demand for liquid milk and dairy products is likely to grow as Chinese consumers become increasingly health conscious following the coronavirus pandemic. China Mengniu highlighted in its FY2019 results presentation that keyword searches relating to immunity "increased by 3 times after COVID-19 outbreak." Kantar Worldpanel also noted in a February 19, 2020, article that "the proportion of liquid dairy products in domestic food shopping baskets in 15 cities in China increased by 2.5% during the SARS (Severe Acute Respiratory Syndrome) period 17 years ago."

Another positive long-term trend for the Chinese dairy market is premiumization, and China Mengniu's FY2019 results suggest that the company is working hard to capitalize on such opportunities. China Mengniu's premium room temperature brands, Milk Deluxe and Just Yogurt, both saw revenue growth in excess of +20% last year. Notably, approximately 15% of the company's premium room temperature product sales were derived from new products.

The company has also made a few acquisitions recently, which increased its presence in the premium segment. These newly-acquired companies include Australian's largest organic infant formula company, Bellamy's Australia Limited (acquisition completed as of end-2019) which owns the premium infant formula brand Bellamy's Organic; and Australia-based branded dairy and beverage company, Lion-Dairy & Drinks Pty Ltd (proposed acquisition expected to be completed in 1H2020) which has a 55% share of the premium yogurt segment in Singapore.

With respect to challenges, new births in China declined from 15.23 million in 2018 to 14.65 million in 2019, which was a 60-year low since 1961. In other words, China's population won't grow as fast it did in the past and could potentially be shrinking going forward. This means that China Mengniu will have to work twice as hard to increase dairy penetration, rather than be reliant on a growing population to drive demand.

At the company's FY2019 earnings call on March 26, 2020, China Mengniu also mentioned increased competition as a key challenge. The company noted that "we have entered into the new era that people are fighting for the incremental bids within a stabilized market." Smaller domestic competitors are increasingly engaging in price competition, while foreign dairy giants are expanding their presence into lower-tier cities.

Valuation

China Mengniu trades at 22.6 times trailing twelve months' P/E and 27.1 times consensus forward next twelve months' P/E based on its share price of HK$26.30 as of May 4, 2020. In comparison, the stock's historical five-year and 10-year mean consensus forward next twelve months' P/E multiples were 21.6 times and 21.9 times respectively.

China Mengniu offers a historical FY2019 dividend yield of 0.7% and a consensus forward FY2020 dividend yield of 0.9%.

Risk Factors

The key risk factors for China Mengniu are stiffer-than-expected price competition as competitors offer discounts to clear excess inventories resulting from the coronavirus pandemic and a failure to adapt to changing consumer preferences and habits following the pandemic.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[Himalayas Research]

Do you have a price target/valuation?

[The Value Pendulum]

Thanks for your comments and question, Himalayas Research. Most dairy, infant formula, beverage and consumer staples companies trade at mean P/E multiples of above 20 times. Assuming a normalized EPS of RMB1.00 or HK$1.10, an entry price of HK$22 implying a 20 times P/E would be attractive in my opinion. When I had a BUY call on Mengniu two years ago, I was targeting 30% upside based on a target price implying 25 times P/E. Hope this clarifies, thanks.

[Himalayas Research]

For China, what's their position in tier 1/2 cities vs foreign brands?

[The Value Pendulum]

Mengniu has market shares of approximately 30%, 35%, 35% and 35% respectively in Tier-1, Tier-2, Tier 3, Tier 4 cities respectively; Yili has market shares of approximately 30%, 40%, 45% and 45% respectively in Tier-1, Tier-2, Tier 3, Tier 4 cities respectively. Nestlé (China) Ltd's market share at the national level is about 1%. The above refer to market share data for China's drinking milk products market in 2019. Hope this helps, thanks.