China Milk: New milk processing plant to drive long term earning

China Milk Products Group Ltd announced in Dec 2008 that its new dairy processing plant has commenced raw milk processing. The Group will produce dairy products such as flavoured milk beverages and yogurt drinks under its own proprietary brand, Yinluo. With a total processing capacity of 100k tonnes annually, the company’s new processing plant will initially process about 50 to 80 tonnes of raw milk per day. As China Milk’s competitors continue to face legal suits due to the melamine scandal, we believe that the commencement of its dairy processing plant is a major step forward in taking advantage of the current situation which will enable them to gain a larger market share in 2009-10.

Focus own-brand sales in Heilongjiang… Management has indicated to us that the development of their own brand, Yinluo was strategic in the midst of many household brands being tainted due to the scandal (Yili, Mengniu, and Sanlu). The company will focus on selling their Yinluo products within Heilongjiang, and the north-eastern provinces of Liaoning and Jilin. Beijing and Shanghai are key markets that they plan to target in the long term when their brand name becomes better known.

…and searching for a right OEM customer. Management has informed us that they are also in the midst of negotiation with a suitable OEM customer with a strong brand name. By strategically partnering with an OEM customer, this will enable China Milk to ride on an already well known brand name. We see this as a key component to China Milk’s long term growth and sustainability. By partnering with an already well known OEM customer this will place China Milk right in the core of China’s dairy sector.

We have raised our earnings forecast. Despite the melamine scandal China Milk managed to obtain an 82.6% YoY increase in 2QFY09 raw milk revenue. With the addition of the new processing plant of 100k tonnes/annum, we have adjusted our revenue and net profit assumptions for FY09 and FY10. In FY09, we believe that China Milk will achieve revenue of RMB715.5m which is 4.0% more than our previous assumption. Management has indicated to us that they expect about RMB24m revenue contribution from its processing plant which is from its 8,000 tonnes of processed milk to be sold in 4QFY2009. We therefore raise our FY09 net profit forecast by 5% to RMB472.2m.

We believe that FY2010 will be a strong year of growth for China Milk. We expect the company to have a total of 90k tonnes of raw milk production capacity in FY10 (was 62k tonnes in FY09), 75k tonnes of which will be used for milk processing. With the addition of the milk processing plant our FY10 revenue is raised by 17.5% to RMB953.6m for FY10. We raise FY10 net profit by 26% to RMB591.4m.

Valuation. We raise our target price from S$0.55 to S$0.67 based on 5x FY09 P/E which is a premium to the FSTC forward P/E of 4.3x. China Milk is currently trading at 3.0x FY09 P/E and 2.4x FY10 P/E, we recommend BUY.

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