China Milk Products - Getting out of the trough; short-term outlook remains challenging

It has been nine months since the outbreak of the melamine scandal in China. Although people’s memories of the incident are fading away, the resulting damage still persists:

a) Dampened consumer confidence. About 40-60% consumers have stopped or cut down on buying local brands of dairy products, according to surveys conducted by Dairy Association of China (DAC). Per capita urban living expenditure on dairy products made a mild recovery in 1Q09 after plummeting in 4Q08, but we believe it will still take time for the dairy industry to see a meaningful turnaround.

b) Inventories piling up, working capital falling short. Laggard demand for dairy products has retarded sales and, in turn, led dairy producers to reduce both the amount and the price of raw milk collected. According to China Statistical Bureau, average raw milk price dropped 11% yoy in 1Q09.

c) Decreasing benefits of cattle raising. Lower raw milk prices and high feed costs have led to losses for dairy farmers. As a result, it has become quite common for farmers to dump milk and slaughter cows.

There are, on the other hand, some positive signs of an industry recovery as well. Apart from the rebound in per capita urban living expenditure on dairy products in 1Q09, dairy production has also recorded consecutive monthly yoy growth since Feb 09 after five consecutive months of yoy decline from Sep 08 to Jan 09. Such growth could partially be due to restocking by dairy producers after months of sharp falls in production and heavy de-stocking following the outbreak of the scandal. Sales of dairy products in supermarkets, in contrast, are not satisfactory, according to our observations. The dairy industry is improving, but there is still a long way to go before it can make a full recovery.

Short-term outlook remains challenging. Demand for dairy products is growing but still weak, and the selling price of raw milk is likely to remain low in 2H09. This, coupled with continued high feed costs, has significantly eroded the benefits of cattle raising and removed the incentives for dairy farmers to expand or even keep their herds. As a result, we expect the shortterm outlook for China Milk Products (CMilk) to remain challenging as the company’s core businesses, namely bull semen and cow embryos, are likely to face pressure from falling selling prices and sales volume.

Promising long-term prospects. For FY11, however, we expect the company to post strong earnings growth as demand for CMilk’s quality bull semen and cow embryo products should remain resilient in the long term. CMilk’s bull semen and cow embryos will continue to play an important role in cattle genetics and milk yield improvement in China. In addition, given the recent outbreak of another mad cow disease in Canada, the Chinese government would be reluctant to lift the import ban on dairy livestock from North America soon. This should enable CMilk to further leverage on its strength as a supplier of high-yield Canadian dairy cow embryos.

Our DCF-based target price remains at S$0.53, implying 5.4x FY10F PE. Maintain BUY.

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