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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China Milk - US$3m principal amount to be repurchased

The tender for the bond repurchase has closed. The final aggregate principal repurchase amount is US$3m, so that the remaining principal of the bond will become US$147m. The clearing price expressed as a percentage of the denomination of the tendered bonds is 95%. Based on that price, the aggregate repurchase amount in cash payable is US$2.85m.

The repurchase amount would translate into about Rmb20m, which is quite insignificant relative to CMILK's Rmb1.9b cash position or its Rmb1b convertible bonds (CB) balance as of 31 Dec 08.

The company is willing to pay up to US$40m for the repurchase, but has received far from enough applications. The CB could be converted into new shares at a conversion price of S$2.00, or be redeemed by the company at 129.58% of the principal at maturity date. The bondholders seem to be at least quite confident about CMILK's repayment ability and are reluctant to sell the bonds at a discount now.

China Milk Technical BUY

On 18th March, China Milk issued a statement to assure shareholders that the Company's cash position as set out in its 2008 Annual Report and the unaudited financial results of the third quarter and nine months ended 31 December 2008 is accurate as stated.

This morning, China Milk took a further step forward in allaying investors’ fears by announcing that it was inviting convertible bond holders to tender their bonds to the Company in return for cash. The offer opens at 9.00am Singapore time on 31st March and will close at 11.59pm on 1st April unless extended.

The zero coupon bonds amounting to US$150m are due in 2012 and China Milk is redeeming a maximum of US$40m worth of bonds. As at end December 2008, China Milk had cash of RMB1,964.7m and the convertible bond liability was RMB1,004.5m.

On the charts, China Milk looks technically attractive. The stock has recovered from its Mar lows of S$0.20 and is now testing to break above the 30- day SMA. We see opportunities to accumulate as the congestion phase over the past one week suggests that a base building formation is in the making.

Although MACD is still negative, it has broken out of its downward channel, which is a sign of recovery. In addition, RSI is still rising towards the upper band of the neutral zone.

There is a minor resistance at its 30-day SMA (S$0.31). Next upside target is at S$0.335 and S$0.35. Immediate support is at S$0.28. Cut losses if it breaks below S$0.26.

China Milk: Strong 3QFY09 raw milk revenue

Strong raw milk revenue contribution despite tainted industry. Raw milk production increased by 26% YoY to 13,187 tonnes in 3QFY09. This is a positive as many of the bigger players in China’s dairy industry have fallen into the pit. Raw milk revenue grew by 24% YoY to RMB42m. We firmly believe that China Milk will be able to sell a total of 54,000/tonnes of raw milk for FY09 which equates to RMB155.5m revenue.

Firm operating profit growth of 27% but weak net profit due to CB. All of China Milk’s core businesses saw strong revenue growth during 3QFY09. Operating profit grew by 27% to RMB150.4m during the same period. However, its convertible bond was the main culprit which caused its net profit to slump to a growth of 1.9% to RMB119.1m in 3QFY09. Due to its change in fair value of derivative financial instruments component in its income statement, the company saw a loss of RMB8.1m in 3QFY09 compared to a gain of RMB24.6m in 3QFY08. We are concerned that China Milk has not bought back these CBs in the open market. We believe that China Milk will continue to monitor these convertible bonds and buy-back when the right opportunity arises.

Strong cash position offsets concerns of CB. The company is sitting on nearly RMB2b worth in cash (US$292.2m) which exceeds its US$150m convertible bond (maturing in 2010). Long term outlook. We believe that the key to China Milk’s success will be going downstream. The commencement of its own proprietary brand, Yinluo is a major step forward. However, the next step for China Milk is sealing what has been a long period of negotiations with an OEM customer. The milk processing business offers China Milk the ability to capture a large market share in China’s dairy industry. We will continue to monitor these developments. Maintain BUY. Pending our earnings revision, we maintain our price target of S$0.67 based on 5.0x FY09 P/E. We have given China Milk a premium to the FSTC FY09 P/E of 3.9x.

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.