China Mengniu Dairy - Excessive boast of sales recovery by market; expensive valuations

Sales dropped more than 30% in Beijing and 25% yoy in Shanghai in 5M09. According to our channel check with a couple of retail giants in Beijing and Shanghai, Mengniu’s sales recovery was not as good as market expectation. In Beijing, sales fell 30% in a big supermarket chain and slumped 44% in another hypermarket chain in 5M09. In Shanghai, sales dropped more than 25% in a leading hypermarket chain.

Mengniu lost market share to Bright Dairy in Shanghai and Sanyuan in Beijing. Sales in Beijing and Shanghai normally account for 60% of its total sales. After the melamine scandal and Deluxe incident, Mengniu’s market share in Beijing declined from 56% to 40% while Sanyuan’s increased from 20% to 36% in 5M09, according to our channel checks. In Shanghai, Mengniu also lost market share to Bright Dairy which was confirmed by a leading hypermarket chain.

Gross margin will improve slightly while operating margin could be flat. According to China Statistical Bureau, average raw milk price dropped 11% yoy to Rmb2.56/kg in 1Q09. We forecast raw milk prices will only decline 7% in FY09 and rebound in 4Q09. Although gross margin will improve in FY09, we see operating margin to stay flal due to higher operation and selling expenses.

Sales to rise 4.3% in 2009. Although the market expects Mengniu’s sales to increase more than 5% yoy in 2009, we maintain our sales growth forecast of 4.3% based on our channel checks. Historically, second-half sales increased 15-17% compared to first-half’s. Even if sales would recover more than 80% in 1H09, which implies sales of Rmb10,961m, annual sales growth could not increase more than 5% in 2009.

Raw milk prices could surge in 2H09. As raw milk prices plunged significantly in 1H09, many dairy farmers sold their cows to slaughterhouses. In Ningxia province, the number of cows fell more than 20,000 in 1Q09. In Liaoning province, many dairy farmers confirmed they will sell their cows to slaughterhouses due to a hike in corn price and bean pulp price in March. In Inter-Mongolia, the number of cows dropped 10.2% to 316.6m in 1Q09. It is highly likely raw milk supply will be in shortage which will affect dairy companies’ gross margins.

High advertising expenses will erode profit in 2009. Mengniu has to put in more effort on its sales campaigns to restore consumer confidence for its products. Management guided advertising expenses will increase from 8.3% of total sales in 2007 to 8.5-8.8% in 2009. Mengniu also has to spend more on advertising to highlight its raw milk quality and product safety, particularly for its Milk Deluxe products.

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China Mengniu Dairy - Quality of products in question

The Chinese authorities are yet to verify the questioned substances found in Mengniu‘s products and this delay could be detrimental to consumers‘ confidence in Mengniu‘s products in the near term. Subjected to the new developments that may arise, one of the key differences of this second quality —scandal“ with the melamine scandal, which occurred less than six months ago, is that Mengniu is the only named dairy player to date, which could bring new uncertainty to its market positioning ahead.

While the premium milk product series account for less than 10% of Mengniu's overall sales, the impact on the overall consumer confidence towards the brand could be affected and consumers may be induced to switch to other brands. Sales aside, the premium milk product series command one of the highest margins for Mengniu and this incident could bring further uncertainty to the maintenance of historical margins. Overall, the event adds to the uncertainty risks of the post-melamine recovery period of Mengniu. We maintain our UNDERPERFORM rating.