Elevator Pitch

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

This is an update of my prior article on China Mengniu published on May 5, 2020. China Mengniu’s share price has increased by +15% from HK$26.30 as of May 4, 2020 to HK$30.40 as of June 22, 2020 since my last update. China Mengniu trades at 34.4 times consensus forward next twelve months’ P/E, and it offers a consensus forward FY2020 dividend yield of 0.7%.

China Mengniu’s profit warning with regards to 45%-60% YoY decrease in net profit attributable to shareholders for 1H2020 was not a surprise, while double digit organic revenue growth in April-May 2020 was better than expected. However, China Mengniu’s earnings recovery in 2H2020 is dependent on multiple factors, such as cost pressures, product mix and integration of recent acquisitions.

Despite the 1H2020 profit warning, China Mengniu has out-performed the Hong Kong benchmark Hang Seng Index year-to-date. The company’s share price is down by approximately -4%, while the Hang Seng Index has declined by -13% since the start of the year. As a result, there could be room for disappointment (e.g. a larger-than-expected increase in raw milk prices) and a valuation de-rating, if China Mengniu’s 2H2020 financial numbers fall short of expectations. As such, I maintain a Neutral rating on the stock.

Readers have the option of trading in China Mengniu shares listed either on the Over-The-Counter Bulletin Board/OTCBB as ADRs with the tickers CIADF and CIADY, or on the Hong Kong Stock Exchange with the ticker 2319:HK. For those shares listed as ADRs on the OTCBB, note that liquidity is low and bid/ask spreads are wide.

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For those shares listed in Hong Kong, there are limited risks associated with buying or selling the shares in terms of trade execution, given that the Hong Kong Stock Exchange is one of the major stock exchanges that is internationally recognized, and there is sufficient trading liquidity. Average daily trading value for the past three months exceeds $50 million, and market capitalization is above $15 billion, which is comparable to the majority of stocks traded on the US stock exchanges. Institutional investors which own China Mengniu shares listed in Hong Kong include Schroder Investment Management, First State Investments, BlackRock, and The Vanguard Group, among others. Investors can invest in key Asian stock markets either using US brokers with international coverage, such as Interactive Brokers, Fidelity, or Charles Schwab, or local brokers operating in their respective domestic markets.

1H2020 Profit Warning And April-May 2020 Sales

On June 8, 2020, China Mengniu announced that the company is issuing a profit warning for 1H2020, and it also disclosed details of its sales growth in the April-May 2020 period.

China Mengniu is expecting a 45%-60% YoY decrease in net profit attributable to shareholders for 1H2020, which does not come as a surprise. As per an earlier March 25, 2020 announcement, the company already cautioned that it suffered from lower revenue and higher costs in February and March 2020 as a result of the coronavirus pandemic. Furthermore, Inner Mongolia Yili Industrial [600887:CH], China Mengniu’s closest competitor, and the country’s market leader in the drinking milk products market, saw a -50% YoY drop in its 1Q2020 earnings, as reported by Bloomberg. Note that as with most Hong Kong-listed companies, China Mengniu reports financial results on a semi-annual basis.

Notably, China Mengniu emphasized in the company’s June 8, 2020 announcement that it “recorded a double-digit (YoY) growth” in organic revenue (adjusted to exclude the effects of acquisitions and disposals in 2019) in the April-May 2020 period. More importantly, the company is guiding for positive organic revenue growth for 1H2020. Market consensus also expects China Mengniu’s full-year core earnings per share to decline by a relatively lower -18% YoY from RMB0.985 in FY2019 to RMB0.805 in FY2020, implying expectations of an earnings recovery in 2H2020.

In other words, China Mengniu’s sales have already recovered since April 2020, and an increase in one-off costs relating to the coronavirus pandemic was the key reason for the company’s expected 45%-60% YoY fall in net profit attributable to shareholders for 1H2020. These additional one-off costs in 1H2020 for China Mengniu included expenses linked to pandemic control, marketing expenses to clear excess inventories which piled up during the February-March 2020 period, and donations of cash and products as part of the company’s corporate social responsibility efforts.

Looking ahead, China Mengiu expects revenue growth to be maintained at the double-digit level with a 30-50 basis points expansion in operating profit margin for 2H2020. The company’s 2H2020 earnings recovery is dependent on its ability to mitigate cost pressures, optimize product mix and integrate recent acquisitions.

Cost Pressures

As highlighted above, China Mengniu incurred certain one-off costs relating to the coronavirus pandemic such as additional marketing expenses to clear excess inventories, which are not likely to be repeated in 2H2020. With China Mengniu noting in its June 8, 2020 announcement that the “inventory levels of the Group have resumed to a healthy level”, promotional activities and product discounts are likely to be toned down in 2H2020 leading to cost savings for the company.

On the flip side, China Mengniu is still expected to suffer from cost pressures in 2H2020, especially relating to raw milk.

According to a DBS Group sell-side research report on the China dairy market published on June 10, 2020, “raw milk prices have seen a stable m-o-m (month-on-month) recovery since Mar’20” with expectations that raw milk prices will “see steady improvements along with the recovery in consumption demand” in 2H2020. This is consistent with China Mengniu’s comments at the company’s FY2019 earnings call on March 26, 2020 that

As an indication of the impact of raw milk prices on the company’s profitability, China Mengniu replied that “we have to look at the overall milk price trend in China to determine that” in response to a question at its FY2019 earnings call on expectations of medium term profitability.

Also, there could be misguided expectations that China Mengniu’s marketing expenses could be lower in FY2020, because of the suspension or deferral of large-scale sporting events such as the Tokyo Olympics. Advertising costs relating to brand building and new products are likely to remain elevated, even in the absence of major sporting events, considering other marketing channels like television and online ads.

Product Mix Optimization

China Mengniu generated 85.9% of the company’s FY2019 revenue from its liquid milk segment, of which UHT (Ultra-High Temperature) milk is the biggest sales contributors.

There are opportunities for China Mengniu to expand its overall profit margin by increasing the revenue contribution of other higher-margin dairy products, which includes fresh milk and organic milk under the liquid milk segment, infant formula products, and cheese & plant-based nutritional food products.

Using fresh milk products as an example, China Mengniu achieved over RMB700 million in fresh milk product sales in FY2019, which represented a “triple-digit” YoY growth last year. China Mengniu has set a medium term goal of delivering RMB5 billion of fresh milk sales, which is reasonable considering that there is still substantial room for further market share growth. According to Nielsen research, China Mengniu only had a 7.1% market share of the fresh milk products market in China in 2019, while the company has in excess of 20% market share in the UHT milk products and chilled yogurt products markets in the country.

China Mengniu is also capitalizing on the product premiumization trend in China. The company’s high end fresh milk products sold under the Shiny Meadow brand saw a five-fold increase in revenue in FY2019. China Mengniu refers to the Shiny Meadow brand as “No.1 in the high-end fresh milk sub-category”, and the company aims to grow Shiny Meadow’s sales contribution as a percentage of total fresh milk sales from 30% in FY2019 to 35% in FY2020.

The extent of China Mengniu’s earnings recovery in 2H2020 will be dependent on the company’s to optimize its product mix for improved profitability.

M&A Integration

China Mengniu also made two key acquisitions recently. These include Australian dairy and beverage company, Lion-Dairy & Drinks Pty Ltd and Australian infant formula company, Bellamy’s Australia Limited. The acquisition of Bellamy’s Australia was completed at the end of last year, while the acquisition Lion-Dairy & Drinks Pty Ltd is expected to be concluded by the first half of this year.

At the company’s FY2019 results briefing on March 26, 2020, China Mengniu noted that “we are already making plans about business integration and synergies” with respect to the recent acquired companies, Bellamy’s Australia and Lion-Dairy & Drinks. It remains to be seen if China Mengniu can integrate these newly-acquired companies successfully and realize the relevant acquisition synergies in time to come.

Notably, the integration of Bellamy’s Australia and Lion-Dairy & Drinks is expected to further improve China Mengniu’s product mix and profitability going forward, as both companies offer significant exposure to the premium product categories. Lion-Dairy & Drinks is the market leader in Singapore’s premium yogurt market accounting for more than half of the segment’s sales, while Bellamy’s Organic (from Bellamy’s Australia) is a well-known premium infant formula brand in Australia.

Valuation

China Mengniu is valued by the market at 26.1 times trailing twelve months’ P/E and 34.4 times consensus forward next twelve months’ P/E based on its share price of HK$30.40 as of June 22, 2020. As a comparison, the stock’s historical five-year and 10-year mean consensus forward next twelve months’ P/E multiples were 21.9 times and 22.0 times, respectively.

China Mengniu offers consensus forward FY2020 and FY2021 dividend yields of 0.7% and 1.0%, respectively.

Risk Factors

The key risk factors for China Mengniu include weaker-than-expected revenue growth in 2H2020, greater-than-expected cost pressures being a drag on the company’s profitability, a failure to optimize its product mix, and unexpected challenges in integrating recent acquisitions.

Note that readers who choose to trade in China Mengniu shares listed as ADRs on the OTCBB (rather than shares listed in Hong Kong) could potentially suffer from lower liquidity and wider bid/ask spreads.

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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.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.