Low per capita consumption, premiumization, production innovation and segmentation are growth drivers of China dairy sector. We expect Mengniu and Yili to gain market share further given their niches and unrivalled A&P spending. We prefer Mengniu (2319.HK, Buy) to Yili (600887.CH, Buy) on stronger profit growth outlook. We give Outperform rating to China Dairy Sector.
- Multiple growth drivers. (1) Low consumption level: China’s dairy consumption per capita is just 1/3 of global average. Low consumption level and B2B development (such as 1st.1688.com) would promote growth in lower tier cities. (2) Product innovation and segmentation: By employing technologies and upgrading flavor, function and packaging to create new product categories and develop new markets. (3) Premiumization: As income level increases, consumers are seeking quality and healthy products. Mengniu and Yili’s high-end UHT milk (Milk Deluxe and Satine) recorded better sales growth than liquid milk segment in FY18 and 1H19. (4) Rising product categories: Chilled fresh milk, cheese and plant-based milk beverages have low penetration in China.
- Top two leaders continue to gain market share. Market share of Yili and Mengniu has risen to 40% in 2018 (vs 32.2% in 2013). Distribution network, brand equity, raw milk supply, capital and R&D are barriers to competitors. Top two players have established many key product brands to grab market share through product innovation and intensive marketing. They reinvested certain gain from market share in A&P so their A&P spending gap between small players has been widening. Smaller players, whose NPM are thin, find it difficult to afford sponsoring major events and top entertainment programs.
- Mengniu (2319 HK, Buy). MN’s revenue growth accelerated in 3Q19 (vs 2Q19) driven by Milk Deluxe and Just Yoghurt. Management expects revenue growth in FY19E could beat guidance of low-teens growth but it could be challenging to achieve 0.5ppt OPM expansion due to stronger-than-expected raw milk price in 2H19E. That said, we think the guidance change should have been priced in. We forecast Mengniu to post 22% adjusted EPS CAGR (ex-Junlebao basis) from FY19E to FY21E led by above-group level growth of Milk Deluxe and Just Yoghurt, product mix upgrade, GPM improvement of ice-cream and infant milk formula segments, more disciplined discount promotion and decrease of non-A&P selling expenses ratio. Our TP of HK$37.00 is based on 28.0x FY20E P/E, in the high-end of 18-30x 1-yr forward P/E range since Mengniu resumed double-digit revenue growth in FY16.
- Yili (600887 CH, Buy). Yili is the market leader with good execution track record. The sales of its high-margin, key product brand Ambrosial grew from launch in FY13 to RMB14bn in FY18. The restricted share award scheme could keep a stable management team for next five years to develop new businesses and overseas markets. We forecast Yili to post 12% adjusted EPS CAGR from FY19E to FY21E, led by 11% revenue CAGR but stable adjusted OPM. Our TP of RMB34.04 is based on 28.0x FY20E P/E, the mid end of its 1-yr forward P/E range of 21x-36x since A-share was said to be included in MSCI Emerging Markets Index in Jun 2017.
