Yili:Slower momentum,higher profitability

Yili’s revenue growth stalled in 1H16; to meet its annual growth target, revenue would need to grow by ~8.95% YoY -not an easily achievablegoal in our view

Improving profitability, rate of return, and working capital management demonstrate the Group’s higher operational efficiency

The Group’s change in portfolio mix raises concerns on product concentration risk

Downgrade to HOLDdue to the murky outlook; TP at RMB 17.61

Growth momentum stalled in 1H16.Yili’s revenue in 1H16 edged downby 0.21% YoY, indicating that its 2Q16 revenuedeclined by2.63% YoY. For segment revenue, liquid milk grew 4.78% YoY, while chilled products and milk formula declined by 1.98% YoY and 24.05% YoY. According to Yili, its 1H16 market share in the dairy product market was ranked first at 20.1%; market shares of its liquid milk and milk formula segments were 30.9% and 4.9%. We believe the stagnant growth in 1H16 was caused by Mengniu’s gain in the market.

Profitability continued to improve.Although Yili’stop-line growthlost momentum in 1H16, bottom lineincreased. Core gross profit and net profit grew by 12.34% YoY and 20.63% YoY, mainly due to the benefits from reduced cost of sales and lower financial costs. However, operating profit declinedby 5.62% YoY, reflecting the stiffening competition thatdrove up the Group’s S&D expenses in 1H16. CoreGPMand NPM improved to 39.53% and 10.67% (1H15: 35.31% and 8.83%). ROAA and ROAE went upto 8.65% and 15.9%(1H15: 6.76% and 14.08%). The improved profitability and return shows that itwas able to raiseoperating efficiency regardless oftheadverse situation.

Subtle change in product portfolio raises concern.In 1H16, Yili’s core revenuecontribution from the liquid milk segment was 79.97%, which was similar to FY15. But the core revenue contribution from milk formula segment declined to 8.62%from 1H15’s 11.4%, which may be the result offierce competitionand lower demandin China’s milk formula market. It is hard to tell whether the Group is moving awayfrom the balanced product mix model to focus onthe liquid milk product.Heavy dependenceon any single product category is strategically dangerous, however.

Murky outlook ahead.The 1H16 results of Yili and Mengniu, the two dairy giants in China, demonstrate the increasing complexity in China’s consumer market. In addition, to achieve its annual revenue growth target of ~2.04% YoY, Yili face greater pressure to boost its performance as it needs to achieve revenue growthof ~8.95% YoY in 2H16.Moreover, recent changes in shareholding structure and halting of share trading raiseconcernsover the possibilitythat Yili may suffer from financial andmanagement disturbances that could potentially distract it from business development.

Downgrade to HOLD; TP at RMB17.61.In our view, the uneven performance of Yili and Mengniu in 1H16 drive us toadjust down the revenue growth outlook. Based on its increased profitability, webelieve Yili’sperformance would improveswiftlyonce growth momentum is restored. We downgrade the Group’s rating to HOLDand raise our TP to RMB 17.61, which represents 2016E P/E and 2017E P/E of 21.24x and 18.01x, and 2016E P/B and 2017E P/B of 4.66x and 4.52x.