Mengniu:Topline growth beat Yili’s at the expense of profitability

Mengniu’s 1H16 revenue growthimproved significantlywith liquid milk as the biggestgrowth driver. The Group’s leadership positionhas been consolidatedfurther

Bottom line suffered due to increasedS&D expenses, showing the Group’s topline growth was partially driven by heavier promotions. This castsdoubtson the sustainability of growth momentum

The lack of new product innovation, underwhelming performance of the milk powder segment, andthe lackluster consumer market environment would continue to weigh on the Group’s share price

TP adjustedtoHK$ 14.53to reflect higher revenue growth; maintain HOLD

Growth at the expense of profitability.Mengniu’s 1H16 revenue grew by 6.62% YoY, with liquid milk as the major growth driver (+8.30% YoY). However, the Group’s profitability declined with its OPM and NPM falling from 5.76% YoY and 5.24% YoY in 1H15 to 5.60% YoY and 3.95% YoY in 1H16. We believe the Group was trading profitability for higher growth and a bigger market share, which is damaging to shareholders in the long term.

Overreliance on liquid milk segment presents risk. In 1H16, the Group’s liquid milk products contributed to 87.18% of total sales (1H15: 85.83%), and the UHT milk product contributed to 42.24% of total sales (1H15: 41.90%). According to the Group, its marketshare of liquid milk and UHT milk improved to 27.4% and 28.4%in 1H16from27.1% and 27.5% in 2H15. Yet, the milk formula segment, whose revenue declined by 6.92% YoY and contributedto6.09%to total, continued to disappoint due to the lackof a turnaround in Yashili’s business amid unfavorable industrysentiment. Higher reliance on liquidmilk, especially the UHT milk, presents a major risk to theGroup.

Working capital management -a mixed picture.Management of working capital improvedas CCC declined to -3.39 days compared to 1.95 days in 1H15. However, the Group’s payable turnover days increased to 58.03 in 1H16 from 54.02 in 1H15, showing difficulties in making on-time payment to suppliers amid the tough market condition. The extension of receivable turnover days to 15.22 may mean increased leniency to distributors to boostproductsales.

A mixed outlook with uncertainties.We believe intensifying competition in the dairy product markets would dampen the growth outlook for industry players. Thepractice of trading profitability for growth is risky and the limited, short-term gain would not compensate for the downside associated with the lack of progress in balancing product portfolio or reforming distribution channels. In addition, the recent managementchange would be a risk factor as the new CEO, Mr. Minfang Lu, who was the former CEO of Yashili, has a rathershort and, in our opinion, lackluster track record.

Maintain HOLD with TPof HK$ 14.53.We revise the Group’s valuation based onits mixedperformancein revenue growth and profitability.We remain cautiously optimistic on the Group’s outlook and set TP at HK$ 14.53, whichrepresents24.13x 2016E P/Eor 25.57x 2017E P/E,and 2.09x 2016E P/Bor 1.98x 2017E P/B. MaintainHOLD.