China Consumer Staples:Look beyond near-term Dairy woes;Mengniu profit warning

Mengniu FY16 profit warning a surprise

On Dec 15, Mengniu issued a profit warning stating that in 2016 it willshow a substantial loss due to: (1) Infant milk formula (IMF) sub Yashili'sgoodwill impairment; and (2) disposal loss on excessive sprayed milkpowder inventory (mgmt. estimate Rmb600mn). While the impairment hadbeen expected by the market, the magnitude was a surprise to us. Weestimate Mengniu will record Rmb3.0-3.5bn impairment losses for 2016(this compares to its 2015 net profit of Rmb2.3bn). We revise our 2016reported EPS to Rmb(0.23) from Rmb0.50 and recurring EPS by -8% fromRmb0.59 to Rmb0.54 due to higher COGS from #2 above, and view #1 as aone-off. Our 12-month target price has not changed under our 2018EEV/GCI vs. CROCI/WACC framework and remains HK$17.8; retain Buy.

Mengniu new CEO’s initiatives: focus on improving efficiency

New CEO Mr. Lu Minfang has also set out his reform plan. Key initiatives:1) streamline headquarters and offer wide decision-making autonomy toeach business unit and 2) centralize procurement. For #1, each businessunit will now have independent P&L metrics internally, enabling businessdecision making (e.g. large scale marketing campaign) without seekingapproval. For #2, the company plans to procure all its milk under the sameplatform and increase the use of imported milk powder for low-end UHTmilk. We think the initiatives will allow Mengniu to more quickly adapt tomarket conditions and improve operational efficiency. 2017 Guidance:Mengniu's priority is profit growth. It aims to maintain higher than industrysales growth while also focusing on improving profit margins. We seesome gross margin upside from using lower-cost milk powder inventoryand as industry prices fall in 2017. We have already built some marginexpansion into GPM.

IMF competition still intense, CMD raw milk price upside limited

We think Yashili's unfavorable result plus weak results from peers (Yili [Buy],Biostime [Neutral], Beingmate [NC]) indicate the IMF market still facesintense competition in next 6 months. Mengniu’s new procurement policyimplies more stable volume for China Modern Dairy (Neutral) (Mengniubuys 70% of CMD’s milk), but we see limited upside risk for raw milk pricesas Mengniu shifts toward market pricing and a focus on gross margins.