China Modern Dairy:Receiving support from Mengniu

Event

China Mengniu Dairy Company (2319 HK, HK$14.86, Neutral, TP: HK$13.30)and China Modern Dairy (CMD) jointly announced before market open thismorning that Mengniu entered a sales and purchase agreement with SuccessDairy II (i.e KKR and CDH) to acquire 965.5m CMD shares, i.e 16.7% ofCMD, for HK$1.87bn, i.e. US$241.5m, or HK$1.94/sh. This triggered amandatory general offer (MGO) whereby Mengniu must offer HK$1.94/sh forup to 90.8% of CMD shares post MGO. We view the move as more beneficialto CMD than Mengniu as Mengniu is committing to helping out CMD’soperations and it also removes uncertainty about CMD’s KKR/CDH deal.

Impact

Stronger support from Mengniu a positive. In addition to Mengniu mgmt’scomments on the transaction, CMD CEO, Ms. Lina Gao, added that 1) thetransaction has gained the support of both Mengniu’s and CMD’s boards,2) Mengniu will maintain CMD’s listed company status and CMD will be ableto ensure stable sales via a strengthened relationship with Mengniu and3) both companies have similar corporate cultures and have been cooperatingsince 2006. We view Mengniu’s controlling stake as positive for CMD as itillustrates Mengniu’s majority shareholder COFCO’s determination to have agood relationship between dairy upstream and downstream companies.

KKR and CDH to exit CMD. As Success Dairy II (i.e KKR& CDH) hasdecided to sell its CMD stake to Mengniu, both KKR and CDH will exit CMDentirely after the transaction is completed. KKR and CDH will also resign fromCMD’s board where they currently have two board seats. Given that KKR&CDH have decided to exercise investor option (see report here), CMD isexpected to issue 488m CMD shares along with a cash top-up amount ofUS$13.4m (i.e HK$104.2m) to KKR& CDH. As highlighted earlier, we arepositive on this as CMD will no longer be subject to the valuation adjustmentmechanism it originally agreed upon with Success Dairy II.

Upstream value in the spotlight and potential synergies in downstream.As noted in our Mengniu report, we believe this transaction emphasizes thevalue of a stable upstream raw milk source and CMD is well positioned tobenefit from a growing need for high quality milk as it is the largest domesticdairy farm. Mgmt also noted that a deepening collaboration with Mengniushouldn’t hurt its raw milk ASP as Mengniu’s raw milk procurement price hasbeen higher than other large dairy companies. CMD should also be able toleverage Mengniu’s extensive sales and distribution network to improve itsown brand business.