China Mengniu Dairy:Still status quo post stake increase

Event

Mengniu and China Modern Dairy (CMD, 1117 HK, HK$1.81, Neutral, TP:HK$1.74) jointly announced before market open this morning that Mengniuhas entered a sales and purchase agreement with Success Dairy II (i.e KKRand CDH) to acquire 965.5m CMD shares, i.e., 16.7% of CMD, forHK$1.87bn, i.e. US$241.5m, or HK$1.94/sh. This triggered a mandatorygeneral offer (MGO) at HK$1.94/sh whereby Mengniu may own up to 90.8%of CMD shares post MGO. We view the move as more beneficial to CMD thanMengniu as Mengniu is committing to helping out CMD’s operations and italso removes uncertainty about CMD’s KKR/CDH deal.

Impact

Increasing CMD stake at reasonable valuation. The offer price ofHK$1.94/sh and fully diluted CMD share count of 6,131m shares implies 25xand 22x FY17/ FY18 P/Es, respectively. Mengniu currently owns 25.4% ofCMD and will own 39.9% of CMD shares after the transaction is complete.

Mengniu may own up to 90.8% of CMD shares post MGO and CMD willmaintain its listed status. The deal is expected to close by mid-March. Wethink Mengniu is adding to its CMD stake at a reasonable valuation as theoffer price represents a 7% premium to CMD’s 4th Jan 2017 close price and itwill finance the share purchase & MGO via internal and external financing.

Secure raw milk supply from a better Mengniu and CMD relationship.The key reasons are: 1) Mengniu will better secure stable and high quality rawmilk supply via CMD to expand its high-end dairy product offering, 2) Mengniuwill be able to leverage CMD’s nationwide dairy farm footprint to develop itslow-temperature dairy products and 3) Better vertical integration to improveoperational efficiency. While we agree with Mengniu’s move to increase itsCMD stake; we expect to see limited earnings contribution from CMD in thenear term. Based on Mengniu’s 39.9% CMD stake post share purchase butbefore the MGO, CMD will contribute 6.6% and 7.4% to Mengniu’s FY17/FY18 earnings respectively from 4.2% and 4.7% currently.

Downstream remains key focus with strategic position in upstream. Management has emphasised that it will remain focused on the downstreambusiness where it has experience, expertise and resources. In terms of A&Pspending, it will continue to invest more in brand building and less inpromotional expenses in sales channels. Meanwhile, the company won’t takean active role in the dairy upstream business but instead maintain a strategicposition in CMD. This transaction reaffirms our view that upstream continuesto be more attractive than downstream in consumer staples space.