Yili:Improved margins in 1Q17

Decent growth momentum in 1Q17.In 1Q17, Yili recorded revenue growth of 3.03% YoY, a decent improvement over the 0.41% YoY in FY16. Gross profit grew 10.49% YoY, while net profit (to shareholders of the Company) rose 11.58% YoY. Growth momentum in 1Q17 suggests adecent recovery.

Continued margin expansion. Although GPM declined slightly from 38.25% in FY16 to 37.93% in 1Q17; NPM improved from 9.34% in FY16 to 10.98% in 1Q17; OPM expanded from 8.56% in FY16 to 12.15% in 1Q17. The margin improvement can be attributed to the lower SG&A/sales ratio (FY16: 28.99% vs. 1Q17: 25.03%). In 1Q17, ROAA increased from 3.9% in 1Q16 to 4.24%while ROAE was 7.24% vs. 7.42% in 1Q16.

Terminating Shengmu acquisitionreduces M&A execution risk.The Group announced its decision to terminate the Shengmuacquisition. Meanwhile,Mengniu’s acquisition of Modern Dairy is in the final stage. We believe Yili’s decision would reducethe related M&A execution risk.

The Group has signaled to focuson the downstream business by disposing all of its upstream business in FY16. In addition, the upstream business is turning less attractive as upstream dairy market remainsfragmented and imported milk powder continues to exert pressure on domestic raw milk price. The changing business models of industry leaders.Recent actionstaken by Yili and Mengniu show divergent management philosophies between the two. Mengniu is buildingan integrated model to enhance its product quality managementwhile Yili chooses to focus on brand buildingand downstream product development.In our view, Yili’s consumer-orientedstrategy would allow it to gain a strongerfoothold in the highly competitive consumer market in China.

Reiterate BUYwith TP at RMB 21.3.Growth and profitability outlook for the Group in FY17remainsdecent based on its results in 1Q17.Termination of the Shengmu acquisition would benefit the Groupby reducing the M&A execution risk in near term.We reiterate BUY. Our current TP represents FY17E/18E P/E of 20.55x and 17.28x and FY17E/18E P/B of 3.72x and 3.38x.

Risk factors: 1) Macroeconomicrisk; 2)Commodity pricerisk; 3)Foodsafety risk; 4)Investment risk