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Morningstar | Higher Selling Expense Drags Yili’s Margin in 2Q; CNY 27 FVE Is Intact on Positive Long-Term Outlook. See Updated Analyst Note from 03 Sep 2018

Despite solid 14% top-line growth in the second quarter, narrow-moat Inner Mongolia Yili Industrial, or Yili, reported net profit of CNY 1.35 billion, down 17.5% year on year, coming in below the market’s and our projection, owing to higher-than-expected marketing and promotion costs for new product launches and advertising expenses during the World Cup games. Operating profit margin deteriorated by 3.5 percentage points from the year-ago quarter to 8%, mainly owing to a 3.9-percentage-point increase in the operating expense ratio. On the bright side, gross margin improved 90 basis points from last year to 40%, helped by favorable product mix toward higher-margin products, partly offset by higher packaging costs, while the raw milk price remained stable.

We revise up our 2018 revenue growth forecast to 14.2% from 11.6% previously, but lower our operating profit forecast to 8.8% from 9.4% previously. We reiterate our fair value estimate for Yili at CNY 27 per share and maintain our narrow-moat and stable trend ratings. Although we think Yili’s profitability will be under pressure in the short term due to higher operating expense, we think the company’s positive outlook in the long term is intact, on the back of its cost advantages and entrenched distribution network, which will allow the company to further gain market share from its competitors. We think the recent share price weakness on the higher expense ratio is overdone, and view the shares as slightly undervalued at current levels.

Revenue increased 19% year on year to CNY 39.6 billion in the first half of 2018, with the liquid milk, ice cream, and milk powder businesses growing 20.5%, 15%, and 27%, respectively, to CNY 21.9 billion, CNY 3.7 billion, and CNY 3.9 billion. Yili’s leadership in the liquid milk segment further strengthened, as its 20.5% revenue was stronger than Mengniu’s 14% sales increase during the same period. Market share was up 2.4% percentage points to 36.7%, according to Nielson’s data. The company’s flagship products, including room-temperature milk Satine and yogurt drink Ambrosial, saw an impressive 30% sales growth in the first half. Meanwhile, new products, such as upgraded products and soy milk drinks, also performed strongly, and the mix was up 5 percentage points. The promising growth of the milk powder business stemmed from the positive results of the new registration policy for infant formulas, as well as the further development in the maternity channel.

Yili’s operating profit margin in the first half decreased 1.6 percentage points to 10.5%, as a result of 2.6 percentage points increase in the selling expense ratio, offset by 90 basis points hike in the gross margin. Net profit increased only 2.4% year on year to CNY 3.45 billion.