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Morningstar | Yili’s 3Q Profit Slightly Misses due to Lower Margins; Cutting FVE to CNY 25.50. See Updated Analyst Note from 01 Nov 2018

Although top-line growth was in line with our forecast, narrow-moat Inner Mongolia Yili Industrial, or Yili, posted a worse-than-expected net profit in the third quarter. Revenue was up 13% year on year to CNY 21.3 billion, driven by strong volume growth of high-end liquid milk and yogurt products, coupled with robust demand in the lower-tier regions. However, the firm’s gross margin was hit by higher raw milk prices and an intensifying pricing war during the period, despite the operating expense ratio improving a bit from last quarter. As a result, net profit grew merely at 1.8% year on year to CNY 1.6 billion, lower than our 6% growth forecast.

We expect to see raw milk price continue to lift for 2019 and the margins will be under pressure in the short term. From the long-term perspective, we think Yili’s gross margin will further improve from current levels, on the back of better product mix and price hikes, underpinned by strong competitive advantages.

We are trimming our fair value estimate for Yili by 6% to CNY 25.50 per share from CNY 27, as we lower its earnings on a lower margin outlook. We now anticipate the company’s revenue and net profit to grow at a CAGR of 9.4% and 9.8%, respectively, through 2022, with gross margin and operating margin averaging at 37.4% and 8.7%, respectively. We think the shares are slightly undervalued at current levels, as they are 13% lower than our new fair value estimate.

On the bright side, we think Yili’s leading position was further enhanced as it continuously gained market share from other smaller players in the third quarter, given its higher sales growth compared with the industry. Market share of room-temperature and low-temperature liquid milk was up 2.7 and 0.9 percentage points, respectively, to 36.9% and 17.2% by the end of third quarter. Infant formula powder also gained 0.6 percentage points in market share to 6.2%, the highest among the domestic dairy companies.

On the revenue front, room-temperature dairy products rose at a double-digit rate, boosted by strong sales growth of high-end products, such as Ambrosial (up 30%) and Satine (up 20%) amid the ongoing premiumization trend, while low-temperature dairy products only grew at single-digit pace, due to escalating competition in the yogurt segment, as well as substitution effect from room-temperature yogurt.

Margins were lower than our forecasts for two consecutive quarters. Gross margin dropped 2.5 percentage points year on year to 35.8% in the third quarter, dragged by the 4%-5% higher raw milk costs, while the average selling price was flat due to pricing competition, despite better product mix. Operating margin was 9%, 90 basis points lower than the year-ago quarter, thanks to effective reduction in the operating expense ratio.