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Morningstar | Mengniu’s 2018 Results Beat Our Forecasts; Raising FVE to HKD 20.50 On Higher Profit Growth Forecast

No-moat China Mengniu Dairy’s 2018 full-year net profit, up 49% year on year, was better than we expected, driven by strong mid-teens revenue growth and operating margin improvement through new premium product launches and sales channel penetrations into lower-tier markets, along with brand building investments. We’re raising our fair value estimate to HKD 20.50 per share from HKD 18.50, as we revise up our earnings growth forecast from a sustainable top-line growth and margin expansions on the back of the growing premiumization trend, along with the lower stage 2 investment rate. However, we think the market’s prospects for the company’s revenue growth and margin expansion are too bullish, and view the shares as overvalued at current levels.

Revenue growth of 14.7% was stronger than our 12% forecast. The largest business (86% of total sales) liquid milk increased 12%, while the ice cream and milk powder segments grew 8.4% and 49%, respectively. Liquid milk sales growth was driven strong volume growth of high-end UHT milk and yoghurt products. We were more surprised by the promising growth of the milk powder business and attributed the upbeat results to the benefits of the new infant formula registration policy which squeezed out other smaller brands. Our view remains positive over the milk powder business and we expect growth to be sustained at mid-teens rates in the medium term. We are not concerned about slowing economic growth that is dampening demand, given the volume consumption per capita is still low in China, particularly in lower-tier regions, and the category still has room for volume growth.

We expect Mengniu will continue to grow faster than the industry and retain its second largest market share position in the medium- to long term, with the gap widening further, compared with other competitors. We anticipate Mengniu’s revenue growth to be maintained at 10% over the next five years, slightly lower than in 2018.

Despite increased raw milk prices in the second half of 2018, the gross margin increased 2.2 percentage points to 37.4%, owing to a better product mix. Operating expense/sales ratio was up 2.6 percentage points, due to one-off marketing expenses for World Cup in the first half, and that ratio came down to a normalized level in the second half. Operating margin increased 70 basis points from last year to 5.6%, which was about 50 basis points higher than our forecast.

Because we don’t expect to see an intensifying pricing war, we estimate the operating margin will improve further, from a better product mix, more contribution from the premium products, and lower costs to sales ratio for marketing and advertising. With lower losses recognized from the associate China Modern Dairy in 2018, net profit increased 49% year on year. Excluding the noncore business, earnings were up 30%, which was still better than our estimates. We anticipate the upstream business is likely to turn profitable in 2019 because raw milk prices are expected to grow moderately, leading to more upside in Mengniu’s profits.