Company Reports

Its modest top-line trend remained as the primary drag to wide-moat Yili’s fourth-quarter 2023 and first-quarter 2024 results. The company decided to reduce channel inventories during the first quarter, which led to a sluggish top-line trend for liquid milk. We think this implies weaker-than-expected sell-out during Lunar New Year, which is supposed to see firm festive demand. We lowered our 2024 revenue projection by 4% to factor in the near-term headwind and think liquid milk sales could remain soft before a turnaround in the fourth quarter. Management also acknowledged the need to increase channel expenses for channel inventory reduction. Despite lower sales and higher expenses, the one-off investment income of CNY 2.58 billion due to the sale of a subsidiary’s shares in the first quarter boosted our 2024 net income projection by over 20%. However, our 2025-27 earnings forecasts are largely unchanged, and we retain our fair value estimate at CNY 36 per share, which implies 17 times 2024 price/earnings, 15 times EV/EBITDA, and a 4.0% dividend yield.

Yili is the largest dairy producer in China, having overtaken Mengniu in revenue and market share in the early 2010s. It has strategically targeted the ultra-high-temperature milk and yogurt segments, given the still underdeveloped cold-chain logistics in China, when dairy consumption and penetration were on its rise. The company’s nationwide distribution network has created scale and operational efficiencies have led to favorable working capital arrangement, which bolster its competitive advantage in a commoditized category. In our view, Yili is well aware that Chinese consumers expect quality and reliability from domestic dairy products following past industry scandals. As a result, the company has steered its product innovation and marketing efforts toward emphasizing functionality and nutrition value, which would also be conducive to increasing customer spend on its products. Yili has the highest number of patents in the dairy industry in China and has set up overseas research and development centers, which serve to enhance its competitiveness among peers in the long term. We think the company has fortressed a virtuous cycle of solid R&D, competitive offerings, scalable distribution and efficient operations.

We trim our 2023-24 earnings forecasts for wide-moat Yili and narrow-moat Mengniu by 4%-15% as we expect only a mild recovery in China's dairy demand. We project the liquid milk segments of both companies to grow in the low to mid-single digits in 2024, while Mengniu continues to slightly outpace Yili. Although the raw milk price is set to trend lower in 2024 and will benefit margins, this also increases the likelihood of price competition from smaller players.

Yili is the largest dairy producer in China, having overtaken Mengniu in revenue and market share in the early 2010s. It has strategically targeted the ultra-high-temperature milk and yogurt segments, given the still underdeveloped cold-chain logistics in China, when dairy consumption and penetration were on its rise. The company’s nationwide distribution network has created scale and operational efficiencies have led to favorable working capital arrangement, which bolster its competitive advantage in a commoditized category. In our view, Yili is well aware that Chinese consumers expect quality and reliability from domestic dairy products following past industry scandals. As a result, the company has steered its product innovation and marketing efforts toward emphasizing functionality and nutrition value, which would also be conducive to increasing customer spend on its products. Yili has the highest number of patents in the dairy industry in China and has set up overseas research and development centers, which serve to enhance its competitiveness among peers in the long term. We think the company has fortressed a virtuous cycle of solid R&D, competitive offerings, scalable distribution and efficient operations.

Wide-moat Yili’s third-quarter earnings exceeded our profit estimates, despite a slight miss in revenue. A rebound in liquid milk sales and control in selling expenses drove the margin beat. We moderately lower our 2023 revenue estimate, which was slightly below management guidance. Yili’s share price has lagged due to investors’ concern over premium dairy demand amidst tight consumer wallets. But we think the company’s competitive advantage in distribution remains intact. Improved third-quarter results could lift near-term sentiment, but we think liquid milk revenue growth may soften in the fourth quarter. Our fair value estimate remains CNY 40 per share, which implies 24 times 2023 price/earnings, and we continue to see shares as undervalued.

Wide-moat Inner Mongolia Yili and narrow-moat China Feihe posted interim results that were broadly in line with our estimates. Sales growth for both was hurt by soft demand in the infant milk formula, or IMF, sector, due to low birthrates and inventory clearance of products under the old national standards. This is consistent with earlier results revealed by a2 Milk Company. Yili and Feihe management teams are optimistic about the second-half trend. Feihe said its excess inventory was mostly cleared in the first half, while Yili updated its full-year top-line and net margin guidance to mid-single-digit growth and 30 basis points of improvement, respectively. Top-line guidance is consistent with our estimates, but we continue to see difficulty in reaching the guided margin.

With weaker-than-expected dairy and infant milk formula demand, we lower our 2023 revenue and profit projections for wide-moat Yili and narrow-moat Mengniu ahead of first-half earnings. We think sluggish consumer sentiment will persist for longer, hurting demand for premium liquid milk products. Infant milk formula, or IMF, sales are also set to slow for both companies, due to headwinds from a low birthrate in 2023. Yili has larger exposure to IMF than Mengniu. We think it would be difficult for both companies to reach their full-year profit guidance, given soft consumer confidence and elevated channel spending. Our fair value estimate for Yili slides to CNY 40 from CNY 42, and for Mengniu to HKD 36 from HKD 39.

Yili is the largest dairy producer in China, having overtaken Mengniu in revenue and market share in the early 2010s. It has strategically targeted the ultra-high-temperature milk and yogurt segments, given the still underdeveloped cold-chain logistics in China, when dairy consumption and penetration were on its rise. The company’s nationwide distribution network has created scale and operational efficiencies have led to favorable working capital arrangement, which bolster its competitive advantage in a commoditized category. In our view, Yili is well aware that Chinese consumers expect quality and reliability from domestic dairy products following past industry scandals. As a result, the company has steered its product innovation and marketing efforts toward emphasizing functionality and nutrition value, which would also be conducive to increasing customer spend on its products. Yili has the highest number of patents in the dairy industry in China and has set up overseas research and development centers, which serve to enhance its competitiveness among peers in the long term. We think the company has fortressed a virtuous cycle of solid R&D, competitive offerings, scalable distribution and efficient operations.

Wide-moat Yili reported 2022 and first-quarter 2023 results that largely met our expectations and, in our view, assured the market of its ability to navigate a challenging operating environment. The stock, which we perceived to be undervalued for some time, reacted positively following the report. We moderately raised our sales and profit estimates for the full year and retain our fair value estimate at CNY 42 per share, which implies 24 times 2023 P/E and is in-line with its 5-year average. We believe the stock continues to be undervalued and the company is on track to see earnings rebound in 2023.

Yili is the market leader in China’s dairy processing market, having overtaken Mengniu in revenue and market share in the early 2010s. It has strategically targeted the ultra-high-temperature milk and yogurt segments, given the still underdeveloped cold-chain logistics in China, when dairy consumption and penetration were on its rise. The company’s nationwide distribution network has created scale and operational efficiencies have led to favorable working capital arrangement, which bolster its competitive advantage in a commoditized category. In our view, Yili is well aware that Chinese consumers expect quality and reliability from domestic dairy products following past industry scandals. As a result, the company has steered its product innovation and marketing efforts toward emphasizing functionality and nutrition value, which would also be conducive to increasing customer spend on its products. Yili has the highest number of patents in the dairy industry in China and has set up overseas research and development centers, which serve to enhance its competitiveness among peers in the long term. We think the company has fortressed a virtuous cycle of solid R&D, competitive offerings, scalable distribution and efficient operations.

Wide-moat Yili's third-quarter results were well below our forecasts because of lackluster consumer sentiment. Liquid milk sales declined year on year during the quarter while selling expenses remained elevated, suppressing net profit significantly. Growth in other subsegments were unable to offset liquid milk weakness. Similar to the brewers, we think dairy manufacturers will face headwinds over the next few quarters as squeezed consumer pockets continue to weigh on product mix. We have lowered our topline and net profit estimates for 2022 and 2023, with the assumption that a sluggish economy would reduce demand for high-end liquid milk in the next few quarters. We lowered our fair value estimate to CNY 42 per share, from CNY 46 per share, accordingly and believe short-term sentiment on the stock will be weak. Signs of recovery in consumer trade-up would be a key catalyst in our view.

Yili is the market leader in China’s dairy processing market, having overtaken Mengniu in revenue and market share in the early 2010s. It has strategically targeted the ultra-high-temperature milk and yogurt segments, given the still underdeveloped cold-chain logistics in China, when dairy consumption and penetration were on its rise. The company’s nationwide distribution network has created scale and operational efficiencies have led to favorable working capital arrangement, which bolster its competitive advantage in a commoditized category. In our view, Yili is well aware that Chinese consumers expect quality and reliability from domestic dairy products following past industry scandals. As a result, the company has steered its product innovation and marketing efforts toward emphasizing functionality and nutrition value, which would also be conducive to increasing customer spend on its products. Yili has the highest number of patents in the dairy industry in China and has set up overseas research and development centers, which serve to enhance its competitiveness among peers in the long term. We think the company has fortressed a virtuous cycle of solid R&D, competitive offerings, scalable distribution and efficient operations.

Wide-moat Yili delivered resilient first half results that were in-line with our estimates, with double-digit growth of revenue and net profit. Robust sales growth in ice cream and share gain in milk powder more than offset flattish liquid milk sales. Yili's success in milk powder also drove faster company sales growth than peers as well as year-on-year improvement in gross and net margin levels. Management set a cautious tone for sales recovery of liquid milk in the third quarter, although it maintained the full year company sales and profit guidance set out in April. We note the pace of premiumization for liquid milk could slow in the near term, but Yili's competitive advantages versus peers, such as stronger operational efficiencies and scalable distribution network, remain unchanged.

Yili reported full-year 2021 and first-quarter 2022 results, with 2021 revenue in line with our forecast but net profit slightly missing our estimates. First-quarter revenue and net profit increased 14% and 24% year on year, respectively. We slightly lowered our liquid milk gross margin assumption to account for higher operating costs with elevated commodity prices and the recent COVID-19 resurgence in China. But the expected stable trend of raw milk prices in 2022 should place Yili at a more advantaged position versus other consumer staples companies. The consolidation of Ausnutria from the second quarter onwards should also lift Yili’s gross and net margins. We project 2022 net income to grow 20% year on year and net margin to reach 8.0%. We retain our CNY 46 fair value estimate and reiterate our view that the shares are attractive at their current level.

Yili is the market leader in China’s dairy processing market, having overtaken Mengniu in revenue and market share in the early 2010s. It has strategically targeted the ultra-high-temperature milk and yogurt segments, given the still underdeveloped cold-chain logistics in China, when dairy consumption and penetration were on its rise. The company’s nationwide distribution network has created scale and operational efficiencies have led to favorable working capital arrangement, which bolster its competitive advantage in a commoditized category. In our view, Yili is well aware that Chinese consumers expect quality and reliability from domestic dairy products following past industry scandals. As a result, the company has steered its product innovation and marketing efforts toward emphasizing functionality and nutrition value, which would also be conducive to increasing customer spend on its products. Yili has the highest number of patents in the dairy industry in China and has set up overseas research and development centers, which serve to enhance its competitiveness among peers in the long term. We think the company has fortressed a virtuous cycle of solid R&D, competitive offerings, scalable distribution and efficient operations.

The recent acceleration in commodity prices as a result of the Russia-Ukraine conflict has exacerbated the margin pressure on packaged food companies brought about by supply disruptions throughout 2021. Various food and beverage companies in China have engaged in price hikes since the third quarter last year to mitigate margin compression. We continue to highlight Yili as our top pick, with our fair value estimate at CNY 46 per share, as we think the premiumization trend and continued penetration of dairy products in China are unchanged. The raw milk cost curve continued to moderate in early March, which should mitigate margin pressure observed since the second half of 2021. Robust sales reported for January and February at 15% growth year on year also confirm our constructive view. We expect categories with more room to maneuver on premiumization and higher concentration of share to command stronger pricing power and face lower margin pressure in the near term.

We reinitiate coverage of Inner Mongolia Yili Industrial Group, or Yili, and and China Mengniu Dairy, or Mengniu, with updated wide and narrow moat ratings, respectively. Yili is our top pick from the two as it offers the most upside to our valuations. We think Yili’s share price is overshadowed by recent raw milk price hikes but the company’s long-term competitive advantages remain intact in our view.

Yili is the market leader in China’s dairy processing market, having overtaken Mengniu in revenue and market share in the early-2010s. It has strategically targeted the ultra-high-temperature, or UHT, milk and yogurt segments, given the still underdeveloped cold-chain logistics in China, when dairy consumption and penetration were on its rise. The company’s nationwide distribution network has created scale and operational efficiencies have led to favorable working capital arrangement, which bolster its competitive advantage in a commoditized category. In our view, Yili is well aware that Chinese consumers expect quality and reliability from domestic dairy products following past industry scandals. As a result, the company has steered its product innovation and marketing efforts toward emphasizing functionality and nutrition value, which would also be conducive to increasing customer spend on its products. Yili has the highest number of patents in the dairy industry in China and has set up overseas R&D centers, which serve to enhance its competitiveness among peers in the long term. We think the company has fortressed a virtuous cycle of solid R&D, competitive offerings, scalable distribution and efficient operations.

We are putting Inner Mongolia Yili Industrial Group under review, pending a change in analyst. We will re-initiate on July 31, 2021.

Narrow-moat Inner Mongolia Yili’s 17% year-on-year growth in recurring earnings in the third quarter was in line with our projection. Despite pressure on the gross margin from raw milk prices, the EBIT margin increased by 1.1 percentage points, thanks to a lower selling expenses/sales ratio. As demand picks up and raw milk supplies remain constrained, we expect raw milk prices are likely to rise over the next 12 months. That said, Yili’s strong competitive advantages should help to lift its operating margin in the medium term, buoyed by a better product mix, improving production efficiency, increasing inputs from overseas, and a more cost-efficient marketing strategy. Thus, we retain our fair value estimate at CNY 36.50 per share and view the shares as fairly priced at current levels.