Corporate China
China Mengniu Dairy Company Limited
Ratings Overview
Issuer Rating ▪ Pengyuan International has assigned a first-time global scale long-term issuer LT Issuer Credit Rating BBB+ credit rating (LTICR) of ‘BBB+’ to China Mengniu Dairy Company Limited (Mengniu), with a stable outlook.
Outlook Stable ▪ Mengniu’s issuer credit rating is derived from the ‘bbb’ standalone credit profile (SACP) and a notch upward adjustment from external support assessment from its parent COFCO Corporation.
▪ Mengniu’s ratings are supported by its leading market position in China, Contents strong product diversification, established distribution channels and potential support from its parent, COFCO Corporation. The Company’s rating is Key Rating Drivers ...... 2 constrained by its limited geographic diversity and competition within the China market. Business Profile…………………....3 ▪ Mengniu engages in the manufacturing and distribution of packaged dairy Financial Profile…………………….5 products. The Company has the second largest market share of dairy Liquidity ...... 6 products in China. Mengniu is the fourth largest listed food and beverage company in China in terms of market capitalization. Company Background ...... 7
Peer comparison ...... 7 Rating Scores Summary ...... 9 Rating Outlook
Related Criteria ...... 9 ▪ The stable outlook for Mengniu reflects Pengyuan International’s expectation that the Company will be able to maintain its market position and operational strength.
▪ We would consider downgrading Mengniu’s issuer credit rating if: 1) There is a material deterioration of the Company’s operating profile. 2) There are continuous loses in market share to other competitors. 3) EBITDA Margins decreased to 6% on a sustainable basis
▪ We would consider an upgrade of Mengniu’s issuer credit ratings if: 1) Leverage measured by Debt to EBITDA drops below 2.0x on a sustainable
basis. 2) EBITDA Margins increased to 10% on a sustainable basis. 3) There was a significant strengthening in its market position
Contacts Financial Summary
Primary Analyst Exhibit 1: Financial Ratios
Name Jonathan Joseph Tai 2018A 2019A 2020F 2021F 2022F Title Analyst Debt/EBITDA 2.2x 2.5x 3.5x 2.9x 2.6x Direct +852 3615 8276 EBITDA Interest Coverage 8.7x 10.2x 7.6x 7.7x 8.5x Email [email protected] Gross Debt/Capitalization 34.4% 41.3% 44.7% 42.3% 39.8%
Secondary Analyst FFO/Debt 41.3% 34.3% 28.3% 33.2% 37.1% OCF/Debt 53.5% 11.8% 32.2% 38.4% 40.7% Name Winnie Guo Title Director FCF/Debt 23.4% -17.7% 2.6% 6.3% 7.3% Direct +852 3615 8344 ROIC 10.1% 11.6% 7.0% 9.6% 10.7% Email [email protected] Source: Company, Pengyuan International estimates
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Key Rating Drivers
Credit Strengths • Leading market position. With established brand recognition, Mengniu has long been one of the top players in the dairy industry. The Company has been on the “Global Dairy Top 20” list by Rabobank for eleven consecutive years. In 2019, Mengniu controlled 22% of the dairy market in China vastly outmatching its nearest competitor, Bright Dairy & Food Co (Bright Dairy), who has a 4% market share.
• Product diversification with strong distribution channels. Mengniu offers a large portfolio of products while most of its competitors only focus on one or two product categories. This product diversification helps Mengniu appeal to a wide range of consumers and capture different niche markets. Mengniu has also been optimizing its distribution channels online and offline. The Company’s online market share for liquid milk increased to 26.7% in 2019 from 24.6% in 2018. We expect Mengniu to continue to maintain its current growth and gain market share through diversifying its product line and strengthening its distribution capabilities.
• Stable growth compounded with low volatility margins. Thanks to its diverse product portfolio and extended supply chain network, Mengniu has shown stable growth in both cash flow and profitability. Mengniu has reported a revenue CAGAR of 13.7% from 2016 to 2019 driven by its strong market position and increasing market penetration in lower tier cities. The Company’s revenue saw a 5.8% decline in the first half of 2020 but this was caused mainly by the disposition of Junlebao. A recovery in the second quarter of 2020 was strongly driven by channel restocking. Mengniu has a track record of maintaining stable gross and EBITDA margins for 5 of the last 6 years EBITDA margins were within 7-9%. Profitability is likely to be lower in 2020 due to increased distribution expenses but we still expect the Company’s EBITDA margin to be around 6.5%.
• Solid financial profile. In our view, Mengniu has a solid financial profile. The Company has been able to maintain a gross debt to total capitalization ratio of below 50% for the past five years, slightly lower than the median of peers of a similar operating scale. The Company’s debt to EBITDA ratio has climbed slowly from 2.2x in 2018 to 2.5x in 2019 and 3.5x in the first half of 2020, pushed mainly by increased borrowings for potential acquisitions and lowered EBITDA. We expect its debt to EBITDA to gradually decrease in 2021 and 2022 with less capital expenditure and an earnings recovery after the pandemic. Credit Weaknesses
• Industry and Market risk. Mengniu’s business is highly concentrated in dairy products. The Company is subject to market risk such as increasing raw milk prices and industry risks such as food safety concerns or price cuts from competitors. Moreover, Mengniu has limited operations overseas and its milk supply is highly concentrated in Mongolia.
• Increasing risk associated with acquisitions. Mengniu has been active in mergers and acquisitions in recent years. This has not only increased the Company’s investment cash outflow but has also increased operating risks as synergies from these mergers and acquisitions may not be as significant as the Company expected. In addition, Mengniu may pay excessive premiums to acquire the targets.
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Exhibit 2: Key Credit Metrics
(RMB in millions) 2018A 2019A 2020F 2021F 2022F Revenue 68,977 79,030 80,497 89,965 99,697 Adjusted EBITDA 5,561 6,582 5,219 6,849 8,505 Adjusted EBITDA Margin 8.1% 8.3% 6.5% 7.6% 8.5% Return on assets (ROA) 5.6% 7.1% 4.0% 5.6% 6.3% Return on invested capital (ROIC) 10.1% 11.6% 7.0% 9.6% 10.7% Cash Flow Measures Funds from operations (FFO) 4,983 5,556 5,100 6,540 8,123 Operating cash flows (OCF) 6,450 1,912 5,812 7,555 8,914 Free cash flow (FCF) 2,828 -2,875 464 1,238 1,595 Discretionary cash flow (DCF) 2,302 -4,249 -39 479 676 Capital expenditure 3,622 4,787 5,348 6,317 7,318 Balance Sheet Measures Cash and liquid investments 16,190 23,019 29,441 30,659 31,661 Excess cash 3,927 7,274 11,290 10,246 8,638 Total debt 15,990 23,473 29,341 29,928 30,526 Adjusted debt 12,063 16,198 18,051 19,682 21,888 Total capitalization 46,454 56,820 65,706 70,732 76,682 Leverage Measures Debt/EBITDA 2.2x 2.5x 3.5x 2.9x 2.6x EBITDA/Interest expense 8.7x 10.2x 7.6x 7.7x 8.5x Gross Debt/Capitalization 34.4% 41.3% 44.7% 42.3% 39.8% FFO/Debt 41.3% 34.3% 28.3% 33.2% 37.1%
OCF/Debt 53.5% 11.8% 32.2% 38.4% 40.7% FCF/Debt 23.4% -17.7% 2.6% 6.3% 7.3% DCF/Debt 19.1% -26.2% -0.2% 2.4% 3.1% Debt/Equity -4.8% 1.4% -0.3% -1.8% -2.5% FFO/Cash interest expense 9.0x 8.6x 7.4x 7.4x 8.1x
Source: Company, Pengyuan International Estimates
Business Profiles
Leading market player in China’s dairy market In 2019 the International Farm Comparison Network ranked Mengniu as the 10th largest dairy company in the world by revenue. Next to Yili, the Company has the second largest market share of dairy products in China. In addition, the Company was the 4th largest publicly traded food and beverage company, by revenue, in China after WH Group, Yili Group and Kweichow Moutai. The Company mainly engages in the development, manufacturing and distribution of packaged dairy products. Mengniu focuses on differentiated products and is the brand owner of its products. Exhibits 3 and 4 show breakdowns of the Company’s business segments.
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Exhibit 3: Revenue breakdown by product category (2019) Exhibit 4: Revenue breakdown by geography (2019)
Overseas, 0.9% Milk Powder Others, Products, 0.9% 10.0% Ice Cream Products, 3.2%
Liquid Milk Products, Mainland 85.89% China, 99.1%
Source: Company, Pengyuan International estimates Source: Company, Pengyuan International estimates
Products diversification with strong distribution channels Mengniu offers a large portfolio of products and has created new products in multiple divisions, including its powdered milk, infant formula, chilled milk, and room temperature milk division. Thanks to its diversified product mix, Mengniu can not only target affluent middle-class Chinese consumers but also market to lower-tier cities throughout the country. It’s because of these diverse product offerings that Mengniu has managed to deliver fairly steady growth. We expect the company to continue to improve its brand recognition and market penetration through product innovation. Liquid milk is the Company’s core segment and major earnings contributor. The segment contributed 86.1% 85.9% and 86.8% of the company’s revenue in 2018, 2019 and first half of 2020 respectively.
Exhibit 5: Segment Profits in RMB millions FY2014 FY2015 FY2016 FY2017 FY2018 FY2019 LIQUID MILK PRODUCTS 2,930.2 3,166.7 2,708.3 3,753.8 3,531.6 3,854.4
ICE CREAM PRODUCTS 4.4 -235.1 -259.0 -210.6 -73.9 -245.7
MILK POWDER PRODUCTS 354.7 -67.1 -2,724.3 -262.6 208.0 -1,875.5
OTHERS -126.9 -244.5 -132.7 -93.9 -30.7 -154.1
TOTAL 3,162.3 2,619.9 -407.7 3,186.7 3,635.0 1,579.0
The fresh milk business is one of the Company’s fastest growing segments. Revenue from the fresh milk business had triple- digit growth in 2019 and saw 700million in sales. This segment started collaborating with Alibaba in second half of 2018 to deliver fresh products effectively to consumers. A significant portion of the Company’s milk formula business is carried out by its listed and consolidated subsidiary, Yashili. Mengniu owns 51% of that business. Yashili mainly offers milk powder products, including milk powder for teenagers, high- end goat milk powder, organic milk powder for infants and milk powder for middle-aged and elderly people. Improving distribution channels has also been one of the most important contributing factors to the Company’s growth. Mengniu has been actively pushing sales in third and fourth tier markets via offline channels and its strategic partnership with Alibaba and 1688.com. The Company is one of the two market players in China that have mastered ultra-high temperature technology and have strong products in these categories. As a result, Mengniu has a much larger geographical presence than most other competitors in the room temperature product segment.
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High market and business concentration Despite good product diversification, all of Mengniu’s products are within the dairy industry and are exposed to similar market and industry risk. In addition, the Company relies primarily on Chinese dairy farms to provide raw milk. Therefore, the Company is subject to quality and pricing risk from one country, in our view. After the acquisition of Australian listed dairy company Bellamy at the end of 2019, the Company should have access to more dairy farms in Australia. This could also introduce more dynamic inventory procurement allowing the Company to compare milk prices and quality between China and Australia. In the last few years Mengniu has tried to diversify its production sites geographically by adding new production facilities in different areas in China and expanding into other countries. As of end of 2019, the Company had a total of 44 production sites with two new factories in Indonesia and Australia newly added. A more scattered production network should also help the Company to handle distribution. Financial Profile
Profitability profile Revenue growth has been strong and mostly consistent, ranging between 9.7% and 14.7% for the past four years and only tailing off as Covid-19 hit the economy. Mengniu has shown impressive resilience in this crisis situation and the Company has been able to quickly recover to double digit revenue growth shortly after the two months of supply chain disruption.
Revenue was down by 5.8% on a year-on-year basis in the first half of 2020. The fall was mainly due to the disposition of Junlebao, China’s 4th largest dairy company. The management has commented that excluding the financials of Junlebao and newly acquired Bellamy, Mengniu would have reported a 9.4% increase in revenue instead which is consistent with growth in previous years. In addition, the Company’s gross margin has been constantly improving since FY2014 due to lower raw milk prices and improving product mix. The Company’s EBITDA, however, has not been showing the same improvements. This is mainly due to the Company increasing its selling and distribution expense proportionally to the increase in gross margin. Consequently, the Company’s EBITDA has stayed flat despite all the volatility from operations. As a comparison, Yili Group were able to increased revenue without increasing selling and distribution expense and showing improvements in profitability.
Exhibit 6: Revenue and EBITDA growth Exhibit 7: Selling and Distribution, and EBITDA Margin
Gross Margin Revenue Growth 80% 45% Adjusted EBITDA Margin Adjusted EBITDA Growth 40% Selling and Distribution 60% 35% 30% 40% 25% 20% 20% 15% 10% 0% FY2015 FY2016 FY2017 FY2018 FY2019 1H2020 5%
-20% 0%
-40%
Source: Company, Pengyuan International estimates Source: Company, Pengyuan International estimates
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Leverage profile Mengniu’s leverage ratios, including Debt to EBITDA, EBITDA interest coverage, have worsened in 2019 and 2020. This is because Mengniu’s total debt level has significantly increase by 46.8% in FY2019 and the Company has increased its debt by another 26.4% in the first half of 2020.
Exhibit 8: Key Leverage Ratios Leverage Ratio 2018A 2019A 2020F 2021F 2022F Debt to EBITDA 2.2x 2.5x 3.5x 2.9x 2.6x EBITDA Interest Coverage 8.7x 10.2x 7.6x 7.7x 8.5x Gross Debt/ Total Capitalization 34.4% 41.3% 44.7% 42.3% 39.8% FFO/Debt 41.3% 34.3% 28.3% 33.2% 37.1%
The increase in debt is partly to prepare for the acquisition of Lion dairy & drinks, the second largest dairy company in Australia, with an anticipated price tag of RMB 29billion. All leverage ratios worsened in the 2019. The acquisition was terminated in August leaving a large amount of unused proceeds. We expect the leverage ratios will gradually improve and be somewhere near 2018’s level by 2022 as acquisition activities slow. Historically Mengniu tends to hold significant amount of financial asset as shown in the chart below. We think this is because the Company has been leveraging its low borrowing costs and investing at a higher rate. We believe these financial assets have good liquidity and can be used to repay debt or expand its business when the Company sees an opportunity.
Exhibit 9: Expect debt level to stay flat and increase Long-term Exhibit 10: Growing Assets through Borrowing, RMB in debt exposure, RMB in billion billion
Short-term debt Long-term debt 40 Total debt Total financial assets Short/Long-term Debt Total debt increase 35 160% 35 140% 30 30 120% 25 100% 25 80% 20 20 60%
15 billion in RMB 15
40% RMB in billions in RMB 10 20% 10 0% 5 5 -20% 0 0 -40% 2016 2017 2018 2019 2020 2021 2022 2016 2017 2018 2019 2020 2021 2022
Source: Company, Pengyuan International estimates Source: Company, Pengyuan International estimates
Liquidity
The Company is a cash rich company and has a record of high liquidity. The Company reported RMB 6.5 and 11.5 billion in cash in FY2019 and 1H2020, or 23.0 and 31.0 billion if we include short-term investments. These figures are significantly higher than the 0.6 and 0.3 billion of interest expense reported in the same period. The current ratio was steady at 1.18x in FY2018 and FY2019 and increased to 1.3x in 1H2020. The quick ratio has improved from 0.76x in FY2018 to 0.84x and 1.1x in FY2019 and 1H2020. The improvements were mainly the result of short-term investments increasing at a faster rate than short-term debt.
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Without any substantial and unexpected changes, the Company should no liquidity problems in the near future. We made the following key projections on Mengniu’s liquidity: ▪ Estimated liquid assets on hand of RMB29,441 and 30,659 million in 2020 and 2021; ▪ Estimated FFO of RMB5,100 and 6,536 million in 2020 and 2021; ▪ Estimated short-term debt payment of RMB14,670 and 14,964 million in 2020 and 2021; ▪ Estimated cash interest of RMB687 and 889 million in 2020 and 2021; ▪ Estimated capital expenditure, excluding M&A spending, of RMB5,348 and 6,317 million in 2020 and 2021.
Company Background
Founded in 1999, China Mengniu Dairy Company Limited through its subsidiaries, manufactures and distributes processed dairy products. The company is based in Inner Mongolia and has the second largest market share of dairy products in China according to Nielsen. It is the fourth largest listed food and beverage company in China by market cap. As of FY2019 over 99% of the Company’s business is in China. The company’s segment and products can be categorized into four big categories: 1) Liquid Milk, 2) Ice Cream, 3) Milk Powder, 4) Others, which mostly is cheese. The Company’s star products include: Milk Deluxe, Just Yoghurt, Fruit Milk Drink, and Pure Milk, Champion, Yoyi C. Champion, to name a few. These star products are mostly under the Room-temperature and Chilled product category. The Company is the market leader in Chilled Yogurt and number two leader in UHT products. As of the end of 2019, Mengniu had a total 44 production sites including two newly added factories in Indonesia and Australia. The Company has a supply chain network covering most of China which none of the other Chinese dairy companies, with the exception of Yili Group, could compare. Peer comparison
Peers can be broken down into two tiers - Yili and international peers. Most other dairy companies in China do not have the same product focus as Mengniu and the same scale. Yili’s operations are largely comparable to Mengniu’s and has been very stable for the last few years. Mengniu current operations are almost all in China and thus not strictly comparable to other international companies that have presence and a supply-chain network across multiple countries. Especially as a lot of these large dairy companies operate in developed countries and have no presence in China and thus are exposed to a very different business environments and dynamics. But it is also important to look at these international companies to reflect how margins and working capital would be if Mengniu were transformed into a multinational company. Here is some brief background information on all of the peers we selected for Mengniu. Inner Mongolia Yili Industrial Group Co., Ltd, also known as Yili, mainly engages in the processing, manufacturing and sales of various dairy products and health drinks. It has several major product series including liquid milk, milk beverages, milk powder, yogurt, frozen drinks, cheese, milk fat, and packaged drinking water. Its products are mainly sold in the domestic market and the company has the largest market share of dairy products in China. The company is based in Inner Mongolia. In total 99.2% of the Company’s total revenue is related to dairy products. The Company also focuses on liquid milk products and these accounted for 81.8% of the Company’s total revenue in 2019. Another 11.1% and 6.2% of revenue are from Milk powder and milk products and cold drinks. Danone SA is a European multinational food-products corporation based in Paris. The Company produces a wide variety of food products including dairy products, baby food, beverages, bottled waters and baked items. Danone products are sold in 120 markets. In 2019, over 54% of the company’s revenue was from Europe, US and Canada with the remaining 46% is from rest of the world. Fresh dairy products represented 52.1% of the company’s total revenue with a further 29.9% coming from Nutrition products which includes milk powder as well as food or other beverages, the remaining is from bottled water. Saputo Inc. is a Canadian dairy company. The company produces a wide array of dairy products, including cheese, fluid milk, extended shelf-life milk and cream products, cultured products and dairy ingredients. The company's products are sold in over 40 countries worldwide but a strong focus is on the North America market. 48.2% of its revenues come from United States and 29.9% from Canada. As of 2019, 100% of the Company’s revenue was from dairy products. Dean Foods produces milk, ice cream, dairy products, cheese, juice, and tea. It was once the largest dairy company in the United States. In November 2019 the company filed for Chapter 11 bankruptcy citing the decline in consumption of cow's milk
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and the growth in demand of plant milk. On May 1, 2020, Dean Foods was acquired by the Dairy Farmers of America. Substantially most of its products are sold in North American with less than 1% in foreign operations. The company focuses on fluid milk and ice cream and as much as 96.5% of its revenue is related to dairy products. Meiji Holdings Co., Ltd. Is a Japanese company that provides customers of all ages a wide range of products, from confectionaries and dairy products to body-enhancing nutrition supplements and vital pharmaceuticals. Apart from dairy products like milk, ice cream, and cheese their lineup includes sports drinks, pizza, chocolate bars and food supplements. In FY2020, 31.5% of total revenue was from fresh & fermented dairy products, the Company’s largest segment. Savencia SA is a French food company specializing in the production of cheeses. Focusing on cheese specialties and high value-added dairy ingredients, Savencia Fromage & Dairy is among the world’s leading milk processors, the No. 2 cheese Company in France and the No. 5 worldwide. Savencia products are sold in 120 markets. 28.5% the company’s revenue is from France, 39.9% from rest of Europe, and the remaining 31.6% is to the rest of the world As a side note, Yili was the only Chinese dairy firm chosen as a comparable. Other Chinese firms focus on different products in the dairy industry and have wildly different profitability and operations, especially in working capital. The following is a table showing selected key information on the company:
Exhibit 8: Peer comparison table (ratios as of FY19)
Leverage Profile Profitability Profile Operating Efficiency Debt/ EBITDA/ Gross Debt/ FFO/ Gross EBITDA Receivable Inventory Payable Conversion Company Name EBITDA Interest Expense Capitalisation Debt Margin Margin ROIC ROA Days Days Days Cycle
Mengniu Dairy 2.46x 10.22x 41.3% 34.3% 37.6% 8.3% 11.6% 7.1% 15.0 34.7 48.6 1.1
Yili Group -0.47x 38.30x 20.6% -117.9% 37.5% 11.6% 46.4% 14.0% 6.3 42.8 64.5 -15.4
Danone 2.8x 11.6x 49.9% 27.5% 49.1% 18.3% 10.6% 7.1% 40.9 53.4 109.6 -15.3 Saputo Inc 1.6x 20.8x 27.7% 48.4% 9.0% 10.2% 14.0% 12.0% 29.6 43.2 38.1 34.6 Dean Foods Co -5.1x -1.9x 770.2% -28.6% 19.6% -1.7% -49.6% -18.4% 29.0 15.7 39.0 5.6 Meiji Hd 0.6x 183.9x 17.5% 120.6% 36.4% 11.4% 17.0% 10.0% 59.1 70.6 87.7 42.0 Savencia Sa 2.3x 23.1x 45.5% 36.5% NA 6.1% 7.8% 3.6% 53.6 NA NA NA
Average 1.9x 18.5x 35.1% 37.5% 28.5% 11.5% 12.4% 8.2% 42.4 45.7 68.6 16.8 Median 1.6x 20.8x 45.5% 36.5% 28.0% 10.2% 10.6% 7.1% 40.9 48.3 63.3 20.1
*grey areas: excluded outliers
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Rating Scores Summary
Business Profile Strong Industry and Operation Risk Profile Strong Macroenvironment Risk Low
Financial Profile bbb+ Preliminary Leverage Profile bbb Cash Flow Variations Neutral Debt Structure and Financial Policy Neutral Financial Volatility Neutral Investments 1 notch Final Leverage Profile bbb+ Profitability Medium
Indicative Credit Score (ICS) bbb- Adjustment Factors Corporate Structure and Governance Neutral Liquidity Moderate Supplementary Analysis Positive
Standalone Credit Profile (SACP) bbb
External Support Parental Support Moderate Government Support N/A Issuer Credit Rating (ICR) BBB+
Note: ratings mentioned in this report are unsolicited rating.
Related Criteria
General Corporate Rating Criteria (15 March 2018)
Government-Related Entities Rating Criteria (31 August 2018)
Financial Adjustments and Ratio Definitions (07 May 2018)
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