16 January 2017 Asia Pacific/China Equity Research Meat, Poultry & Fish

China Mengniu Dairy (2319.HK / 2319 HK) Rating (from OUTPERFORM) UNDERPERFORM Price (16-Jan-17, HK$) 14.66 DOWNGRADE RATING Target price (HK$) (from 17.50) 11.60 Upside/downside (%) -20.9

Mkt cap (HK$/US$ mn) 57,541 / 7,420 Cost inflation victim Enterprise value (Rmb mn) 53,695 ■ Downgrade to UNDERPERFORM (from Outperform). We are concerned Number of shares (mn) 3,925 Free float (%) 68.0 that: (1) Markets still underestimate the sector-wide cost headwinds that 52-wk price range (HK$) 16.38-10.60 overpower Mengniu's internal efforts, thus hurting its margin; and (2) its CMD ADTO-6M (US$ mn) 19.8 (China Modern Dairy) acquisition introduces higher leverage and Target price is for 12 months. uncertainties, thus leading to de-rating. We lower 2017E earnings by 10%, to Research Analysts 8% below consensus, and cut TP by 34% to HK$11.60. Mark Mao 852 2101 6710 ■ Sector-wide cost headwinds to erode margin. We identify four major cost [email protected] overhangs that could hurt margins by 510 bp YoY in 2017: (1) a 6% increase Michael Shen in domestic raw milk price to erode margin by 180 bp; (2) a 30% hike in milk 852 2101 6711 powder price to contract margin by 120 bp; (3) an 8% increase of packaging [email protected] cost to erode margin by 110 bp; and (4) 20% rise in logistics cost to hurt Raymond Ching margin by 100 bp. We believe markets have not fully priced in these cost 852 2101 7852 headwinds, especially packaging and logistics. This could be critical to [email protected] Mengniu, whose net margin was only 4.8%/4.0% in 2015/1H16.

■ Mengniu's own endeavours cannot fully offset cost pressure. We forecast Mengniu's liquid milk business margin to contract 70 bp. the company could fight against margin pressure with: (1) mix improvement; (2) the sold-off excessive high-cost raw milk powder inventory in 2016 and using more milk powder in 2017; (3) easing price competition; and (4) leveraging its strong bargaining power against suppliers. Nevertheless, these could only help margins increase by 440 bp, not enough to fully offset the cost increase. ■ CMD acquisition would introduce higher leverage and risks, and lead to de-rating, in our view. We expect the mandatory cash offer to result in Mengniu taking the majority shares of CMD, with total consideration up to maximum HK$8.3 bn. This will lift Mengniu's net gearing from 10% to 37%, and lower its earnings visibility, as the dairy farm business is volatile by nature. Moreover, CMD's high-cost raw milk might not help Mengniu's low- temperature business development in the future. Therefore, we derive our target price from 16x 2017E P/E, 1 sd below its historical average 19x P/E.

Share price performance Financial and valuation metrics

Year 12/15A 12/16E 12/17E 12/18E Revenue (Rmb mn) 49,026.5 52,917.9 56,688.1 60,719.0 EBITDA (Rmb mn) 4,089.1 3,981.2 4,331.6 4,641.7 EBIT (Rmb mn) 2,647.9 2,524.9 2,876.2 3,213.2 Net profit (Rmb mn) 2,367.2 2,200.2 2,528.7 2,776.1 EPS (CS adj.) (Rmb) 0.61 0.56 0.65 0.71 Change from previous EPS (%) n.a. - (9.9) (14.6) Consensus EPS (Rmb) n.a. 0.62 0.71 0.79 EPS growth (%) 0.7 (7.1) 14.9 9.8 The price relative chart measures performance against the P/E (x) 21.4 23.1 20.1 18.3 MSCI CHINA F IDX which closed at 6,233.06 on 16/01/17. Dividend yield (%) 2.2 0.0 2.0 2.2 On 16/01/17 the spot exchange rate was HK$7.76/US$1 EV/EBITDA (x) 13.3 13.5 12.4 11.6

Performance 1M 3M 12M P/B (x) 2.29 2.30 2.16 2.01 Absolute (%) -2.3 -0.8 35.2 ROE (%) 10.9 10.0 11.1 11.4 Relative (%) -6.4 2.9 17.2 Net debt/equity (%) 11.9 9.7 9.5 9.8

Source: Company data, Thomson Reuters, Credit Suisse estimates

DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, LEGAL ENTITY DISCLOSURE AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

16 January 2017

Focus charts and table

Figure 1: Mengniu liquid milk business margin change analysis, 2017 vs 2016

Sector cost inflation hurt margin Mengniu's own effort cannot fully offest

Import milk Mix Narrowed Milk powder Bargaining Raw milk cost powder cost Packaging cost Logistics cost improvement promotions saving power 2017 vs. 2016 0%

-1% -0.7% +0.5% -2% -1.8% -3% +1.3% -1.2% -4% -1.1% -5% +2.0% -1.0% +0.6% -6%

Source: Company data, Credit Suisse estimates

Figure 2: Imported WMP still cheaper than domestic Figure 3: Logistics and cardboard cost hiked 140% 1,400 5,000 120% 1,300 100% 4,500

80% 1,200 60% 4,000 40% 1,100 20% 3,500 1,000 0% 3,000 -20% 900 -40% -60% 800 2,500 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 Mik powder price, China vs. import Truckload Freight Index Cardboard paper price (Rmb/ton)

Source: NBS, Bloomberg, Credit Suisse estimates Source: Wind, Credit Suisse estimates

Figure 4: CMD acquisition barely contributes to profit but increased leverage on Mengniu Figure 5: Liquid milk sector to grow 5% YoY in 2017

400 Rmb bn Mengniu profit change if acquire CMD Net cash(debt) to equity 13% 13% 20% 5% 5% 7% 350 3% 202 12% -184 0% 300 -20% 2,529 2,546 250 35% 200 -40% -10% 150 295 316 259 267 281 -60% 229 -37% 100 203 -80% 50

2017E Profit Interest Pro-forma Mengniu, Mengniu, Yili 0 -100% earnings from CMD expenses 2017E net before after CMD 2012 2013 2014 2015 2016E 2017E 2018E for CMD profit CMD acquistion acquistion Liquid milk YoY

Source: Bloomberg; Credit Suisse estimates Source: Euromonitor, Credit Suisse estimates

Figure 6: Mengniu forecast change and valuation Company Ticker Rating Mkt cap (US$) New TP TP change Upside/Downside 2017E earnings change Vs. Cons Trading P/E (x) Target P/E (x) Mengniu 2319.HK UNDERPERFORM 7,612 11.6 -34% -21% -10% -8% 18.8 16.0 Source: Company data, Credit Suisse estimates

China Mengniu Dairy (2319.HK / 2319 HK) 2 16 January 2017

Cost inflation victim While markets are expecting price competition to increase and Mengniu's internal reform to expand its margin in 2017, we are concerned that: (1) Markets still underestimate the sector-wide cost headwinds, which overpower selling expenses savings and Mengniu's internal improvement efforts, thus hurting margin; (2) CMD acquisition introduces higher leverage and volatiles, as well as uncertainties in the future development, thus leading to de-rating. Sector-wide cost headwinds contract margin We identified four major cost inflations that could hurt margin by 510 bp YoY in 2017: (1) Raw milk price increase by 6% would erode margins by 180 bp; (2) Imported milk powder price hike by 30% will erode margin by 120 bp; (3) Packaging cost might increase 8% and erode margin by 110 bp; (4) Logistics cost might grow 20% and erode margin by 100 bp. We believe markets haven't fully priced in these cost headwinds, especially packaging and logistics. This could be critical to all dairy makers, because most of them have only single digit net margin, including Mengniu, which had 4.8%/4.0% in 2015/1H16. Meanwhile, we forecast liquid milk revenue to increase 5% YoY in 2017E, of which, 2%/1%/2% came from mix improvement/pricing recovery/volume growth. As demand growth is mild, even with the help from narrowed promotions, it still cannot offset the cost increase; therefore, sector margin will contract. Mengniu cannot fully offset margin erosion Markets expect Mengniu to expand its margin via sector-wide promotion reduction, and with Mengniu's internal efforts to save cost. However, we quantified that these are not enough to offset all the cost pressure, and Mengniu should see around 70 bp margin contraction in the liquid milk business: (1) We forecast Mengniu's liquid milk to slightly gain market share with 8% revenue growth, of which, mix improvement could lift margin by 60 bp; (2) Sold-off excessive high-cost raw milk powder inventory in 2016 will help margin by 110 bp, and the use of more milk powder in 2017 will help margin by 20 bp; (3) Easing sector-wide price competition might help margin by 200 bp; (4) Leveraging scale economy to bargain for 50 bp less cost increase from suppliers. The abovementioned could help margin increase by 440 bp, unable to cover the 510 bp cost increase. CMD acquisition will trigger de-rating If the mandatory cash offer results in Mengniu taking majority of shares of CMD, which is likely in our view, it will cause a de-rating for Mengniu. It might total to HK$8.3 bn consideration, and therefore lift Mengniu's net gearing from 10% to 37%, vs Yili's 35% net cash; the incremental profits from CMD could barely cover the interest expenses for the deal; it will lower Mengniu's earnings visibility as the dairy farm business is volatile by nature. Moreover, CMD's high-cost raw milk might not help Mengniu's low-temperature business development in the future. Valuation and risks We lower 2017E earnings by 10% to Rmb2.5 bn, which is 8% below consensus. We cut target price by 34% to HK$11.60, which is derived from 16x 2017E P/E; this is 1 sd below its historical average 19x forward P/E. Upside risks include: dairy makers reduce discount mainly through pricing recovery, which could lead to better-than-expected top line growth; raw milk and imported milk powder price could stabilise; lower-than-expected cost increase from packaging and logistics.

China Mengniu Dairy (2319.HK / 2319 HK) 3 16 January 2017

China Mengniu Dairy (2319.HK / 2319 HK) Price (16 Jan 2017): HK$14.66; Rating: (from OUTPERFORM) UNDERPERFORM; Target Price: (from HK$17.50) HK$11.60; Analyst: Mark Mao Income Statement (Rmb mn) 12/15A 12/16E 12/17E 12/18E Company Background Sales revenue 49,027 52,918 56,688 60,719 China Mengniu Dairy Co Ltd and its subsidiaries manufacture and Cost of goods sold 33,651 35,560 38,172 40,778 distribute quality dairy products in China. It is one of the leading EBITDA 4,089 3,981 4,332 4,642 dairy product manufacturers in China, with MENGNIU as the core EBIT 2,648 2,525 2,876 3,213 brand. The Group boasts a diverse product range in milk. Net interest expense/(inc.) (245) (194) (209) (198) Recurring PBT 3,030 2,671 3,210 3,539 Blue/Grey Sky Scenario Profit after tax 2,520 (117) 2,664 2,938 Reported net profit 2,367 (100) 2,529 2,776 Net profit (Credit Suisse) 2,367 2,200 2,529 2,776 Balance Sheet (Rmb mn) 12/15A 12/16E 12/17E 12/18E Cash & cash equivalents 7,931 8,538 8,422 8,161 Current receivables 1,618 1,383 1,450 1,087 Inventories 4,340 4,587 4,924 5,260 Other current assets 8,532 7,621 7,702 7,881 Current assets 22,420 22,129 22,498 22,389 Property, plant & equip. 11,638 13,019 14,400 15,808 Investments 6,534 7,778 8,161 8,858 Intangibles 8,470 6,348 6,348 6,348 Other non-current assets 1,590 1,648 1,718 1,801 Total assets 50,653 50,922 53,125 55,204 Current liabilities 15,976 16,357 16,899 17,188 Total liabilities 24,037 24,424 24,971 25,250 Shareholders' equity 22,136 22,036 23,554 25,219 Minority interests 4,479 4,462 4,597 4,759 Total liabilities & equity 50,653 50,922 53,122 55,228 Cash Flow (Rmb mn) 12/15A 12/16E 12/17E 12/18E EBIT 2,648 2,525 2,876 3,213 Net interest (563) (494) (509) (497) Tax paid (654) (476) (534) (589) Working capital (593) 212 (262) (612) Other cash & non-cash items 1,525 1,049 1,027 1,132 Our Blue Sky Scenario (HK$) (from 19.50) 13.60 Operating cash flow 2,363 2,816 2,599 2,646 xx Capex (2,922) (2,776) (2,776) (2,776) Free cash flow to the firm (559) 40 (177) (130) Our Grey Sky Scenario (HK$) (from 15.50) 9.60 Investing cash flow (2,140) (2,209) (2,209) (2,352) xx Equity raised 0 0 0 0 Dividends paid (547) 0 (506) (555) Share price performance Financing cash flow (547) 0 (506) (555) Total cash flow (324) 607 (116) (261) Adjustments 0 0 0 0 Net change in cash (324) 607 (116) (261) Per share 12/15A 12/16E 12/17E 12/18E Shares (wtd avg.) (mn) 3,897 3,897 3,897 3,897 EPS (Credit Suisse) (Rmb) 0.61 0.56 0.65 0.71 DPS (Rmb) 0.28 0.00 0.26 0.29 Operating CFPS (Rmb) 0.61 0.72 0.67 0.68 Earnings 12/15A 12/16E 12/17E 12/18E Growth (%) Sales revenue (2.0) 7.9 7.1 7.1 EBIT (0.6) (4.6) 13.9 11.7 EPS 0.7 (7.1) 14.9 9.8 Margins (%) The price relative chart measures performance against the MSCI CHINA F IDX EBITDA 8.3 7.5 7.6 7.6 which closed at 6,233.06 on 16-Jan-2017 EBIT 5.4 4.8 5.1 5.3 On 16-Jan-2017 the spot exchange rate was HK$7.76/US$1 Valuation (x) 12/15A 12/16E 12/17E 12/18E P/E 21.4 23.1 20.1 18.3 P/B 2.29 2.30 2.16 2.01 Dividend yield (%) 2.2 0.0 2.0 2.2 EV/sales 1.1 1.0 0.9 0.9 EV/EBITDA 13.3 13.5 12.4 11.6 EV/EBIT 20.5 21.3 18.7 16.8 ROE analysis (%) 12/15A 12/16E 12/17E 12/18E ROE 10.9 10.0 11.1 11.4 ROIC 7.4 (2.7) 8.0 8.4 Credit ratios 12/15A 12/16E 12/17E 12/18E Net debt/equity (%) 11.9 9.7 9.5 9.8 Net debt/EBITDA (x) 0.77 0.64 0.62 0.63

Source: Company data, Thomson Reuters, Credit Suisse estimates

China Mengniu Dairy (2319.HK / 2319 HK) 4 16 January 2017

Sector-wide cost headwinds contract margin We are concerned about the sector-wide cost inflation in liquid milk, especially domestic raw milk, imported milk powder, packaging, and logistics, which might lead to 510 bp margin erosion. Meanwhile, top line growth might stay mild at 5% in 2017E, of which, 2% and 1% came from mix improvement and pricing recovery, while volume growth is still sluggish at 2%.

Figure 7: Sector cost inflation to hurt Mengniu's margin by 510 bp as % of revenue YoY Impact on margin Remark Raw milk cost 29% 6.0% -1.8% Increase from Rmb3.47/kg in 2016 to Rmb3.70/kg in 2017E Milk powder cost 4% 30.0% -1.2% GDT WMP price rose from 2016 average US$2,463/MT to US$3,294/MT in Jan-2017 Packaging cost 13% 8.0% -1.1% Liquid packaging board, polyethylene and aluminium prices all increased Logistics cost 5% 20.0% -1.0% China gov't strictly regulating heavy truck over-load Total 51% -5.1% Source: Credit Suisse estimates Cost increase across the board We identified four major cost inflations in 2017: domestic raw milk, imported milk powder, packaging and logistics. These four items account for 51% of liquid milk revenue, and their cost inflation might lead to a 510 bp margin contraction in 2017. Domestic raw milk price to rise 6% YoY in 2017E Raw milk accounted for around 45% of the CoGS, or 29% of the revenue. Consensus agrees that raw milk price has been entering an uptrend since 4Q16. We forecast domestic raw milk price to rise gradually to Rmb3.8 in 2Q-3Q17 and then stabilise. This implies that the annual average raw milk price will increase 6%, from Rmb3.47/kg in 2016E to Rmb3.70/kg in 2017E. As a result, this could erode liquid milk producers' gross margin by 180 bp. We expect the raw milk price to increase gradually, not sharply. On the demand side, volume demand for raw milk is likely to increase by only 3-5% YoY in 2017. Liquid milk mix improvement will lead to higher demand for raw milk, but would be partly offset by more imported milk powder, whose price is still cheaper than domestic raw milk. On the supply side, we believe raw milk supply could increase simply by improving yield in 2017. We noticed that the herd size has already stabilised since the end of 3Q16, and some scaled farms were reducing their production simply by controlling yield (as some have cut yield by as much as 10%). As it takes only a few months for scaled farms to lift yield, we believe the supply will gradually catch up with the demand. Imported milk powder price to surge 30% YoY in 2017E Imported milk powder has been a critical supply item for Chinese dairy producers, especially since 2013. Consensus believes that imported milk powder price will increase in 2017E, due to global supply-demand rebalance. We forecast imported milk powder to account for 6% of Mengniu's CoGS, or 4% of revenue. We forecast imported milk powder price to increase 30% YoY in 2017, which will hurt Mengniu's margin by 120 bp. GDT auction price has surged over 30% recently. Actual transaction price, a leading indicator of GDT price, is now still 17% cheaper than domestic raw milk, considering all the logistics and taxation cost. Therefore, we expect imported milk powder (translated into raw milk) to account for 18% of the sector supply in 2017E, slightly improved from 17% in 2016E.

China Mengniu Dairy (2319.HK / 2319 HK) 5 16 January 2017

Figure 8: China raw milk price and vs imported WMP Figure 9: Imported WMP as % of supply in China

5 150% 100% 6% 13% 19% 19% 22% 17% 17% 18% 30% 30% 4 80% 100%

3 60% 50% 94% 87% 2 40% 81% 81% 78% 83% 83% 82% 70% 70% 0% 1 20%

0 -50% 0% Jan-13 Jan-14 Jan-15 Jan-16 2008 2009 2010 2011 2012 2013 2014 2015 2016E 2017E China raw milk (Rmb/kg) (LHS) Mik powder price, China vs. import (RHS) Import milk powder Domestic raw milk

Source: The BLOOMBERG PROFESSIONAL™ service; NBS; Credit Suisse estimates Source: Credit Suisse estimates

Packaging cost to increase 8% YoY in 2017E Packaging accounts for 20% of Mengniu's CoGS, or 13% of its revenue. We expect its cost to increase by 8% YoY in 2017E due to raw material cost hike, thus hurting gross margin by 110 bp in 2017E. Liquid milk packaging is a highly concentrated market, with tetra pack and GAPACK (468.HK) having 70% and 15% market share in China, respectively. In addition, they have strong bargaining power. According to GAPACK, liquid packaging board/ polyethylene aluminium foil/ other materials account for 30%/ 10%/ 18% of its revenue, and these three key materials are likely to see cost increase in 2017E. (1) Recovered paper cost surged by 40% in China in December 2016, and we expect it to correct a bit after the Chinese New Year, but it is still likely to see a 20% YoY cost increase in 2017E. We expect the liquid packaging board to follow a similar trend; (2) Polyethylene cost goes in line with crude oil, and it was at its trough in 2016. Our house view forecast Brent crude oil price to increase by 27% YoY to $56/bbl in 2017E; (3) Aluminium price will also increase by 9% YoY in 2017E, according our house view. The abovementioned should lift its CoGS by over 10%, and we expect packaging suppliers to absorb some of the cost increase themselves, and charge 8% higher price for liquid mild producers. Logistics cost to increase 20% YoY in 2017E China government has started to implement strict over-load penalties for heavy trucks since 3Q16. Maximum freight carried per truck was reduced by 10-16%. Therefore, we regard the logistics cost increase as sustainable, and forecast average freight cost to increase 20% YoY in 2017E. As logistics cost accounts for 5% of revenue, margin is likely to erode by 100 bp in 2017E.

Dairy players have only single digit NPM, and have to fight against cost pressure Most dairy makers have only single digit net margin, and these 510 bp margin contractions could be critical to the industry. We see two key measures: (1) Ease price competition. We expect the sector-wide price war to ease, via either selling price recovery, or reduced selling expenses; and (2) Leading players will leverage their strong bargaining power to fight for less price hike. For instance, Yili's logistics cost follows the freight cost trend, but at half the amount.

China Mengniu Dairy (2319.HK / 2319 HK) 6 16 January 2017

Figure 10: Packaging cost structure Figure 11: Crude and aluminium cost to rise in 2017

1,745 56.0 1,662 Liquid NPM, 15% 1,605 packaging 52.3 board, 30% Others, 14%

44.1 Other CoGS, Polyethylene, 13% 10% Aluminium foil, ink, and other material, 18%

2015 2016 2017E 2015 2016 2017E Brent crude (USD/bbl) Aluminium (USD/ton) Source: GAPACK, Credit Suisse estimates Source: Wind

Figure 12: Logistics/cardboard cost rose in end-16 Figure 13: Yili logistics expenses vs freight index

1,400 5,000 5.6% 1,250 1,200 1,300 5.4% 4,500 5.2% 1,150 1,200 1,100 4,000 5.0% 1,100 1,050 4.8% 3,500 1,000 1,000 4.6% 950 3,000 900 4.4% 900 4.2% 800 2,500 850 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 4.0% 800 1H13 2H13 1H14 2H14 1H15 2H15 1H16 Truckload Freight Index Cardboard paper price (Rmb/ton) Yili logistics cost as % of revenue China freight index

Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates

Sluggish demand, but less promotion might help We forecast China liquid milk sector to see 5% revenue growth in 2017E, on the back of: (1) 2% mix improvement, as high-end UHT and yogurt are seeing higher growth; (2) 1% price improvement on these high-end products, on less promotion due to cost pressure; (3) 2% total volume growth. We estimate such mix improvement should help the liquid milk sector; its gross margin is likely to increase by 50 bp YoY in 2017E, or 55-60 bp YoY if excluding pasteurised milk.

China Mengniu Dairy (2319.HK / 2319 HK) 7 16 January 2017

Figure 14: Liquid milk sector revenue growth Figure 15: Gross margin estimates by product 400 Rmb bn 60% 13% 13% 20% 5% 5% 7% 350 3% 12% 50% 0% 300 40% 250 -20% 30% 200 -40% 316 150 295 20% 259 267 281 -60% 229 100 203 10% -80% 50 0% 0 -100% High end Other UHT Pasteurized Flavor milk UHT yogurt Other yogurt 2012 2013 2014 2015 2016E 2017E 2018E UHT fresh fresh milk milk Liquid milk YoY milk

Source: Euromonitor, Credit Suisse estimates Source: Credit Suisse estimates

Figure 16: Liquid milk volume growth forecast Figure 17: China per capital dairy consumption (kg)

40 mn tonnes 25 8% 8% 20% 8% 2% 2% 4% 35 0% 19.1 18.4 18.2 18.5 18.8 0% 20 17.1 30 16.0 14.8 4.2 -20% 13.4 3.6 4.8 5.6 6.3 7.1 25 15 12.2 3.2 11.0 2.9 20 2.6 -40% 2.3 5.2 5.5 5.5 10 2.1 4.7 5.0 5.6 5.7 4.4 5.8 15 4.3 2.1 26 27 -60% 4.1 1.9 2.0 2.1 23 25 25 25 1.8 2.2 10 21 5 1.7 2.3 2.4 1.6 1.7 -80% 5.4 5.9 6.3 6.6 5.8 5.1 5 3.2 3.9 4.7 4.5 3.8 0 0 -100% 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017E 2018E 2012 2013 2014 2015 2016E 2017E 2018E Yoghurt Fresh Milk - UHT milk Liquid milk YoY Fresh Milk - pasteurised milk Flavoured Milk Drinks

Source: Euromonitor, Credit Suisse estimates Source: Euromonitor, Credit Suisse estimates

Liquid milk sector volume growth remains sluggish at 2% YoY in 2017 The growth is attributed to consumption upgrade, as higher-price products, especially high- end UHT fresh milk and yogurt (esp. UHT yogurt), will offset the decline in milk beverages: (1) High-end UHT volume is likely to increase by 8% YoY, driven by demand upgrade from mass-market UHT, flavoured milk and other drinks; (2) UHT yogurt volume to increase 40% YoY, still huge potential for further penetrating, though decelerated from 60-70% in 2016; (3) other yogurt products should continue to increase by 10% YoY; and (4) we forecast flavoured milk to further decline by 11% YoY in 2017, due to customers' rising awareness for less healthier reconstituted milk, and better affordability for higher-priced milk products. We are conservative on volume growth, because: (1) Cost will increase sector wide in 2017, and therefore dairy companies will narrow their promotions and try to lift selling price. This will cap demand from end customers, especially for low-end products. (2) Per capita dairy consumption has matured in higher tier cities, yet still takes time to penetrate to lower tier cites. In China, tier 1 and 2 cities' per capita dairy consumption has already reached 45-55 kg/year, and has stabilised in recent years. As a result, volume growth is mainly driven by tier 3 and 4 cities, where per capital dairy consumption is still low at 5-10 kg/year, but it takes time to change their habits.

China Mengniu Dairy (2319.HK / 2319 HK) 8 16 January 2017

Mengniu cannot fully offset margin erosion We expect Mengniu to fight against sector-wide margin erosion, and it will benefit from: (1) Mix improvement to improve margin by 60 bp; (2) Sold-off excessive high-cost raw milk powder inventory in 2016 helping margin increase by 110 bp, and increased use of imported milk powder might help boost margin by 20 bp; (3) Sector-wide price competition to help ease margin by 200 bp; and (4) Leveraging scale economy to bargain for less price hike helping margin by 50 bp. As abovementioned could help its margin by 440 bp, we forecast Mengniu's liquid milk business to have 70 bp margin contraction in 2017E.

Figure 18: Mengniu liquid milk business margin change analyst, 2017 vs 2016

Sector cost inflation hurt margin Mengniu's own effort cannot fully offest

Import milk Mix Narrowed Milk powder Bargaining Raw milk cost powder cost Packaging cost Logistics cost improvement promotions saving power 2017 vs. 2016 0%

-1% -0.7% +0.5% -2% -1.8% -3% +1.3% -1.2% -4% -1.1% -5% +2.0% -1.0% +0.6% -6%

Source: Company data, Credit Suisse estimates

Mix improvement will continue to help, with some share gains We forecast Mengniu's liquid milk revenue to increase 8% YoY in 2017E, higher than the sector average of 5% growth. We believe cost inflation would benefit the company in gaining some shares. More importantly, we expect Mengniu to continue to benefit from product mix improvement. We forecast its high-end UHT yogurt to have 30% growth YoY, chilled yogurt to see 10% YoY growth and high-end UHT milk "Milk Delux" to improve 10% YoY in 2017E; these products have relatively high margins compared to the rest. We expect its plain milk/milk beverage to see 2%/0% growth in 2017. As a result, such mix improvement is likely to help Mengniu's margin increase by 60 bp.

China Mengniu Dairy (2319.HK / 2319 HK) 9 16 January 2017

Figure 19: Mengniu revenue and growth Figure 20: Mengniu revenue breakdown, 2016E

100 Rmb bn 40% 20% 90 15% 20% 24% 8% 7% 7% 80 -2% -3% 10% 70 0% 25% 60.7 11% Plain milk 56.7 60 52.9 50.0 49.0 -20% "Milk deluxe" 50 43.4 17% Milk beverage 37.4 -40% 40 36.1 18% Other yogurt 30 -60% 19% "Just yogurt" 20 -80% Others 10 0 -100% 2011 2012 2013 2014 2015 2016E 2017E 2018E Revenue YoY

Source: Company data, Credit Suisse estimates Notes: Company data, Credit Suisse estimates

Figure 21: Liquid milk sales and GPM forecast Figure 22: Downstream dairy company net margin

80% 50.0% 15% 30%

10% 10% 10% 60% 2% 0% 0.0% 5%

40% 0%

-50.0% -5% 20% -10%

0% -100.0% -15% Plain milk "Milk deluxe" Milk beverage Other yogurt "Just yogurt" 1H13 2H13 1H14 2H14 1H15 2H15 1H16 Yili Mengniu Bright Sanyuan GPM (LHS) 2017 revenue growth (RHS)

Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates

Less promotion is a double-edged sword With costs increasing across the board, we expect dairy companies to narrow their price discounts to protect margin, which would result in both pricing recovery and promotions' reduction. We generously project that into the 200 bp SG&A savings. However, this lifted pricing and reduced discount could be a double-edged sword, as it would cap volume growth on the demand side.

Raw milk powder to help in 2017, though mostly one-off Mengniu has sold off its excessive high-cost milk powder inventory in 2016, and claimed that it cost the company Rmb600 mn. Though one-off, this could help Mengniu's margin by 110 bp in 2017. Meanwhile, as imported milk powder is still cheaper than domestic raw milk, we expect Mengniu to increase its milk powder usage from 8% to 12%. This might help increase its margin by 20 bp in 2017E.

China Mengniu Dairy (2319.HK / 2319 HK) 10 16 January 2017

Mengniu could leverage its bargain powder for less price hike As the second largest dairy company in China, we expect Mengniu to leverage its bargain power for less cost increase, especially in packaging and logistics. We project a total 50 bp cost savings, from the original 110/100 bp cost increase in packaging and logistics.

Figure 23: Mengniu's key operations and financials P&L (Rmb mn) 2013 2014 2015 2016E 2017E BS (Rmb mn) 2013 2014 2015 2016E 2017E Revenue 43,357 50,049 49,027 52,918 56,793 PPE 9,246 9,667 11,638 13,019 14,400 - Liquid Milk 37,903 43,036 43,327 47,470 51,345 Construction in progress 1,276 2,030 901 901 901 - Milk powder 2,431 4,297 3,559 3,243 3,243 Investment in associate 2,843 3,841 4,186 5,176 5,300 - Ice cream 3,023 2,716 2,141 2,205 2,205 Goodwill 5,695 5,838 5,851 3,551 3,551 Revenue YoY 20.4% 15.4% -2.0% 7.9% 7.3% Non-current assets 24,018 26,748 28,232 28,793 30,627 - Liquid Milk 17.2% 13.5% 0.7% 9.6% 8.2% Inventories 2,577 4,342 4,340 4,587 4,923 - Milk powder 393.1% 76.8% -17.2% -8.9% 0.0% Trade receivables 754 1,148 1,618 1,383 1,450 - Ice cream -4.7% -10.2% -21.2% 3.0% 0.0% Current assets 15,225 20,324 22,036 22,129 23,057 GP margin 27.0% 30.8% 31.4% 32.8% 32.8% Trade payables 4,761 4,992 4,644 5,095 5,468 - Liquid milk 26.0% 29.7% 30.5% 32.3% 32.5% ST loans 8,462 4,361 6,081 6,081 6,081 - Milk powder 52.0% 49.0% 49.0% 44.0% 42.0% Current liabilities 17,860 14,351 15,961 16,357 16,897 - Ice cream 24.5% 29.0% 19.0% 28.0% 26.0% LT loans 3,236 5,464 4,970 4,970 4,970 SG&A/sales 23.3% 26.4% 27.0% 29.1% 28.7% Non-current liabilities 4,265 8,237 8,061 8,067 8,072 - Selling exp 18.8% 21.1% 22.4% 24.1% 23.8% Equity 18,011 24,493 26,615 26,498 28,715 ** A&P 6.3% 8.3% 8.3% 10.6% 9.8% Net debt 4,688 5,298 3,166 -2,559 -2,115 - Admin exp 3.7% 3.9% 3.8% 4.2% 4.2% Net gearing 26.0% 21.6% 11.9% 9.7% 7.4% - Other exp 0.8% 1.4% 0.8% 0.8% 0.8% CFS (Rmb mn) 2013 2014 2015 2016E 2017E OP profit 1,852 2,665 2,648 2,525 2,944 Operating cash flow 2,007 3,284 3,080 2,271 2,591 YoY 22.3% 43.9% -0.6% -4.6% 16.6% - Change in WC 496 -470 -593 212 -262 OP margin 4.3% 5.3% 5.4% 4.8% 5.2% Investing cash flow -3,239 -15,269 -6,415 -1,664 -1,629 Net earnings 1,631 2,351 2,367 2,200 2,588 - CAPEX -2,299 -2,857 -2,922 -2,776 -2,776 YoY 29.7% 44.1% 0.7% -7.1% 17.6% Free cash flow 426 157 -559 -505 -185 Net margin 3.8% 4.7% 4.8% 4.2% 4.6% Financing cash flow 12,331 3,619 -547 0 -518 ROE 13% 15% 10% 10% 11% Increase in cash 346 283 -324 607 445 Source: Company data; Credit Suisse estimates

China Mengniu Dairy (2319.HK / 2319 HK) 11 16 January 2017

CMD acquisition to trigger de-rating We do not appreciate the company's acquisition of CMD, because it is likely to end up with Mengniu taking the majority stake in CMD, and therefore it will introduce higher leverage and earnings volatility. It does help with Mengniu's earnings, and might not support its low- temperature business development. We expect this deal to lead to de-rating. CMD acquisition Mengniu announced on 5 January that it will offer HK$1.94/share to acquire a 16.7% stake in CMD from CDH/KKR. The consideration amounts to HK$1,873 mn (or US$241mn). Post the deal, Mengniu’s stake in CMD will increase from 25.4% to 39.9%. Meanwhile, the deal will trigger a general mandatory cash offer to the rest of the CMD shareholders (excluding the 9.2% non-accepting stakeholders) with the same acquiring price of HK$1.94/share. This implies that Mengniu’s stake in CMD could be up to 90.8% with a total consideration up to HK$8,797 mn (or US$1,134 mn) under this general cash offer. The offer price implies a 17x 2017E P/E and 1.3x 2017E P/B for CMD, based on our estimation. Management stated the deal will be financed by both internal cash and external debt financing. Mengniu owned Rmb5.2 bn cash (or US$754 mn) as of end-1H16. This deal is contingent upon shareholders’ approval, and management expects it to be finalised by 15 March. Upon the approval, CMD will pay US$13.4 mn cash to CDH/KKR as the total consideration to terminate the Valuation Adjustment was signed in July-15.

Figure 24: CMD's shareholding structure change No. of shares Current After exercise of After the completion of After the completion of potion deal mandatory of cash offer Mengniu 1,347,903,000 1,347,903,000 2,313,368,750 5,566,422,768 Success Dairy II 477,429,132 965,465,750 0 0 Xinmu 671,021,025 671,021,025 671,021,025 0 Yinmu 446,465,419 446,465,419 446,465,419 0 Jinmu 221,581,733 221,581,733 221,581,733 221,581,733 Lina Gao (CEO) 4,800,000 4,800,000 4,800,000 4,800,000 Other public 2,135,567,574 2,135,567,574 2,135,567,574 338,602,205 Total 5,304,767,883 5,792,804,501 5,792,804,501 6,131,406,706 % Stake Current After exercise of After the completion of After the completion of potion SPA mandatory of cash offer Mengniu 25.4% 23.3% 39.9% 90.8% Success Dairy II 9.0% 16.7% 0.0% 0.0% Xinmu 12.6% 11.6% 11.6% 0.0% Yinmu 8.4% 7.7% 7.7% 0.0% Jinmu 4.2% 3.8% 3.8% 3.6% Lina Gao (CEO) 0.1% 0.1% 0.1% 0.1% Other public 40.3% 36.9% 36.9% 5.5% Total 100.0% 100.0% 100.0% 100.0% Note: Success Dairy IIis 100% owned by CDH/KKR. Source: Company data

Will raise Mengniu's gearing to 37%, compared to Yili's 35% net cash We expect this mandatory cash offer will result in Mengniu taking the majority shares of CMD, and total consideration could land up to a maximum HK$8.3 bn. As a result, Mengniu's net gearing will increase from current 10% to 37% vs Yili's 35% net cash.

China Mengniu Dairy (2319.HK / 2319 HK) 12 16 January 2017

Incremental profits from CMD barely cover interest expenses If we assume Mengniu increases its stake from 25% to 90%, it will increase Mengniu's earnings by Rmb202 mn in the full year 2017, which is a good year for CMD as raw milk price is in the uptrend. However, the incremental interest expense could be Rmb220 mn, if we assume a 3% interest rate and 17% tax rate, Mengniu's incremental interest expenses will be Rmb184 mn. Therefore, the CMD acquisition barely contributes to earnings increase for Mengniu.

Figure 25: Net cash (debt) to equity, Mengniu vs Yili Figure 26: CMD acquisition impact on Mengniu

40% 35% 3,500

30% 3,000 202 20% -184 2,500 10% 2,000 0% -10% 1,500 -10% 2,529 2,546 -20% 1,000

-30% 500 -40% -37% 0 -50% 2017E net profit Incremental profit Interest expenses Pro-forma 2017E Mengniu, before CMD Mengniu, after CMD Yili from CMD for CMD net profit acquistion acquistion acquistion

Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates

CMD's high cost raw milk might constrain Mengniu's future strategy Mengniu explained that it acquired CMD for its well-located farm around China, which would be a strategic supply to develop Mengniu's low-temperature milk products (especially pasteurised milk and chilled yogurt) business in nearby developed cities. However, we are concerned that CMD has a relatively high cost structure, as its raw milk price is above competitors' average, yet still has a lower margin. Therefore, Mengniu might face higher a cost structure for low-temperature business, especially in competing with local players.

Lower earnings visibility and lift volatility We expect Mengniu to consolidate CMD after the deal, and that will lead to lower visibility and higher volatility to Mengniu's profit. Downstream dairy companies generally have a stable single digit net margin, while upstream dairy farms' net margin could be volatile from -30% to +50%, by the nature of their business. According to history, if consolidated, CMD could lift or drag down Mengniu's earnings by as much as 50%.

China Mengniu Dairy (2319.HK / 2319 HK) 13 16 January 2017

Figure 27: Downstream dairy companies' net margin Figure 28: Upstream dairy farms' net margin

12% 50%

40% 10% 30% 8% 20%

6% 10% 0% 4% -10% 2% -20%

0% -30% 1H13 2H13 1H14 2H14 1H15 2H15 1H16 1H13 2H13 1H14 2H14 1H15 2H15 1H16 Yili Mengniu Bright CMD YST Shengmu Huishan

Source: Company data, Credit Suisse estimates Source: Company data, Credit Suisse estimates

China Mengniu Dairy (2319.HK / 2319 HK) 14 16 January 2017

Valuation and risks Valuations We revise down 2017E earnings by 10% to Rmb2.5 bn (8% below consensus). We keep our top line forecast largely unchanged. We revise down Mengniu's OP margin by 40 bp, due to abovementioned cost concerns. We lower our target price by 34% to HK$11.60. the new target price is derived from 16x 2017E P/E (compared with previous 21x 2017E P/E), which is 1 sd below its historical average of 19x forward P/E. We expect Mengniu to de-rate on: (1) Market would factor in margin concerns caused by cost inflation; (2) CMD acquisition would result in Mengniu taking majority shares. Our new target price implies 23% potential downside. Mengniu is currently trading at 18x consensus 2017E P/E, or 19x CS forecast 2017E P/E.

Figure 29: Mengniu forecast and valuation changes Company Ticker Rating Market cap New TP TP Upside/ 2017E earnings vs . Trading P/E Target P/E (US$) change Downside change Consensus (x) (x)

Mengniu 2319.HK UNDERPERFORM 7,612 11.6 -34% -21% -10% -8% 18.8 16.0 Source: Company data, Credit Suisse estimates

Figure 30: Mengniu historical 12M forward P/E Figure 31: Yili historical 12M forward P/E 30 35

30 25

25 20 20

15 15

10 10 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 12M forward P/E Average +1 STDEV -1 STDEV 12M forward P/E Average +1 STDEV -1 STDEV

Source: The BLOOMBERG PROFESSIONAL™ service Source: The BLOOMBERG PROFESSIONAL™ service

Risks Upside risks include: (1) Narrowed promotion might lead to better-than-expected retail price recovering; (2) Volume growth could beat expectation due to faster growth in lower- tier cities; (3) Raw milk or import milk powder price could stabilise; (4) There could be less than expected cost increase from packaging and logistics; (5) Mengniu's internal reform could execute faster than expected with better-than-expected outcome.

China Mengniu Dairy (2319.HK / 2319 HK) 15

Dairy Mengniu China Figure 32: Upstream peer comparison

CMD YST Shengmu Huishan Rmb mn 2013 2014 2015 1H16 Rmb mn 2013 2014 2015 1H16 Rmb mn 2013 2014 2015 1H16 Rmb mn FY14 FY15 FY16 FY1H17 Cow count 186,838 201,507 225,542 220,493 Cow count 40,396 44,623 49,795 51,177 Cow count 60,457 103,252 111,395 122,046 Cow count 130,861 180,331 200,892 196,996 - Milkable cows 98,791 107,578 114,751 114,587 - Milkable cows 21,544 26,005 25,064 26,558 - Milkable cows 35,850 55,032 66,790 64,235 - Milkable cows 61,286 74,389 96,339 95,093

(2319.HK / 2319 HK) 2319 / (2319.HK - Heifers & calves 88,047 93,929 110,791 105,906 - Heifers & calves 18,852 18,618 24,731 24,619 - Heifers & calves 24,607 48,220 44,605 57,811 - Heifers & calves 69,575 105,942 104,553 101,903 Sales vol (ton) 650,093 837,232 752,314 389,437 Sales vol (ton) 183,702 230,121 233,275 128,439 Sales vol (ton) 203,796 344,696 514,668 278,260 Sales vol (ton) 196,119 211,769 217,936 103,972 - YoY 30.8% 28.8% -10.1% 7.2% - YoY 9.3% 25.3% 1.4% 9.0% - YoY 29.5% 69.1% 49.3% 10.7% - YoY 29.5% 8.0% 2.9% -8.5% Yield (ton/annual) 8.5 8.9 9.1 9.4 Yield 9.0 9.4 9.9 10.2 Yield 8.5 Yield (ton/annual) 9.1 9.1 8.6 7.8 - YoY 6.4% 5.3% 2.2% 3.3% - YoY 1.1% 4.4% 5.3% 6.3% - YoY - YoY 0.0% 0.0% -5.5% -10.3%

ASP (Rmb/kg) 4.57 5.01 4.42 4.04 ASP (Rmb/kg) 4.8 5.05 4.43 4.01 ASP (Rmb/kg) 4.7 5.3 4.9 4.7 ASP (Rmb/kg) 5.0 4.9 4.4 3.8 - YoY 13.6% 9.7% -11.8% -11.0% - YoY 16.9% 5.4% -12.4% -12.9% - YoY 8.4% 12.4% -6.7% -6.3% - YoY 12.2% -3.7% -9.1% -15.5% Sales 3,289 5,027 4,826 2,229 Sales 881 1,163 1,033 514 Sales 1,144 2,132 3,101 1,617 Sales 3,530 3,923 4,527 2,516 - Upstream 2,968 4,194 3,324 1,574 - Upstream 881 1,163 1,033 514 - Upstream 841 1,393 1,445 558 - Upstream 989 1,028 947 391 - Downstream 321 833 1,502 655 - Downstream 0 0 0 0 - Downstream 303 739 1,656 1,059 - Downstream 2,541 2,895 3,580 2,125 Sales mix 100% 100% 100% 100% Sales mix 100% 100% 100% 100% Sales mix 100% 100% 100% 100% Sales mix 100% 100% 100% 100% - Upstream 90% 83% 69% 71% - Upstream 100% 100% 100% 100% - Upstream 74% 65% 47% 35% - Upstream 28% 26% 21% 16% - Downstream 10% 17% 31% 29% - Downstream 0% 0% 0% 0% - Downstream 26% 35% 53% 66% - Downstream 72% 74% 79% 84% Sales YoY 62.0% 53.0% -4.0% -8.5% Sales YoY 27.8% 32.0% -11.2% -5.0% Sales YoY 63.2% 86.4% 45.4% 16.8% Sales YoY 38.3% 11.1% 15.4% 17.7% - Upstream 50.0% 41.0% -21.0% -4.5% - Upstream 27.8% 32.0% -11.2% -5.0% - Upstream 26.1% 65.6% 3.7% -21.3% - Upstream 45.2% 3.9% -7.9% -22.7% - Downstream 470% 159% 80% -17% - Downstream - Downstream 791.2% 143.9% 124.1% 56.9% - Downstream 35.8% 13.9% 23.6% 30.3% Gross margin 30.0% 37.1% 34.4% 32.5% Gross margin 42.6% 45.7% 36.8% 34.3% Gross margin 42.9% 50.2% 47.7% 47.8% Gross margin 20.1% 22.7% 20.8% 22.6% - Upstream 30.3% 41.2% 38.6% 32.8% - Upstream - Upstream - Upstream - Downstream 27.0% 16.4% 25.0% 32.0% - Downstream - Downstream - Downstream SG&A/sales -6.3% -6.5% -9.1% -11.9% SG&A/sales 6.7% 6.5% 10.3% 12.0% SG&A/sales -8.5% -10.8% -12.1% -12.9% SG&A/sales -20.3% -25.7% -25.0% -22.8% - Selling exp -1.7% -2.2% -4.0% -6.1% - Selling exp 2.2% 1.8% 2.0% 1.8% - Selling exp -6.3% -6.0% -8.6% -8.2% - Selling exp -9.8% -15.2% -15.4% -14.3% - Admin exp -4.60% -4.30% -5.00% -5.80% - Admin exp 4.6% 4.7% 8.3% 10.3% - Admin exp -2.2% -4.8% -3.5% -4.7% - Admin exp -10.5% -10.5% -9.6% -8.5% Operating profit 843 1,574 1,248 496 Operating profit 316 456 274 115 Operating profit 393 840 1,105 565 Operating profit 1,500 1,259 1,421 1,045 - YoY 99.5% 86.8% -20.7% -31.0% - YoY 43% 44% -40% -24% - YoY 97.5% 113.7% 31.5% 19.5% - YoY 30.0% -16.1% 12.8% -7.9% OP margin 25.6% 31.3% 25.9% 22.2% OP margin 35.8% 39.2% 26.5% 22.3% OP margin 34.4% 39.4% 35.6% 34.9% OP margin 42.5% 32.1% 31.4% 41.5% Net earnings 481 735 321 -566 Net earnings 218 419 66 -136 Net earnings 327 711 801 402 Net earnings 1249 877 662 618 - YoY 17.7% 52.8% -56.0% -219.0% - YoY 4% 92% -84% -1339% - YoY 67.2% 117.3% 12.6% 20.6% - YoY 32.1% -29.8% -24.5% -17.9% Net margin 14.6% 14.6% 6.7% -25.4% Net margin 24.7% 36.0% 6.4% -26.4% Net margin 28.6% 33.4% 25.8% 24.9% Net margin 35.4% 22.4% 14.6% 24.6% Source: Company data

16 January 2017 16 January

16

Dairy Mengniu China Figure 33: Downstream peer comparison Yili Mengniu Bright Dairy Sanyuan Rmb mn 2013 2014 2015 1H16 Rmb mn 2013 2014 2015 1H16 Rmb mn 2013 2014 2015 1H16 Rmb mn 2013 2014 2015 1H16 Revenue 47,454 53,487 58,755 29,367 Revenue 43,357 50,049 49,027 27,257 Revenue 16,179 20,494 19,115 9,988 Revenue 3,745 4,399 4,402 2,195 - Liquid milk 37,116 42,406 47,151 23,495 - Liquid Milk 37,903 43,036 43,327 23,762 - Dairy products 15,412 19,074 17,341 9,249 - Liquid milk 3,015 3,256 3,211 1,513

(2319.HK / (2319.HK - Milk powder 5,512 6,013 6,447 2,534 - Milk powder 2,431 4,297 3,559 1,792 ** Liquid milk 11,620 15,090 14,266 7,448 - Milk powder 730 1,143 1,191 592 - Ice cream 4,243 4,284 4,098 2,931 - Ice cream 3,023 2,716 2,141 1,703 ** Other dairy 3,792 3,983 3,075 1,802 - Milk beverage 89 - Feedstock 583 783 1,058 408 - Others 767 1,420 1,775 817

2319 HK) 2319 Revenue mix 100% 100% 100% 100% Revenue mix 100% 100% 100% 100% Revenue mix 100% 100% 100% 100% Revenue mix 100% 100% 100% 100% - Liquid milk 78% 79% 80% 80% - Liquid Milk 87% 86% 88% 87% - Dairy products 95% 93% 91% 93% - Liquid milk 80% 74% 73% 69%

- Milk powder 12% 11% 11% 9% - Milk powder 6% 9% 7% 7% ** Liquid milk 72% 74% 75% 75% - Milk powder 20% 26% 27% 27% - Ice cream 9% 8% 7% 10% - Ice cream 7% 5% 4% 6% ** Other dairy 23% 19% 16% 18% - Milk beverage 0% 0% 0% 4% - Feedstock 1% 1% 2% 1% - Others 5% 7% 9% 8% Revenue YoY 13.7% 12.7% 9.8% 0.3% Revenue YoY 20.4% 15.4% -2.0% 6.6% Revenue YoY 18.7% 25.0% -6.7% 1.0% Revenue YoY 6.6% 17.5% 0.1% 1.5% - Liquid milk 15.0% 14.3% 11.2% 4.8% - Liquid Milk 17.2% 13.5% 0.7% 8.3% - Dairy products 18.1% 23.8% -9.1% -1.1% - Liquid milk 5.0% 8.0% -1.4% 2.8% - Milk powder 22.9% 9.1% 7.2% -24.1% - Milk powder 393.1% 76.8% -17.2% -9.4% ** Liquid milk 17.5% 29.9% -5.5% -1.7% - Milk powder 13.7% 56.4% 4.3% 3.6% - Ice cream -1.2% 1.0% -4.3% -2.0% - Ice cream -4.7% -10.2% -21.2% 3.6% ** Other dairy 19.8% 5.0% -22.8% 1.6% - Milk beverage -25.1% - Feedstock -15.1% 34.3% 35.1% -22.3% - Others 32.6% 50.7% 25.0% 32.7% GP margin 28.6% 32.6% 36.4% 39.5% GP margin 27.0% 30.8% 31.4% 33.7% GP margin 34.9% 34.9% 36.3% 41.4% GP margin 17.7% 26.5% 32.1% 33.5% - Liquid milk 26.1% 30.8% 34.1% 37.2% - Liquid milk 26.0% 29.7% 30.5% 33.1% - Dairy products 36.0% 36.3% 38.9% 44.8% - Liquid milk 16.9% 26.8% 31.4% 30.5% - Milk powder 43.8% 45.6% 56.0% 58.5% - Milk powder 52.0% 49.0% 49.0% 45.0% ** Liquid milk 42.9% 42.6% 43.9% 50.4% - Milk powder 22.0% 25.5% 33.8% 42.3% - Ice cream 32.8% 35.0% 36.3% 43.7% - Ice cream 24.5% 29.0% 19.0% 29.5% ** Other dairy 15.0% 12.4% 15.8% 21.6% - Milk beverage 25.9% - Feedstock 11.3% 15.6% 20.1% 24.7% - Others 12.1% 12.9% 11.6% 3.8% SG&A/sales 22.9% 24.5% 27.9% 28.9% SG&A/sales 23.3% 26.4% 27.0% 28.7% SG&A/sales 30.0% 29.7% 31.4% 35.4% SG&A/sales 27.1% 25.6% 29.2% 31.9% - Selling exp 17.9% 18.7% 22.1% 23.6% - Selling exp 18.8% 21.1% 22.4% 23.7% - Selling exp 27.1% 26.8% 27.8% 32.1% - Selling exp 21.8% 21.5% 24.8% 26.4% ** A&P 8.2% 8.6% 12.2% 13.6% ** A&P 6.3% 8.3% 8.3% 10.4% ** A&P 17.1% 17.5% 18.3% 22.2% ** A&P 7.2% 8.1% 9.0% 10.5% - Admin exp 5.0% 5.9% 5.8% 5.2% - Admin exp 3.7% 3.9% 3.8% 4.2% - Admin exp 3.0% 2.8% 3.5% 3.3% - Admin exp 5.3% 4.1% 4.4% 5.5% - Other exp 0.8% 1.4% 0.8% 0.8% OP profit 2,626 4,545 5,192 3,284 OP profit 1,852 2,665 2,648 1,525 Operating profit 679 776 808 527 OP profit -294 -295 67 31 YoY 57.7% 73.1% 14.2% -0.2% YoY 22.3% 43.9% -0.6% 3.7% YoY 61.8% 14.3% 4.3% 15.2% YoY N/A N/A N/A -1.0% OP margin 5.5% 8.4% 8.7% 11.0% OP margin 4.3% 5.3% 5.4% 5.6% OP margin 4.2% 3.8% 4.2% 5.1% OP margin -7.8% -6.7% 1.5% 1.4% Net earnings 3,187 4,144 4,632 3,211 Net earnings 1,631 2,351 2,367 1,077 Net earnings 406 568 418 241 Net earnings -226.54 53.28 78.73 153.33 YoY 85.6% 30.0% 11.8% 20.6% YoY 29.7% 44.1% 0.7% -19.5% YoY 30.4% 39.9% -26.7% 20.2% YoY N/A N/A 47.8% 209.3% Net margin 6.7% 7.7% 7.7% 10.7% Net margin 3.8% 4.7% 4.8% 4.0% Net margin 2.5% 2.8% 2.2% 2.3% Net margin -6.0% 1.2% 1.8% 7.0% ROE 27% 24% 24% 26% ROE 13% 15% 10% 10% ROE 10% 13% 9% 11% ROE -13% 3% 2% 3% Net gearing -25% -29% -34% -44% Net gearing 26% 22% 12% 19% Net gearing -25% 15% -12% -10% Net gearing 34% 44% -61% -42% OpCF 5,475 2,436 9,536 7,494 OpCF 3,284 3,080 1,909 2,904 OpCF 1,305 338 1,866 641 OpCF -39 13 461 156

16 January 2017 16 January FCF 2,234 (1,510) 5,884 5,936 FCF 426 157 (1,126) 1,423 FCF 111 (1,458) (300) 147 FCF -195 -388 9 -127 Source: Company data

17

Dairy Mengniu China Figure 34: Valuation matrix—Global dairy comparison EPS PEG Div Company name Ticker Mkt cap Performance (%) P/E (x) EV/EBITDA (x) P/B (x) ROE (%) CAGR % yld Reuters (US$ mn) 1M 3M 12M 2015 2016 2017 2015 2016 2015 2016 2015 2016 2015-17 2016 12MF Global dairy products producers

(2319.HK / 2319 HK) 2319 / (2319.HK Nestle NESN.VX 229,560 3% -1% 6% 22.5 22.0 20.6 13.2 13.1 3.7 3.5 15.4% 16.2% 4.4% 5.0 3.3% Abbott ABT.N 70,653 7% -1% 1% 19.0 18.6 16.9 14.6 14.0 2.8 2.9 13.6% 14.7% 6.1% 3.0 2.5% Danone DANO.PA 42,151 -1% -5% 3% 20.7 19.9 18.5 10.6 9.8 3.0 2.8 14.7% 14.4% 5.7% 3.5 2.9% Mead Johnson MJN.N 13,091 -2% -12% 1% 20.5 20.4 20.3 12.1 12.5 (20.8) (22.8) N.M -77% 0.4% 45.4 2.6% Yakult 2267.T 7,845 2% 16% 5% 35.7 31.0 34.1 14.9 14.6 2.8 2.7 8.4% 8.8% 2.4% 13.1 0.6%

Fonterra FSF.NZ 8,259 4% 5% 4% 15.9 12.1 11.5 7.1 6.1 1.5 n.a. 9.6% 12.3% 17.3% 0.7 6.5% Meiji Foods 2269.T 11,791 2% -12% -2% 43.5 21.5 22.8 13.9 11.6 3.6 3.3 8.9% 16.1% 38.1% 0.6 1.4% Parmalat PLT.MI 5,972 20% 28% 29% 38.9 37.9 31.6 12.1 11.9 1.9 1.7 4.7% 4.7% 10.9% 3.5 0.7% Vina Milk VNM.HM 8,161 -2% -12% 27% 26.1 20.5 19.1 18.1 14.9 8.7 8.9 38.2% 43.9% 16.8% 1.2 4.3% Dean Foods DF.N 1,893 -5% 25% 16% 17.0 13.0 13.2 4.7 4.1 3.5 3.1 19.7% 25.5% 13.6% 1.0 1.8% Dairy Crest DCG.L 1,079 4% -1% 4% 16.9 18.6 17.6 6.6 7.8 3.0 6.7 -17.9% -22.5% -2.2% (8.5) 3.7% Morinaga Milk 2264.T 1,746 3% -4% 59% 47.8 18.8 18.6 8.1 n.a. 1.6 n.a. 3.4% 60.2% 0.8 1.0% Simple avg. 27.0 21.2 20.4 11.3 10.9 1.3 1.3 9.9% 5.2% 14.5% 1.9 2.6% Weighted avg. 22.8 21.2 20.0 13.1 12.6 2.7 2.5 14.3% 12.7% 6.5% 3.5 3.0% Chinese dairy products producers Inner Mongolia Yili 600887.SS 15,780 2% 11% 26% 23.6 20.5 17.7 14.9 14.2 5.4 5.0 23.9% 24.8% 15.5% 1.3 2.8% Mengniu Dairy 2319.HK 7,420 -2% -1% 35% 21.5 20.9 18.3 11.8 11.3 2.1 2.1 10.9% 5.2% 8.4% 2.5 1.3% Bright Dairy 600597.SS 2,229 -4% -11% 5% 36.7 29.3 24.5 11.6 10.3 3.4 3.1 9.3% 11.0% 22.4% 1.3 1.3% Simple avg. 27.3 23.6 20.2 12.7 11.9 3.6 3.4 14.7% 13.7% 15.4% 1.8 1.8% Weighted avg. 24.1 21.4 18.5 13.7 13.0 4.3 4.0 18.8% 17.9% 14.0% 1.7 2.2% Chinese raw milk producers Huishan 6863.HK 4,987 4% -1% -3% 36.4 39.2 35.6 20.4 17.7 3.4 n.a. 6.7% 6.3% 1.1% 36.3 0.7% China Modern Dairy 1117.HK 1,313 3% 14% 28% 27.1 (122) 18.7 5.5 7.8 1.1 1.1 4.5% 2.4% 20.2% 0.6 0.1% Simple avg. 23.0 (41.3) 27.2 5.3 12.8 0.7 1.1 6.1% 4.4% 10.6% 0.7 0.4% Weighted avg. 33.3 5.4 30.8 5.4 15.0 0.9 0.2 6.3% 5.3% 16.8% 4.9 0.0% Chinese milk powder producers Beingmate 1112.HK 1,840 -7% 6% 13% 124.0 (40.9) 459.3 47.3 (65.0) 3.5 3.7 2.9% -9.3% -48.0% 0.9 Biostime International 002570.SZ 1,963 5% 22% 53% 48.9 20.8 19.2 15.1 8.3 3.7 3.2 9.4% 16.1% 59.6% 0.3 Yashili 1230.HK 893 -1% -15% -16% 45.5 (156) 100.9 49.2 345.8 0.7 1.0 2.6% -0.2% -32.8% 4.8 0.4% Simple avg. 72.8 (58.8) 193.1 37.2 96.4 2.6 2.7 5.0% 2.2% -7.1% (10.3) 0.4% Weighted avg. 67.6 (32.2) 180.1 29.7 38.1 2.7 2.6 4.8% 2.6% -0.1% (480) 0.1% Note: Share price as of 16 Jan 2017. Source: Reuters; Credit Suisse estimates

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16 January 2017

Companies Mentioned (Price as of 16-Jan-2017) Abbott Laboratories (ABT.N, $40.93) Beingmate (002570.SZ, Rmb12.4) Biostime Intl (1112.HK, HK$24.15) Bright Dairy & Food Co., Ltd (600597.SS, Rmb12.48) China Mengniu Dairy (2319.HK, HK$14.66, UNDERPERFORM, TP HK$11.6) China Modern Dairy (1117.HK, HK$1.92)

China Shengmu (1432.HK, HK$2.13) Dairy Crest (DCG.L, 635.5p) Danone (DANO.PA, €60.53) Dean Foods Company (DF.N, $20.92) Fonterra Shareholders' Fund (FSF.NZ, NZ$6.18) Huishan (6863.HK, HK$2.87) Inner Mongolia Yili Industrial Group (600887.SS, Rmb17.93) Mead Johnson Nutrition Co. (MJN.N, $70.39) Meiji Holdings (2269.T, ¥9,130) Morinaga Milk (2264.T, ¥806) Nestle (NESN.S, SFr74.5) Parmalat (PLT.MI, €3.032) Sanyuan Foods (600429.SS, Rmb7.51) Vietnam Dairy Products Joint Stock Company (VNM.HM, D126500.0) Yakult Honsha (2267.T, ¥5,410) Yashili (1230.HK, HK$1.46) YuanShengTai Dairy Farm (1431.HK, HK$0.53)

Disclosure Appendix Analyst Certification Mark Mao, Michael Shen and Raymond Ching each certify, with respect to the companies or securities that the individual analyzes, that (1) the views expressed in this report accurately reflect his or her personal views about all of the subject companies and securities and (2) no part of his or her compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report.

3-Year Price and Rating History for China Mengniu Dairy (2319.HK)

2319.HK Closing Price Target Price Date (HK$) (HK$) Rating 12-Feb-14 18.98 23.75 O 27-Mar-14 19.58 24.50 14-Jul-14 18.62 23.25 28-Aug-14 17.72 22.50 02-Oct-14 16.00 17.50 N 12-Jan-15 16.85 20.00 O 26-Mar-15 19.35 22.50 21-Apr-15 21.28 25.00 11-Aug-15 16.60 21.00 27-Aug-15 14.45 20.00 OUTPERFORM NEUTRAL 13-Nov-15 13.64 17.20

16 January 2017 16 January 23-Mar-16 11.12 12.00 N 22-Aug-16 13.18 14.50 25-Aug-16 14.58 16.80 O 19-Sep-16 14.30 19.00

17-Nov-16 14.98 * 15-Dec-16 15.40 17.50 O * Asterisk signifies initiation or assumption of coverage. The analyst(s) responsible for preparing this research report received Compensation that is based upon various factors including Credit Suisse's total revenues, a portion of which are generated by Credit Suisse's investment banking activities As of December 10, 2012 Analysts’ stock rating are defined as follows: Outperform (O) : The stock’s total return is expected to outperform the relevant benchmark* over the next 12 months. Neutral (N) : The stock’s total return is expected to be in line with the relevant benchmark* over the next 12 months. Underperform (U) : The stock’s total return is expected to underperform the relevant benchmark* over the next 12 months. *Relevant benchmark by region: As of 10th December 2012, Japanese ratings are based on a stock’s total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. As of 2nd October 2012, U.S. and Canadian as well as European ra tings are based on a stock’s total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. For Latin American and non-Japan Asia stocks, ratings are based on a stock’s total return relative to the average total return of the relevant country or regional benchmark; prior to 2nd October 2012 U.S. and Canadian ratings were based on (1) a stock’s absolute total return potential to its current share price and (2) the relative attractiveness of a stock’s total return potential within an analyst’s coverage universe. For Australian and New Zealand stocks, the expected total return (ETR) calculation includes 12-month rolling dividend yield. An Outperform rating is assigned where an ETR is greater than or equal to 7.5%; Underperform where an ETR less than or equal to 5%. A Neutral may be assigned where the ETR is between -5% and 15%. The overlapping rating range allows analysts to assign a rating that puts ETR in the context of associated risks. Prior to 18 China Mengniu Dairy (2319.HK / 2319 HK) 19 16 January 2017

May 2015, ETR ranges for Outperform and Underperform ratings did not overlap with Neutral thresholds between 15% and 7.5%, which was in operation from 7 July 2011. Restricted (R) : In certain circumstances, Credit Suisse policy and/or applicable law and regulations preclude certain types of communications, including an investment recommendation, during the course of Credit Suisse's engagement in an investment banking transaction and in certain other circumstances. Not Rated (NR) : Credit Suisse Equity Research does not have an investment rating or view on the stock or any other securities related to the company at this time. Not Covered (NC) : Credit Suisse Equity Research does not provide ongoing coverage of the company or offer an investment rating or investment view on the equity security of the company or related products. Volatility Indicator [V] : A stock is defined as volatile if the stock price has moved up or down by 20% or more in a month in at least 8 of the past 24 months or the analyst expects significant volatility going forward. Analysts’ sector weightings are distinct from analysts’ stock ratings and are based on the analyst’s expectations for the fundamentals and/or valuation of the sector* relative to the group’s historic fundamentals and/or valuation: Overweight : The analyst’s expectation for the sector’s fundamentals and/or valuation is favorable over the next 12 months. Market Weight : The analyst’s expectation for the sector’s fundamentals and/or valuation is neutral over the next 12 months. Underweight : The analyst’s expectation for the sector’s fundamentals and/or valuation is cautious over the next 12 months. *An analyst’s coverage sector consists of all companies covered by the analyst within the relevant sector. An analyst may cover multiple sectors. Credit Suisse's distribution of stock ratings (and banking clients) is:

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Target Price and Rating Valuation Methodology and Risks: (12 months) for China Mengniu Dairy (2319.HK) Method: Our target price of HKD11.60 for China Mengniu Dairy is based on 16x 2017E P/E (price-to-earnigns), which is 1STDEV below its historical average 19x forward P/E, as we expect the sector cost headwinds and CMD acquisition lead to a de-rate. We rate Mengniu at Underperform as we are concerned that (1) Markets haven't fully priced in the cost headwinds sector wide; (2) CMD acquisition brings uncertainties and increase financial burden, leading to de-rating. Risk: Upside risks to our Underperform rating and HKD11.60 target price for China Mengniu Dairy include: (1) cost increase less than expect, especially raw milk, milk powder, logistics, and packaging cost; (2) dairy demand better than expectation, which might came from lower tier cities demand growth faster than expectation .

Please refer to the firm's disclosure website at https://rave.credit-suisse.com/disclosures for the definitions of abbreviations typically used in the target price method and risk sections. See the Companies Mentioned section for full company names The subject company (600597.SS, DANO.PA, 2269.T, FSF.NZ, DF.N, 2267.T, DCG.L, NESN.S, MJN.N) currently is, or was during the 12-month period preceding the date of distribution of this report, a client of Credit Suisse. Credit Suisse provided investment banking services to the subject company (NESN.S, MJN.N) within the past 12 months. Credit Suisse has managed or co-managed a public offering of securities for the subject company (NESN.S) within the past 12 months. Credit Suisse has received investment banking related compensation from the subject company (NESN.S, MJN.N) within the past 12 months

China Mengniu Dairy (2319.HK / 2319 HK) 20 16 January 2017

Credit Suisse expects to receive or intends to seek investment banking related compensation from the subject company (2319.HK, 600887.SS, 600597.SS, DANO.PA, 2269.T, FSF.NZ, DF.N, DCG.L, VNM.HM, NESN.S, MJN.N) within the next 3 months. As of the end of the preceding month, Credit Suisse beneficially own between 1-3% of a class of common equity securities of (NESN.S). For other important disclosures concerning companies featured in this report, including price charts, please visit the website at https://rave.credit- suisse.com/disclosures or call +1 (877) 291-2683.

For date and time of production, dissemination and history of recommendation for the subject company(ies) featured in this report, disseminated within the past 12 months, please refer to the link: https://rave.credit-suisse.com/disclosures/view/report?i=278340&v=-26z2igb5281yogdf7214byle5 . Important Regional Disclosures Singapore recipients should contact Credit Suisse AG, Singapore Branch for any matters arising from this research report. The analyst(s) involved in the preparation of this report may participate in events hosted by the subject company, including site visits. Credit Suisse does not accept or permit analysts to accept payment or reimbursement for travel expenses associated with these events. Restrictions on certain Canadian securities are indicated by the following abbreviations: NVS--Non-Voting shares; RVS--Restricted Voting Shares; SVS--Subordinate Voting Shares. Individuals receiving this report from a Canadian investment dealer that is not affiliated with Credit Suisse should be advised that this report may not contain regulatory disclosures the non-affiliated Canadian investment dealer would be required to make if this were its own report. For Credit Suisse Securities (Canada), Inc.'s policies and procedures regarding the dissemination of equity research, please visit https://www.credit- suisse.com/sites/disclaimers-ib/en/canada-research-policy.html. The following disclosed European company/ies have estimates that comply with IFRS: (DANO.PA, DCG.L, NESN.S). Credit Suisse has acted as lead manager or syndicate member in a public offering of securities for the subject company (NESN.S) within the past 3 years. Principal is not guaranteed in the case of equities because equity prices are variable. Commission is the commission rate or the amount agreed with a customer when setting up an account or at any time after that. Credit Suisse has entered into a strategic partnership with First NZ Capital ("FNZC"). Pursuant to this agreement, (FSF.NZ) is jointly covered by Credit Suisse and First NZ Capital. This research report is authored by: Credit Suisse (Hong Kong) Limited ...... Mark Mao ; Raymond Ching Credit Suisse (Hong Kong) Limited Shanghai Representative Office ...... Michael Shen To the extent this is a report authored in whole or in part by a non-U.S. analyst and is made available in the U.S., the following are important disclosures regarding any non-U.S. analyst contributors: The non-U.S. research analysts listed below (if any) are not registered/qualified as research analysts with FINRA. The non-U.S. research analysts listed below may not be associated persons of CSSU and therefore may not be subject to the NASD Rule 2711 and NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account. Credit Suisse (Hong Kong) Limited ...... Mark Mao ; Raymond Ching Credit Suisse (Hong Kong) Limited Shanghai Representative Office ...... Michael Shen For Credit Suisse disclosure information on other companies mentioned in this report, please visit the website at https://rave.credit- suisse.com/disclosures or call +1 (877) 291-2683.

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China Mengniu Dairy (2319.HK / 2319 HK) 21 16 January 2017

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In jurisdictions where CS is not already registered or licensed to trade in securities, transactions will only be effected in accordance with applicable securities legislation, which will vary from jurisdiction to jurisdiction and may require that the trade 2017 16 January be made in accordance with applicable exemptions from registration or licensing requirements. Non-US customers wishing to effect a transaction should contact a CS entity in their local jurisdiction unless governing law permits otherwise. US customers wishing to effect a transaction should do so only by contacting a representative at Credit Suisse Securities (USA) LLC in the US. Please note that this research was originally prepared and issued by CS for distribution to their market professional and institutional investor customers. Recipients who are not market professional or institutional investor customers of CS should seek the advice of their independent financial advisor prior to taking any investment decision based on this report or for any necessary explanation of its contents. This research may relate to investments or services of a person outside of the UK or to other matters which are not authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority or in respect of which the protections of the Prudential Regulation Authority and Financial Conduct Authority for private customers and/or the UK compensation scheme may not be available, and further details as to where this may be the case are available upon request in respect of this report.

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