EQUITY RESEARCH REPORT FOOD & BEVERAGE October 2018 By: Katharine Song (S1700517120001) https://www.research.hsbc.com China Baijiu China China Baijiu A toast to the national drink Drinking baijiu is part of daily life in China, which makes it a compelling domestic consumer story in a time of tariffs We show how the addressable market is growing and explain why leading companies can increase their market share Initiate coverage on four stocks and assume Equities // Food & Beverage coverage on industry leaders Kweichow Moutai and Wuliangye; Moutai is our preferred pick (Buy) October 2018 October Disclaimer & Disclosures: This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it EQUITIES FOOD & BEVERAGE October 2018 China’s national drink: baijiu’s leading companies Consumption Demographics and urbanisation ASP the long-term driver Despite the big change in the customer base, Consumers who have moved into cities now have The consumption upgrade story is not limited to the Baijiu’s share of overall alcohol consumption more money, attach greater importance to brand and high end – it is taking place throughout the product remains stable, in line with global trends quality and don’t mind paying for it range all the way down to the mass market Total alcohol sales in China, market share Baijiu sales will benefit from urbanisation Sales volume of 3 major high-end Baijiu brands Urbanisation rate 70,000 (RHS) tonnes 13% CAGR 2018e-20e 60,000 Other 50% Baijiu 2012 50,000 Monthly disposable income of urban residents per capita 40,000 46% (LHS) 2017 30,000 Total alcoholic drinks by market share Top six baijiu company revenue mix 20,000 48% 49% 10,000 Beer sales in Wine sales in 0 Germany France 2012 2014 2016 2018e 2020e Market share of top five baijiu companies Demand for high-end baijiu (tonnes) 19.6% 21.6% Current 2012 2017 demand … 80,000 … but supply limited to 60,000 Estimated supply by 2020 81,000 We have four stocks rated Buy BUY BUY BUY BUY Kweichow Moutai (600519 CH) Wuliangye (000858 CH) Yanghe Brewery (002304 CH) Luzhou Laojiao (000568 CH) Moutai, the market leader in revenue, Core premium products, led by Puwu Famous regional baijiu company with Luzhou Laojiao is ranked fourth in is the most recognised brand and has (52-degree Wuliangye Classic), two big brands, and ranked third in terms of revenue and its products strong pricing power contributed 71% of total revenue sales revenue cover all price levels Source: Company reports, CEIC, Euromonitor, NBS, Wind, HSBC Qianhai Securities 1 EQUITIES FOOD & BEVERAGE October 2018 Why read this report? Looking for a compelling investment story in China’s domestic consumer market? Try baijiu. The addressable market is growing and the price of premium baijiu, the main profit driver, is rising. Valuations look attractive, too. We compare industry leaders on different metrics. We have four Buys, with Moutai as our preferred pick. With this report, Katharine Song assumes primary coverage of Kweichow Moutai and Wuliangye on behalf of HSBC Qianhai Securities Limited. 2 EQUITIES ● FOOD & BEVERAGE October 2018 Contents Good spirits: a toast to baijiu 4 Buying into the baijiu story 13 Company profiles 25 Kweichow Moutai (600519 CH) 26 Wuliangye (000858 CH) 38 Jiangsu Yanghe Brewery (002304 CH) 49 Luzhou Laojiao (000568 CH) 64 Shanxi Xinghuacun Fen Wine (600809 CH) 76 Swellfun (600779 CH) 88 Disclosure appendix 100 Disclaimer 103 3 EQUITIES ● FOOD & BEVERAGE October 2018 Good spirits: a toast to baijiu China’s leading baijiu companies are some of the most profitable state-owned enterprises in the country. And, at a time of trade tensions when the market is looking to the domestic market to fortify the economy, we believe China’s national drink represents a compelling investment story. The outlook remains bright as the addressable market is growing and the price of premium baijiu, the main profit driver, is rising. Since suffering from the crackdown on excessive government spending market leaders have used their brand strength and distribution reach to recalibrate their businesses and strengthen their market share. We assume coverage on industry leaders Kweichow Moutai and Wuliangye with Buy ratings, and initiate on four other stocks – Jiangsu Yanghe Brewery (Buy), Luzhou Laojiao (Buy), Shanxi Fen Wine (Hold) and Swellfun (Hold). Moutai is our preferred pick. Part of the national culture The custom of raising a glass of baijiu has been embedded in Chinese culture for hundreds of years. As with wine in France and beer in Germany, the fiery spirit is part of daily life, whether that be a business dinner, a major celebration, a family gathering or a drink with friends. And the business is booming again after a difficult period when the industry was hit hard by the government clampdown on excessive official spending during 2013-15. We estimate government business accounted for 40% of sales before the crackdown. We believe that figure has now shrunk to about 5%. The austerity drive hit the industry hard as sales slumped. But showing all the smarts normally The austerity drive hit the industry hard associated with the private sector, these nimble state-owned enterprises (SOEs) have reconfigured their sales, marketing and distribution channels to reduce their reliance on government orders and appeal to a much broader consumer market. For the market leaders in a fragmented market – there are more than 1,500 liquor companies in China – this remains a high-margin business that generates strong profit growth. And, at a time of trade tensions with the US when the market is looking to the domestic market to fortify the domestic economy, we believe China’s national drink represents a compelling investment story. So far this year, the baijiu index has declined 14% compared to the 21.3% fall in the CSI 300, the index for the 300 largest and most liquid A-share stocks. The sector features rising ROE and dividends payments, strong cash flow, high entry barriers and low levels of debt and capex. 4 EQUITIES ● FOOD & BEVERAGE October 2018 Despite the big change in the customer base, Baijiu’s share of overall alcohol consumption remains stable, similar to the trends for beer in Germany and wine in France. The difference for baijiu is that there are opportunities to boost the addressable market in two areas specific to the China market – demographics and consumption upgrades. Simply put, China is ageing and is one of the few countries where drinking alcohol increases as As consumers get wealthier they are happy to spend people get older. Encouragingly, the size of the 30-59 age-group – baijiu’s key market – will more on high-end baijiu keep increasing until 2023. And as with many other parts of the consumer sector in the country, as consumers get wealthier, they are happy to spend more on high-end baijiu, which is a hugely important part of the market. But we believe the consumption upgrade story isn’t limited to the high end – it is taking place throughout the product range all the way down to the mass market. So, despite short-term concerns about China’s economy, we are still bullish about the outlook for baijiu, especially the market leaders; we have four Buys and two Holds. Indeed, for an industry that was in crisis just a couple of years ago, the baijiu business can raise a glass to its current good health and bright future. This report covers the following areas: The addressable market, how and why it should grow. Demographic trends and consumer upgrades are important factors. Market share – how the leaders can increase their grip, especially in the luxury market. How higher prices rather than sales volumes are driving growth in revenues, margins and profits Valuations – why we think they are attractive. Sector forward PE has dropped from 29x at the beginning of 2018 to 16x in Oct, the same level as in February 2016 at the height of the government’s austerity drive. As assessment of six leading baijiu companies – Kweichow Moutai, Wuliangye, Yanghe, Luzhou Laojiao, Fen Wine and Swellfun. We compare them on below metrics – premium products, distribution channels, marketing expense ratios, SOE reform/management incentives, margin and ROE. Based on our comparison metrics, Moutai is our preferred pick. Leaders should continue to gain market share According to Euromonitor, the retail market for China’s spirits – essentialy baijiu – is the largest The retail market for China’s spirits – essentialy baijiu – is in the world. In 2017, sales of baijiu accounted for 46% of all alcoholic beverages in China. the largest in the world Although this is down from 50% in 2012 – in line with global trends – it remains below the level in developed markets like Germany and France, where their respective beer and wine sales account for 48% and 49% of the total market for alcoholic drinks. This metric suggests there’s room for baijiu to grow its market share in terms of the overall contribution it makes to alcoholic drinks in China. We have also compared the level of market concentration in the three countries. In terms of the top five last year, in Germany, the leaders had 41% market share and in France, it was 24%. In China, we estimate the top five baijiu companies had a market share of 21.6% last year, up from 19.6% in 2012. This trend is accelerating. In terms of company revenue, the market share of the top three baijiu makers was 18.7% last year, up from 15.6% during the previous boom in 2012. Industry leader Moutai has increased its share of revenue from 4.9% to 10.3% during this period, 5.3 ppts ahead of Wuliangye in second place.