December 19, 2016 China: Consumer Staples Equity Research Look beyond near-term Dairy woes; Mengniu profit warning Mengniu FY16 profit warning a surprise On Dec 15, Mengniu issued a profit warning stating that in 2016 it will show a substantial loss due to: (1) Infant milk formula (IMF) sub Yashili's goodwill impairment; and (2) disposal loss on excessive sprayed milk powder inventory (mgmt. estimate Rmb600mn). While the impairment had been expected by the market, the magnitude was a surprise to us. We estimate Mengniu will record Rmb3.0-3.5bn impairment losses for 2016 (this compares to its 2015 net profit of Rmb2.3bn). We revise our 2016 reported EPS to Rmb(0.23) from Rmb0.50 and recurring EPS by -8% from Rmb0.59 to Rmb0.54 due to higher COGS from #2 above, and view #1 as a one-off. Our 12-month target price has not changed under our 2018E EV/GCI vs. CROCI/WACC framework and remains HK$17.8; retain Buy. Mengniu new CEO’s initiatives: focus on improving efficiency New CEO Mr. Lu Minfang has also set out his reform plan. Key initiatives: 1) streamline headquarters and offer wide decision-making autonomy to each business unit and 2) centralize procurement. For #1, each business unit will now have independent P&L metrics internally, enabling business decision making (e.g. large scale marketing campaign) without seeking approval. For #2, the company plans to procure all its milk under the same platform and increase the use of imported milk powder for low-end UHT milk. We think the initiatives will allow Mengniu to more quickly adapt to market conditions and improve operational efficiency. 2017 Guidance: Mengniu's priority is profit growth. It aims to maintain higher than industry sales growth while also focusing on improving profit margins. We see some gross margin upside from using lower-cost milk powder inventory and as industry prices fall in 2017. We have already built some margin expansion into GPM. IMF competition still intense, CMD raw milk price upside limited We think Yashili's unfavorable result plus weak results from peers (Yili [Buy], Biostime [Neutral], Beingmate [NC]) indicate the IMF market still faces intense competition in next 6 months. Mengniu’s new procurement policy implies more stable volume for China Modern Dairy (Neutral) (Mengniu buys 70% of CMD’s milk), but we see limited upside risk for raw milk prices as Mengniu shifts toward market pricing and a focus on gross margins. Lincoln Kong, CFA +852-2978-6603 [email protected] Goldman Sachs (Asia) L.L.C. Goldman Sachs does and seeks to do business with Joshua Lu companies covered in its research reports. As a result, +852-2978-1024 [email protected] Goldman Sachs (Asia) L.L.C. investors should be aware that the firm may have a conflict of Kevin Li interest that could affect the objectivity of this report. Investors +65-6654-5190 [email protected] Goldman Sachs (Singapore) Pte should consider this report as only a single factor in making their investment decision. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html. Analysts employed by non- US affiliates are not registered/qualified as research analysts with FINRA in the U.S. The Goldman Sachs Group, Inc. Global Investment Research December 19, 2016 China: Consumer Staples Exhibit 1: We expect limited upside risk for Mengniu’s Exhibit 2: We expect margin improvement in 2016-18E raw milk cost, and largely offset by lower milk powder from further gross margin expansion in the core business cost Mengniu GPM and OPM Mengniu Raw milk cost Raw milk purchase cost (RMB/kg) GP OPM 40% 4.80 35% 4.60 34.1% 34.7% 35.0% 30% 4.40 30.8% 31.4% 25% 27.0% 4.20 25.0% 20% 4.00 15% 3.80 10% 6.2% 5.7% 6.0% 3.60 4.6% 4.9% 5.2% 5.3% 5% 3.40 2013 2014 1H15 2H15 1H16 2H16E 1H17E 2H17E 2018E 0% 2012 2013 2014 2015 2016E 2017E 2018E Source: Company data, Goldman Sachs Global Investment Research. Source: Company data, Goldman Sachs Global Investment Research. Exhibit 3: China Modern Dairy has seen two consecutive Exhibit 4: Mengniu has seen its share in the IMF market interims of losses fall to only 1.4% from c.6% four years ago China Modern Dairy Semi-Annual earnings Modern Trade & Mom/Baby Channel Market Share MEAD JOHNSON Wyeth BEINGMATE Rmb mn Net profit (inc bio asset) BIOSTIME ABBOTT MENGNIU 18.0% 600 523.2 Wyeth 15.6% 477.0 16.0% 354.8 400 14.0% 212.2 12.0% MJN 10.7% 200 10.0% Abbott 8.1% 0 8.0% 6.0% Biostime 7.2% (200) (155.7) 4.0% Beingmate 4.7% MENGNIU, 1.4% (400) 2.0% (600) 0.0% JF13 JF14 JF15 JF16 JA12 JA13 JA14 JA15 JA16 SO12 SO13 SO14 SO15 MJ13 MJ14 MJ15 MJ16 (565.7) ND12 ND13 ND14 ND15 (800) MA13 MA14 MA15 MA16 1H14 2H14 1H15 2H15 1H16 2H16E Source: Company data, Goldman Sachs Global Investment Research. Source: Nielsen. Goldman Sachs Global Investment Research 2 December 19, 2016 China: Consumer Staples Exhibit 5: Yashili’s sales have not recovered since falling Exhibit 6: Yashili profits have fallen to below Rmb100mn in 1H13 since 2H14 Yashili Semi-Annual Sales Yashili Semi-Annual Profit Sales (Rmb) yoy growth NPAT (mn) yoy growth Rmb mn 34.1% 2,500 40% 350.0 40.0% 2,152.9 25.9% 30% 300.0 293.6 8.3% 20.0% 2,000 27.5% 1,737.1 20% 250.0 0.0% 1,545.7 1,600.0 209.4 1,146.5 10% 1,500 1,270.7 200.0 ‐20.0% 1,161.5 0% 144.0 150.0 ‐28.7% ‐40.0% 1,000 ‐1.3% ‐10% ‐63.9% ‐42.3% ‐72.6% ‐80.1% ‐11.6% ‐20% 100.0 ‐60.0% 500 75.6 50.0 39.4 42.7 ‐80.0% ‐24.9% ‐30% ‐28.2% ‐26.8% 15.07 0 ‐40% 0.0 ‐100.0% 1H13 2H13 1H14 2H14 1H15 2H15 1H16 1H13 2H13 1H14 2H14 1H15 2H15 1H16 Source: Company data. Source: Company data. Exhibit 7: Our ratings and target prices for Mengniu and CMD are unchanged Mengniu/CMD rating, target price methodology and key risks Ticker Company Name Rating 12m Target Price TP Methodology Risks Sharp rebound of domestic milk price, 2319.HK Mengniu Buy HK$ 17.8 2018E EV/GCI vs CROCI/WACC intensifying competition Upstream: stronger/weaker WMP prices, herd disease 1117.HK China Modern Dairy Neutral HK$ 1.67 DCF Downstream: better/worse than expected sales growth/OPM Source: Goldman Sachs Global Investment Research. December 16 closing prices: Mengniu: HK$15.00 CMD: HK$1.87 Yili: Rmb17.58 Biostime: HK$23.05 Goldman Sachs Global Investment Research 3 December 19, 2016 China: Consumer Staples Disclosure Appendix Reg AC We, Lincoln Kong, CFA, Joshua Lu and Kevin Li, hereby certify that all of the views expressed in this report accurately reflect our personal views about the subject company or companies and its or their securities. We also certify that no part of our compensation was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. Unless otherwise stated, the individuals listed on the cover page of this report are analysts in Goldman Sachs' Global Investment Research division. Investment Profile The Goldman Sachs Investment Profile provides investment context for a security by comparing key attributes of that security to its peer group and market. The four key attributes depicted are: growth, returns, multiple and volatility. Growth, returns and multiple are indexed based on composites of several methodologies to determine the stocks percentile ranking within the region's coverage universe. The precise calculation of each metric may vary depending on the fiscal year, industry and region but the standard approach is as follows: Growth is a composite of next year's estimate over current year's estimate, e.g. EPS, EBITDA, Revenue. Return is a year one prospective aggregate of various return on capital measures, e.g. CROCI, ROACE, and ROE. Multiple is a composite of one-year forward valuation ratios, e.g. P/E, dividend yield, EV/FCF, EV/EBITDA, EV/DACF, Price/Book. Volatility is measured as trailing twelve-month volatility adjusted for dividends. Quantum Quantum is Goldman Sachs' proprietary database providing access to detailed financial statement histories, forecasts and ratios. It can be used for in-depth analysis of a single company, or to make comparisons between companies in different sectors and markets. GS SUSTAIN GS SUSTAIN is a global investment strategy aimed at long-term, long-only performance with a low turnover of ideas. The GS SUSTAIN focus list includes leaders our analysis shows to be well positioned to deliver long term outperformance through sustained competitive advantage and superior returns on capital relative to their global industry peers. Leaders are identified based on quantifiable analysis of three aspects of corporate performance: cash return on cash invested, industry positioning and management quality (the effectiveness of companies' management of the environmental, social and governance issues facing their industry). Disclosures Coverage group(s) of stocks by primary analyst(s) Lincoln Kong, CFA: A-share Food & Beverage, China Consumer Products. Joshua Lu: Greater China Retail. A-share Food & Beverage: Anhui Gujing Distillery Co., Jiangsu Yanghe, Kweichow Moutai, Luzhou Laojiao, Qinghai Huzhu Barley Wine Co., Shanxi Xinghuacun Fen Wine, Tsingtao Brewery (A), Wuliangye Yibin.