INITIATION Company Note Food & Beverages│China│October 17, 2019 Insert Insert China Luzhou Laojiao ADD Successful channel reforms Consensus ratings*: Buy 26 Hold 5 Sell 0 ■ We like Luzhou Laojiao for its successful distribution channel reforms, strong Current price: Rmb86.12 profitability improvement and potential ASP hike for its star brand – Cellar 1573. Target price: Rmb122.0 ■ We forecast a 27% EPS CAGR in FY18–21F, driven by a 23%/24% sales CAGR from its high-end and mid-range product segments, respectively. Previous target: Rmb ■ We initiate with an Add rating and DCF-based TP of Rmb122 (WACC:9.6%) Up/downside: 41.7% CGS-CIMB / Consensus: 21.4% New distribution network starting to reap benefits Since 2015, Laojiao has taken four years to restructure its distribution network, providing Reuters: 000568.SZ stronger market support for its distributors and restoring its high-end brand image. Now Bloomberg: 000568 CH Laojiao has around 3,000 distributors with over 8,000 of its own salespeople. Its brand Market cap: US$17,826m value rose by 40% yoy to US$5.3bn in 2019, according to Brand Finance. Backed with Rmb126,144m this strong distribution network, we expect Laojiao’s channel reforms to start to bear fruit Average daily turnover: US$129.7m and its sales to grow at a 19% CAGR in FY18–21F. We also expect its high S&D Rmb916.1m expenses ratio of 26% in 2018 to gradually fall back by 5%pts to 21% in 2021F, leading Current shares o/s: 1,465m to OPM expansion of 8.4%pts from 34.2% in FY18 to 42.4% in FY21F. Free float: 99.7% Product portfolio premiumization to capture consumption upgrade *Source: Bloomberg Laojiao’s product structure has been continually been upgraded. Its high-end baijiu (i.e. Key changes in this note Cellar 1573) sales grew rapidly by 37% yoy to Rmb6.4bn, accounting for 50% of baijiu N/A sales in FY18; while its middle-range baijiu was up by 28% yoy to Rmb3.7bn, contributing 22% of sales. Laojiao has gradually lifted its retail selling price (RSP) YTD because of Price Close Relative to SHCOMP (RHS) strong market demand and low channel inventory. According to JD.com, its RSP for 109.00 232 major products has risen by 7% to 38% YTD, and Laojiao has successfully captured the 89.00 192 consumption upgrade trend. 69.00 152 49.00 112 ASP hike could be a near-term catalyst 29.00 72 40 Laojiao’s price strategy is closely pegged with that of Wuliangye, which successfully 30 th 20 increased its ex-factory price by 12.6% through launching the 8 generation of Wuliangye 10 Vol m Vol in June 2019. We expect Laojiao to follow Wuliangye, increasing its ex-factory price of 10月-18 1月-19 4月-19 7月-19 Cellar 1573 in the near future. Meanwhile, due to a supply shortage of premium baijiu in the RSP range of Rmb1,000–2,000/bottle, we expect Cellar 1573 to ramp up by 7% Source: Bloomberg volume CAGR and 15% ASP CAGR in FY18–21F. Price performance 1M 3M 12M Initiate coverage with an Add rating and DCF-based TP of Rmb122 Absolute (%) -1.9 2 105.1 We initiate coverage on Laojiao with an ADD rating and DCF-based TP of Rmb122 Relative (%) -1.9 .4 88.9 (WACC: 9.6%), implying 38x/31x FY19F/20F P/E. Laojiao is currently trading at 27x FY19F P/E, 2.0 s.d. above its historical average of 19x since its listing in 2009. In the Major shareholders % held past, Laojiao’s valuation was largely in line with, or slightly below, the industry average. Luzhou Laojiao Group Co. Ltd 26.0 We believe that Laojiao deserves to trade at premium vs. its peers owing to a potential ASP hike for its super-premium Cellar 1573 products and strong sales growth Insert momentum, boosted by its profit-sharing distribution model. Downside risks are as follows: 1) over 67% of its sales are derived from its top five customers, which indicates the key distributors have strong bargaining power and influence on Laojiao’s distribution channels, which might be a tail risk in the long term; and 2) a macroeconomic slowdown may affect super-premium baijiu consumption. Financial Summary Dec-17A Dec-18A Dec-19F Dec-20F Dec-21F Revenue (Rmbm) 10,395 13,055 16,264 18,930 22,097 Operating EBITDA (Rmbm) 3,330 4,502 6,107 7,647 9,594 Net Profit (Rmbm) 2,558 3,486 4,697 5,802 7,222 Core EPS (Rmb) 1.75 2.38 3.21 3.97 4.94 Core EPS Growth 26.9% 36.2% 34.7% 23.5% 24.5% FD Core P/E (x) 48.14 36.12 26.82 21.72 17.45 Analysts DPS (Rmb) 1.25 1.55 2.09 2.58 3.21 Lei Yang Dividend Yield 1.45% 1.80% 2.43% 3.00% 3.73% T (86) 21 6162 9676 EV/EBITDA (x) 35.39 25.97 19.10 15.11 11.85 P/FCFE (x) 52.35 44.52 37.07 25.56 19.09 E [email protected] Net Gearing (55.2%) (54.7%) (51.7%) (52.1%) (54.5%) Sun Feifei P/BV (x) 8.31 7.44 6.78 6.12 5.45 T (86) 21 6162 5750 ROE 19.6% 21.7% 26.5% 29.6% 33.0% E [email protected] % Change In Core EPS Estimates CGI/consensus EPS (x) 1.00 0.99 1.02 SOURCES: CGIS RESEARCH, COMPANY DATA, BLOOMBERG Powered by the EFA Platform Food & Beverages│China Luzhou Laojiao│October 17, 2019 Successful channel reforms Investment summary Laojiao expects to be the next baiju company to tap RSP above Rmb1,000 per bottle after Wuliangye In the current new growth cycle of the China baijiu sector, starting from 2018, with the consumption upgrade trend, top tier brand Moutai increased its retail selling price (RSP) of 53°Feitian MT to Rmb2,700 per bottle from Rmb1,499 per bottle. This has triggered strong customer demand for other baijiu products with a strong brand name but a more reasonable RSP in the range of Rmb1,000–2,000 per bottle in the super premium baijiu market. In Jun 2018, another top-tier baijiu brand, Wuliangye, successfully launched its new 52° Wuliangye on the market with an RSP of Rmb1,000–1,300 per bottle, from the previous Rmb920–950 per bottle. Wuliangye has partially filled in the price gap for the RSP range of Rmb1,000–2,000 per bottle through this product upgrade. Wuliangye increased its ex-factory price from Rmb789/bottle to Rmb889/bottle, up 13%. We expect total sales volume of 52°Wuliangye to reach 18,000 tonnes in 2019F, up 15% YoY. We believe Luzhou Laojiao (Laojiao) can raise its ex-factory price after Wuliangye’s price increase, supported by its strong brand name and sufficient production capacity for Cellar 1573. Currently, the ex-factory price for Laojiao Cellar 1573 is Rmb780/bottle, with a first-layer wholesale price of Rmb820/bottle and an RSP of Rmb919/bottle. We expect Laojiao’s sales to grow at a 19% CAGR from Rmb13bn in 2018 to Rmb22bn in 2021F, driven mainly by ASP improvement through product upgrades and volume growth. Figure 1: Core super-premium baijiu products with strong brand names in the China consumer market SOURCES: CGIS RESEARCH, COMPANY DATA, BLOOMBERG 2 Food & Beverages│China Luzhou Laojiao│October 17, 2019 Figure 2: 2002–21F Laojiao sales performance in the different baijiu phases (Rmb m) Baijiu Baijiu new growth 25,000 Baijiu recovery 80% Baijiu fast growth period adjustment period (2018-) period (2015-2017) 22,097 (2003-2012) period (2013-2014) 60% 20,000 18,930 16,264 40% 15,000 13,055 20% 11,556 0% 10,000 In Jan 2001, Laojiao launched its star -20% product - Cellar1573 5,000 -40% 0 -60% FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18 FY19F FY20F FY21F Laojiao's revenue YoY (RHS， %） SOURCES: CGIS RESEARCH, COMPANY DATA Laojiao Cellar 1573 brand with strong revenue resilience The intrinsic value of Laojiao’s baijiu comes from its wholly-owned 10,086 aged cellars, 1,619 of which are more than 100 years old. The oldest ones can be traced back to the Wanli Period of the Ming Dynasty in 1573 A.D. To promote Luzhou’s intrinsic value in the baiju market, the company launched a high-end Cellar 1573 (国窖1573) product in Jan 2001. This was followed by a large marketing campaign to promote and strengthen its Laojiao brand among consumers as one of the top high-end brands. The strategy was quite successful, as Laojiao achieved a 23% sales CAGR in 2000–2012, 5.8%pts higher than Wuliangye’s 17% CAGR. Laojiao also gradually raised its ex-factory price of Cellar 1573 from Rmb268 per bottle in 2002 to Rmb889 per bottle in 2012; and in 2012, the RSP of Cellar 1573 reached Rmb1,389 per bottle in the end consumer market, 25% higher than 52° Wuliangye’s RSP of Rmb1,109 per bottle at the time. In the last baijiu growth cycle, we think Laojiao successfully built up its high-end brand image nationwide and established a solid customer base for long-term market development. However, in the 2013–15 baijiu sector restructuring period, Laojiao management misjudged the negative impact on high-end baijiu consumption of the government’s anti-corruption measures and implemented an inappropriate marketing strategy to cope with oversupply in the baijiu market; eventually Laojiao’s sales declined at a 16% CAGR in 2012–15; and sales volume of the high-end Cellar 1573 brand slumped from a peak of over 4,000 tonnes in 2012 to a trough of about 900 tonnes in 2014.