China Dairy @ 53.5 cts (Milk / China) 2 comments

Final Poll Results: 9:3

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Main issues

1.Unattractive valuation vs much larger peers

2.Possible margin crimp (stiff competition given top-heavy industry structure and possible high distribution costs

Ok since it's now China-bashing season for me nowadays it is natural that this next one I'm covering is also a China stock. To digress a bit, I have covered a few China stocks in the past and readers might want to read through them. Some are terribly misguided in light of their share price run-ups nowadays, but the business and valuation risks pointed out earlier are likely to remain valid. In 2006 I have talked about China Sky, Sky China and China Flexible Packaging. In 2005, those covered include Midas, Keda, United Envirotech, Asia Tiger, China Paper, Pine Agritech, Beauty China, Cosco.

China Dairy is a major manufacturer of liquid milk and milk powder in Northwest China, being based in Xi'an, capital of Shaanxi. It got its listing on the SGX via a reverse-takeover of loss-making TSM Resources, and has had relatively steady earnings and stock prices (ranged around 35 cents) until the recent tide of interest in China stocks lifted it up as well. Last Friday it was a top gainer, rising ~18% from 45.5 to 53.5 cents. Undoubtedly, its rise is linked to the "China domestic consumption" theme that has served many China stocks, such as Hongguo and China Hongxing, well these last few months.

As usual, I'll approach the stock from the relative valuation vs business value approach.

What PE is China Dairy trading at now? Based on its total outstanding shares of 430M and outstanding 35M in-the-money warrants, and attributable net profit of S$12.49M, it works out to a whopping 20X trailing PE. And this trailing PE is based on a set of results that was just released, so it is hardly conservative. It is no longer "undervalued" compared to China dairy stocks listed on the HK exchange (although I don't see why valuations should arbitrage across borders given differences in accounting standards, liquidity and investor risk tolerance): look at Mengniu which has 30X diluted FY04 PE; its FY05 results have not been released (will be soon) but based on its 1H05 results 30% bottomline growth is likely which brings the FY05 PE to 23X, in direct comparison with China Dairy's current FY05 PE of 20X. And Mengniu sells about RMB6B worth of liquid milk, and is the No.1 liquid milk producer in China, commanding a quarter of the market; compare that to China Dairy which sells RMB0.5B worth of liquid milk, a twelfth of Mengniu's market share. Although the sectors are similar, the scale of operations are disproportionate. (Of course, if China Dairy is growing much faster than Mengniu, it would justifiably command higher PEs, but a discussion of the business case below does not suggest so.)

Indeed, if one were to use comparables on the SGX as the yardstick for comparison, we could draw out one or two examples. Based on the theme being improvement both in quality and quantity of the Chinese diet, we can pick Pacific Andes (fish) and People's Food (pork). The former is 17X FY05 PE, but since its FY ends in March, a better comparison is FY06 PE which would bring it down to 13-14X (assuming 25-30% earnings growth); the latter trades at 10X FY05 PE. China Dairy looks positively exorbitant.

The fundamental trend appears good, but the earnings and margins trends of China Dairy suggest that profit may not be able to improve in-step with revenue. Market research consistently put the liquid milk market in China as experiencing 20-30% annual growth, but that is on the demand side. On the supply side, competition is fierce, with 60% of the market dominated by the top three players (of which Mengniu is one). Milk being a rather undifferentiated product, one would expect competition on costs, which has two implications: (1)scale of operations is important; (2)constant margin pressure. Considering segmental operations, liquid milk revenue grew >60% from RMB62M to RMB101M (due to completion of a production development), but profit grew by only 30%, from RMB5.7M to RMB7.5M. It may be interesting to know that the margin pressure comes not from average selling prices of the milk (gross margin dropped slightly), but from distribution costs which rose >50%. As it tries to expand sales to neighbouring regions (within China), the distribution costs are likely to escalate rapidly, especially since the mainland interior is less developed and poorly linked (if you want to play the theme of development of second-tier China cities, go for infrastructure and agriculture). Larger players would be able to enjoy economies of scale in such aspects. Another interesting thing to note would be that Mengniu draws about 5-6% pre-tax profit margins from its revenue, while China Dairy drew about 7-8% in its FY05 performance, a surprising outperformance given that this industry seems to favour large operational scale. I tend to think China Dairy's liquid milk margins would revert to the mean ie. correct downwards further, especially when it has already been on a declining trend since 2003 (when it was 12%).

Note that all this while I have been talking about liquid milk. That is because this segment is seen as the company's growth driver. The milk powder segment actually comprises 40% of the company's revenue, a significant amount, but is not expected to generate much growth. One might remember the uproar over the reportedly horrendous quality of made-in-China milk powder which in some cases contained harmful ingredients, causing many mainland Chinese to resort to buying from Hong Kong during their trips over. That label has presumably stuck and China Dairy in fact saw a drop in profits for its milk powder segment for FY05.

For the record, analysts are also not expecting great things of China Dairy. Nomura Securities expects China Dairy's net profit in 2006 to grow only 9 percent, and then another 38 percent in 2007 (now that's a bit far away, isn't it?). This was in fact the analyst report that supposedly triggered the surge last Friday, but it only targeted 58 cents! JP Morgan in a mid-March report said the company had projected that revenue and gross profits were likely to grow ~30% in FY06, but operating margins were likely to go lower.

Most will recognise it as a stable company, and it's even got F&N as a 20% stakeholder, but it does not appear that there is much more meat in this counter. It's another case of fair stock, interesting industry, expensive valuation. One might want to hold and wait for earnings to catch up with the valuation, but then it does not even reward the patient investor well, going by its dividend: 0.5 cents for FY05, or <1% dividend yield based on today's share price.

References:
(1) Reuters report 31 Mar 06: Singapore Hot Stocks- China Dairy soars on earnings hopes
(2) Corporate announcements from Mengniu (counter 2319) on HK Ex