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Important disclosures can be found in the Disclosures Appendix All rights reserved. Standard Chartered Bank 2012 http://research.standardchartered.com
l Equity Research l China l Food & Beverage l 8 October 2012
China dairy Inner Mongolia visit – prevailing misconceptions
As a follow up to our recent SCout report “China dairy – Land of milk and money”, published on 3 July 2012, we
conducted on the ground channel checks in suburban areas of Inner Mongolia, one of the largest raw milk production provinces in China
Feed cost inflation is only one of the key reasons impacting individual farmers‟ profitability; however, we highlight effective milkable time (i.e. how many months of raw milk production per annum) as a more important profitability concern
Raw milk quality control for individual farms is much better than market perception
Our channel checks support our positive view on China Modern Dairy and China Mengniu, the upstream and downstream dairy leaders, respectively.
2 new channel check findings A local milk collection station in Inner Mongolia
Misconception 1: Feed costs to squeeze out individual
farms. The market and even individual farmers themselves
are blaming increasing feed costs (while the price of raw milk
remains flat) for shrinking profits. However, our conversations
with industry professionals and other channel checks
revealed that a more material reason for shrinking profitability
is the lower-than-expected milkable time. Our profit and loss
summary sheet for local individual farms suggests that the
per cow profit generated from 7 months of milkable time per
year is more than 3 times higher than the prevailing individual
farmer average milkable time of 6 months.
Misconception 2: Raw milk quality control is still
questionable. Raw milk quality is still the main concern
relating to the dairy sector. We believe that industry quality
control has improved significantly and is much better than
what the market currently perceives: 1) safety awareness is
now embedded in grass root farmers‟ thinking and
processes; 2) all the milk collection stations are now
monitored by Mengniu‟s staff, who reside onsite, and; 3) the
raw milk quality can be traced back to each specific
household/farmer.
Source: Standard Chartered Survey
Dairy farmer driving cows to the milk station
Source: Standard Chartered Survey
The Bottom Line
Positive for CMD and Mengniu: We believe the above two
new findings are positive for both China Modern Dairy
(1117 HK, OP: close: HK$1.93, PT: HK$2.85), the market
leader among large-scale modern farms in China, and
China Mengniu (2319HK, OP, close: HK$23.2, PT:
HK$26.8), the downstream leader. This underpins a rerating
opportunity for the sector and for these two stocks.
Did you know… Annual per capita milk consumption in China was only 7kg in 2011? 100kg is the global average, 450kg in France, 350kg in the US, 1,400kg in New Zealand and 100kg in India/Japan.
Charles Z. Yan [email protected]
+852 3983 8523
Tallan Zhou [email protected]
+852 3983 8520
Dairy farmers use the equipment to milk their own cows
Farmers drive their cows to the milk station
China dairy l 8 October 2012
l Equity Research l 2
Misconception 1: Feed cost to squeeze out individual farms
Most individual farmers complain about shrinking profitability as a result of 1) increasing
feed costs and 2) depressed raw milk prices. The village we visited incorporated 60-70
households and we randomly picked two households as data sources (household herd size is
typically 6-10 cows). Farmers think decreasing profitability is solely due to increasing feed
costs. The households we interviewed complained that the surge in feed costs had shrunk their
profits. Feed costs have increased by >20% YoY, according to them, and is still rising. The cost
of 50kg of forage (97% of feed costs) is rising at Rmb5 per month. Currently, forage costs
Rmb2.7/kg and could reach Rmb3.0/kg by year end at this pace.
Fig 1: Corn price (Rmb/kg), 2011-Sept 2012 Fig 2: Soybean price (Rmb/kg), 2011-Sept 2012
Source: CEIC, Standard Chartered Research Source: CEIC, Standard Chartered Research
Farmers also attribute raw milk’s depressed price to their low negotiating power: Village
households supply raw milk to both Mengniu and Yili. Each household had signed an
exclusive agreement with either Mengniu or Yili several years ago when the village ventured
into the raw milk business. Mengniu and Yili currently pay the same price for raw milk.
Farmers are paid Rmb3.0/kg by milk collection stations, while Mengniu or Yili pay Rmb3.4/kg
to milk collection stations. Farmers complain that though feed costs have risen, the price of
raw milk has remained flat due to their low negotiating power.
Fig 3: Raw milk price and supply value chain for individual farms
Source: Standard Chartered Research survey
Nevertheless, we believe that the low profitability is also due to the shorter milkable time,
which is a more material reason and generally ignored by the market: After further
discussions with individual farmers and our analysis, we concluded that a more relevant reason
for individual farmers‟ low profitability was the shorter milkable time.
Milkable time at 6-7 months per year for individual farms vs 10 at large modern farms.
We found that milkable time at individual farms averaged 6-7 months per year. In contrast,
milkable time at large farms, such as those owned by China Modern Dairy, averaged 10
months (with a 60-day resting period). Individual farmers explained that low-quality cows and
lack of proper training led to more time for cows to conceive. As this process could sometimes
take 3 or more months, it resulted in milkable time of only 6 months given a 2-month resting
period.
2.10
2.15
2.20
2.25
2.30
2.35
2.40
2.45
2.50
2.55
1/5
/2011
3/5
/2011
5/5
/2011
7/5
/2011
9/5
/2011
11/5
/2011
1/5
/2012
3/5
/2012
5/5
/2012
7/5
/2012
9/5
/2012 3.35
3.40
3.45
3.50
3.55
3.60
3.65
3.70
3.75
3.80
3.85
3.90
1/2
011
3/2
011
5/2
011
7/2
011
9/2
011
11/2
011
1/2
012
3/2
012
5/2
012
7/2
012
Individual farms
Milk collection stations
Mengniu/Yilimanufactuer
Individual farms Individual farms Individual farms Individual farms Individual farms
Rmb3.0/kg
Rmb3.4/kg
China dairy l 8 October 2012
l Equity Research l 3
6-7 months of milkable time makes a huge difference in profitability: The tables below
show our profit and loss calculations and sensitivity analysis between feed costs and milkable
time for individual farmers. At current feed costs, a farmer‟s annual profit would be only
Rmb990 at a milkable time of only 6 months. It then jumps 3 times to Rmb3,240 when
milkable time rises to 7 months on average. Most farmers say high-quality cows make an
annual profit of around Rmb3,000 and low-quality cows only breakeven. Given the average
10-month milkable time at large-scale dairy farms, we believe the low milkable time is the
fundamental reason why individual farmers‟ profitability shrinks as feed costs rise.
Fig 4: Annual per cow profit analysis for individual farmers
Individual farmer's profitability analysis
1 Average per cow yield (kg)/day 25.0 25.0 25.0 25.0 25.0
2 Average per cow yield (kg)/month 750.0 750.0 750.0 750.0 750.0
3 Milkable time (months/annual) 6.0 7.0 8.0 9.0 10.0
4=2*3 Raw milk production (kg)/annual 4,500.0 5,250.0 6,000.0 6,750.0 7,500.0
5 Raw milk price (Rmb/kg) 3.0 3.0 3.0 3.0 3.0
6=5*4 Annual revenue per cow (Rmb) 13,500.0 15,750.0 18,000.0 20,250.0 22,500.0
7 -Per kg forage cost (Rmb) 2.7 2.7 2.7 2.7 2.7
8 -Forage required per cow per day (kg) 12.5 12.5 12.5 12.5 12.5
9=7*8 Forage cost per cow per day 33.8 33.8 33.8 33.8 33.8
10 Grass cost per day (Rmb) 1.0 1.0 1.0 1.0 1.0
11=10+9 Total feed cost per day (Rmb) 34.8 34.8 34.8 34.8 34.8
Annual feed cost per cow 12,510.0 12,510.0 12,510.0 12,510.0 12,510.0
12=6-11 Annual per cow profit 990.0 3,240.0 5,490.0 7,740.0 9,990.0
Source: Standard Chartered Research estimates
“2x2x2” return analysis of imported cows and domestic cows. After our channel checks and
discussions with industry professionals, we arrived at a “2x2x2” return difference between
imported cows and domestic cows.
2x output: imported cows produce 10-11 tons of milk pa vs 5-6 tons for domestic cows.
Imported cows normally produce double the annual raw milk compared with domestic cows
even at the same milkable time simply because of a being better breeds.
2x lactations and calves: imported cows lactate 6-7 times vs only 3-4 for domestic cows.
Individual farmers told us their cows can only lactate 3-4 times compared with 6-7 for cows at
large-scale farms. That is to say, high-quality cows have a longer milk-producing lifetime and
can give birth to 6-7 calves. Given the same per cow yield, an imported cow can produce
double the raw milk and double the calves compared with a domestic cow.
2x female calves: 95% of the time, imported cows give birth to female calves vs the
domestic cows’ rate of 50%. That is to say, half of the calves produced by domestic cows
cannot produce raw milk.
Low milkable time arises from lack of training and scientific knowledge. Most farmers we
interviewed believe that managing dairy cows does not require any professional training and
scientific methods. In addition, they were reluctant to purchase high-quality cows, which are more
expensive than normal domestic cows. Even after explaining the 2x2x2 benefits, most farmers
were still concerned about the expensive initial investment.
This is the key reason why individual farmers’’ profitability is shrinking
3 times profitability impact
China dairy l 8 October 2012
l Equity Research l 4
Misconception 2: Raw milk quality control is still questionable
Safety awareness is now embedded in grassroot farmers’ thinking and processes:
Individual famers explained that food quality standards are very strict these days, eg, if the
protein content is less than 2.7%, the raw milk will not be accepted by Mengniu. In addition, we
saw several posters in the villages regarding cow feeds, etc, indicating that quality awareness
has penetrated to the grass roots.
Mengniu has imposed tough raw milk quality standards: We also found that Mengniu has
recently raised its raw milk quality standards.
All milk collection centers are now monitored by Mengniu’s staff, who reside onsite:
Mengniu has sent its own staff to supervise raw milk quality in local milk collection centers.
The Mengniu employee is in charge of 1) testing raw milk quality and 2) preventing external
visitors to improve the median environment.
Milk can be traced to each specific household/farmer: Raw milk contributed is linked to
each household, who have a labeled tube for a sample to be tested at the milk collection
centre. A test takes a day. If the raw milk from one household is found to be bad, the raw milk
collected from the whole village will be discarded, as they are held in the same tank. The
household then has to compensate for 80% of the loss, while the milk collection station pays
the rest. By implementing such a strategy, individual farmers end up paying more attention to
quality, thus improving the quality of milk from the whole village.
Positive for China Modern Dairy and Mengniu
Positive for China Modern Dairy (CMD): large-scale modern farms likely to squeeze out
small farms when CMD is the market leader. The farm business runs on economies of scale
and technology. As shown above, individual farmers will have to eventually give up this business
if feed costs continue to rise and they remain reluctant to change methods. We believe China will
follow the same path as the US took. CMD, as the No 1 dairy farm in China, is likely to benefit
from such a trend and will set a good example for the rest of the farms (for details refer to our
SCout report “China dairy – Land of milk and money” published on 3 July 2012).
What happened in the US: According to the US Department of Agriculture, the total number
of farms that shut in 1960s reached 96,000, and then dropped to 37,000 in the 1970s. In
recent years, shutdowns have declined to 2,000–5,000 pa. Meanwhile, the steady increase in
productivity and per-cow yield in raw milk has more than offset the decline in the number of
dairy farms and cows, resulting in a steady upward trend in total milk production. Between
2005 and 2009, the number of farms with cows fewer than 500 declined, while the number of
farms with 500–999 cows held steady. On the other hand, the number of farms with 1,000 or
more cows increased by 20% during the same period, driven by significantly lower costs of
production. In 2009, more than 47% of raw milk in the US came from farms with more than
1,000 cows, while in China, that number was only 7%.
China dairy l 8 October 2012
l Equity Research l 5
Fig 5: No. of farms and per-cow yield milk production in the US, 1984–2011
Source: US Department of Agriculture, Standard Chartered Research
Fig 6: Share of milk production by farms of different sizes in the US, 2005–09
Year 1 to 49 50 to 99 100 to 499 500 to 999 1,000+
2005 6.4% 15.2% 28.8% 14.3% 35.3%
2006 6.1% 14.2% 28.2% 13.4% 38.1%
2007 5.3% 12.0% 25.7% 12.3% 44.7%
2008 5.1% 11.5% 24.9% 12.5% 46.0%
2009 5.0% 11.4% 24.1% 12.6% 46.9%
Source: USDA, Standard Chartered Research estimates
What could happen in China: Currently, the market is dominated by small, family-owned
dairy farms, which produce more than 75% of total raw milk supply. The top five dairy farms
together accounted for less than 2% of China‟s dairy cows in 2010 (total cows: 12.6m). We
believe the pattern in China is similar to that in the US, and that China will also experience
consolidation in the next 1–2 decades by when the market would be dominated by large,
modern farms.
Positive for Mengniu as it has done the most to control quality: The market is still concerned
about Mengniu‟s food quality. Nevertheless, our channel checks suggest that Mengniu has done
the most to improve the quality of its raw milk, all the way down the value chain. As our analysis
shows, all the individual farmers we spoke to had the right knowledge and attitude towards safety
of milk. In addition, Mengniu‟s own staff were monitoring milk collection. Therefore, we believe
Mengniu has done the most to control the quality of raw milk and therefore believe it is positive
for Mengniu.
2,800.00
3,300.00
3,800.00
4,300.00
4,800.00
5,300.00
5,800.00
0
50,000
100,000
150,000
200,000
250,000
300,000
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Total number of farms (LHS) Per-cow yield (lb) (RHS)
China dairy l 8 October 2012
l Equity Research l 6
Disclosures appendix The information and opinions in this report were prepared by Standard Chartered Bank (Hong Kong) Limited, Standard Chartered Bank Singapore Branch, Standard Chartered Securities (India) Limited, Standard Chartered Securities Korea Limited and/or one or more of its affiliates (together with its group of companies, ”SCB”) and the research analyst(s) named in this report. THIS RESEARCH HAS NOT BEEN PRODUCED IN THE UNITED STATES. Analyst Certification Disclosure: The research analyst or analysts responsible for the content of this research report certify
that: (1) the views expressed and attributed to the research analyst or analysts in the research report accurately reflect their personal opinion(s) about the subject securities and issuers and/or other subject matter as appropriate; and (2) no part of his or her compensation was, is or will be directly or indirectly related to the specific recommendations or views contained in this research report. On a general basis, the efficacy of recommendations is a factor in the performance appraisals of analysts.
Where “disclosure date” appears below, this means the day prior to the report date. All share prices quoted are the closing price for the business day prior to the date of the report, unless otherwise stated.
181920212223242526272829
Oct 11 Nov 11 Dec 11 Jan 12 Feb 12 Mar 12 Apr 12 May 12 Jun 12 Jul 12 Aug 12 Sep 12 Oct 12
China Mengniu Dairy Co. Ltd.
03/07/12 OP : HK$28.00
29/08/12 OP : HK$26.80
Source: FactSet prices / SCB ratings and price targets
1.4
1.6
1.8
2.0
2.2
2.4
2.6
2.8
3.0
Oct 11 Nov 11 Dec 11 Jan 12 Feb 12 Mar 12 Apr 12 May 12 Jun 12 Jul 12 Aug 12 Sep 12 Oct 12
China Modern Dairy Holdings Ltd.
03/07/12 OP : HK$2.85
Source: FactSet prices / SCB ratings and price targets Recommendation Distribution and Investment Banking Relationships
As of 30 June 2012
% of covered companies
currently assigned this rating
% of companies assigned this rating with which SCB has provided investment
banking services over the past 12 months
OUTPERFORM 61.1% 11.0%
IN-LINE 30.7% 12.3%
UNDERPERFORM 8.2% 8.3%
Research Recommendation
Terminology Definitions
OUTPERFORM (OP) The total return on the security is expected to outperform the relevant market index by 5% or more over the next 12 months
IN-LINE (IL) The total return on the security is not expected to outperform or underperform the relevant market index by 5% or more over the next 12 months
UNDERPERFORM (UP) The total return on the security is expected to underperform the relevant market index by 5% or more over the next 12 months
SCB uses an investment horizon of 12 months for its price targets. Additional information, including disclosures, with respect to any securities referred to herein will be available upon request. Requests should be sent to [email protected]. Global Disclaimer: Standard Chartered Bank and/or its affiliates ("SCB”) makes no representation or warranty of any kind, express, implied or statutory regarding this document or any information contained or referred to in the document. The information in this document is provided for information purposes only. It does not constitute any offer, recommendation or solicitation to any person to enter into any transaction or adopt any hedging, trading or investment strategy, nor does it constitute any prediction of likely future movements in rates or prices or represent that any such future movements will not
China dairy l 8 October 2012
l Equity Research l 7
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China dairy l 8 October 2012
l Equity Research l 8
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