China Milk Products Group - Better execution needed

Global milk price has been rising due to strong demand growth from China
and India. As a reference for milk prices, fluid milk future on the Chicago
Mercantile Exchange has risen 60% over the past year. On the supply side,
production growth has not kept up with demand. Farmers have been reluctant
to increase their herd size due to high feed costs. The main sources of dairy
feed - corn and soy bean - have seen prices rise more than 50% over the past
year with increasing demand from ethanol production. Also, bad weather
conditions in dairy countries such as Australia and US have also reduced supply.
C Milk is beneficiary of high milk prices and high feed costs as farmers have
every reason to get more milk out of their cows. Sales of C Milk’s pedigree bull
semen and cow embryos have been enjoying strong growth under the breedimprovement
programmes. The Chinese government has been promoting the
use of pedigree bull semen and embryo to raise the milk yield and productivity
of the dairy farms. In China, raw milk price is on an uptrend and major dairy
companies such as China Mengniu is expecting another 2-3% increase in
average market prices for 2007. C Milk is seeing high milk prices as its ASP
increased from Rmb1.8/kg to Rmb2.1/kg in FY07. On the hand, feed costs
remain manageable as the company grows a portion of its feed requirements and
has its own feed processing factory.
Investor sentiment likely to be cautious. While the Mar FY07 results met
market expectation, it was disappointing in terms of operational performance.
Raw milk production was below our expectation and the company was not able
to conclude a dairy processing contract with its customer. The company has
missed its guidance twice regarding the commencement of its dairy processing
plant. While there is no significant impact for FY07 results, we believe4 the
creditability of management is dented and investors are likely to be cautious
about the new guidance from the company. In addition, the lack of disclosure
regarding the use of its huge cash balance, more than Rmb1.7b as at Mar 07,
has further damped confidence in the company.
We do not expect any significant development from the company until the
announcement of the dairy processing contract. The next milestones are the
import of Australian cows in October and the commencement of the milk
production plant in November. We will be watching these developments closely.
Higher-than-expected financing costs. From the financing costs and the
additional disclosure from C Milk, we estimate the effective borrowing cost of C
Milk’s convertible bond is about 10% vs our initial estimate of 5.5%. Hence, we
adjust our forecasts and target price to factor in the higher finance costs.
Cheaper way to milk China dairy theme. Compared with other listed dairy
companies, C Milk is a cheaper way to ride on the rising dairy consumption
trend in China, trading at 10x FY08 PE vs 30x for other major listed Chinese
dairy companies. With C Milk’s positive industry dynamics, strong growth and
leading position in the pedigree bull semen business, the current disparity is too
wide even after taking into account the fact that C Milk is not a consumer stock.