KKR milks Mengniu’s fear of food safety scares

The private equity firm’s sale of its China Modern Dairy stake is nicely timed as it raises funds. But for buyer Mengnui the deal poses considerable integration risk.

China Mengniu Dairy is on a mission to clean up its safety record after a series of food scandals. So when a chance came along to raise its stake in a key milk supplier, it wasn’t going to say no.

Mengniu has offered to buy another 16.7% stake in China Modern Dairy from private equity firm KKR for about $242 million, triggering a wider offer to all shareholders that values the entire group at around $1.6 billion. 

Modern Dairy is China’s the largest dairy farming company in terms of herd size as well as the largest raw milk producer in China. The company, which is headquartered in China’s eastern province of Anhui, has 27 farms with 220,493 dairy cows as of June 30.

But its integration poses a significant challenge for Mengnui's management. It may be a headache they could have done without.

Mengniu’s 25% stake in Modern Dairy and long-term relationship was already securing about 70% of its output to Mengniu.

Mengniu started buying Modern Dairy’s raw milk in 2006 and in 2008 secured a 10-year supply off-take agreement. Mengniu backed this up in May 2013 by paying HK$3.2 billion for a 26.9% stake and as of January 4 was Modern Dairy’s single largest shareholder with a 25.4% stake.

It does not have a great track record of swiftly integrating companies. The acquisition of Yashili in 2013, for instance, has taken more than two years, due primarily to management changes and a challenging operating environment.

“Mengniu will now need to tackle all the challenges of running an upstream business, potentially stretching the management team along with capex requirements,” said Ebru Sener Kurumlu, an analyst at JP Morgan, in a report to investors after the deal was announced on Thursday morning.

Deutsche Bank analysts Mark Yuan and Charlie Chen went further. They said that during a conference call following the announcement, Mengniu's management did not indicate "a clear strategy on the consolidation between two brands".

But Mengniu’s new CEO, Lu Minfang, is understandably keen to make his mark and take action after Mengniu’s 2016 profit warning.

The company said it will record a substantial net loss for the year ending December 31, due to a disappointing performance by infant milk formula subsidiary Yashili.

The fact that Yashili’s poor results mirror weak performance by peers Yili, Biostime and Beingmate shows that the industry is in for a rough ride. Goldman analyst Lincoln Kong said in a research note that Chinese infant milk formula makers face intense competition over the next six months.

But given Mengniu’s size it could have riden out the storm without making more acquisitions. It has been a leader in the liquid milk market over the past six to seven years, according to research firm AC Nielsen.

More consolidation is likely in the highly-fragmented industry as well as overseas purchases by dairy firms looking to diversify, according to M&A bankers. But it is the smaller baby milk powder players that have the more pressing need to bulk up. 

Spilt milk

Mengniu's executives may be thinking about more than just competition, however. The company faces political pressure to clean up its supply chain after its involvement in the melamine tainted milk scandal in 2008 and when the carcinogen aflatoxin exceeded safety levels in its products in 2011.

Both incidents highlighted the importance of controlling the quality of raw milk.

The company's largest shareholder is state-controlled Cofco and according to analysts Mengniu and Cofco share joint responsibility for developing a quality dairy business in China.

Lu, who became CEO in September, has quickly put together a reform plan including centralising procurement and increasing the use of imported milk powder for low-end UHT milk.

Mengniu has long planned to boost its stake in its biggest supplier, and after KKR exercised an option on December 12 to receive 448 million new shares, boosting its stake to 16.7%, it decided to act. 

The timing also made sense for KKR. Investors are keen to see exits from China and KKR is in the midst of raising $7 billion for its third Asian fund. Further, KKR's board member at Modern Dairy, Julian Wolhardt, is leaving to start a new China-focused investment firm.

Wolhardt and Chi Kin Max Hui, from private equity firm CDH, will resign as directors of Modern Dairy.

Deal details

Mengniu has agreed to acquire 965,465,750 Modern Dairy shares from KKR and a much smaller stake from CDH for HK$1,873 million ($242 million) — or HK$1.94 per share, according to a stock exchange filing.

The deal will raise Mengniu’s stake to 39.9% from 25.4%, which triggered a mandatory cash offer for all the issued Modern Dairy's shares, in line with Hong Kong Stock Exchange rules.

In terms of financial impact, the acquisition plus the cash offer of about HK$8.3 billion is not significant given Mengniu’s size.

The offer price represents a premium of 3.2% to Modern Dairy's closing price of HK$1.88 on January 3 and 26% over the audited consolidated net assets per share of HK$1.54 on June 30.

About 9% of shareholders have already said they will not tender their shares at this price. Mengniu expects that around 15% of the register will not do so, according to a person familiar with the deal process. As a result, Mengniu will maintain the listing status of Modern Dairy, as it has with Yashili.

The deal implies a valuation of around Rmb11 billion for the Modern Dairy, pointing to 19 times 2017 estimated earnings based on Bloomberg consensus estimates. This is the same price-to-earnings ratio as Mengniu, which is also trading at a price of 19 times 2017 estimated earnings on consensus estimates.

The selling entities are KKR China Growth Fund L.P. and CDH Fund IV, L.P. 

UBS is advising Mengniu on the transaction, bolstering a long-standing relationship with the firm after working with it on its stake purchase in 2013 from KKR. DBS is providing a offshore facility for payment and the funds are already in place.

Mengniu used law firm Sullivan & Cromwell while KKR used Cleary Gottlieb. 


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