Meng Niu: will the milk man deliver?

Roadshows begin on Wednesday May 25 for a $125 million to $175 million IPO.

Lead managers BNP Paribas Peregrine and Morgan Stanley are in the final stages of collecting pre-marketing feedback for the Hong Kong flotation of China's first dairy producer to list overseas (editor's note: this article was first published on Monday May 24). Meng Niu Dairy will offer 35% of its issued share capital as a result of the deal, which has a split of 75% primary shares and 25% secondary shares.

While a number of reports suggest fund managers are lowballing valuations into the low teens, pre-marketing feedback is said to be showing strong indications around the mid-teens level, with the prospect of pushing the valuation higher should markets continue to firm over the next two weeks.

A $125 million to $175 million IPO range is based on a 2004 profit forecast of Rmb300 million ($36.3 million), although some syndicate members are projecting more than Rmb310 million. But the range is complicated slightly by the existing of a deep-in-the money convertible bond, which will potentially dilute public investors by 30% post IPO.

Pre IPO, the company has a shareholding structure in which management owns 72% and financial investors 28%. Post IPO and pre-conversion, these stakes will drop to 54% and 11%, with the remaining 35% in freefloat.

On full conversion of the CB, however, management will own 45%, financial investors 34% and 25% will be in freefloat. Of the financial investors, MS Dairy (an offshoot of Morgan Stanley Capital Partners) will own 24%, GCU-CDC 4% and CDH and others the remaining 6%.

At the top end of the valuation range, Morgan Stanley's post IPO stake will be worth about $110 million, not a bad return for an $18 million one-and-a-half year investment. Together the three main financial investors put up $26 million at the end of 2002.

Formal roadshows for the deal are scheduled to begin this Wednesday, with pricing slated for Friday June 5. Alongside the leads, co-managers are Cazenove, CICC and Daiwa SMBC.

There are a number of comparables against which to benchmark the stock, including two listed dairy producers in China. These are Yili Industrial, the country's biggest producer with a 20% market share at end of 2002 and Shanghai Bright on 12%. The former is currently trading at about 19 times 2004 earnings and the latter at 21.5 times.

The A share market nearly always commands a premium to Hong Kong listed stocks, though in this instance, Meng Niu supporters say it is offset by Meng Niu's higher returns and its private sector/VC background. At the end of 2002, it ranked three with an 8% market share.

In the Hong Kong market, specialists say fund managers are looking at a number of comparables including the Chinese breweries and supermarkets. Where the former is concerned, breweries like Harbin and Tsingtao are currently trading around 25 to 28 times 2004 earnings, although there is currently an M&A premium attached to the sector.

Supermarket chains such as Linhua, on the other hand, are presently trading in the low 20's. Aside from the need for an IPO discount, most investors would also expect a milk producer to come at an additional small discount because of greater risks inherent in the industry.

Regionally, there are two main benchmarks, Nestle Malaysia and Nestle India, which are respectively trading at 22 and 17 times 2004 earnings. Globally, dairy producers such as Danone and Nestle trade around 16 to 17 times 2004 earnings, though growth levels are fairly flat.

Meng Niu's main challenge lies in convincing fund managers that the supply/demand imbalance in China's milk industry is being rectified. For while the downstream processors such as Meng Niu are rapidly expanding capacity to meet growing national demand for milk, the country's upstream sector - ie the cows - cannot keep up, because there are not enough of them and yields are low.

For example, according to the China Dairy yearbook, there were about seven million cows in China at the end of 2003. But three million cows were on farms of only one to four cows. A further two million were on farms of five to 19 cows.

Meng Niu believes it has a number of advantages that helps overcome this. Firstly it is located in Inner Mongolia where most of the country's large herds are based. Secondly, farmers are increasingly dealing with the big dairy groups that can guarantee payment rather than smaller producers, which are going out of business because they cannot source milk, or afford the high prices farmers are charging.

Thirdly, the big farmers have been aggressively importing livestock from Australia and US to improve yields. The cow population is expected to grow by 15% in 2004 and 20% in 2005, while yields are expected to rise 34% in 2004 and 25% in 2005.

Meng Niu, meanwhile, is forecasting capex of Rmb903 million ($109 million) in 2004 and Rmb567 million ($61 million) in 2005. It currently runs a net cash position. It hopes to increase overall capacity from 1.26 million tonnes in 2003 to 2.04 million in 2005 and 2.758 million in 2005.

This will expand its liquid milk lines from 97 in 2003 to 164 in 2004 and 233 in 2005. Its ice cream lines will expand from 27 in 2003 to 50 in 2004 and 60 in 2005, while its yoghurt and other lines will increase from 11 in 2003 to 61 in 2004 and 110 in 2005.

At the end of 2003, the company reported a net profit of Rmb164 million ($19.8 million), which is forecast to expand to Rmb300 in 2004 and Rmb436 million ($53 million) in 2005.

At the end of 2003, 72% of revenue derived from UHT milk, 10% from flavoured milk, 12% from ice cream, 4% from yoghurt and 2% other. It is hoping to move more production into higher margin products such as ice cream and yoghurts.

At the end of 2001, for example, it had only 1.8% of the ice cream market behind Walls on 6.9% and Yili 7.6%. By the end of 2002, it had significantly closed the gap, with a 3.8% share, versus 6.1% Walls and 7.9% Yili.

Company supporters say the company's efficiency can be measured by a much higher ROE. Post IPO, Meng Nui is expected to report a 2004 ROE of 22% compared to 13% for Shanghai Bright and 15% for Yili, which both have SOE backgrounds.

The whole industry, however, suffers from low margins. Net margins were 4.2% at the end of 2003, compared to 3.2% for Yili and 4.7% for Shanghai Bright.

Meng Niu is also renowned for its high ad spend - 6% of sales compared to a 2% industry average. It hit the headlines in 2003 when it paid a record Rmb310 million for one advertising slot after the evening news and sponsored the launch of China's first astronaut.

The whole Chinese food industry has also recently been under the spotlight thanks to innumerable stories relating to tainted products. Again, company supporters believe this will help Meng Niu over the medium term because consumers will increasingly turn to trustworthy leading brands.

Consumption of liquid milk is growing rapidly on the Mainland, recording a CAGR of 25% versus 8% for packaged foods. However, the country lies a long way down the global chain. At the end of 2003, China consumed 6.4kg of liquid milk per capita compared to 90kg in the USA, 120kg in the UK and 140kg in Denmark - the latter two are the world's largest consumers per capita.

Because of the inefficiency of cold storage distribution facilities in China, over 70% of milk is long-life UHT. The figure in developed countries such as the UK and US is more like 5% to 10%.