The company's recent situation
The reason behind Erie's announcement to end the acquisition of Seimu due to certain preconditions not being met may be more complicated than the announcement. If the company needs to rely on its own strength for future development, we might as well return to focusing on the company's intrinsic value, and not rule out the possibility that it will seek future cooperation with Mengniu, but the method may be different.
reviews
The uniqueness of organic milk has become the company's core value, making it more attractive than modern animal husbandry. Under similar costs, raw milk enjoys a sales premium, and downstream dairy products are more profitable.
In terms of debt ratio, Seimu is also safer than modern animal husbandry, although heavier downstream capital expenses are incurred to penetrate further downstream and achieve sustainable growth, it may delay the generation of free cash flow until next year.
Earnings are expected to stabilize this year and to resume growth next year. The price of raw milk is expected to bottom out and remain stable this year, although there may still be a slight year-on-year decline throughout the year. The increase in downstream sales prices since the fourth quarter of 2016 at the cost of contraction may mean a slowdown in revenue growth this year (flat year-on-year in the first quarter). However, with price support, we expect downstream profit margins to rise.
Future growth prospects are optimistic: 1) Considering that organic UHT milk and yogurt currently together contribute less than 2% of the total consumption of liquid milk (including yogurt) in China (while the market penetration rate in most developed countries around the world is over 5%), there is still room for organic UHT milk and yogurt to penetrate the market. The penetration rate of organic food and beverages in other food and beverage sub-industries is also much higher. 2) The innovative promotion of on-site production and sale of organic yogurt using yogurt machines went smoothly. We expect the sales contribution of yogurt to increase significantly to 15% by the end of this year, which will help offset the sales pressure faced by UHT milk due to price increases. 3) A new organic infant formula project will be launched at the end of the year, and the joint venture established with Hong Kong United Foods (which produces organic dairy products for children) will jointly contribute to future sales and profit growth.
We don't rule out the possibility of cooperating with Mengniu. Mengniu has about 5.8% of the company's remaining shares. Organic dairy products are a good selling point, which helps Mengniu's high-end strategy. However, the potential cooperation method may be different, as Mengniu has just completed an increase in Hyundai Animal Husbandry's stock holdings. Potential synergies mainly come from better digesting raw milk, speeding up downstream processing rates, and cooperating in brand building and downstream product sales.
Valuation recommendations
We lowered our earnings forecasts for fiscal years 2017 and 2018 by 16% and 25.9%, mainly excluding the assumption of Erie's involvement in downstream synergies. Earnings are expected to stabilize this year, and the growth rate may increase in 2018. We lowered our target price for the end of 2017 from HK$2.73 to HK$2.36. We believe that most of the risk of Erie terminating the acquisition has been reflected through Shengmu's weak stock price performance (compared to the level when the acquisition was announced in 6 months). Based on Shengmu's intrinsic value (the company's healthy growth prospects and potential partnership opportunities with Mengniu), the current stock price level should be supported.
The target price is based on the DCF model. Maintain recommendations.
risks
Demand for dairy products has slowed, and the price of raw milk has declined further.