Recurring profit for the first half of 2016 surged 24% year on year. China Shengmu announced the results for the first half of 2016: revenue of 1,617 billion yuan, up 16.9% year on year; net profit of 402 million yuan, up 20.6% year on year, corresponding to earnings of 0.06 yuan per share. Recurring earnings (fair value adjustments excluding biological assets) increased 24% year over year, thanks to strong demand for organic milk products. Sales of organic milk products increased by more than 50% year over year, while prices remained stable (down only 1.7% year over year). Rapid downstream volume release also reduced the pressure on export sales of organic raw milk when the upstream market was weak (as reflected by an 11% year-on-year decline in prices in the first half of the year) (sales volume in the first half of the year decreased 6% year on year). The non-organic raw milk portion continued to shrink, with prices falling 13% year over year with the market, but demand remained stable under active risk management (export volume of raw milk and processed milk increased 8.2% year over year in the first half of the year). The development trend is expected to continue high downstream growth in the second half of the year, mainly due to: 1) organic milk products are still highly recognized, as reflected in the retail premium of organic milk over non-organic high-end UHT milk; and 2) the company's efforts to develop new products. In the future, it will launch frozen yogurt, organic infant formula, and other high-end dairy products through joint ventures with Hong Kong partners to further penetrate the market. Although prices in the upstream market are declining, risk management will help reduce pressure on sales volume. The rapid penetration of downstream organic milk products has reduced the pressure on upstream organic raw milk sales, making the decline in export prices less than the reduction in unit production costs (down 13% year on year in the first half of the year). At the same time, as the company continues to switch from non-organic cows to organic cows and increases the elimination rate of non-organic cows, the non-organic milk portion continues to decline; although prices are declining with the market, proactive risk management to find more downstream customers for non-organic raw milk can help improve sales prospects. However, the generation of free-running cash flow may not be generated until next year. This is due to the fact that this year the company implemented a model of centralized procurement of raw materials, which significantly shortened the number of days for turnover of accounts payable, leading to distortions in working capital. Looking ahead to 2017, with the normalization of working capital days, net operating cash flow is expected to reach more than 1 billion yuan, while total capital expenditure can still be kept below 1 billion yuan (same level as this year), so net cash flow from free operations is expected to be generated. Profit Forecast We have lowered our overly aggressive downstream sales assumptions, and as a precaution, we have lowered our 2016/17 recurring profit forecast by 18.9%/24.3% to 890 million/1.1 billion yuan. Valuation and recommendations Currently, the company's stock price corresponds to 9.4 times the 2016 price-earnings ratio. We maintained the recommended rating, but lowered the target price by 23.31% to HK$2.27, which is 37.58% higher than the current stock price, corresponding to 12.9 times the 2016 price-earnings ratio. Despite the current temporary difficulties in the upstream market, we are still optimistic about the future of organic dairy products. Maintain recommendations. The price trend of risky raw milk is unfavorable; it is difficult to further penetrate the downstream organic milk market.