According to the Zhizhong Finance APP, Huachuang Securities released Research Reports stating that since 2022, the net cash flow of farms, including capital expenditures, has remained negative, and the net debt ratio may have exceeded previous highs, indicating that the direction of capacity reduction remains clear. Observation points suggest that the inventory reduction in the off-season after the Spring Festival is expected to accelerate, followed by an anticipated reversal of the raw milk cycle in Q3 2025. Currently, enterprises are gradually reducing inventory, and various impairments in the upstream are gradually converging as the reduction progresses. Moreover, corporate operations are becoming more rational and pragmatic, and the Sector has emerged from the bottom. Once the raw milk cycle reverses and demand rebounds or even catalyzes price increases, the Sector is expected to welcome a dual hit in performance and valuation opportunities.

Main points from Huachuang Securities are as follows:

Raw milk cycle: To what extent has this cycle progressed? The net cash flow of farms continues to be negative, and the net debt may exceed previous highs, with a neutral view that milk prices in Q3 2025 are likely to reverse.

The demand-supply growth rate gap of fresh milk is a relatively optimal indicator for observing and judging the price trend of raw milk. Currently, the negative growth rate gap is narrowing, and it is expected that the supply side will be key to future milk price fluctuations. Due to continuous declines in milk prices over the past three years since October 2021, with a cumulative drop of nearly 30%, the industry is generally at a loss, thus indicating that the inventory peaked and began to decline from February 2024. Although large-scale farms have enhanced their risk resistance due to strengthened capabilities, the introduction of a series of policies, and a slowdown in feed cost reductions easing short-term pressures, along with seasonal increases in calves resulting in relatively mild short-term inventory reduction speeds, it is essential to consider that since 2022, the net cash flow of farms, including capital expenditures, has been persistently negative, and the net debt ratio may have already exceeded previous highs, indicating a clear direction of capacity reduction. Observing future points, it is expected that the inventory reduction in the off-season after the Spring Festival will accelerate, followed by an anticipated reversal of the raw milk cycle in Q3 2025.

Demand outlook: Is the positioning of 'just need' weakening? Sales have not declined in the past two years, primarily due to falling prices, and penetration is increasing against the odds, with both volume and price still having room for growth.

Although the pandemic has depleted consumer spending power, leading to a slowdown in sales growth, when considering production and inventory alongside volume-price disaggregation across two dimensions, it is estimated that sales will remain stable over the next two years without decline. However, due to oversupply of raw milk, passive promotions have increased, and consumer demand for cost-effectiveness has risen, resulting in price declines that have become a key drag on industry scale. At the same time, it is worth noting that under external pressures, the penetration rate of dairy product consumers has still increased against the odds, and as the economy rebounds, milk prices rise, and enterprises resume new product launches, the industry is poised to return to an upward trajectory.

From the perspective of dairy companies: strengthening barriers amid cycles.

Corporate profitability: from dominating the competitive landscape to internalizing the raw milk cycle, sharing honor and disgrace across the entire industry chain. In fact, the impact of the raw milk cycle on dairy companies cannot be directly referenced from history; previously, sales volume and structure were the core of income growth, and the competitive landscape was key to changes in profitability. Since 2020, due to accelerated reverse integration, there has been a trend of shared honor and disgrace between upstream and downstream; even without considering the pressure from promotions, the various impairment losses due to raw milk surplus have expanded to account for over 10% of the pre-tax profits of Yili and MENGNIU DAIRY in 24H1, making raw milk prices critical to later profitability recovery.

Strengthening barriers: reshuffle amid cycles, leading dairy companies will strengthen their control over upstream suppliers. Firstly, under the supplier grading management system of leading dairy companies, mid-tier and lower-tier suppliers face significantly greater survival pressure, and future farms may tend to maintain long-term stable cooperation with the leaders; secondly, considering that calves take at least 2 years to grow and produce milk, during this round of stock reduction, small and medium farms are eliminating replacement heifers to survive, with some farms increasing their breeding cow ratio to 80% or even 100%, which means a loss in future growth potential. When the raw milk cycle reverses, the production capacity of breeding cows will lag behind, leading farms will accelerate share acquisition, indicating that barriers to milk source for leading dairy companies will strengthen, amplifying potential profitability elasticity.

Operational strategy: actively respond to competition, accelerate deep processing layout, and smooth long-term operating cycles.

Since 2023, leading dairy companies have faced continuous operational pressure, mainly due to the dual impact of actively reducing inventories under the intention to stabilize the entire industry chain and declining market share. Looking ahead, during the raw milk surplus phase, leaders will launch high-quality price ratio products and increase layout in emerging channels to actively respond to competition. Meanwhile, as raw milk prices reverse, market share will also accelerate recovery. Additionally, external pressures are forcing companies to think longer-term; leading companies are accelerating the layout of to B businesses and deep processing capacities. For reference, Fonterra's Greater China region revenue is nearly 30 billion for the 2024 fiscal year, with to B business net margins reaching around 10%, expected to contribute beneficial increments. Deep processing is also expected to enrich the utilization of raw milk and enhance product added value, thereby improving the competitiveness of the entire industry chain while smoothing operating cycles.

Investment advice: improving logic gradually unfolds, highlighting the value of sector allocation.

Huachuang Securities believes that there is still space for industry volume and price; supply-side barriers are reinforced amid fluctuations in the raw milk cycle, and long-term logic of the industry remains unchanged. Currently, companies are gradually reducing inventories, and various impairments in upstream are gradually receding with the reduction. Furthermore, corporate operations are becoming more rational and pragmatic, with the sector having exited the bottom. Once the raw milk cycle reverses and demand recovers or even triggers price increases, the sector is expected to welcome a double opportunity for performance and valuation. As for targets, bundle allocation of the leading duo Yili (600887.SH) and MENGNIU DAIRY (02319), recommend New Hope Dairy (002946.SZ), and pay attention to small and medium dairy companies and leading farms restoring elasticity, including Xinjiang Tianrun Dairy (600419.SH), Youran Livestock (09858), and CH MODERN D (01117), among others.

Risk warning: The cost of feed may decline more than expected, causing stock reduction not to meet expectations; demand recovery may also fall short of expectations.