Mengniu moving up value chain as costs rise

PUBLISHED : Monday, 14 April, 2008, 12:00am
UPDATED : Monday, 14 April, 2008, 12:00am

Known to be keen on promoting corporate social responsibility, Niu Gensheng, China Mengniu Dairy's chairman, has made it clear that it is not a goal of his company to profiteer.

Mindful of the fledgling nature of a lifestyle change that favours milk drinking, the nation's largest dairy products maker with a 40.7 per cent market share has been keeping its gross margin at between 22 per cent and 23 per cent.

But as raw milk prices and other selling expenses rise, the company based in Hohhot, Inner Mongolia, may not need to worry about making too fat a margin anymore.

On the contrary, along with other industry players including Shanghai-listed Inner Mongolia Yili Industrial Group and Bright Dairy and Food, Hong Kong-listed Mengniu will need to work on keeping its margin intact.

Last year, Mengniu's annualised margin eased to 22.5 per cent from 22.9 per cent in 2006. Since October last year, the price of raw milk has risen 40 per cent, reducing the second-half margin to 20.82 per cent, compared with 24.46 per cent in the first half.

To make matters worse, an inflation-conscious central government stipulated in January that distributors of food commodities or food items need to seek approval before revising selling prices. Mengniu's share price had slumped almost 25 per cent by the time smaller rivals Bright Dairy and Sanlu Group successfully applied for selling price increments last month.

Fortunately for Mengniu, product prices were adjusted upwards by about 15 per cent in December last year. However, will the company seek more price increases?

At the results announcement last Tuesday, chief financial officer Yao Tongshan was ambiguous on whether Mengniu would do so. But he said the company was determined to move up the value chain by offering more nutritious and high-end products such as whole-fat milk, vitamin-rich milk for children and its first organic milk to ease the margin pressure brought on by rising costs.

Mengniu's gross profit margin would have been worse had it not improved its product mix, said Credit Suisse analyst Catherine Lim. Given the poor operating environment, Mengniu's margin decline of 0.4 per cent year on year was better than Yili's 1.5 per cent decrease.

Since most analysts had lowered their forecasts on Mengniu's earnings before the annual results announcement, they are issuing 'buy' calls on the firm after it announced a net profit increase of 28.7 per cent, slightly better than expected.

Mr Yao said the price of raw milk had stabilised in recent months and he saw no sign of the 'explosive' price increases in the second half. According to the Ministry of Agriculture, the price of domestic raw milk in February rose to 2.9 yuan per kilogram, up 4.7 per cent from the previous month.

But the country's No1 milk producer faces other challenges.

First, the low effective tax rate, which helped lift last year's net profit growth, is unlikely to be kept at the same beneficial level this year. Second, more advertising expenses will be incurred for the Beijing Olympic Games. Third, competition is set to further intensify following the signing of a Sino-New Zealand free trade pact.

With 21 of its subsidiaries enjoying tax concessions under various circumstances - including Sino-foreign setups and local government support for the industry - Mengniu's effective income tax rate dropped to 1.9 per cent last year from 8 per cent in 2006.

Management indicated, however, that the effective income tax rate will reach 10 per cent this year as the concessions are phased out.

To maintain its market leading position, this Olympics year will likely see Mengniu increase spending on advertising and promotion, even though Yili is the official dairy industry sponsor for the Olympics.

Selling and distribution costs rose to 15.5 per cent of revenue last year, compared with 14.6 per cent in 2006.

Luo Lei, an analyst at Guotai Junan Securities, said Mengniu needs to control its administration expenses to offset the growth of advertising costs. Mengniu managed to scale back its administration and other operating costs to 2.3 per cent of total revenue last year from 2.7 per cent the previous year.

However, the Sino-New Zealand free trade agreement covering goods and services and investment may be another cause for concern.

Hundreds of New Zealand dairy companies are likely to take advantage of the benefits to get a foothold in the world's fastest-growing market.

One of the beneficiaries of the free trade agreement would be Mengniu's smaller rival Sanlu Group, in which New Zealand's Fonterra Co-operative Group, the world's biggest exporter of dairy products, acquired a 43 per cent stake in 2005. Sanlu is eyeing a listing either in the A-share market or the Hong Kong bourse.

But Mengniu remains unfazed. Mr Yao said he welcomed the opening up of the market because competition would be good for the industry.