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Mengniu’s deal to increase China Modern Dairy stake seen as rescue by some, synergy by others

Mengniu is increasing its stake in CMD, which controls China’s largest cattle herd, from 25.4 to 39.9pc by buying a 9.8pc stake from another investor, KKR

PUBLISHED : Monday, 09 January, 2017, 6:46pm
UPDATED : Monday, 09 January, 2017, 11:22pm

Analysts are divided on the merits of China Mengniu Dairy’s acquisition of China Modern Dairy (CMD), with some viewing it as nothing more than a “rescue” while others see synergy between the two mainland Chinese dairy firms.

On January 5, Mengniu announced it would increase its stake in CMD, which controls China’s largest cattle herd, from 25.4 per cent to 39.9 per cent by buying a 9.8 per cent stake from another investor, global investment firm, Kohlberg Kravis Roberts (KKR).

“We view this deal a pure rescue for China Modern Dairy given the stretched valuation Mengniu paid to become CMD’s largest shareholder, while it helped CMD get rid of the VAM (valuation adjustment mechanism) with KKR],” China International Capital Corp analyst Paul Yuan Feiyang said in a report.

Rating agency S&P placed the “A-” rating on Mengniu’s long term corporate credit on watching list, warning that Mengniu will potentially face higher financial burden following the proposed increase in its stake in China Modern Dairy Holdings.

We view this deal a pure rescue for China Modern Dairy given the stretched valuation Mengniu paid to become CMD’s largest shareholder, while it helped CMD get rid of the VAM (valuation adjustment mechanism)
Paul Yuan Feiyang, analyst, China International Capital Corp

As part of the deal Mengniu will also receive a share placement from CMD priced at HK$1.94 per cent per share, 7.2 per cent higher than CMD’s closing price before the announcement. Mengniu is spending a total of HK$1.9 billion for the KKR stake and the share placement.

The deal will trigger a general offer since Mengniu has increased its CMD stake to more than 30 per cent. It will also terminate CMD’s July 2015 VAM with Success Dairy, controlled by KKR and CDH China Management Company.

The VAM stated that if the average market value of Success Dairy’s 477 million shares in CMD did not reach US$308 million during the last 45 trading days before the three-year lock-up period, CMD would pay the price difference to Success Dairy. As of January 5, the shares held by Success Dairy were worth only approximately US$111 million.

Analysts remain concerned over any clear synergy created from the deal for both parties.

Yuan said that Mengniu’s reluctance to raise its CMD stake beyond 40 per cent may suggest it was worried that adding CMD’s financial results to its own books would have a detrimental impact on its own cash flow and leverage.

CMD is still losing cash and in order to reverse its negative free cash flow status the company may have to rely on boosting the downstream business, imposing restrictions on further expansion, maintaining a high culling ratio, and managing the heifer population at a reasonably low level, Yuan said.

Strengthening the downstream business of finished dairy products will be difficult without Mengniu’s help, but CMD is a direct competitor of Mengniu in that area, Yuan added.

Since 2012, CMD has developed high-end UHT milk and yoghurt as well as high-end pasteurised milk, profitable products that are sought after by almost all downstream dairy giants, including Mengniu.

“As Mengniu mainly uses CMD raw milk to produce premium milk products... we won’t expect Mengniu to help CMD’s downstream business, which is currently facing difficulty, at the expense of slowing sales and earnings growth for [Mengniu’s] own premium category since CMD only contributes 40 per cent of its earnings to Mengniu,” the CICC note said .

We view this deal a pure rescue for China Modern Dairy given the stretched valuation Mengniu paid to become CMD’s largest shareholder
Paul Yuan Feiyang, China International Capital Corp

However, Deutsche Bank analysts said the CMD deal will help secure Mengniu’s raw milk supply and reduce competition in downstream brands.

Additionally, by increasing its stake in CMD, Mengniu will book a 2017 profit gain of 1 per cent or 32 million yuan, to 179 million yuan.

“We view this to be a reasonable deal for Mengniu, given that the company could gain controlling interest after acquiring incremental interest. With controlling interest, Mengniu will have more secure raw milk supply for its current high end milk sales and future low temperature milk business,” said Deutsche Bank.

There has been fierce competition between Mengniu’s high-end “Deluxe” brand milk and CMD’s downstream branded milk in retail outlets over the past two years.

Deutsche Bank said Mengniu’s controlling stake should help to reduce competition in downstream brands, and therefore could increase sales growth and profitability for its high-end milk, although the company’s management has not yet indicated a clear post-deal strategy.

“The biggest difference it will make is that Mengniu will thus be able to consolidate Modern Dairy’s accounting records into its own earnings with an ownership of over 50 per cent of Modern’s shares [if the general offer is completed],” said Samson Lo, UBS head of M&A for Asia, who advised on the deal.

Additional reporting by Celine Ge

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