Picking up sesame seeds while dropping the watermelon. On the evening of March 24, just before Mengniu Dairy (02319.HK) released its 2019 financial report, Miaokeland announced plans to raise 890 million yuan through a private placement to Mengniu, which would become its second-largest shareholder. This adds another chapter to Mengniu's continuous acquisition spree in recent years, while also laying hidden dangers for its high debt ratio compared to peers. Analysts believe that Mengniu's upcoming 2019 financial report will maintain growth in both revenue and net profit. However, behind the impressive report lies the low base in 2018 and excessive promotions in 2019, with the high growth in net profit attributed to the sale of its high-quality asset, Junlebao. The "overexerted" 2019 financial report may have a "spillover drag" on 2020 performance. As early as 2017, Mengniu Dairy proposed the "Double 100 Billion" goal, aiming for sales and market value to reach 100 billion yuan by 2020. Now, with market value hovering around 100 billion, and having sold the cash cow Junlebao and purchased Bellamy's with declining performance, such puzzling operations bring unpredictable uncertainties to the "Double 100 Billion" goal. -01- Acquiring Bad Assets for Revenue, Selling Original Assets for Profit Mengniu's solution is acquisition, using external expansion to address weak revenue growth. Over the past decade, Mengniu-style acquisitions have often surprised the industry and stunned the capital market. In 2010, it acquired Junlebao; in 2013, it took control of Yashili; in 2016, it acquired Dumex; in 2017, it took control of Modern Dairy; and in 2018, it acquired China Shengmu. The revenue scale growth from acquisitions is obvious. In fiscal years 2011 and 2013, Mengniu achieved over 20% revenue growth, and in 2014, it grew by more than 15%. From 2016 to 2018, it achieved double-digit revenue growth for three consecutive years. Of course, this growth dependent on "sick acquisitions" of bad assets is not stable, as revenue recorded negative growth in fiscal years 2012 and 2015. The reason lies in Mengniu's "accept all comers, gobble up dates" acquisition strategy. Over the decade, except for Junlebao, all other acquired companies had varying degrees of problems. In 2018, Yashili International lost 132 million yuan, Modern Dairy lost 496 million yuan, and China Shengmu lost 2.2 billion yuan. Such acquisitions, besides expanding revenue scale, significantly eroded Mengniu's net profit. In 2014 and 2015, it maintained net profits of about 2.3 billion yuan, but in 2016, it suddenly suffered a loss of over 700 million yuan, and then in 2017 and 2018, it soared to two to three billion yuan like a roller coaster. The fluctuation in net profit is consistently correlated with the "sick acquisitions" of bad assets. Seeing the drastic fluctuations in net profit, Mengniu turned its attention to its previously acquired assets. On the seesaw of revenue and net profit, sometimes pressing down net profit to boost revenue scale, sometimes ignoring revenue to desperately lift net profit, Mengniu becomes increasingly skilled at this delicate and fragile balancing act. In 2019, Mengniu sold off its better-quality Junlebao, with 51% equity for 4.011 billion yuan, a capital gain of up to 9 times compared to the acquisition price of 469 million yuan in 2010. From a pure return perspective, this was a good deal. Precisely because it was a good "deal," in the long run, Mengniu "lost big." Because Junlebao was a "cash cow" for Mengniu. In 2018 alone, Junlebao contributed nearly 10% of Mengniu's net profit, and its revenue growth far exceeded Mengniu's, reaching 28% compared to Mengniu's 14.7%. More importantly, in the milk powder business that Mengniu values highly, Junlebao contributed over 68% of the performance growth. Paradoxically, after selling Junlebao, Mengniu turned around and acquired Bellamy's, another milk powder company, at a premium of 52%. In the first half of 2019, Bellamy's net profit fell by 49%. In contrast, Junlebao's sales revenue in 2019 was expected to grow by 25% year-on-year. Furthermore, Bellamy's has not yet passed China's infant formula formula registration, so its products cannot be produced and sold domestically. Bellamy's has admitted that this is one of the reasons for its declining performance. Such puzzling operations as selling Junlebao and buying Bellamy's left investors baffled. Earlier, when the announcement of acquiring Bellamy's was made, Mengniu Dairy led the decline among blue chips in the Hong Kong stock market, falling by up to 2.92%, while Bellamy's surged over 54.87% on the Australian Securities Exchange. Perhaps between the "sesame seeds" and the "watermelon," Mengniu and the capital market have different views. -02- Leveraging Up to Push Debt Higher, Borrowing to Repay Loans The traits that once made you successful can also destroy your city. To build a "moat," Mengniu has continued to increase acquisitions in recent years, and the continuous "buy, buy, buy" has led Mengniu down the path of counter-cyclical leverage. Financial reports show that in the first half of 2019, its debt ratio reached 57.06%, a record high in recent years. The median for Hong Kong-listed peers was 53.48%, and for A-share peers it was 31.93%. Mengniu's debt ratio was higher than both Hong Kong and A-share listed peers. Looking vertically, in 2017, 2018, and the first half of 2019, Mengniu's asset-liability ratios were 53.37%, 54.16%, and 57.06%, respectively. Clearly, the asset-liability ratio has been rising year after year, but Mengniu seems unconcerned, embarking on another large-scale acquisition spree in 2019. In September, it acquired Bellamy's for HK$7.86 billion, and in November, it acquired LDD for HK$3.187 billion. In January this year, Mengniu acquired 5% of Miaokeland's shares and 42.9% of its subsidiary Jilin Guangze Dairy for 740 million yuan. On the evening of March 24, Miaokeland announced plans to raise funds through a private placement to Mengniu. Once completed, Mengniu would invest a total of 1.055 billion yuan and become the second-largest shareholder of Miaokeland. Financial analysts said that the persistently high debt ratio means the company's leverage space is continuously shrinking and nearly exhausted, and Mengniu's strategy of relying on financing and acquisitions to drive growth may fail. In fact, the net profit margin has fully reflected this. Data shows that in 2017 and 2018, Mengniu's net profit margins were 3.38% and 4.64%, respectively. During the same period, the average net profit margins for the domestic raw milk and dairy processing industry were 5.62% and 5.81%, respectively. High debt to expand acquisitions and drive revenue scale, but unable to curb the low-level operation of net profit margin, nor ensure stable growth of net profit. On the other hand, Mengniu's debt expansion route also has hidden concerns, namely that its debt is mostly interest-bearing, with an interest-bearing debt ratio of 33%, indicating hidden dangers in Mengniu's balance sheet. The cash flow statement also confirms this. At the end of the 2019 interim report, in 2018, and in 2017, Mengniu's net investment cash flows were -6.024 billion, -4.232 billion, and -11.45 billion yuan, respectively, mostly used for constructing fixed assets and acquiring companies, with operating cash flow far from supporting its investment expenditures. During the same period, financing cash flows were 2.463 billion, -900 million, and 5.748 billion yuan, respectively. A large proportion of financing was used to repay old debts, with debt repayment expenditures of -3.253 billion, -6.306 billion, and -14.892 billion yuan, respectively, showing signs of borrowing to repay loans. The high interest-bearing debt ratio also indicates hidden concerns about Mengniu's control over the industry chain: even though revenue and net profit show scale characteristics, its control over upstream and downstream is still insufficient, especially over downstream channels. This situation did not form overnight. As early as the 2008 melamine incident, all dairy companies suffered heavy losses, but Mengniu chose to transfer risks, requiring channel partners to share risks equally, leading to deepening estrangement with channel partners and further weakening its industry chain operational capabilities. Industry analysts point out that this is mainly affected by the defects of its large-dealer channel structure, which will become increasingly apparent with scale expansion. Mengniu cannot achieve a year-on-year decline in expense ratio through scale effects, causing the growth rates of net profit margin and revenue to diverge further, implying "structural defects in industrial competitiveness and control." Source: Caijing Wuji (ID: caijwj) Author: Rouye Tips will be paid 400-2000 yuan once adopted.