Author: Feishu Xi Source: HK Stocks (hkstocks)
Is the ceiling for the infant formula industry low? Obviously not. There's a question: "What product can increase sales by raising prices?" I think infant formula in the Chinese market is definitely one of the answers. Think about the position of children's consumption in Chinese household spending, and you'll know the ceiling for the infant formula industry is high.
So why has it been so miserable in the past? In a few words: the competitive landscape is too bad.
▌The Competitive Landscape Is Ruined
Honestly, in an industry where consumers place such high importance on quality, it's rare to see a competitive landscape like that of China's infant formula industry. There is no strong dominant brand in the market! Regarding the market share of various infant formula brands in China, data from different institutions vary, but they all point to one direction: the industry concentration is very low. For example, Euromonitor data:
If we look at the top 5, China's CR5 ratio is not only lower than that of Europe, America, Japan, and South Korea, but also lower than the world average.
Infant formula is considered a standard product. With such a competitive landscape in a standard product industry, it's not easy for investors to make money. On the other hand, after so many years of rapid economic growth in China, the competitive landscape of consumer goods industries that can be standardized has basically stabilized. For example, in beer, five major players take 75% of the market share. Why is infant formula played this way?
To explain this, we need to look at the development history of Chinese infant formula. Most people know about the 2008 melamine incident, which was indeed a watershed for Chinese infant formula. Before 2008, the main players in the Chinese infant formula market were domestic brands. Especially after the 2005 Nestlé infant formula iodine超标 incident, the market share of foreign brands declined significantly, and domestic brands once accounted for about 80%.
The melamine incident severely damaged domestic consumers' confidence in domestic brands, and the competitive landscape of China's infant formula industry underwent significant changes. Old players like Yashili and Synutra lost market share, Sanlu was directly out, and foreign players kept pouring in, with their market share rising. In addition, unaffected domestic dairy companies like Beingmate and Feihe were also beneficiaries. Biostime seized the opportunity, entering the infant formula industry in 2008, focusing on French imports, and also benefited.
This incident also brought about an impact: high prices and foreign brands were regarded as high-end and high-quality, while low-priced formula raised concerns about quality. Because parents are willing to pay high prices for high-quality formula for their children, consumers in this industry are not price-sensitive.
Foreign brands and new formula companies represented by Biostime seized this consumer psychology to raise prices or launch original imported high-priced formula, and other domestic brands followed suit. In addition, from 2010 to 2014, raw milk prices kept rising. Before the 2013 anti-monopoly investigation, the domestic formula industry's price increase wave never stopped.
A simultaneous rise in price and volume is the best time for an industry, and basically all players benefited. But in a standard product industry, it's destined that comfortable days won't last long under such a competitive landscape.
The 2013 administrative anti-monopoly investigation was certainly a factor (in 2013, the NDRC launched a price anti-monopoly investigation into formula companies; Mead Johnson, Dumex, Biostime, etc. were fined for restricting distributors from lowering prices, and the price increase wave temporarily came to an end), but the more important factor was that under such a competitive landscape, such high profit margins would inevitably attract more production capacity.
After the anti-monopoly investigation, launching new formulas and upgrading formulas became new price increase methods for formula companies. There were numerous brands and formulas on the market, leaving consumers unable to choose.
Coupled with the rise of cross-border e-commerce and overseas purchasing after 2013, information transparency allowed consumers to see the price differences of the same brand of formula at home and abroad, and more foreign formula entered the Chinese market through online channels.
Afterwards, raw milk prices peaked in the first half of 2014 and began a downward cycle. Lower raw milk prices reduced production costs for formula companies, and downstream promotions intensified.
It can be said that at this point, the competitive landscape of China's infant formula industry was completely ruined, and no one had it easy. Biostime's profits plummeted, and Beingmate and Yashili suffered consecutive losses.
▌What Does the Registration System Mean?
The infant formula industry is a perfectly competitive industry. Under the above competitive landscape, even if the government did not intervene, some players would eventually be eliminated. Every industry crisis is an opportunity to increase industry concentration.
However, if this market-led capacity reduction is allowed, the ones eliminated will definitely be domestic formula brands, not foreign brands. In terms of financial strength, most domestic formula brands cannot match foreign brands. In addition, foreign formula prices are on average higher than domestic ones, leaving more room for profit to survive the winter. But domestic formula is hard to say. For example, Beingmate, if the current competitive landscape continues, whether it can survive would be a question.
Moreover, although the melamine incident has passed for many years, consumers still psychologically believe that foreign brands are safer. This is why domestic formula brands have been building factories overseas to increase their "foreign" content.
Therefore, it is certain that if the market is left to its own devices, after a new competitive landscape forms, China's infant formula industry will be further dominated by foreign companies. This should be something no major country's government wants to see.
Look at the United States, South Korea, and Japan; the infant formula industry is basically dominated by domestic brands. Whether for "face" or due to lobbying by domestic formula companies, the Chinese government has the motivation to support local formula companies.
Therefore, the formula registration system is a government-led capacity reduction in the infant formula industry, replacing market-led capacity reduction. It is similar to the upstream industry capacity reduction since last year, and there is an intention to support domestic formula brands.
On November 16, 2016, the supporting documents for the infant formula registration system were officially issued, and companies could formally submit application materials. The deadline is January 1, 2018. Before that, formula not registered will not be allowed to be sold domestically in the future, and both imported and domestic formula are included in the management scope. According to the registration system, a factory can have at most 3 formula brands and 9 formula numbers. Therefore, whether domestic or foreign formula companies, many brands will be cut.
Currently, there are 103 domestic factories with QS certificates and 71 overseas factories, while there are more than 2,000 brands circulating in the market. This means nearly 70% of brands will exit the market, freeing up shelf space for the remaining brands.
▌Who Will Benefit?
Knowing the government's intentions and the current predicament of the formula industry, one can roughly judge that the formula industry, which has been miserable for more than three years, is about to see the dawn.
But since the formal implementation will be on January 1, 2018, and the list of formula names obtained by companies will be announced gradually from August this year, before that, the channels will inevitably be cautious, because this year's inventory may not be sold next year.
Therefore, at this time, channels will be cautious in taking goods, and destocking is a priority. It's not surprising that the performance of the formula industry in the first half of the year still did not improve significantly; Yashili and Beingmate still suffered large losses.
Starting from August, the Drug Administration will gradually announce the approved formula lists, which means the industry's uncertainty will gradually become clear. Only when uncertainty disappears can business be done well. And channels have been working hard to destock for over a year. After the policy becomes clear, from the second half of this year to next year, there will be a demand for restocking.
Therefore, for current formula companies, in the short term, after the improvement of the competitive landscape, domestic formula will all benefit, and the industry reversal is a good stimulus for stock prices. In addition, there is another good news: international raw milk prices have been rising since last year, and it is highly likely to enter a new upward cycle. Rising raw material costs will also, to some extent, constrain the promotion intensity of the downstream dairy industry.
In the long term, obviously, for a standard product industry like infant formula, the competitive landscape will not stay at the current level. The concentration of the formula industry is bound to continue to rise, and more players will be kicked out of the market. This requires long-term tracking of factors such as company management, brand strength, and financial strength. At present, it is not clear who will laugh last.
There are mainly three listed formula companies in Hong Kong:
Biostime: Biostime is now focusing on both health products and formula. Luo Fei's management ability is excellent, and he has strategic vision, as seen from the company seizing the 2008 industry crisis to enter the formula industry from probiotics, and entering the health products industry in 2015. In the first half of 2017, the company's formula business revenue had already resumed positive growth.
Yashili: Yashili was originally an old brand in China. After 2008, its market share declined rapidly, and it has been very difficult in recent years. The impressive thing is that Yashili cut the leeks of Mengniu and Danone in 2013 and 2014 (both entered at a cost of HKD 3.5 per share). After Mengniu and Danone entered, they merged their respective formula brands into Yashili. Currently, Yashili has the original Yashili brand, as well as Oushi Mengniu and Ruibuen from Mengniu, and Dumex from Danone.
Yashili is a controlling subsidiary of Mengniu. The current head of Mengniu was originally the head of Yashili. For Mengniu to catch up with Yashili, it needs to fill the short board of formula. From this perspective, Mengniu has the motivation to tilt resources towards Yashili.
Ausnutria: Ausnutria is an anomaly in the formula industry. When the whole industry was struggling, Ausnutria issued profit alerts in both 2016 and 2017, maintaining rapid growth in revenue and profit. The company's formula business is divided into three parts: its own brand milk formula, its own brand goat milk formula, and private label (producing infant formula for other customers around the world). The company's "Kabrita" goat milk formula ranks first in market share in China's goat milk formula market.
In 2011, due to unresolved issues discovered by Ernst & Young, the stock was suspended until August 4, 2014, and on the first day of resumption, it rose 47.25%. In November 2014, the original two major shareholders exited, and Shengde Pharmaceutical (Chairman Lin Rongjin) acquired 25.8% of the equity from the two major shareholders. In August 2015, Shengde Pharmaceutical, together with persons acting in concert, completed a tender offer for Ausnutria, with the concert party holding 60.54% of the shares.
In the A-share market, the pure formula company is Beingmate, which has suffered severe losses in the past two years.
In addition, there are Yili and Sanyuan. Yili's formula business ranks first in market share among domestic formula brands, and in the first half of 2017, its formula business also resumed positive growth. Of course, infant formula is not their largest revenue contributor.
▌Conclusion
An industry with a relatively high ceiling is not a good time to invest if the competitive landscape has deteriorated. But the competitive landscape of an industry will not stay bad forever. Whether through market pressure or government intervention, a new competitive landscape will be formed. That may be the time to invest.
The formula registration system is government intervention to improve the competitive landscape of the formula industry. In the short term, domestic formula is expected to benefit. Of course, to confirm, we need to look at the full-year annual reports. If the industry does reverse, a wave cannot end in just two or three weeks.
In the long term, government intervention is only to prevent the competitive landscape of the formula industry from continuing to be chaotic. For a standard product industry like infant formula, the future trend is that industry concentration will further increase, and more players will be kicked out of the market, freeing up market space for the surviving winners. Judging the final winner requires continuous tracking of factors such as company management, brand strength, and financial strength.
Finally, let's talk about something else. In the market, the most feared thing is being cut. When we understand a company, the annual report is an important window. This window is audited by auditors. The three Hong Kong-listed formula companies, plus the dairy giant Mengniu, are all audited by Ernst & Young. How much does Ernst & Young charge?
(Look at the picture and don't speak. If interested, match it yourself.)
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