---
title: "In-Depth Report: How Mengniu Dairy Is Adjusting Its Strategy for a Fresh Start"
description: "In the first half of 2017, Mengniu Dairy's net profit was only one-third of Yili's. This report examines Mengniu's development trends for the second half of the year and beyond, covering raw milk costs, market competition, and strategic reforms."
author: "于杰、申晟"
publisher: "New Distribution"
email: "zhaobo258@gmail.com"
telephone: "+8615854817671"
published: "2017-09-30"
language: "en"
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# In-Depth Report: How Mengniu Dairy Is Adjusting Its Strategy for a Fresh Start

> In the first half of 2017, Mengniu Dairy's net profit was only one-third of Yili's. This report examines Mengniu's development trends for the second half of the year and beyond, covering raw milk costs, market competition, and strategic reforms.

In the first half of 2017, Mengniu Dairy's net profit was only one-third of Yili's. How will Mengniu develop in the second half of this year and in the coming years? Let's take a look at the in-depth report on Mengniu.

**Raw milk costs remain ample; watch for price recovery in H2**

Given that downstream dairy production has not seen significant growth, despite a slight decline in domestic fresh milk output, imported milk powder has replenished some inventory, and supply and demand are currently balanced. We expect that unless a systemic black swan event occurs, supply and demand will remain balanced in the second half of this year.

**Domestic raw milk purchase prices at seasonal lows; downstream entering peak milk usage period**

In summer, downstream dairy companies are in the off-season, with demand concentrated on bulk milk powder for making cold drinks and dairy beverages. Combined with high temperatures causing more fresh milk transportation issues, fresh milk prices remain at annual lows during summer. In the first week of September, the purchase price of fresh milk was 3.43 yuan/kg, flat month-on-month and up 0.3% year-on-year. So far this year, domestic milk prices have remained similar to last year, with little fluctuation. Entering September, the downstream is about to enter the stocking period, and raw milk prices are seasonally recovering, expected to rise slightly month-on-month.

**Domestic fresh milk production declines year-on-year; downstream dairy production growth slows compared to last year**

On the upstream side, fresh milk production in July fell 3.8% year-on-year and 3.0% month-on-month, mainly due to hot summer weather and declining herd numbers. We estimate cumulative fresh milk production in the first seven months fell 1%. As the share of large-scale farms continues to rise, future fluctuations in domestic fresh milk production will narrow.

**High-priced milk powder continues to arrive, expected to drive domestic fresh milk conversion demand**

The latest July arrival price of whole milk powder, converted to fresh milk, is about 3.2 yuan/kg, already below the current domestic fresh milk purchase price of 3.41 yuan/kg. The highest arrival price for whole milk powder was in May, but it had little short-term impact on domestic milk prices. We expect that if arrival prices of whole milk powder remain high and stable in H2, it will boost domestic fresh milk conversion demand, thereby driving up purchase prices.

Fresh milk accounts for about 40% of overall dairy production costs, and milk powder about 20%. Based on current bulk powder arrivals, we expect this to gradually reflect in costs in H2. According to the Dairy Association, herd numbers continued to decline in 2017, and with the conversion demand from high-priced imported bulk powder, we expect raw milk prices to rise slightly in H2, reaching 3.5-3.6 yuan/kg.

With Fonterra's high-priced milk powder arriving in batches and domestic fresh milk prices remaining stable, we believe this will reduce vicious low-price competition caused by raw milk oversupply, leading to stable development of the downstream dairy industry. Reduced local price promotions will benefit the two leading dairy companies, Yili and Mengniu, in gaining market share. This year, they enjoy a relatively milder competitive environment than last year; they have deep and broad channel systems, making it easier to benefit from consumption upgrades and higher share of premium products; they have the management and financing capabilities to integrate upstream and downstream vertically and expand product lines horizontally, so they grow more steadily when the industry is stable.

**Comparison of Mengniu and Yili's expansion paths**

**Domestic upstream supply chain: Mengniu lagged behind Yili**

Dairy processing companies generally have large fixed asset investments, mainly because:
1) Different products require different production lines;
2) Dairy products have short shelf lives, so to ensure freshness of raw milk and reduce transportation costs, downstream companies typically build plants close to raw milk bases;
3) China's raw milk processing areas are concentrated in the north (Inner Mongolia, Heilongjiang, Hebei, etc.), while major consumer groups are in South and East China, so downstream companies must also consider transportation costs and build plants near major consumption areas.

Since 2010, Yili's capital expenditure has been significantly higher than Mengniu's. We believe this is closely related to Yili's continuous strengthening of its "milk cooperative + own farm" model, while Mengniu adopted a "light asset" approach, relying on third-party milk sources and its strong marketing model to quickly capture the market in the early stage. In recent years, Mengniu has also begun to strengthen its own milk source construction, with biological assets increasing year by year, while Yili's biological assets have decreased significantly due to the transfer of Youran Dairy equity.

**Overseas expansion: Mengniu earlier than Yili**

Compared to Yili, Mengniu started its overseas expansion earlier. Leveraging COFCO's industrial chain and influence, Mengniu's overseas layout mostly involves introducing overseas strategic alliances, while also acquiring domestic brands to fill gaps in upstream, low-temperature milk, and milk powder.

Unlike Mengniu's continuous introduction of strategic partners, Yili focuses more on overseas upstream milk sources, production enterprises, and R&D centers to smooth out price fluctuations of imported bulk powder.

**Management changes and incentives at Mengniu and Yili**

Yili's CEO, Mr. Pan Gang, has been actively investing in capital and channel expansion since becoming the leader in 2005. Although the 2008 melamine incident hit Yili hard, Mr. Pan and Yili overcame the difficulties together, with sales growing over 20% in 2010, and finally surpassing Mengniu in 2012.

**Mengniu's management changes have been more frequent.** After the melamine incident, Mengniu adopted a more conservative market strategy. Founder Niu Gensheng sold his 20% stake to COFCO and Hopu in 2009; subsequent events like the Telunsu OMP incident and the milk aflatoxin incident continued to damage the brand image; in 2012, Ms. Sun Yiping from COFCO officially took over Mengniu and implemented a series of reforms, making Mengniu more low-key and focusing on supply chain integration and milk source construction; in 2016, Mr. Lu Minfang, former president of Yashili, became president of Mengniu, starting to integrate upstream milk sources and standardize the sales system to narrow the gap with Yili.

**Comparison of financial data between Mengniu and Yili**

**Yili leads Mengniu in market share**

In the first half of this year, Yili recorded revenue of 33.5 billion yuan vs. Mengniu's 29.5 billion yuan, a gap of about 11.9%. In liquid milk, Yili's revenue was 26.5 billion yuan vs. Mengniu's 25.4 billion yuan, with the gap widening to 4.2%; in milk powder, Yili's revenue was 3.04 billion yuan vs. Mengniu's 1.79 billion yuan, both improving year-on-year due to a low base last year; in cold drinks, Yili's revenue was 3.24 billion yuan vs. Mengniu's 1.99 billion yuan, both up over 10% year-on-year due to hot weather and proactive product mix adjustments. Mengniu's revenue gaps in milk powder and cold drinks narrowed to 41% and 39%, respectively.

As for market share data at the terminal, different consulting agencies provide varying figures. Overall, Yili leads Mengniu in room-temperature products, while in low-temperature products, Mengniu benefits from Junlebao and Danone's low-temperature yogurt advantages, leading Yili.

In H2 2016, due to losses from selling bulk milk powder inventory, impairment of Yashili goodwill, and Modern Farming's losses, Mengniu recorded a book loss of 751 million yuan, but its core liquid milk business continued to grow strongly. In H1 this year, Mengniu returned to profit with a net margin of 3.8%.

From 2011 to 2016, Yili's net margin nearly doubled, while Mengniu's remained roughly flat due to drags from Modern Farming and Yashili. However, from 2005 to 2010, Mengniu's net margin was twice that of Yili. We will try to analyze the reasons from product, channel, and marketing perspectives.

**Mengniu's revenue is more concentrated in liquid milk; Yili has a higher proportion of high-margin products**

**In 2016, Yili's gross margin reached 37.9%, higher than Mengniu's 32.8%. We believe the main reasons are:**

**1) Yili has a higher proportion of milk powder revenue**, accounting for 9.1% of total revenue in 2016 vs. Mengniu's 5.9%. Milk powder has higher gross margins: Yili's milk powder segment achieved a gross margin of 56.2%, much higher than the overall liquid milk margin of 37.9%. Mengniu's Yashili had a gross margin of 47.1% in 2016; excluding Yashili, Mengniu's gross margin drops to 29.6%.

**2) Yili leads in milk beverage sales**: According to Euromonitor, Yili's terminal sales of milk beverages are about twice those of Mengniu. Since milk beverages are mostly made from bulk powder, we estimate their gross margin is similar to cold drinks, exceeding 40%.

**3) Yili has a higher proportion of high-margin liquid milk products**: In Yili's liquid milk business, we estimate high-margin products account for about 50% of total liquid milk sales, while Mengniu's star brands (Telunsu, Guanyiru, etc.) plus opportunity brands (Chunzhen, etc.) accounted for about 45% of sales in 2016.

**Mengniu's channels are more concentrated; Yili's channels are more down-market**

Since Yili began its "networking action" in 2006, pushing channels down to townships, Yili's channels are flatter than Mengniu's. To date, Yili has about 6,000 first-level distributors and a sales team of nearly 15,000. Mengniu, on the other hand, implemented a "big distributor" strategy. The advantages of the big distributor strategy in early expansion were obvious:
1) Leveraging the local connections of big distributors to quickly open large markets,
2) Big distributors typically form their own sales teams and bear sales expenses, reducing early investment for the dairy company.

However, its later disadvantages cannot be ignored: 1) As big distributors grow larger, their efficiency declines, and they lose the motivation to further expand downward; 2) Big distributors, accounting for a high proportion of dairy company sales, have significant bargaining power.

**Intensifying industry competition leads to surging advertising and promotion expenses for Yili and Mengniu**

**2010-2013: Yili's advertising efficiency was higher**: During 2010-2013, Yili gradually entered an era of refined channel management, while Mengniu's aggressive market expansion slowed due to internal management changes. The overall dairy industry competition was relatively mild. Yili's total advertising and promotion expenses ranged between 3.5-4 billion yuan, with high efficiency, as the expense ratio gradually decreased from 12.9% in 2010 to 8.2%. Mengniu's advertising expenses during this period also remained between 2.3-3 billion yuan, but the decline in expense ratio was less than Yili's, dropping 1.8 percentage points from 2010 to about 6.0% in 2013.

**From 2013, advertising shifted to reality show sponsorships**: Starting in 2013, local satellite TV reality shows gradually rose, and major brands began competing for sponsorship rights. High program ratings increased brand exposure, driving up sponsorship fees and pushing up soft advertising costs. At the same time, with the rise of e-commerce platforms, low-priced imported milk became a major traffic-driving product. Combined with the gradual opening of cross-border bonded zones, the volume of imported fresh milk doubled. The rapid online channel expansion and offline channel penetration still took away traffic and exposure from leading companies, pushing up sales expenses for the two giants.

In 2015, vicious industry competition began: Starting in 2015, raw milk prices remained low, and some companies primarily focused on upstream began shifting to downstream dairy business. They used promotional low prices to seize market channels, and other companies blindly followed, leading to significant discounts in the overall liquid milk market. For example, at Carrefour in Shanghai in Q3 2015, Mengniu Telunsu offered a 22% discount (spend 66 yuan, deduct 15 yuan), while Yili Jindian offered a 25% discount (buy two boxes, second box half price).

We believe that as vicious competition gradually eased in H2 2016, and with no major new products launched by major companies, advertising and promotion expenses are expected to decline compared to 2016. However, considering the dairy industry has entered a relatively stable development period, we believe normal marketing expenses such as ground promotion, shelf fees, and promotional rebates will decline limitedly, with more adjustment in soft advertising spending.

**Mengniu adjusts and starts anew**

**Mengniu's own business continues to grow steadily, with profit margins recovering**

Excluding Yashili, Mengniu's own liquid milk business has maintained relatively stable growth in recent years. In 2016 and H1 2017, revenue grew 10.2% and 9.0% year-on-year, respectively, compared to Yili's 0.4% and 11.3% in the same periods, showing more balanced and stable growth.

As of H1 this year, about 6% of Mengniu's revenue growth came from volume, and 2% from average price increases. With more new products launched in Q3, management expects full-year 2017 revenue to maintain high single-digit growth. The average price increase mainly comes from a higher share of star products. This year, the company's sales expenses are focused on star products like Telunsu, Chunzhen, and Zhen Guoli, with sales of these three products up 10%, 35%, and 25% year-on-year in H1, respectively. The decline in UHT milk growth is mainly due to low- and mid-tier products, as the company has less inventory pressure from raw milk this year, reducing promotions for these products and shifting focus to high-end UHT products.

With gradual product mix optimization, the company's gross margin in H1 increased 1.9 percentage points year-on-year to 35.6% (excluding Modern Farming). We expect gross margin to continue improving as upstream supply coordination becomes smoother, offsetting rising packaging and transportation costs. On the expense side, sales expense targets are more focused and effective. Management expects Mengniu's sales expense ratio will not exceed the 2016 level of 25%. With improved gross margin and more efficient sales spending, H1 2017 EBIT margin increased 2.1 percentage points year-on-year to 7.8%. Excluding the approximately 315 million yuan loss from bulk powder sales in H1 last year, EBIT margin increased 0.8 percentage points year-on-year, and EBIT value increased 23% year-on-year, showing significant profit recovery.

**Mengniu's reforms: adjusting organizational structure, strengthening terminal management, and improving profit margins**

After Mr. Lu took over from Ms. Sun, he implemented many reforms to Mengniu's strategy, focusing on the following five aspects:

**(1) Adjust organizational structure to increase competitiveness of each department**

Shift from a functional structure to a business unit system, making decisions department-oriented to improve scale effects and operational efficiency.

**(2) Improve operational efficiency, reduce costs, and strengthen profitability**

▪ Centralize bidding and standardize central bidding operations to save costs;
▪ Borrow experience from Danone and Arla to improve supply chain efficiency and control costs in each business unit;
▪ Benchmark against peers to improve production efficiency.

**(3) More effective use of domestic and international upstream resources**

▪ Centralize procurement of raw milk and bulk powder;
▪ Strengthen control over high-quality raw milk sources domestically to develop high-end UHT and low-temperature milk;
▪ Help Modern Farming develop downstream liquid milk business to increase Mengniu's market share in mid-to-high-end segments;
▪ Develop upstream raw milk resources from a global perspective.

**(4) Focus on star products and drive product upgrades across categories**

▪ Brand building: Strengthen cooperation with international brands to enhance brand internationalization; increase brand awareness through sponsoring reality shows or other high-quality entertainment programs;
▪ R&D and innovation: Fully utilize the three R&D centers to actively develop new products and improve old ones; focus on nutrition development and integrate it into products; achieve sustainable and healthy development by developing high value-added products;
▪ Product line management: Formulate a high-end product strategy; focus on star products and optimize the product portfolio.

**(5) Implement a "deep distribution" strategy to strengthen channel competitiveness**

The company will work to transform regional subsidiaries into profit centers, enhance accountability and management systems; stabilize the distributor system, and develop direct sales to strengthen control over terminal markets. Specific measures include: balancing distributors, sales companies, and business units;
▪ Further penetrate lower-tier cities;
▪ Enhance KA management through big data collection, differentiated market strategies, and cooperation with retailers;
▪ Focus on developing special channels such as convenience stores, campuses, catering, and e-commerce;
▪ Strengthen e-commerce platform construction to maintain a leading position.

We believe Mengniu's reforms are effective. This year, dairy industry growth is mainly concentrated in consumption upgrades in third- and fourth-tier cities and rural areas, where the company's channel efficiency is not as good as Yili's. Despite a high base last year, changes in regional managers, and reduced promotions for basic white milk, Mengniu still maintained 8% revenue growth in H1 2017, further demonstrating the significant results of focusing on high-end products, improving supply chain efficiency, and enhancing profit margins. We are optimistic about the continued improvement in institutional efficiency brought by Mengniu's reforms. With the repositioning of Modern Farming and Yashili, Mengniu is expected to further narrow the gap with Yili.

**Modern Farming: enhancing upstream raw milk supply synergy; Mengniu aims to enter pasteurized milk business**

As of now, excluding convertible bond effects, Mengniu holds 60.8% of Modern Farming. As of H1 this year, Modern Farming operated 26 farms with 223,000 dairy cows. In 2016, total raw milk sales were 855,000 tons, accounting for 69.6% of revenue, with over 70% of external raw milk sales supplied to Mengniu. In H1 this year, Modern Farming lost 666 million yuan, with losses widening year-on-year, mainly due to: (1) raw milk prices falling 11% year-on-year, (2) losses from Mengniu's mandatory offer, cancellation of unexercised equity, and management equity, and (3) bad debt provisions for accounts receivable.

**Upstream raw milk business:** In H1 2017, raw milk revenue increased 23.23% year-on-year, while raw milk unit price fell 11.14% to 3.59 yuan/kg. Thanks to cost control and higher yield per cow, the gross margin of raw milk sales decreased 5.5 percentage points, less than the decline in raw milk prices. In 2016, Modern Farming lost 742 million yuan, mainly due to changes in fair value of dairy cows and excessive investment in downstream liquid milk market.

In 2017, Modern Farming's raw milk sales prices still face pressure due to: (1) stronger bargaining power given Mengniu's high stake, (2) balanced supply and demand in the upstream raw milk market this year, with little upward price momentum, and (3) Modern Farming's raw milk cost (excluding depreciation) in 2016 was about 2.53 yuan/kg, down 9.59% from 2.80 yuan/kg in 2015, so cost pressure is low and there is little incentive to raise prices.

**Downstream liquid milk business:** Due to business adjustments, Modern Farming's liquid milk revenue in H1 this year decreased 38% year-on-year to 405 million yuan, with revenue share dropping to 17.28%, and sales volume down 43.5% to 76,000 tons. Due to declining sales and insufficient capacity, liquid milk gross profit decreased 60% year-on-year.

The main adjustments in liquid milk are:
(1) No blind price wars; raise selling prices and increase marketing and channel investment;
(2) Modern Farming's UHT milk is priced at 45-49 yuan per box, avoiding the price range of Mengniu Telunsu at 55-65 yuan per box;
(3) Except for the East China market, which Modern Farming develops itself, other regions sell products to Mengniu in bulk for distribution through its channels.

We believe raising prices will affect some sales, weakening Modern Farming's previously obvious price advantage, and handing over channel development in other regions to Mengniu will weaken liquid milk gross margins. Modern Farming will focus on the raw milk business, and liquid milk will not be a future business focus. Modern Farming's future performance will rely more on raw milk price trends. Currently, with Mengniu's high stake and still-depressed raw milk prices, Modern Farming faces significant performance pressure this year. In the long term, Mengniu's increased stake in Modern Farming will bring the following improvement opportunities:

**(1) Upstream raw milk:** Technical synergy to improve scale effects;
**(2) Production OEM:** Modern Farming will produce high-end UHT and low-temperature milk for Mengniu on an OEM basis;
**(3) Marketing channels:** Modern Farming will leverage Mengniu's marketing channel resources to expand channel coverage and depth;
**(4) Distribution system:** Modern Farming will sell some downstream liquid milk products to Mengniu's distributors, who will help develop regions outside East China where Modern Farming is less familiar;
**(5) Financing and loans:** Mengniu can use its cash to provide entrusted loans to Modern Farming, earning higher interest than bank deposits while reducing Modern Farming's borrowing costs.

**In the future, Mengniu tends to operate dual brands in the high-end UHT segment (Mengniu's Telunsu and Modern Farming's "2 Hours"), while leveraging Modern Farming's upstream farm advantages to gradually enter the low-temperature pasteurized fresh milk segment, where it has been weak.**

**Yashili International: Smooth implementation of registration system; infant formula business sets sail again**

Yashili has focused on producing and selling infant formula and nutritional products since 1998. According to Euromonitor, in 2016 it held about 4% of the domestic infant formula market, ranking third among domestic brands after Yili and Beingmate.

(1) Impact of imported brands and cross-border e-commerce; (2) uncertainty before the implementation of the formula registration system, leading to inventory dumping in the industry; (3) increased costs due to low capacity utilization at the New Zealand plant; (4) high expenses from Yashili's brand channel transformation and internal integration. In 2016, due to these four reasons, Yashili's performance declined significantly.

In 2016, revenue was 2.20 billion yuan, down 20.2% year-on-year, with a net loss attributable to shareholders of 320 million yuan. In H1 this year, the company changed sales channels, withdrew from some inefficient channels, shifted to maternal and infant and e-commerce channels, increased expenses, and continued to suffer losses due to registration system uncertainty. Revenue fell 15.7% to 967 million yuan, gross margin increased 3.1 percentage points quarter-on-quarter, but net loss continued at 122 million yuan.

We expect that with the implementation of the infant formula registration system, the industry's chaotic situation over the past two years will ease, benefiting Yashili's performance improvement. In August, Yashili became one of the first companies to receive CFDA formula registration, with 7 series and 21 formulas approved, the highest number among the first batch. To seize the industry space released by the registration system and the second-child policy, the company has been focusing on brand layout, channel sales, and supply chain integration since its 2016 loss to meet market opportunities.

**(1) Brand: Streamline brand lines, reposition products, and promote differentiated brand layout**

**Each series is positioned at different levels to highlight competitive advantages:** "Yashili" focuses on basic nutrition; Mengniu's "Ruibuen" focuses on differentiated competition, targeting the organic market; "Dumex" is positioned to build a professional image and research pediatric solutions; "Arla" as a shareholder strategic brand emphasizes the royal concept. **In terms of regional strategy,** the ultra-premium brand "Arla Baby & Me" and mid-to-high-end "Dumex" target first- and second-tier cities, starting to penetrate the eastern region; mid-to-high-end "Ruibuen" and mid-end "Yashili" target third- and fourth-tier markets, penetrating the central region.

**(2) Marketing organization restructuring: Build a CBU structure segmented by channel and category**

The company has also adjusted its sales organization strategy. Marketing has shifted from a brand-segmented business unit system to a channel-segmented business unit, better targeting each channel's characteristics and strengthening brand-channel resonance.

The company uses "Maternal and Infant CBU" to support brand upgrades and channel transformation, "Supermarket CBU" to promote direct supply to maternal and infant stores, completing partial transformation with significant KA loss reduction, and "High-end Maternal and Infant CBU" to stabilize sales and curb losses by strictly controlling supermarket channel expenses and strengthening maternal and infant chain channels; "Innovation CBU" builds on the existing e-commerce base to expand community marketing to acquire new customers.

**(3) Strengthen sales support systems: Continue to optimize logistics, production, procurement, and warehousing support**

In logistics, select appropriate distribution centers to improve delivery efficiency; in production, match capacity with products based on factory capacity allocation to improve utilization; in procurement, continue global procurement and improve procurement and bidding systems; in warehousing, strengthen production-sales coordination and sales forecasting, set reasonable safety stock for products and raw materials, and accelerate inventory turnover.

**Earnings forecast**

**With the launch of high-end products and concentrated investment in star products in H2 this year, we expect revenue to maintain high single-digit growth.** Mengniu's main business revenue for 2017-2019 is projected at 56.00 billion / 61.17 billion / 65.84 billion yuan, up 8.5% / 9.3% / 7.6% year-on-year. Yashili's revenue for 2017-2019 is projected at 2.20 billion / 2.27 billion / 2.34 billion yuan, flat to +3%. Thus, Mengniu's total revenue for 2017-2019 is projected at 58.17 billion / 63.45 billion / 68.17 billion yuan, up 8.2% / 9.1% / 7.4% year-on-year.

We believe that with the increasing share of large-scale farms, raw milk price fluctuations will narrow, and the rising share of high-end products will continue to drive gross margin improvement. We forecast Mengniu's overall gross margin for 2017-2019 at 35.3% / 35.7% / 36.6%. On expenses, with many high-end new products expected to launch at year-end, the sales expense ratio will rise slightly in H2. We forecast overall expense ratios for 2017-2019 at 30.6% / 30.3% / 30.1%.

We forecast Mengniu's main business net profit attributable to shareholders for 2017-2019 at 2.341 billion / 3.115 billion / 3.729 billion yuan, with net margins of 4.2% / 5.1% / 5.7%. Yashili and Modern Farming will still record losses this year. Mengniu's overall net profit attributable to shareholders for 2017-2019 is projected at 2.258 billion / 3.394 billion / 4.240 billion yuan, with EPS of 0.581 yuan / 0.873 yuan / 1.091 yuan.

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