The Value of Bottom Fishing in the Chinese Dairy Industry

The consumer industry is in a slump, with major consumer stocks being cleared out by funds.

Consumer data is indeed not good, with social zero growth already lower than GDP growth, and financial reports in the consumer goods industry are more alarming than surprising. However, while the growth rate of the consumer market has dropped by a few points, the decline in stock prices is much greater. Consumer stocks that have fallen by more than 30% since the beginning of this year are everywhere.

Investing in dividends seems more reliable. Unknowingly, some consumer companies have fallen to dividend yields comparable to banks. For example, the current dividend yields of the two giants in the Chinese dairy industry, Mengniu and Yili, are 4% and 5% respectively. It's time to explore the bottom-fishing value of the Chinese dairy industry.

I. Peak in Advance

Regarding dairy investment, the original logic was smooth sailing. Based on the estimation of the consumer bull market five years ago, the per capita dairy consumption in China is less than half of the global average, much lower than Japan and South Korea. Therefore, milk consumption is bound to steadily increase with economic growth. Doubling the quantity, even if prices do not rise, still has at least double the space.

The ideal is beautiful, but reality is harsh. China has its own dietary habits, and there is no rule that says it must consume dairy products like Japan and South Korea. Since 2021, per capita dairy consumption in China has begun to peak and decline, continuing to decline for nearly two years.

While GDP is growing, consumption has been continuously declining. Isn't this a peak?

With an aging population, the proportion of elderly people is increasing while the proportion of children is decreasing. The latter's intake of dairy products is greater than the former, to some extent leading to the decline in per capita consumption. Coupled with a declining population, this reduction is even greater.

On the other hand, in recent years, the entrepreneurial boom in new beverage consumption has emerged, with many brands such as Luckin Coffee, HEYTEA, HEYTEA ICE CITY, Naixue, and Bawang Tea Princess stepping out. The rise of coffee and fruit tea beverages has gradually replaced traditional milk tea, leading to a decrease in the milk content of mainstream beverages on the market.

The idea of benchmarking the international per capita consumption level must have loopholes. For example, the per capita consumption of soy sauce and herbal tea in Europe and America is definitely far below the global average. In other words, there is also huge growth potential. Does this mean that selling herbal tea and soy sauce in European and American countries is a very promising business? Obviously not When it comes to Japan and South Korea, dairy consumption has also stalled after the population stagnation. Population is the biggest influencing factor. Secondly, the consumption of dairy products in Japan and South Korea is much higher than in China, largely due to the high consumption of dry dairy products. Japanese bread, sushi, Korean cuisine, all commonly use cheese in cooking. Currently, there is no trend of increasing cheese consumption in Chinese dietary structure.

So, it is not surprising that milk consumption in China has peaked. The level of vegetable and fruit cultivation in China, as well as the relatively developed freshwater aquaculture industry, provide additional sources of calcium and protein, to some extent compensating for the insufficient milk consumption.

The last factor is the issue of milk prices. In the United States, where prices have soared, currently the lowest price for 1 gallon (3.8L) of milk is only $3, equivalent to about 5.5 RMB/L. This price cannot be found in China. Considering the purchasing power of the US dollar, it is understandable why many people still consider milk prices in China to be expensive.

In comparison to Japan, as a country with material scarcity and a large need for food imports, Japan's ability to control prices is far inferior to the United States. In Japan, milk can be found at 190 Japanese yen/L, which is the same as the mainstream price in Chinese supermarkets. However, salaries in Japan are still much higher than in China. Overall, domestic milk prices are too high, inhibiting consumption.

Previously, the expectation of increasing milk consumption while keeping prices unchanged was unrealistic. Based on China's labor and logistics levels, theoretically, prices should be lower than in Japan.

Therefore, expecting China's per capita dairy consumption to match that of Japan and South Korea also requires anticipating a inevitable decrease in milk prices. It is difficult to say that this market is a high-growth market.

Taking into account the above factors, it is not difficult to understand why this market has peaked so quickly. Population is the biggest variable, with decreasing demand and no decrease in production capacity, leading to drastic adjustments. From upstream demand to downstream transmission, from retail milk prices to raw milk prices, there has been a sharp decline.

Of course, the most affected are not dairy companies at the moment, as they have pricing power and have successfully passed on the reduction in income to the cost side. Currently, the most affected are the upstream dairy farmers, who are scattered and isolated, lacking pricing power, and incidents of pouring out milk and culling cows have already occurred On the level of listed companies, the entire dairy industry is experiencing a simultaneous decline in both volume and price. There were signs of a slowdown in revenue growth last year, and Yili's revenue decline in the first quarter is worrying as it may enter a long-term stagnant state. Population decline and aging cannot be reversed.

In industries like consumer goods where performance has inertia, entering a negative growth phase, just looking at a dividend yield of 4-5% may not be enough to provide a safety margin. For example, Feihe, which only produces milk powder, has a high dividend payout ratio of 8%, but it does not necessarily feel secure.

II. Is there no future in milk?

For China's dairy industry giants, their performance in the past period cannot be considered poor. From the perspective of market share, they have been steadily increasing over the past few years, maintaining stable high profit margins while second-tier dairy companies have almost all suffered significant performance declines.

In fact, it is difficult to achieve good profit margins in the dairy business. Many international dairy giants are also facing difficulties, with the top-ranked Lactalis and the second-ranked American dairy farmers both having very poor profits.

Lactalis had profits of 384 million and 428 million euros in 2022-2023, while DFA had profits of around 200 million US dollars. In comparison to revenue, they are barely profitable.

Nestle and Danone have relatively good profit margins, both above 8%, with better profits than Yili. However, these two companies have already diversified their businesses away from milk. Their core dairy products include milk powder, coffee, water, and snacks.

DFA in the United States is not a dairy product brand, but a cooperative of dairy farms that supply dairy processing companies or retailers. The upstream collaboration has disrupted the midstream, and the dairy processing brands in the United States have already experienced a round of closures, with Dean Foods going bankrupt as a result At this point, it can be seen that the growth and profitability of the top dairy companies do not rely on producing milk.

In addition, except for DFA, the other top four companies are all global companies, while Yili and Mengniu, when venturing abroad, are basically ignored.

Considering the demand, the ceiling for global dairy companies is not high. Yili and Mengniu are still milk processors, with their products mainly limited to dairy products. Relying solely on the Chinese market, it is indeed unlikely for them to continue to rise.

Therefore, this peak seems to be a permanent revenue peak. It may be difficult for them to move further up this ranking.

The current population issue has reversed the supply and demand, bringing the contradictions of the model ahead of time.

Companies like Lactalis, Danone, and Nestle in Europe are taking the route of comprehensive food and beverage companies, following the European model: the more diversified Nestle's profit margin, the better, while Lactalis has the least diversified products, with dairy products (mainly cheese) dominating, resulting in the lowest profit margin.

The American model focuses on upstream collaboration, with cooperatives that do not pursue profits helping to unify voices and management, passing the profits to dairy farmers, de-branding, turning milk into a homogenous product. Retailers can easily build brands using their channel advantages, creating a structure with large players at both ends and small players in the middle. This model is quite good, resulting in the lowest milk prices globally in the U.S., but ironically, it is the least friendly model for Mengniu and Yili.

The model currently used by Chinese giants is actually the Japanese model. The core is to build concepts through marketing, continuously enhance the premium pricing capability, with high expenses but also decent profit margins.

In the past, they focused on UHT milk as their core product, reducing inventory challenges caused by the short shelf life of milk. It may not taste as good, but it is more profitable.

After reaching saturation with UHT milk, they upgraded products, flavors, and introduced popular room-temperature yogurt products. After reaching saturation with yogurt, they began heavily promoting higher value-added milk and yogurt products, including various so-called sugar-free, high-protein, multi-functional fresh milk and yogurt products.

This is also known as the "milk assassin", with milk priced at 30 RMB/L and yogurt at 50-60 RMB/L not uncommon in supermarkets. Along with significant advertising investment and concept marketing, Yili and Mengniu are core sponsors of the Olympics and frequent sponsors of various entertainment shows in the market. Looking globally, no other milk-selling company has been seen doing this level of promotion.

This is also why these two companies, by not going global, not selling snacks and soft drinks, can still maintain such high profits.

Japan's milk is the teacher of this strategy. After all, Japan is known for its craftsmanship and milk experts. If you want to buy the most expensive milk on the market, choosing a Japanese brand is a safe bet. However, there is not a single Japanese dairy company in the top ten globally, as this strategy is limited to the domestic market, with limited scale. The growth rate of the market is far behind the rate of price increases, showing that the dividend of China's large market is quite good With the economic downturn, the strategy of high-end dairy products is gradually becoming troublesome. Changing business models is definitely not an easy task.

Therefore, the current scale, profits, and market value of Chinese dairy industry giants are already a rare gift. Diversified food and beverage, globalization, are reasonable ways to achieve greater growth. Because the European model is the direction with the largest market value.

However, this is not easy. Yili and Mengniu are currently struggling to break out of their comfort zones. Water, plant protein, tea, carbonated drinks, fruit juice, and coffee beverages are not visible, not to mention the snack business.

As for global business, Yili, as the big brother, had overseas business accounting for 2% of revenue in 2023, with a growth rate of 10%.

And true globalization, such as Danone, has a market revenue structure like this:

III. Conclusion

For bottom fishing in Chinese dairy companies, looking at dividend yield is too simplistic, as investors in Feihe should deeply understand. Relying on economic, population, and market dividends is a thing of the past, and population issues have exposed all other problems. The remaining breakthroughs can only be achieved by themselves.

Referring to foreign experiences, the only way for food and beverage companies to have a large market value space is through diversified globalization, selling only dairy products is very limited.

If the dividend yield is at this level, and Yili has shown the determination to become a top global food and beverage company, growth and high margins can coexist, even if short-term performance declines are acceptable. However, the problem is that there have been no results so far. Yili has tried carbonated drinks, tea beverages, and plant protein beverages, but none have achieved good results. The overseas business with a growth rate of 10% is also very concerning.

Of course, the development of things is dynamic, and Yili will always wait for that long-awaited new explosive product moment, but when it comes is very important. In the current pessimistic market, vague options are not enough. Compared to certain dividend and buyback plans, firm global revenue targets, product structure goals, are what can boost everyone's confidence. In the long run, the market is not lacking in money or liquidity, what is lacking are top global companies in various industries