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(Bloomberg) -- A decade after Chinese dairy companies were roiled by a scandal that poisoned thousands of children, investors are seeing the biggest players as safe bets.
Inner Mongolia Yili Industrial Group Co. and China Mengniu Dairy Co. have soared to all-time highs as the companies hunt aggressively to build up their milk supply chains through foreign acquisition. Also underpinning the bullishness is the virtual duopoly’s rosy earnings prospects amid a shift to more profitable segments like premium yogurt and infant formula.
With China’s dairy demand forecast to grow 37 percent to $76 billion in five years -- overtaking the U.S. to become the world’s biggest dairy market -- the bull run may have further to go.
“These stocks have actually become safe harbor blue chips, and their growth will have sustained momentum given government support and their ambitious acquisition strategy,” said Meng Shen, Beijing-based director of the boutique investment fund Chanson & Co.
Mengniu’s stock was raised to a buy by Daiwa Capital Markets Securities analyst Anson Chan on Monday. The shares increased 1.4 percent as of 10:04 a.m. in Hong Kong on Monday. Yili gained 1.3 percent in Shanghai trading.
The effort to gobble up smaller rivals at home and secure upstream supply on foreign turf has played a pivotal role in allowing Yili and Mengniu to tighten their grip on a sector that took a decade to recover after a deadly scandal in 2008. The two have a combined 44 percent of the dairy-products market in China, according to data from Euromonitor International. Shanghai-based Bright Food Group Co. is a distant third with a 4.8 percent market share.
Mengniu has spent about $2 billion on acquisitions at home since 2014, while Yili has concentrated on shifting its product mix into higher-margin segments and boosted its nationwide marketing. Now the focus is moving overseas: both have made bids for Australia’s biggest dairy producer, Murray Goulburn Co-operative Co., in a deal that may value it at more than A$1 billion ($784 million) including debt.
Yili and Mengniu are cash-rich -- they posted 23.5 billion yuan ($3.6 billion) in cash and equivalents combined as of the end of 2016 -- and hungry thanks to their success in pushing gross profit margins past the 30 percent threshold.
To Haitong International Securities analyst Nicolas Wang, this means they’ve gone from being the bedmates of agriculture companies and OEM manufacturers to becoming standalone brands chalking up margins nearer to that of household names Danone SA and Nestle SA.
“In the food and beverage sector, a gross profit margin of over 30, 35 percent means that companies are not just manufacturers but have brands that significantly add value,” Wang said.
Over the past 12 months, both Yili and Mengniu shares have gained more than 40 percent, far outperforming the 11 percent advance in the Shanghai Composite Index and 24 percent increase in the Hang Seng Index.
Even after this year’s bull run, Yili still appears to be an undervalued play, with a price-to-earnings ratio of 28, below the average of consumer staples in China. It’s also well below sector peers in emerging markets in the Asia-Pacific region, where the average ratio is 39.
According to data compiled by Bloomberg, Yili still boasts 26 buy ratings, two holds and no sells, while Mengniu has 23 buys and four holds.
With the scrapping of China’s one-child policy, the two dairy giants, with a combined market value of more than $36 billion, are striving to become more competitive in infant formula, a dairy product where profit hovers in the 50 percent range.
But since the 2008 scandal where melamine-tainted milk killed six infants and sickened tens of thousands, Chinese consumers have preferred foreign brands for baby formula. The local market is led by Nestle, Danone and Mead Johnson-owner Reckitt Benckiser Group Plc. Many parents also insist on baby formula that comes directly from overseas supermarket shelves, brought back to China in suitcases or through free-trade zones.
Yili’s been trying to build up an upstream supply on foreign grass: in 2013, it took over Oceania Dairy in New Zealand, after the previous owners ran out of funds to build a dairy factory. Since then, it’s invested $600 million into facilities that include an infant-formula canning line and a whole milk dryer.
The Oceania plant is currently being supplied by 67 farmers. Murray Goulburn, the Australian cooperative that both Yili and Mengniu want, is supplied by 2,000 farmers. Acquiring such a large, stable milk source and dairy processing facility could catapult their products to the next level in the local consumer market.
(Updates with analyst upgrade and share prices in 5th paragraph.)
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