Cofco and Hopu buy 20% stake in Mengniu

Foodstuff enterprise Cofco (Hong Kong) and Hopu Investment Management have agreed to buy a 20% stake in China Mengniu Dairy Company. The HK$6.1 billion ($782 million) investment by the two firms will allow Mengniu to raise some new funding as well as provide liquidity to some existing shareholders who will reduce their holding in the dairy company.
 
The two investors will make the investment via a joint venture, which will be 70% owned by Cofco and 30% owned by Hopu. Half of the investment is made up of newly issued shares while the remainder will be purchased from current shareholders. Once the deal is completed, the investor consortium will become Mengniu's single largest shareholder. The current management will remain in charge, but their shareholding will drop to 15.2% from 28%.
 
The transaction price for the shares is HK$17.60 each, which translates into a 7.85% discount to the trading price on July 3, the last traded price before the deal was announced. Mengniu's shares have traded in a range of HK$18 to HK$18.50 in the last fortnight. They have recovered from a low of HK$6 in October last year, though there is still some way to go before they reach their 52-week high of HK$25.
 
The new investors have also negotiated the right to nominate two non-executive directors to the Mengniu board for every 10% of the company they own, up to a maximum of four, so with their current stake, Cofco and Hopu will have four board seats.
 
The fact that Cofco, which is a state-owned company, is buying into China's only non-state-owned dairy company is viewed as a positive by analysts because it eradicates the idea that Mengniu lacks support from the government. There has been a question mark over the future of Mengniu and China's other dairy companies since their involvement in the melamine-tainted milk scandal last year, which resurrected concerns about food safety in China.
 
The combination of both public and private capital in a strategic partnership, makes the deal an example of the "multi-ownership" model that the Chinese government currently advocates.
 
Mengniu has not made any clear announcement regarding what it intends to do with the capital raised. It was not in need of money to begin with - as of the end of 2008, the company had HK$1.13 billion in the bank compared to a 2009 capex plan that requires only HK$800 million to HK$900 million.
 
A research note put out by J.P. Morgan yesterday suggested three potential investments that the money could be used for: upstream cattle ranch investments; the acquisition of regional milk processors; and developing its milk powder business.
 
But whatever Mengniu spends its money on, it doesn't excite J.P. Morgan: "At this point, return on new investment is still not visible," said the report. "As Mengniu is not short of capital before the transaction, we believe earnings are likely to dilute in FY09 and FY10."
 
The bank retains it "underweight" position on the company, with a target price of HK$14.50 compared to its latest price of HK$19.10.
 
The fortunes of Mengniu are somewhat better than its peers in China's dairy sector: in the first quarter of the year, the company's sales volume had recovered 80% of the losses brought about by last autumn's milk scandal.
 
More generally however, the milk industry is shrinking. In April, the national cow inventory decreased by 5.6% year-on-year and raw milk production decreased by 10.75%, according to a report released in mid-June by Guotai Junan. And in March, the liquid milk production of 18 large dairy companies was down by 20% year-on-year. The brokerage predicted that milk sales volumes will grow by just 0.4% this year, with healthier increases of 23.4% and 19.7% in 2010 and 2011.
 
The deal brings together players of size in their respective industries. Mengniu is China's largest dairy company with Rmb23.86 billion ($3.5 billion) of turnover in 2008. Cofco is China's largest importer and exporter of food with a focus on oils, grains, vegetables, beverages and sugar. Managing funds worth $2.5 billion, Hopu is China's largest private equity firm, founded by erstwhile Goldman Sachs China rainmaker, Fang Fenglei. The capital came from big-name investors such as Temasek and Goldman Sachs.