China Shengmu Organic Milk launched a HK$1.1 billion to HK$1.3 billion ($139 million to $169 million) IPO on Monday, a far cry from original ambitions to source up to US$800 million.
Timing is far from optimal given a souring of investor sentiment towards the milk sector in recent months. As a result, Shengmu has shaved the amount of equity it plans to sell to the regulatory bare minimum - 7% of its enlarged share capital, pre-greenshoe.
Nevertheless, it has still opted to plough ahead with a small-scale deal in order to raise money to fund its expansion plans to build a further six dairies and buy 30,000 more cows.
The BOCI and Goldman Sachs led transaction comprises 444.8 million shares, with the usual 90%/10% split between institutional and retail investors, according to a term sheet seen by FinanceAsia. The deal is being marketed at HK$2.39 to HK$2.95 per share, which represents a p/e range of 17 to 21 times estimated 2014 earnings.
So far, the deal has been on a fairly accelerated timetable, with the normal two-week pre-marketing period cut to just one. Pricing is now set for July 7, with listing scheduled for July 15.
The deal comprises all new shares, with none of the company's existing private equity investors cashing out at this stage. These comprise Baring, BOCI Investment, Goldman Sachs and Sequoia Capital.
Together, they will own a combined 20.59% stake assuming the greenshoe is not exercised. The controlling shareholders, led by Mengniu Dairy's former CFO Yao Tonghshan, will own 56.56%, while Mengniu itself will hold 4.25%.
The deal has also secured one cornerstone investor, Bao Hua Investments, which will take $30 million. This is a fund owned by state-owned food giant COFCO and a couple of international partners including Sumitomo Misui Banking.
Valuation
The deal is being pitched at a discount to industry leaders Mengniu and Fonterra but at a premium to the rest of the Chinese milk sector.
China's biggest milk company, Mengniu is currently trading at 26.5 times estimated 2014 earnings according to Bloomberg. Year-to-date, it has been relatively unscathed by downward selling pressure, dropping just 2.8%.
At this level, it is valued at a discount to New Zealand and global leader, Fonterra Co-operative, which is trading at a heady 38.9 times 2014 earnings.
But the rest of the Chinese milk sector has had an extremely poor 2014. Raw milk producer YST Dairy leads the herd, down 44.9% to just 8.41 times 2014 earnings. This marks a very steep drop from its November 2013 IPO at 17 times forward earnings.
Not far behind lies vertically integrated producer China Huishan Dairy, which also listed in 2013 and is down 39.3% year-to-date to 11.24 times March 2015 earnings. The country's biggest upstream producer, China Modern Dairy, has also had a bad year, down 27.4% to trade at 13.1 times 2014 earnings.
The rot set in around the time of YST Dairy’s IPO in November and accelerated again April when news broke that some of Huishan’s pre-IPO investors had sold down their stakes as soon as the six-month lock-up expired.
Concerns across the sector have centred on volatile raw milk average selling prices (ASPs), alongside signs of higher promotional costs and larger inventories.
Selling points
Shengmu is pitching itself as a premium player that benefits from high and rising margins, particularly in its fast-growing downstream business.
Sources close to the deal said the growth profile of its own-brand milk business has attracted the most investor attention because the company is creating brand value rather than simply passing through raw milk to downstream distributors. Overall sales of liquid milk have grown from 4.8% of revenues in 2012 to 26.5% in 2013, while gross margins have expanded from 43.3% to 54%.
Its major customer is Mengniu Dairy, which accounted for 58.3% of total sales in 2013. However, unlike China Modern Dairy, which is locked into a 10-year off-take with Mengniu, Shengmu has been able to diversify its client base, for example, signing up Want Want in 2014.
Shengmu has a 25.3% market share in organic liquid milk sales in China and a dominant 54.2% share for its dairy farming business (organic raw milk production). Gross margins on this side of the business also expanded from 31.8% to 44% between 2012 and 2013.
In some respects its closest comparable is Shanghai-listed Yili, which also has a vertically integrated grass to glass model and a 23.1% market share in organic raw milk production, second to Shengmu.
Year-to-date, Yili is down 15.3% to trade at 18 times 2014 earnings, which means Shengmu is being pitched at a slight premium at the mid to upper end of its indicative IPO price range.
In terms of dairy herds, Shengmu has China’s third largest with 30,621 cows at its 13 organic dairy farms and 60,457 at its 12 non-organic farms. China Modern Dairy is the country’s largest producer with a herd of 191,500 cows at the end of March, followed by Huishan.
Both China Modern Dairy and Huishan are achieving better yields per cow and ASP’s than Shengmu in the non-organic milk production side of the dairy farming business. This accounted for 54.7% of Shengmu’s dairy farming business in 2013.
At the end of the first quarter, Huishan reported an average yield per cow of nine tonnes and ASP of Rmb5,017 compared to respective ratios of 8.51 tonnes and Rmb5,150 for China Modern Dairy and 8.5 tonnes (end 2013) and Rmb4,820 for Shengmu.
However, the ASP of Shengmu’s liquid milk products is what gives the overall equity story a lift. At the end of 2013, this stood at Rmb14,624, rising to Rmb14,960 at the end of the first quarter.
Investor concerns
At 0.5%, organic raw milk production in China represents a fraction of the overall market. But it is growing fast, with Frost & Sullivan projecting a compound annual growth rate (CAGR) of 53.3% through to 2018.
Sales are being partly driven by fears of contamination in the food chain. A People’s Daily survey in February revealed food safety to be readers’ third biggest concern, up from seventh place in 2013. But this consumer wariness also extends to the organic sector, with resistance compounded by prices, which are two to three times higher than ordinary milk.
Chinese milk producers also face competition from foreign brands such as Denmark’s Arla Foods, which began selling organic milk with its joint-venture partner Mengniu in the second half of 2013. Australian producers are also gearing up to expand their exports to China having shortened the lead-time in getting fresh milk onto the mainland.
However, some of the shine came off foreign brands last year following Fonterra’s problems. The New Zealand group had to recall infant milk formula after it discovered one of the ingredients was contaminated with bacteria that could cause botulism.
“It’s all cows for courses when it comes to foreign or local organic brands,” said one source close to the deal. “There will be plenty of investors who will give Shengmu’s deal a wide berth because of the short-term noise surrounding the sector.
“But this is an interesting theme,” he added. “It will be China’s only listed pure play in the organic food sector.”
