What's Behind S&P's Recently Assigned Investment-Grade Rating On China Mengniu Dairy Co. Ltd.?

Primary Credit Analyst: Lillian Chiou, Hong Kong (852) 2533-3530; lillian.chiou@standardandpoors.com Secondary Contact: Joe Poon, Hong Kong (852) 2533-3507; joe.poon@standardandpoors.com

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Frequently Asked Questions Related Research

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What's Behind S&P's Recently Assigned Investment-Grade Rating On China Mengniu Dairy Co. Ltd.?
China Mengniu Dairy Co. Ltd. has been producing and distributing milk products in Inner Mongolia since 1999, and is now one of the largest dairy companies in mainland China. Mengniu recently announced plans to issue U.S. dollar-denominated notes, the proceeds from which it will use to pay down a bridge loan. On Nov. 14, 2013, Standard & Poor's Ratings Services assigned its 'A-' long-term corporate credit rating with a stable outlook to the company. In addition, we rated the proposed notes 'A-'. In 2008 and 2011, samples of the company's dairy products were discovered to be contaminated, a blow to its reputation at that time. Some investors have asked us further questions about this risk area and other factors that may strain or support Mengniu's creditworthiness.

Frequently Asked Questions

How much of a risk factor are food-safety issues for Mengniu?
We believe Mengniu has taken decisive steps to improve its quality controls. The food-safety problems in 2008 and 2011 were mainly because of the poor quality of raw milk from small dairy farms, which typically had fewer than 100 cows. Mengniu has improved its controls over raw milk supplies by reducing sourcing from small farms, increasing sourcing from owned dairy farms, and investing in farms on which it can impose high quality standards. Small farms account for only 6% of Mengniu's producers as of June 30, 2013, compared with more than 50% in 2008. We expect the company to completely end its association with small farms within the next two to three years. Instead, Mengniu will source from large-scale, modern dairy farms that have more sophisticated management and advanced technology. Further, Mengniu is building its own dairy farms to lower the reliance on third parties for raw milk. We expect Mengniu's owned dairy farms and raw milk from China Modern Dairy Holdings Ltd. to provide about 22% of its raw milk requirements by 2015, compared with 18% in 2012. Mengniu acquired a stake of about 28% in China Modern Dairy earlier this year, and is now the largest shareholder. Strategic alliances with internationally renowned brands, such as Danone Group and Arla Foods Amba, should further strengthen Mengniu's quality-control technology and image. We also expect Mengniu's strategic shareholder, China National Cereals, Oils and Foodstuffs Corp. (COFCO), to offer management expertise in food-safety controls. And that should increase consumer confidence. COFCO is the largest food conglomerate in China and a government-owned entity. Importantly, Mengniu's financial performance remained resilient even after the previous food-safety incidents. The company maintained a consistent net cash position from 2007-2012. Its revenue and profitability also quickly recovered from the one-off expenses related to the contamination problems in 2008 and 2011.

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What's Behind S&P's Recently Assigned Investment-Grade Rating On China Mengniu Dairy Co. Ltd.?

Why is Mengniu likely to deleverage in 2014?

We estimate that Mengniu will reduce its total gross debt to about Chinese renminbi (RMB) 6 billion-RMB7 billion by the end of 2014. That's because we expect the company to pay down the bridge loan during the first half of next year using the proceeds from the proposed bond issuance, internally generated cash, and its existing cash balance. The company's leverage has increased in 2013 because the debt measure includes the existing bridge loan and proposed bond issuance. We expect Mengniu's operating cash flows to remain strong as the gross margin will improve in 2014, and EBITDA will increase even faster than revenue growth after the company fully consolidates the financial performance of Yahili International Holdings Ltd. Yahili is a more profitable milk powder producer that Mengniu acquired in August 2013.

Why does Standard & Poor's base case assume significantly higher expenditure on acquisitions than Mengniu's management?
We expect Mengniu to continue to invest in upstream dairy farms because the Chinese government encourages industry consolidation and upstream integration as a means to improve food-safety controls and product quality. Last week, for example, Mengniu agreed to buy US$60 million worth of shares in YuanShengTai Dairy Farm following its initial public offering; YuanShengTai is another upstream supplier of raw milk to Mengniu. Mengniu could also strengthen its less-established market position in the milk powder or ice cream sectors through acquiring other smaller brands. But this is a less likely scenario, in our view. We assume an additional RMB2.5 billion expenditure for potential mergers and acquisitions. This is significantly higher than management's assumption. The company's capital expenditure has typically been RMB2 billion-RMB3 billion a year. In our base-case calculation, Mengniu can support this potential acquisition expenditure through internal cash flows and its cash balance without incurring additional debt. The company could therefore maintain a "minimal" financial risk profile. However, the rating may come under pressure if any debt-funded expansion is more material than we expect under our base case and its financial performance deteriorates for a prolonged period.

Why does Mengniu have a "minimal" financial risk profile, the lowest risk level?
The financial risk profile reflects Mengniu's consistent record of conservative financial management, its high cash balance, and cautious approach to investments. We considered 75% of Mengniu's cash balance as surplus cash and deducted it against total gross debt. This is mainly because China's dairy industry isn't very cyclical and Mengniu typically doesn't require large working capital cash flow, given favorable payment terms from its customers. In addition, the company's capital expenditure plan is scalable. On the other hand, our base case factors in much higher spending on acquisitions than management's assumption. The ratio of debt to EBITDA, after our adjustments for surplus cash, could stay at about 0.4x-0.7x in the next 12-24 months. Over the same period, the ratio of funds from operations to debt, also adjusted for surplus cash, will be more than 150%. Mengniu's strong financial position provides a buffer against event risk, such as a temporary industry slowdown, a small-scale food safety incident, or moderate acquisitions. The company's very conservative capital structure also underpins our assessment.

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What's Behind S&P's Recently Assigned Investment-Grade Rating On China Mengniu Dairy Co. Ltd.?

What is the competitive landscape like for Mengniu?

Mengniu operates in both sides of the dairy industry: liquid milk and milk powder. We expect Mengniu to maintain its leading market share of about 25% for liquid milk, which is a more consolidated and mature segment. The market for milk powder is smaller, but it's growing rapidly. Mengniu has increased its market share in this segment to 6%-7% and strengthened its market position to become one of the top 3 domestic brands. The company's market position has become particularly good in second- and third-tier cities since it acquired the domestic brand Yashili. Foreign brands dominate the milk powder segment, particularly for infant formula. The segment is therefore challenging for domestic brands, such as Mengniu's. However, the Chinese government is encouraging the formation of larger domestic brands. Industry consolidation could alter the competitive landscape over the next three to five years.

Related Research
China Mengniu Dairy Co. Ltd., Nov. 19, 2013 China Mengniu Dairy Co. Ltd. Assigned 'A-' Rating, Outlook Stable; Proposed Notes Rated 'A-', Nov. 14, 2013

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