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China Mengniu Dairy (2319.HK) - Safety consumption of Milk Deluxe (OMP) products by the Ministry of Health

Monday, February 23, 2009

6844

China Mengniu Dairy(2319)

Recommendation on 23 February 2009
Recommendation	Hold
Price on Recommendation Date	$9.810
Target Price	$9.600

Weekly Special - 603179.CH Xinquan

Summary

The Ministry of Health confirmed safety of Milk Deluxe (OMP) products –

On 15 February, the Ministry of Health announced that they confirm safety of Milk Deluxe (OMP) products. Previously, certain media reported on the use of “OMP” and “IGF-1” in the “Milk Deluxe (OMP)” milk products of the Mengniu Dairy. And some reports quoted that experts said excessive levels of IGF-1 could cause cancer and the event sparked fear amongst consumers.

Approval from the Ministry of Health on using OMP is required –

Approval shall be obtained from the Ministry of Health for importation of OMP products. The Group is currently going through the reporting and approval processes.

Event implication and analysis --

We believe the impact would be small as Milk Deluxe OMP only accounts for 2-3% of the company's revenue.

Substantial loss for the 2008 year-end result --

Approximately RMB 900 million for the financial year ending 31 December 2008 is incurred mainly as a result of and in connection with the “melamine incident”

Valuation—

Our target price is HK$9.6 Hold.

The Ministry of Health confirmed safety of Milk Deluxe (OMP) products

Certain media reported on the use of “OMP” and “IGF-1” in the “Milk Deluxe (OMP)” milk products of the Mengniu Dairy. And some reports quoted that experts said excessive levels of IGF-1 could cause cancer and the event sparked fear amongst consumers.On 15 February, the Ministry of Health announced that they confirm safety of Milk Deluxe (OMP) products. The Ministry of Health of the People's Republic of China (the PRC) together with the Ministry of Industry and Information Technology, the Ministry of Agriculture, the Ministry of Commerce, the State Administration for Industry and Commerce and the General Administration of Quality Supervision, Inspection and Quarantine of the PRC gathered experts from various professions such as professions of health, nutrition, toxicology, food science and agriculture to discuss the safety of OMP used by the Company. After considering the source, production and application quantity of OMP, test reports and governmental approval on similar products and usage of OMP in other countries, the experts confirmed that consumption of “Milk Deluxe (OMP)” currently available in the market is not hazardous to health.

OMP (which is also known as “MBP (milk basic protein)” in the United States and Japan) is milk basic protein which is a natural ingredient extracted directly from raw milk and it has been used in countries and places such as the United States, Europe, Japan, Korea and Taiwan for years and has been certified to be safe by the Food and Drug Administration in the United State (FDA) and the New Zealand Food Safety Authority. The Company has also engaged various universities in the PRC including Shanghai Institute for Preventive Medicine (上海預防醫學研究院), Health Science Centre of Peking University (北京大學醫學部) and Harbin Institute of Technology (哈爾濱工業大學) to conduct tests on OMP and the results were all positive. OMP and IGF-1 are two different substances. IGF-1 is polypeptide protein existing in human blood, breast milk and milk. The content level of IGF-1 in the “Milk Deluxe(OMP)” milk products is the same as that of the other ordinary milk products.

Insulin-like growth factor 1 (IGF-1) that was once called somatomedin C, is a polypeptide protein hormone similar in molecular structure to insulin. It plays an important role in childhood growth and continues to have anabolic effects in adults.

Approval from the Ministry of Health on using OMP is required

We also noted the comment of the Ministry of Health that approval shall be obtained from the Ministry of Health for importation of OMP products. The Group is currently going through the reporting and approval processes according to the relevant law and will provide full assistance to the relevant department in the supervision process.

Event implication and analysis

The sales of OMP products could have been affected in the past few days. However, we believe the impact would be small as Milk Deluxe OMP only accounts for 2-3% of the company's revenue. And with consumers` rising concern on food safety, the ministry of health is paying more attention to food quality and to set up higher food safety practice. We believe it would increase the expenditure for the sector on food safety issue. We believe it would accelerate the consolidation of industry and is positive for Mengniu, one of the industry leaders for long term. As the unqualified food producers would be squeezed out of the market gradually. And we believe the announcement by the Ministry of Health would help lessen consumers concern and Mengniu's leading position is unchanged.

Substantial loss for the 2008 year-end result

The board of directors of the Mengniu Dairy preliminarily estimated that the Group was likely to incur a loss in the region of approximately RMB 900 million for the financial year ending 31 December 2008. Such possible loss is incurred mainly as a result of and in connection with the “melamine incident” which has adversely affected the performance of the Group including, in particular, a decrease in sales, writing off of certain inventories and additional costs for the disposal of raw milk and for sales promotional campaigns.

Risk factors

--Consumers concern on food safety

--Contingent litigation and compensation

--Slower sales recovery than expectation

Valuation

We recommend a “Hold” rating on Mengniu Dairy. It has been traded between 9x and 39.4x throughout this year and currently 13.5x. We forecast 2009 EPS to be HKD 0.48, and 12-month target price is HK$ 9.6 implying 2009 P/E of 20x. Its historical PE is trading at 9x to 50x in the past 4.5years. We believe Mengniu Dairy trading at its fair value because of its market leading position, and strong brand name.

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