Investment Thesis:

New high-value added products should help sustain Mengniu’s robust growth:
We believe that Mengniu through its strong brand, innovative products, and ultra efficient distribution network will be able to ride the wave on the transition from traditional milk products to higher value dairy products. Mengniu has already demonstrated its ability to take advantage of new products and markets when it first introduced UHT milk to the Chinese market. Concurrently, we believe growing UHT sales to rural communities should help off-set someone of the growth slow-down from near saturated urban markets.

ASP should remain stable or see a slight increase as higher value products reach market:
A recent increase in government price caps coupled with solid performance of Mengiu’s products should help sustain Mengniu’s ASP for the foreseeable future. We anticipate that despite some downward pressures Mengniu’s new higher value products and price cap increases should help maintain or slightly improve its 2008 ASP.

Higher costs should be offset by rising and eventually stable ASP coupled with falling raw milk prices:
Higher costs via new product development, company branding and distribution could place downward pressure on Mengniu’s margins. Yet, we anticipate that in 2008 margin pressure will be more than off-set by reductions in raw milk prices and increases in the ASP for Mengniu’s products. We currently expect Mengniu’s gross margin to improve to 22.8% in 2008 vs. 22.5% in 2007 and to remain somewhat stable in 2009. Since Mengniu owns only a very small percentage of its own livestock and pastures, it remains extremely susceptible to changes in raw milk costs, both on the upside and downside. Meaning a continued moderation in raw milk prices could have a large positive impact on Mengniu’s bottom line. Based on the current inflation outlook we expect raw milk prices will continue to moderate, eventually stabilizing by year end.

Our DCF based price target is currently HKD26.16:
Given Mengniu’s historically strong growth, its ability to generate cash, and continued leading market position in the liquid milk industry we have decided to run a DCF model to value the company’s equity. Using a 10.6% WACC, based on our calculated cost of equity, and a terminal growth rate of 2% starting in 2019 we calculated a price target of HKD26.16. Please take a look at the chart below for our model’s sensitivities to changes in WACC and the terminal growth rate. According to our calculations a price target of HKD26.16 would imply a 12 month forward P/E ratio of x26.79 and a 24 month forward P/E ratio of x19.95. This is in-line with Mengniu’s recent performance as can be seen in the chart below.