China Consumer Staples-Infant formula sector:supply side reform is bearing fruit

IMF sector turning around; buy Mengniu to ride the cycleAfter two years of headwinds from oversupply and uncertain regulation, weleading brands should begin to report positive growth from 2H17, helped by aneasing in price competition and channel re-stocking due to implementation ofnew CFDA regulation. Meanwhile, we expect a higher consolidation level inIMF sector as a result of higher entry barriers and consumers’ increasing brandawareness. We believe Mengniu is the best proxy to ride the recovery cycle, asits IMF segment could recover from loss-making in 2016 to profitable in 2017-18. We reiterate Buy on Mengniu.

    Near-term: channel de-stocking reverses to channel re-stockingMajor domestic IMF brands report that sales declined in 2016, due to theheavy de-stocking of private brands, which can no longer be sold after Jan2018, in accordance with new regulations. However, we believe the worst of itpassed in 2016. Now, with the approach of the implementation date, privatelabels’ channel stocking is at a low level. Further, we expect the first batch ofthe registered list to be announced by the CFDA in 3Q17, and after its release,we expect a new round of channel re-stocking for main domestic brands.

    Long term: de-consolidation reverses to consolidationDifferent from most other consumer sub-sectors in China, the IMF market hasbecome more fragmented in the past five years, due to low entry barriers andunsophisticated consumers. However, we expect the trend to reverse because1) new IMF regulations, to be implemented in Jan 2018, raise entry barrierssignificantly; and 2) consumers will have gained brand awareness. We expectlead brands to gain market share while small brands exit the market.