2007 outlook - Dairy boom
continues

China's dairy sector in multi-year growth phase
Rising disposable income and modernisation of retail channels should help China's
dairy industry grow. But ferocious competition will likely force small players to
lose market share to market leaders. Mengniu is our top Buy in the sector. We
Maintain our Sell ratings on Yili and Bright Dairy on stretched valuations.

Company
Industry Focus Research
2007 – Dairy boom continues
2006 was another strong year for China’s dairy industry, reporting over 20% yoy
increase in output growth. Into 2007, we believe China’s dairy consumption will
stay on the growth trajectory at c.20% pa, spurred by rising disposable income
and modernization of retail channels. Key trends are:
􀂃 Faster growth in 2nd-3rd tier cities due to low penetration rates, while in
urban areas, consumption mix upgrade is the key driver.
􀂃 Overall product quality is improving. Increasing media pressure and
consumer awareness of food safety – after a spate of food quality scandals –
compelled dairy enterprises to improve product quality. This is good news for
consumers.
􀂃 Competition on product innovation and marketing campaigns. High
value-added products are key profit drivers. In a harsh operating
environment with lingering cost pressure, dairy product companies compete
by rolling out more value-added products to counter irrational price wars on
“commoditized” products.
􀂃 Ongoing consolidation continues to phase out small-to-medium sized
players. This leads to market share polarization between big and small
players.
􀂃 More tie-ups between local and foreign players to be formed this year. A
win-win for both parties as local players can leverage off foreign technical
expertise, while foreign players can utilize local partners’ existing sales
networks and raw milk supply.
Mengniu Dairy is our top pick in China’s dairy industry
We like Mengniu for its robust earnings growth outlook (42% EPS CAGR in FY06-
08E), high ROE of 29% and strong FCF generation. This is one of a few Chinese
companies that we think can grow robustly without sacrificing its cash flow. We
see Mengniu as a “must-own” stock in China's consumer space in the long run.
Maintain Buy and our TP of HK$28.3 is based on 1x PE/G.
Sell Yili and Bright Dairy on stretched valuations
Due to a bull run in the A-share market, Yili and Bright Dairy are now trading at 41x
and 44x FY07E P/E, respectively. The implied 21-45% premium to Mengniu is not
justifiable in our view due to its slower earnings growth outlook. We peg a 15%
discount to Mengniu’s target P/E in FY07E to arrive at a fair value of Rmb28 for Yili
and Rmb6.8 for Bright. Maintain Sell on both stocks on pricey valuations.
Key risks
Key earnings risks: fierce competition, price wars, input cost pressure, escalating
marketing expenses and product quality scandals. Risks to our call include M&A
and liquidity flow into or out of A-share and/or H-share market.

Table of Contents
Investment thesis .............................................................................. 3
Outlook ....................................................................................................................................3
Valuation ..................................................................................................................................3
Risks ........................................................................................................................................3
China’s consumer sector has re-rated in the past two years ....................................................5
2006 – A strong year.......................................................................... 6
Strong output growth................................................................................................................6
…but, listed dairy players reported a mixed bag of results.......................................................6
Key events ...............................................................................................................................7
2007 – Still booming.......................................................................... 8
Dairy consumption growth, driven by quantity and trading up .................................................8
Overall product quality is improving – Good news for consumers .........................................10
Lingering cost pressure ..........................................................................................................10
Competition on prices, product innovation and creative marketing ........................................11
Market polarization between large and small players .............................................................13
More M&A or strategic tie-ups ...............................................................................................14
China Mengniu Dairy Co Ltd........................................................... 16
Inner Mongolia Yili .......................................................................... 24
Bright Dairy ...................................................................................... 30