Infant Milk Formula China By Macquarie

5/24/2018 Infant Milk Formula China By Macquarie

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Please refer to page 68 for important disclosures and analyst certification, or on our websitewww.macquarie.com/research/disclosures.

CHINA

Inside

Turning sour, switch to mothers milk 2Valuation 4Volume consumption to peak in 2017 8Policy directed consolidation,price ceiling 13Distribution channel revolution 18

Biostime 23

Yashili International 42

Mengniu 59

China infant formula stocks

Ticker Company Rating Price TP

Up/Down

side1112 HK Biostime UP 51.40 38.50 -25%1230 HK Yashili UP 2.87 1.45 -50%

Mkt Cap ADTV PER (x)Company US$m US$m CY14E CY15E

Biostime 4,004 10.1 25.7 21.3Yashili 1,318 2.2 34.4 29.8

Source: Bloomberg, Macquarie Research, June 2014;pricing date 10 June 2014

Analyst(s)Jamie Zhou, CFA

+852 3922 1147 [email protected] June 2014Macquarie Capital Securities Limited

China infant formulaTurning sour, switch to mothers milkWe initiate coverage on Chinas infantformula sector with a cautious view and

Underperform ratings on Yashili and Biostime. A falling fertility rate and already

high market penetration (85%) would limit volume growth to barely a 5% CAGR

through 2018 before total consumption starts to decline, by our estimates. Recent

policy moves would further cap pricing power in an increasingly competitive

market as young Chinese parents bargain-hunt for imported brands online and

shy away from local brands such as Yashili. Nonetheless, a consumption upgrade

trend to the mid-to-high tier segment should create opportunities for brands, like

Biostime, that can continue to innovate.

2-child policy no silver bullet, volume CAGR to slow to 5%We believe market excitement over a potential baby boom from relaxation of the

One Child Policy is overdone. Total formula consumption is likely to peak in 2018

while the volume CAGR would be barely 5%, and a mix shift would drive about

8% sales CAGR. Demographic expert Dr. Clint Laurent expects a temporary boost

of 3m new babies by 2017 would be insufficient to reverse a multi-decade falling

fertility profile.Chinas fertility rate of 1.7 (already below the world average of 2.8),

compared to most developed Asian cities, indicates the rate could fall even further

(HK 1.3, Shanghai 0.7). Meanwhile, Chinas formula penetration already reached

85% in 2013 and the government is promoting breastfeeding, hoping to raise the

low ratio from 16% (2012) to 50% by 2020.

Government investigation, competition cap pricing powerBeijing has been on the move over the past year to consolidate the fragmented

domestic infant formula industry. We believe the governments end goal is t o build

a strong domestic industry with high quality and safety standards to restore

Chinese consumers confidence in domestic infant formula. In the interim, policy

makers are concerned about the affordability of infant formula, with retail prices

double those of equivalent products overseas and in HK. Beijing has taken firm

measures against brands that are making excessive profits and this has sparked

price cuts. Coupled with intensifying competition, we see downside risks to the

high margins currently being earned (Biostime GM 65%, Yashili 53% (FY13).

Maternity, ecommerce rapidly eroding supermarket sales

The post-80s generation of convenience-seeking and tech-savvy consumers areincreasingly shopping at neighbourhood maternity shops and online. Infant

formula sales at supermarkets fell by 4% YoY in 2013, for the first time ever, and

companies that rely heavily on supermarket sales suffered market share loss

(Yashili). We expect this consumption habit shift to accelerate, particularly towards

ecommerce as parents bargain hunt for imported brands. The proliferation of

ecommerce has effectively lowered the entry barriers in lower-tier markets

previously dominated by local brands with offline distribution.

Earnings downside, 31% for Biostime, 60% for Yashili

We initiate on Biostime and Yashili with Underperform ratings. We believe the

market remains too optimistic: our FY14/15E forecasts are 16%/31% below

Consensus on Biostime and 55%/60% on Yashili; upcoming interim results should

catalyse Street downgrades. While we believe Biostime can maintain its market

leadership with the Adimil and O2O model, its valuation is rich at 26x/21x

FY14/15E PER. Yashilis shares appearsignificantly overvalued at 34x/30x PER;

a 43% decline in FY14E earnings would mean its dividend is at risk.


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Macquarie Research China infant formula

11 June 2014 2

Turning sour, switch to mothers milkVolume consumption to peak in 2017E, opportunities exist inupgrade to mid-to-high tiers, driving 8% total market CAGR

Based on demographic expert Dr. Clint Laurents forecasts, we project Chinas infant formula

consumption to grow at barely a 5% volume CAGR through 2018. With an expected

consumption upgrade from lower tier to mid- and high-tier categories, we expect the overall

market size to grow at a faster pace of 8% CAGR. Our cautious view on the industry growth

potential is mainly due to:

Relaxation of the one child policy, which will temporarily add up to 3m births, before

starting to decline in 2018E

Expectations of Chinas fertility rate of 1.7 continuing to fall; HK/SG are at 1.3,

Shanghai is at 0.7

Infant formula consumption penetration already being high at 85% as of 2013

The Chinese government actively encouraging breastfeeding (16% in urban China vs.

world avg 37% in 2013) and banning hospitals from marketing infant formula products.

Fig 1 # of infants to peak with births in 2017 Fig 2 85% penetration, volume CAGR only 5%

Source: Global Demographics, Macquarie Research, June 2014 Source: Global demographics, Macquarie Research, June 2014

Consolidation, price investigation and competition to erode margins

Various policy measures have been announced in the past 12 months aimed at reforming the

infant formula industry. We believe the governments goal is to build a strong domestic

industry with high quality and safety standards to restore Chinese consumers confidence in

local brands. In the domestic industry, the government has taken the following actions:

Strengthening safety standards, banning OEM production of infant formula

Increase accountability, requiring players to own or control their upstream milk sources

Eliminating weak, smaller players production licenses

As of June 2014, 82 out of 133 domestic infant formula makers have successfully

passed China FDAs quality examination and have production permits renewed

In the interim, policy makers are concerned about the affordability of infant formula and have

taken measures against imported brands that are making excessive profits:

NDRC investigation of six brands over monopolistic pricing behaviour (reaping above-

normal profits), resulting in heavy penalties and price cuts (up to 20%)

Requiring all imported products to be packaged in final retail format with labels printed

in Chinese, thus banning the cheaper repackaging methods previously used

As of June 2014, 94 foreign infant formula brands have received import approval from

the General Administration of Quality Supervision, Inspection and Quarantine.

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11 June 2014 3

Local brands that rely on supermarket sales have lost market share

Infant formula sales at supermarkets dropped by 4% YoY in 2013, for the first time ever, and

companies that rely on significant sales from supermarkets suffered. Despite the overall

market still growing in the low-teens, sales of infant formula in supermarkets were largely flat

over the past three years. We expect the shift towards to maternity shops and ecommerce to

accelerate and that the beneficiaries will be those that can successfully capture thisconsumption habit change.

The generation born after 1980 are typically technology-savvy and convenience seeking

consumers. They were the first to develop online shopping habits and when they have

babies, they are increasingly buying infant formula from two emerging channels (Fig 31):

Maternity shops: neighbourhood Mom & Pop baby product shops, low entry barriers,

very fragmented. Early mover brands have secured an advantage in terms of shelf

space

Ecommerce: infant formula sold through Chinas leading B2C sites, a brand driven

model where brand awareness attracts sales.

Fig 3 Selective growth opportunities in Mid-High Tier Fig 4 Sales shifting to maternity and ecommerce

Source: Nielsen, Global Demographics, Macquarie Research, June 2014 Source: Nielsen, June 2014

Biostime the rising star; Yashili the fallen angel

Between the two HK listed plays, Yashili has a higher reliance on supermarket (>60% of

sales) while Biostimes success was attributable to its earlyentry into maternity channels

(74% of sales), but it lacks in ecommerce which it plans to counter with its O2O sales model.

Fig 5 Biostime: a miracle infant formula growth story Fig 6 China infant formula top 12 players, Jan 2014

Source: Bloomberg, Company data, Macquarie Research, June 2014 Source: Nielsen, Macquarie Research, June 2014

13%

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Low Mid High Supreme Overallmarket

09-13 13-18E

Market growth (5-year CAGR)

44% 43%36%

33% 41%42%

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Biostime Yash il i Beingmate Mead Johnson (China)

Infant formula sales (RMB billion)

MeadJohnson,

14.5%

Wyeth, 13.3%

Beingmate,8.5%

Biostime,7.5%

Abbott , 7.0%Yili, 6.2%

Nestle, 4.4%

Yashili, 4.1%

Friso, 3.9%

Dumex, 3.6%

Feihe, 3.5%

Synutra, 3.2%

Others, 20.3%


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11 June 2014 4

ValuationOur primary valuation is based on PER, which we then cross check against our DCF fair

valuation.

Biostime (Underperform) with HK$38.50/sh target, 16x FY15E PER

Our 12-month target price of HK$38.50/sh is based on 16x FY15E PER, the average of its

valuation since listing. We like the 34% ROE, strong FCF generation and consistent dividend

payout of 70%, however we are cautious on the rich valuation given we expect growth to slow

down significantly to just an 11% earnings CAGR for FY13-15E. Our FY14/15E earnings

forecasts are 16%/31% below Consensus. The founders lock-up expired on May 20thwhich

may also pose a sell-down overhang for the stock.

We cross-check with our DCF model, which suggest a fair valuation of HK$40/sh.

Yashili (Underperform) with HK$1.45/sh target, 15x FY15E PER

Our target price is based on 15x FY15E PER. Yashilis profitability and return on capital have

fallen significantly (low teens EBIT margin and high single digit ROIC) since 1H13. Yashili has

been losing market share since the 2008 Melamine Crisis, particularly in Tier 1 & 2 cities, andcontinues to be weak in two increasingly dominating channels: maternity and ecommerce.

Our Yashili DCF fair valuation is HK$1.29/sh. FCF turned negative in FY13 and with the

ongoing capex commitment with the New Zealand plant, we expect FCF to stay negative until

at least FY16. Prior to the takeover by Mengniu in Aug 2013, a special dividend representing

229% of FY13 NP was paid out to shareholders, which reduced the cash position by

RMB1bn. We believe the regular dividend is likely to be reduced significantly by 76% from

RMB11 cents in FY13 to just 3 cents in FY14.

Fig 7 Infant formula valuation comps

Price TP Mkt Cap PER (x) EV/EBITDA(x)

EPS

growth(%) EBITmargin ROE(%)

Div

yield(%) P/BkTicker Company Rec lc lc % US$m CY14E CY15E CY14E CY15E 13-15E CY13 CY13 CY13 FY13

1112 HK Biostime UP 51.40 38.50 -25% 4,004 25.7 21.3 16.3 13.9 11.3 23.5 33.9 2.9 9.9Biostime at TP 38.50 19.2 16.0 11.5 9.8

1230 HK ashili UP 2.87 1.45 -49% 1,318 34.4 29.8 19.3 14.4 -19.0 9.6 12.2 15.4 2.6Yashili at TP 1.45 17.4 15.0 8.5 6.3

Infant formula pure-playsMJN US Mead Johnson NR 87.39 17,662 23.6 21.1 15.6 14.0 7.6 23.9 418.4 1.6 51.1002570 CH Beingmate NR 13.10 2,152 13.4 11.0 13.7 11.4 28.2 13.3 16.8 2.0 3.41112 HK Biostime UP 51.40 38.50 -25% 4,004 25.7 21.3 15.7 13.4 11.3 23.5 33.9 2.9 9.91230 HK Yashili UP 2.87 1.45 -49% 1,318 34.4 29.8 18.8 14.0 -19.0 9.6 12.2 15.4 2.6Average 21.6 18.3 15.8 13.1 7.0 17.6 120.3 5.5 5.1

Diversified dairies2319 HK Mengniu UP 38.05 27.90 -27% 9,612 30.1 25.5 14.9 12.6 11.9 4.6 12.6 0.7 3.7600887 CH Yili NR 31.99 10,498 14.4 12.0 8.4 NA 21.0 7.4 20.3 2.0 3.8600597 CH Bright NR 16.27 3,200 21.4 17.6 NA NA 30.5 5.1 12.8 1.6 4.5NESN VX Nestl NR 69.55 249,344 20.0 18.6 13.5 12.5 5.3 15.8 16.2 3.3 3.5BN FP Danone NR 54.76 47,750 19.8 17.9 12.3 11.2 6.8 13.2 12.4 2.8 3.2FSF NZ Fonterra N 5.95 6.65 12% 8,094 35.1 21.5 11.8 9.7 -31.3 3.1 3.5 2.1 1.4Average 21.6 17.9 11.7 11.4 7.4 8.2 13.0 2.1 3.0

China large cap staples151 HK Want Want OP 10.70 13.00 21% 18,237 23.1 19.9 15.6 13.2 15.4 23.0 37.9 2.9 9.4322 HK Tingyi OP 21.90 24.40 11% 15,817 32.6 27.0 11.7 10.3 19.7 7.4 16.0 1.5 5.51044 HK Hengan N 81.70 84.00 3% 12,945 22.9 19.2 16.4 13.5 23.3 20.2 25.2 2.6 6.12319 HK Mengniu UP 38.05 27.90 -27% 9,612 30.1 25.5 14.9 12.6 11.9 4.6 12.6 0.7 3.7168 HK Tsingtao Brewery NR 61.70 9,866 30.2 25.5 15.2 12.7 5.9 7.2 14.9 0.9 4.6Average 27.2 23.0 14.6 12.4 15.2 12.5 21.3 1.7 5.4

Pricing date 10 June 2014. Valuations and forecasts for non-rated stocks are from Bloomberg.Recommendation legend - OP: Outperform, N: Neutral, UP: Underperform, NR: not rated.

Source: Bloomberg, Macquarie Research, June 2014


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11 June 2014 5

Among the listed dairy companies globally that have infant formula businesses in China, we

identify two baskets of comps:

Infant formula pure-plays

Biostime(1112.HK)China based, premium products made in France, imported. #4

in market share (Jan 2014)

Yashili(1230.HK)China based, imported ingredients from NZ. #8 in market share.

Mead Johnson(MJN.US)U.S. based global infant formula maker, imported into

China. #1 market share holder in China

Beingmate(000257.CH)China based infant formula maker, ingredients sourced

50/50 from domestic/imported sources. #3 in market share, highest among local

brands.

Diversified dairies

Mengniu(2319.HK)Chinas largest liquid milk maker, holds 68% stake in Yashili

Yili (600887.CH)Chinas largest liquid milk maker, #6 market share in infant formula

Nestl (NESN.VX)Global dairy giant, two brands in China: Wyeth (#2 market share)

and Nestl (#7)

Danone (BN.FP)Global dairy giant, owner of the Dumex brand (#10 in China)

Bright Dairy (600597.CH)Shanghai based national diversified dairy, sells imported

infant formula, not a top 10 brand.

Fonterra(FSF.NZ)Global dairy giant, sells imported powder in China, not a top 10.

We also examined Abbott Laboratories(ABT.US) whose Abbott brand of infant formula

commands 7% market share in China at the #5 spot. However, given that 70% of the listcos

revenue is from the healthcare segment, we chose not to include it in the comps.


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11 June 2014 6

Infant formula pure-plays

With growth slowing, rising competition and government price caps, we believe infant formula

plays should trade at the low-end of their historical valuation range of 16-22x forward PER.

We think the price data over the past three years shows a fair representation of the infant

formula industrys risks and opportunities.

The three domestic infant formula pure-plays were all were listed in late-2010/early-2011.However, their forward valuations fluctuated greatly in 2013, due to three major industry

catalysts:

Positive: Mid-2013 Chinese government announces infant formula consolidation plans

Negative: July 2013 NDRC investigation which resulted in fines and price cuts

Positive: November 2013 relaxation of One Child Policy

Mead Johnsons average forwardPER is also a good proxy in our view, due to its global

diversification, which limits short term noise in the China market. MJNs forward PER has

been steady in the range of 18x to 25.5x since mid 2009.

Fig 8 Biostime has traded on 16x PER on average Fig 9 Yashili has traded on 22x PER on average

Source: Bloomberg, Macquarie Research, June 2014 Source: Bloomberg, Macquarie Research, June 2014

Fig 10 Mead Johnson has traded on 22x PER onaverage Fig 11 Beingmate has traded on 22x PER on average

Forward earnings are based on Bloomberg Consensus estimates. Forward earnings are based on Bloomberg Consensus estimates.


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11 June 2014 7

Diversified dairies trading on lower valuation than infant formula

As a group, diversified dairies have been trading at a lower valuation than infant formula pure-

plays due to lower margins on the liquid milk business. The average EBIT margin of our

diversified dairies for FY13 was only 8% vs. 17% for infant formula pure-plays.

Most of the diversified dairies traded around 18x forward earnings on average over the past

five years. The exception is Mengniu, which traded on average at 25x PER. This is largelydue to a number of high profile M&A catalysts over the past few years (COFCO stake,

Danone JV and stake, Modern Dairy acquisition, Yashili acquisition, Arla partnership, White

Wave partnership).

Fig 12 Mengniu traded on 25x PER on average Fig 13 Yili traded on 17x PER on average

Forward earnings are based on Bloomberg Consensus estimates.


Fig 14 Nestl traded on 18x PER on average Fig 15 Danone traded on 16x PER on average

Forward earnings are based on Bloomberg Consensus estimates. Forward earnings are based on Bloomberg Consensus estimates.


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11 June 2014 8

Volume consumption to peak in 2017Opportunities exist in upgrade to mid-to-high tiers

Based on Dr. Clint Laurents demographic forecasts, we project Chinas infant formula

consumption to grow at barely a 5% volume CAGR through 2018. With an expected

consumption upgrade from lower tier to mid- and high-tier categories, the overall market sizeshould grow at a faster pace of 8% CAGR.

Our cautious view on the industry growth potential is mainly due to:

The dismal outlook for the fertility rate despite relaxation of the one child policy

Infant formula consumption penetration being already high at 85% as of 2013

Limited upside to per-capita consumption as the government is actively encouraging

breastfeeding

Our volume forecasts are based on 2014 per-capita consumption of 11 kg/baby/year. The

typical infant formula consumption age for a baby is from 6 months to 2 years old. Upside

exists in wealthier families feeding infant formula to babies 2 years old and above.

Fig 16 # of infants to peak with births in 2017 Fig 17 Penetration of 85% in 2013 has little upside

Source: Global Demographics, Macquarie Research, June 2014 Source: Global Demographics, Macquarie Research, June 2014

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11 June 2014 9

Fig 18 Volume demand to peak in 2017 Fig 19 Upgrade trend to drive higher sales growth

Historical figures on market size and breakdown by tier from Euromonitor. Forecasts are Macquarie sbased on Global Demographics.

Tier breakdown by retail ASP for 900g can: Low: RMB300.

Source: Euromonitor, Global Demographics, Macquarie Research, June2014


Out of the four price segments, we see Low Tier (below RMB100 per can) seeing the biggest

decline with an -8% market CAGR through 2018E. The Supreme Tier (above RMB300 per

can) market, which was the fastest growing in the past five years, is slowing down to just 7%

CAGR for the next five.

Selective opportunities still exist in the Mid- and High- tiers where growth could be sustained

above 10% CAGR. However, competition has already intensified within these segments.

Fig 20 Market growth to shift to Mid- to High- tiers Fig 21 Mid tier accounts for 42% of total market



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11 June 2014 10

Two Child Policyto only temporarily boost births by 3m until 2017

To forecast the market growth potential for infant formula, we need to understand Chinas

demographic profile on birth rates. We turned to demographic expert and the Founder of

Global Demographic Ltd, Dr. Clint Laurent, for clues on future birth trends.

In October 2013, the Chinese government relaxed the One Child Policy such thatif eitherof

a couple is a single child they are allowed to have a second baby. However, this is not thefirst time the Policy was relaxed by the government; as early as 2002, families where both

spouses were a single child were already allowed to have two children.

Dr. Laurent sees the crucial distinction in the new policy definition changing from AND to OR

having a less profound impact on the birth rate than first meets the eye. Only 4.9 million urban

and 23 million rural women fall under the new definition who were not qualified under the old

one.

Those newly qualified must also satisfy the below conditions:

Is a Han Chinese and a single child herself

Already has a child

And if they are a rural Hukou, the first child is male (rural women with a daughter could

already have a second child)

Dr. Laurent calculates only 1.6m urban and 0.9m rural incremental births under the relaxed

rule. He expects the birth rate to rise from 14m as of 2012 to a peak of 18m in 2017 before

declining.At the max, he does not expect Chinas total child bearing capacity to exceed 18

million. The maximum uplift of 3 million addition births per year would be insufficient to offset

what is otherwise a declining birth profile.

Fig 22 Relaxed rule to temporarily boost births up to3m before falling again in 2018

Fig 23 More than half of the new births would be fromrural families

Source: Global Demographics, Macquarie Research, June 2014 Source: Global Demographics, Macquarie Research, June 2014

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11 June 2014 11

Low fertility rate poised to drop further

According to the World Bank and Chinas National Health and Family Planning Commission

(the government body that implements and oversees the One Child Policy), as of 2013

Chinas fertility rate was 1.7 (births per woman), lower than 1.9 in the United States and far

below the global average of 2.8.

If developed Asian populations are any indication for China, fertility rates could go much lowertowards 1.1. Shanghai, as an extreme example, has a fertility rate of only 0.7 and ranks

globally the lowest.

Chinese fertility rates have been declining for the past five decades due partly to the one child

policy (1978) but also in recent decades to the decreasing propensity to have children,

particularly because of:

High urban property prices

High cost of raising a child (education, maternity, healthcare).

Fig 24 Chinas fertility profile in structural decline,

due to policy and declining propensity to have children

Fig 25 Developed Asian populations indicate Chinas

fertility has much downside

*2010 Census

Source: World Bank, Macquarie Research, June 2014 Source: World Bank, Macquarie Research, June 2014

ThisNew York Times articleillustrates the challenge for many families: sky high real estate

prices (home ownership is often a prerequisite for men to provide before marriage) and the

subsequent high cost of infant formula, medical expenses and education are putting many

young urban couples off from having children.

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1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

China U.S.

Births p er woman

One Child Policy introduced

One Child Policy relaxed

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http://www.nytimes.com/2014/02/26/world/asia/many-couples-in-china-will-pass-on-a-new-chance-for-a-second-child.html?_r=0http://www.nytimes.com/2014/02/26/world/asia/many-couples-in-china-will-pass-on-a-new-chance-for-a-second-child.html?_r=0http://www.nytimes.com/2014/02/26/world/asia/many-couples-in-china-will-pass-on-a-new-chance-for-a-second-child.html?_r=0http://www.nytimes.com/2014/02/26/world/asia/many-couples-in-china-will-pass-on-a-new-chance-for-a-second-child.html?_r=0


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11 June 2014 12

Per-capita consumption capped by already low breastfeeding ratio

We think the current per-capita consumption of infant formula has very little upside due to the

already low breastfeeding ratio in China. The government has been taking proactive

measures to encourage breastfeeding.

The ratio of babies being exclusively breastfed (ie not given infant formula as well) for up to

six months old in China was only 28% as of 2013 vs. the world average of 39%. This is evenlower is for urban Chinese babies, where less than 16% are exclusively breastfed.

We see several reasons for this in urban China:

High female labour participation ratio

Lack of public or workplace nursery facilities

Aggressive promotion by infant formula makers, and in some instances illegal activities

taking place to promote infant formula (Sept 2013 CCTVs uncovering of illegal bribes

given to hospital staff)

Fig 26 Breastfeeding ratio in Urban China is among the lowest in the world

Source: World Bank, National Health and Family Planning Commission, Macquarie Research, June 2014

Breastfeeding is now being encouraged in many countries around the world as extensive

research has proven the natural health benefits over artificial infant formula. During the first

six months after birth, the mothers breast milk provides essential ingredients critical for the

infants immune system development that isnt provided by infant formula substitutes.

Governments and institutions around the world have been advocating breastfeeding over

infant formula, through initiatives such as UNESCO/WHOs1992 Innocenti Declaration.

Chinese government taking action to increase breastfeeding ratio

The Chinese government recognizes the health benefits of breastfeeding and has been

taking action to increase the ratio:

To achieve a 50% breastfeeding ratio by 2020: set out by the 2020 China Children

Development Plan in 2011 (seeofficial link in Chinese)

Ban on healthcare professional marketing and promoting breastfeeding

substitutes (infant formula): Following the Sept 2013 CCTVsuncovering of illegal

sales practices by certain infant formula makers, the National Health and Family

Planning Commission set out a new regulation (seeofficial link in Chinese)

67%

51%

28% 28%

16%

30%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

1998 2003 2008 2013

Ch in a average Urban Ch ina Rural Ch ina

% of n ew borns with exclusive breast feeding up to 6 months old

World average 39%
http://tv.cntv.cn/video/C10329/ba64e8796ca340cb96fa0156ba00cf85http://tv.cntv.cn/video/C10329/ba64e8796ca340cb96fa0156ba00cf85http://tv.cntv.cn/video/C10329/ba64e8796ca340cb96fa0156ba00cf85http://tv.cntv.cn/video/C10329/ba64e8796ca340cb96fa0156ba00cf85http://tv.cntv.cn/video/C10329/ba64e8796ca340cb96fa0156ba00cf85http://www.unicef.org/programme/breastfeeding/innocenti.htmhttp://www.unicef.org/programme/breastfeeding/innocenti.htmhttp://www.unicef.org/programme/breastfeeding/innocenti.htmhttp://www.gov.cn/gongbao/content/2011/content_1927200.htmhttp://www.gov.cn/gongbao/content/2011/content_1927200.htmhttp://www.gov.cn/gongbao/content/2011/content_1927200.htmhttp://www.gov.cn/jrzg/2013-09/17/content_2490399.htmhttp://www.gov.cn/jrzg/2013-09/17/content_2490399.htmhttp://www.gov.cn/jrzg/2013-09/17/content_2490399.htmhttp://www.gov.cn/jrzg/2013-09/17/content_2490399.htmhttp://www.gov.cn/gongbao/content/2011/content_1927200.htmhttp://www.unicef.org/programme/breastfeeding/innocenti.htmhttp://tv.cntv.cn/video/C10329/ba64e8796ca340cb96fa0156ba00cf85http://tv.cntv.cn/video/C10329/ba64e8796ca340cb96fa0156ba00cf85


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11 June 2014 13

Policy directed consolidation, price ceilingVisible hand directing industry consolidation, capping prices

Various policy measures have been announced in the past 12 months aimed at reforming the

infant formula industry. We believe the governments end goal is to build a strong domestic

industry with high quality and safety standards to restore Chinese consumersconfidence indomestic infant formula. In the interim, policy makers are concerned about the affordability of

infant formula and have taken measures against imported brands making excessive profits.

In the domestic infant formula industry, the Chinese government is taking the following steps:

Strengthening safety standards, banning OEM production of infant formula

Increasing accountability, requiring players to own or control their upstream milk

sources

Eliminating weak, smaller playersproduction licenses

Establishing a list of national champion brands

Consolidating the industry from the current 200+ players to just 50

As of June 2014, 82 out of 133 domestic infant formula makers have successfully

passed the China FDAs quality examination and had their production permits renewed

The government has also taken action against the imported infant formula brands:

NDRC investigation of six imported brands over monopolistic pricing behaviour

(reaping above-normal profits) which resulted in heavy penalties and price cuts of up

to 20%

Requiring all imported products to be packaged in final retail format with labels printed

in Chinese, thus banning the cheaper repackaging methods previously used

Banning hospital staff from marketing infant formula products

As of June 2014, 94 foreign infant formula brands have received import approval from

the General Administration of Quality Supervision, Inspection and Quarantine.


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11 June 2014 14

Fig 27 Major policy announcements/events in the dairy industry over the past 12 months

Date Regulatory body Announcement, event and implication

May 2013 Premier Li Keqiang and theState Council

Exploring Options to Further Strengthening Quality and Safety of InfantFormula

June 2013 Ministry of Industry andInformation Technology

Plan to Improve Infant formula Quality Standards, to Raise Public ConsumerConfidence

June 2013 State Council and 9ministries

Opinion on Further Strengthening Quality and Safety of Infant Formula,first major blueprint for industry consolidation

July 2013 National Development andReform Commission

Investigating six infant formula brands on violating Anti Monopoly Law,resulted in 5-20% price drop and hefty fines

August 2013 China Customs Fonterrascontaminated whey powder incident prompted Chinese Customsto temporarily suspend imports. Fonterra later admit it was a false alarm

September 2013 China Central Television Exposed certain global infant formula brandsillegal bribes paid to hospitalemployees to promote sales of infant formula products

September 2013 National Health and FamilyPlanning Commission

Ban on healthcare professional marketing and promoting breastfeedingsubstitutes (infant formula)

September 2013 China Dairy IndustryAssociation

Held new product launch conference. First batch of infant formula 'NationalTeam' brands announced: Yili, Mengniu Yashily, Wonderful Sun, Feihe,Wissun, and Treasure of Plateau

September 2013 General Administration ofQuality Supervision,Inspection and Quarantine

Guidelines on Strengthening the Management of Imported of Infant Formula,requiring all imported infant formula to be prepared in final retail packagingwith Chinese labels on and after April 1, 2014

December 2013 China Food and DrugAdministration

Infant Formula Production License Examination Details, requiring all infantformula players to undergo strict re-examination under pharmaceuticalstandards in order to gain renewal of production licenses.

January 2014 China Dairy IndustryAssociation

Second batch of infant formula 'National Team' brands: Sanyuan,Beingmate, Yinqiao, Huishan, and Baiyue

May 2014 China Food and DrugAdministration

Report on Infant Formula Production License Examination: 82 of 133domestic infant formula makers passed the test and had their licenses

renewed while 51 failed or were postponed.

June 2014 General Administration ofQuality Supervision,Inspection and Quarantine

94 foreign infant formula brands have received import approval, includingDumex, Abbott, Nestl, Wyeth and Biostime

Source: Chinese government and its various ministries, Macquarie Research, June 2014


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11 June 2014 15

State CouncilsOpinion marks the start of industry consolidation

On June 20, 2013, the State Council and its nine ministries, including the State Food and

Drug Administration and Ministry of Industries and Information Technology (MIIT), issued a

joint-communiqu, Opinions on further strengthening the quality and safety of infant formula.

The general aim of this policy announcement is to encourage domestic infant formula

producers to consolidate and strengthen supply chain quality control. Specifically, it called forthe following actions:

Producers of infant formulas to operate and control their own raw milk sources

Strengthen quality inspection throughout the supply chain

Consolidate processing industry and eliminate sub-standard players through production

license renewal starting May 2014

Ban repackaging or OEM production of infant formula

Strengthen and promote standardisation of scaled dairy farming

NDRC investigation of pricing power abuse and subsequent price

cutsOn July 2, 2013, the National Development and Reform Commission (NDRC) launched an

investigation into six imported infant formula brands on the grounds of monopolistic pricing

behaviour. Prior to this, imported premium infant formulas were sold for RMB300-500/900g,

representing 50% more than equivalent products sold overseas and in the HK market.

NDRC announced in early August the results of its investigation: six infant formula brands

were found guilty of manipulating retail prices and were ordered to pay a total penalty of

RMB668m. Out of the six brands, Mead Johnson was ordered to pay the highest penalty of

RMB204m, however Biostimes RMB163m penalty represented the most severe based on

percentage of sales.

Fig 28 NDRC investigation: hefty penalty, price cuts

Brand Company Penalty (% of sales) Company reaction

Biostime Biostime RMB163m (6%) 5-10% price reduction, 50% extra rewards for membersEnfamil Mead Johnson RMB204m (4%) 10-20% price reductionDumex Danone RMB172m (3%) 5-20% price reductionSimilac Abbott RMB77m (3%) 4-12% price reductionFriso FrieslandCampina RMB48m (3%) 5% reductionFonterra Fonterra RMB4m (3%)Wyeth Nestl No penalty Average 11% reduction, max 20%Nestl Nestl No penalty Up to 20% reductionBeingmate Beingmate No penalty 5-20% price reductionMeiji Meiji No penalty

Source: NDRC, Company data, June 2014


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11 June 2014 16

Policy and competition to drive infant formula prices, margins lower

We think the NDRC investigation was targeted squarely at the imported brands that have

been charging high prices and earning superior profitability on the back of Chinese

consumersconcerns over domestic quality.

On the one hand, NDRC is buying time for the domestic players to consolidate and regain

market share. On the other hand, these price cuts should improve affordability for averageincome families and thus ease one of the factors that have lowered young Chinese parents

propensity to have children.

The latter has much larger implications for Chinas looming demographic crisis, where the

ageing population has already started to shrink the size of the workforce. The last thing the

government would want to see is foreign brands benefitting excessively from Chinese

consumerslong standing concerns over domestic food safety by reaping above-normal

profits. For details on Chinas looming demographic crisis, please readJake Lynchs

Demographic Techtonics.
https://www.macquarieresearch.com/rp/d/r/p/_ODU0Mzk0?u=MTkxNDchttps://www.macquarieresearch.com/rp/d/r/p/_ODU0Mzk0?u=MTkxNDchttps://www.macquarieresearch.com/rp/d/r/p/_ODU0Mzk0?u=MTkxNDchttps://www.macquarieresearch.com/rp/d/r/p/_ODU0Mzk0?u=MTkxNDchttps://www.macquarieresearch.com/rp/d/r/p/_ODU0Mzk0?u=MTkxNDchttps://www.macquarieresearch.com/rp/d/r/p/_ODU0Mzk0?u=MTkxNDc


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11 June 2014 17

Junlebaos RMB130/can price war

The initial price cuts among major players in 2H2013 were just the beginning. New

competitors will likely further drive prices lower. Hebei based Junlebao (in which Mengniu

owns a 50% stake) surprised the industry in April 2014 by introducing a RMB130/can retail

price infant formula product (see the products onJunlebaos own ecommerce site).

Fig 29 Junlebaos RMB130/can, direct channel-only infant formula

Source: Company data, May 2014

Comparable products from most major brands retail for at least RMB200/can, and Junlebaos

products are likely to be appealing to price sensitive consumers.

Different from traditional offline channels such as supermarkets or maternity shops,

Junlebaos newly launched infant formula will be sold exclusively through direct channels

(telephone or online). In the chart below, we calculate two major cost components Junlebao

can eliminate: distributor costs and retail discounts.

Fig 30 Direct selling model cuts out middleman

Source: Macquarie Research, June 2014

Junlebao has expressed confidence in its unique selling model. We think Junlebaos key

challenge will be the lack of brand awareness, given that this is its first infant formula product

launched. Without offline A&P, it may be difficult to gain meaningful market share in this

competitive industry.

Nevertheless, the Junlebao case indicates that industry players have already begun looking

for ways to undercut the already high prices to gain market share given the limited upside

potential from future ASP hikes.

0 50 100 150 200 250

Traditional

Direct sell ing

Ex-facto ry p rice VAT S&D co st Distributor discount Retail mark-up

RMB per 900gcan of high grade infant formula

Retail price RMB130

RMB220
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11 June 2014 18

Distribution channel revolutionLocal brands that rely on supermarkets have lost market share

Infant formula sales at supermarkets dropped by 4% YoY in 2013, for the first time ever, and

companies that have significant sales from supermarkets suffered. Despite the overall market

still growing in the low-teens, sales of infant formula in supermarkets were largely flat over thepast three years. We expect the shift towards maternity shops and ecommerce to accelerate

and the beneficiaries to be those that can successfully capture this consumption habit

change.

The generation born after 1980 are typically technology-savvy and convenience seeking

consumers. They were the first to develop online shopping habits and when they have babies

they are increasingly buying infant formula from two emerging channels:

Maternity shops: neighbourhood Mom & Pop baby product shops, low entry barriers,

very fragmented. Early mover brands can secure an advantage in sales

Ecommerce: infant formula sold through Chinas leading B2C sites , a brand driven

model where brand awareness attracts sales.

Fig 31 Infant formula purchases are shifting fromsupermarkets to maternity shops and ecommerce

Fig 32 Supermarket sales on the decline, Ecommercegrowing rapidly

Source: Nielsen, June 2014 Source: Nielsen, June 2014

44% 43%36%

33% 41%42%

23%16% 22%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2011 2012 2013


% of in fant formula sales, China

5%

-4%

36%

17%

23%

60%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

2012 2013


Channel growthYoY


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11 June 2014 19

Between the two HK listed plays, Yashilis reliance on supermarket sales is the highest

(>60% of sales) while Biostimes success in recent years was attributable to its early-mover

entry into the maternity channels. However, Biostime lacks in terms of Ecommerce.

Fig 33 Biostimes early move in maternity was instrumental to its success

Source: Nielsen, Company data, Macquarie Research, June 2014

23%

70%

43%26%

64%

36%

77%

30%

41% 74%

36%

42%

16% 22%

0%

20%

40%

60%

80%

100%

Biostime Yashili Industry Biostime Yashili Industry


2012 2013

% of infant fo rmula sales


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11 June 2014 20

Chinese consumers prefer imported brands

Hundreds of foreign brands have entered Chinasinfant formula market since the 2008

Melamine Scandal which killed six babies and caused thousands of others to fall sick.

Domestic brands that were once market leaders, such as Yashili, Synutra and Feihe, have all

conceded significant market share to companies such as Mead Johnson, Danone and Nestl.

Fig 34 Infant formula market share, March 2012 Fig 35 Infant formula market share, January 2014

Source: Nielsen, Macquarie Research, June 2014 Source: Nielsen, Macquarie Research, June 2014

According to the Dairy Association of China, the infant formula market in China was evenly

split between domestic and foreign brands before the 2008 Melamine Scandal. As of 2013,

domestic brands total market share has dropped to below 40%, while in 1sttier cities

imported brands control more than 80% share.

The imported powder premiumisation drive came at the expense of domestic players. Not

only did domestic players lose market share to foreign ones, the industry actually became

more fragmented as a result.

We believe this consumer behaviour phenomenon that rapidly transformed the infant formula

industry was due to the following inter-related causes:

Imported infant formulasperceived superior quality assurance

The mediasnegative portrayal of domestic infant formula following numerous

incidents, fuelling already high mistrust of domestic products

Rising outbound travel (including to Hong Kong) of Chinese citizens, increasing

access to and awareness of foreign brands

Strong marketing capability of foreign brands

Emergence of ecommerce, and specifically online maternity shops and overseas

group-buying sites

Consumerswillingness to pay a premium for quality for their children, particularly

among the younger generation of Chinese parents (those born after 1980).

The only exception is Biostime, the Guangzhou based company which entered the infant

formula market only in the wake of the Melamine Incident, as it was able to capture significant

market share with its European sourced premium product positioning and innovative

membership sales strategy. As of January 2014, Biostime commanded 7.5% market share

and was the #4 player in the infant formula market and dominated the top spot in the supreme

segment (>RMB300/can ASP).

MeadJohnson,

13.8%

Wyeth, 9.8%

Beingmate,9.6%

Abbott ,7.1%

Yili, 10.4%

Nestle, 4.0%Yashili, 5.1%

Dumex, 13.5%

Feihe, 4.6%

Synutra, 5.2%

Others, 16.9%

MeadJohnson,

14.5%

Wyeth, 13.3%

Beingmate,8.5%

Biostime,7.5%

Abbott , 7.0%Yili, 6.2%

Nestle, 4.4%

Yashili, 4.1%

Friso, 3.9%

Dumex, 3.6%

Feihe, 3.5%

Synutra, 3.2%

Others, 20.3%


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11 June 2014 21

Lack of offline retail presence drives ecommerce sales

According to Alibabas IPOprospectus, Chinas offline physical retail infrastructure lags

behind developed nations, particularly in lower tier cities. Official statistics show that 19% of

Tier 1 & 2 urban consumers accounted for 41% of total retail sales in 2013, or three times

more on a per-capita basis. Ecommerce allows consumers in less developed regions to

leapfrog underdeveloped offline retail infrastructure to meet their consumption needs. In the infant formula industry, this is demonstrated first in the lack of supermarkets in lower

tier cities, where much smaller maternity shops have found an opportunity to penetrate and

gain market share. More recently, ecommerce has allowed imported brands to penetrate

lower tier markets that they were previously unable to access due to traditional distribution

channelslimitations.

Fig 36 Chinas ecommerce market to grow at doubledigits, while penetration remains low

Fig 37 Under-developed offline retail presentsopportunities for ecommerce to tap unmet demand

Source: Alibaba Prospectus (Euromonitor), June 2014 Source: Alibaba Prospectus (Euromonitor), June 2014

0%

2%

4%

6%

8%

10%

12%

14%

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

Eco mmerce revenue Pen etratio n

Total on line sales (RMB billion)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

China U.S. U.K. Japan Germany

Retail space square meter per-capita


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11 June 2014 22

Imported brands dominate ecommerce

Although two of the top five infant formula brands by sales are domestic companies

(Beingmate and Biostime), imported brands capture the top five spots in ecommerce with

60% market share.

Global brands with higher perceived quality and strong A&P capabilities are highly

recognized by Chinese consumers. With the proliferation of social media and ecommerce,consumers in lower tier cities can now conveniently make their purchases online.

Fig 38 Overall infant formula sales spread betweendomestic and imported brands Fig 39 Imported brands dominate ecommerce

Source: Nielsen, Macquarie Research, June 2014 Source: iResearch, Macquarie Research, June 2014

MeadJohnson,

14.5%

Wyeth,

13.3%

Beingmate,8.5%

Biostime,7.5%

Abbott, 7.0%Yili, 6.2%

Nestle, 4.4%

Yashi li, 4.1%

Friso , 3.9%

Dumex,3.6%

Feihe, 3.5%

Synutra,3.2%

Others,20.3%

Infan t formula (Jan 2014)

MeadJohnson

14.8%

Wyeth12.3%

Friso11.2%

Abbott11.0%

Dumex10.5%

Others40.2%

Ecommerce market share, infant formula (2013)


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11 June 2014 23

HONG KONG

1112 HK Underperform

Price (at 13:45, 10 Jun 2014 GMT) HK$51.40

Valuation HK$ 40.01- DCF (WACC 13.4%, beta 1.2, ERP 7.0%, RFR 5.0%, TGR 2.0%)12-month target HK$ 38.50

Upside/Downside % -25.1

12-month TSR % -22.0

Volatility Index High

GICS sector Food, Beverage& Tobacco

Market cap HK$m 31,040

Market cap US$m 4,004

Free float % 25

30-day avg turnover US$m 6.3

Number shares on issue m 603.9

Investment fundamentalsYear end 31 Dec 2013A 2014E 2015E 2016E

Revenue m 4,561.3 5,416.6 6,307.8 7,090.0EBIT m 1,284.8 1,389.7 1,625.7 1,876.7EBIT growth % 24.2 8.2 17.0 15.4Reported profit m 820.7 987.3 1,189.6 1,364.5

Adjusted profit m 961.0 987.3 1,189.6 1,364.5EPS rep Rmb 1.34 1.61 1.94 2.23EPS rep growth % 10.3 20.3 20.5 14.7EPS adj Rmb 1.57 1.61 1.94 2.23EPS adj growth % 31.3 2.8 20.5 14.7PER rep x 30.9 25.7 21.3 18.6PER adj x 26.4 25.7 21.3 18.6Total DPS Rmb 1.23 1.15 1.39 1.59Total div yield % 3.0 2.8 3.4 3.9ROA % 31.5 19.9 16.5 17.8ROE % 39.7 36.6 38.3 38.3EV/EBITDA x 18.3 16.3 13.9 12.0

Net debt/equity % -36.3 -37.1 -34.8 -36.3P/BV x 9.9 8.6 7.5 6.5

Source: FactSet, Macquarie Research, June 2014

(all figures in Rmb unless noted, TP in HKD)

Analyst(s)Jamie Zhou, CFA+852 3922 1147 [email protected]

11 June 2014Macquarie Capital Securities Limited

BiostimeNo longer the new kid on the block

Initiating with Underperform, TP HK$38.50, 25% downsideWe believe Biostime is Chinas most extraordinary infant formula growth story in

recent years: born in the midst of the 2008 Melamine Scandal as the new kid on

the block and through its premium positioning, innovative membership strategy,

unique supply chain and early mover advantage in capturing the rapid growth of

the maternity channel, it has quickly grown to become the #4 player with 7.6%

market share (2013). However, Biostime is facing challenges from muted industry

volume growth with falling fertility rates, limited pricing power from government-led

consolidation, and rising competition from proliferation of ecommerce. The stock is

expensive at a 26x/21x FY14/15E PER; our target HK$38.50 implies 16x FY15E

EPS, on par with the historical average. Founders lock-up expiration poses a sell-

down overhang on the stock.

Growth slows RMB300/can) with 55% market share, Biostime is

looking for growth in the high (RMB200-300) and mid-tier (RMB100-200). Mid/high

tier have lower margins (GM 56% and 62%) vs. Supreme (69%). We forecast OP

margin to drop by 160bps to 26.6%.

Market share scenario suggests downside is meaningful

While we believe Biostime can continue to maintain its market leadership with the

newly launched Adimil brand and the O2O sales model, with growth slowing faster

than expected, we see 16%/31% downside to Consensus estimates for

FY14/15E. Our base case scenario assumes Biostime 1) maintains market share

in the High Tier, 2) has a slight share loss in Supreme and 3) establishes a

presence in the Mid Tier. Our Bear Case suggests a further 8-15% earnings

decline should the company lose Supreme market share quicker than can be

offset with Adimil.

O2O (online-to-offline): killing two birds with one stone

Biostime launched its O2O sales model (online ordering to offline home delivery

by member shops) in September 2013 and targets deriving 10% of its FY14

revenue from O2O. The initiative may at first appear as a defensive strategy

against rapidly rising ecommerce sales of imported infant formula brands (total

sales up 60% in 2013). We think Biostime is achieving two goals in one: 1)offering consumers the convenience shopping experience of online/mobile and 2)

strengthening relationships with its most important offline partners, the maternity

shops, by sharing value chain profits with participating stores.

Mama100 monetisation with horizontal expansion

Biostime hopes to develop the Mama100 membership program into an

ecommerce ecosystem of maternity products. The Dec 2013 JV with Coco Health

may be a major step in penetrating the lucrative diapers market (penetration

remains low at 40%) which has a high cross-selling ratio (19%) to infant formula

sales. Biostime intends to make more horizontal acquisitions into other maternity-

related FMCG categories, and the newly issued RMB2.4bn CB puts it in a strong

balance sheet position to do so.


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11 June 2014 24

Inside

Market share scenario: downside risk is

meaningful 25Valuation 27

O2O: killing two birds with one stone 30Mama100 monetisation 32Management and corporate governance 33Financials 36

1112 HK rel HSI performance

Source: FactSet, Macquarie Research, June 2014

(all figures in Rmb unless noted, TP in HKD)

A miracle born in the midst of a crisisCompany profile

Founded in Guanzhou in 1999, we believe Biostime is Chinas most

extraordinary infant formula growth story in recent years: infant formula

products were launched in the midst of the 2008 Melamine Scandal andthrough its innovative membership sales strategy, unique supply chain model

and early mover advantage in capturing the rapid growth of the maternity

channel, the company has quickly grown to become the #4 player, capturing

7.6% market share (2013). The company also sells a range of infant care,

probiotic supplements, infant food and nutritional products under the BM Care

brand. In September 2013, the company introduced the specialty function

infant formula brand Adimil.

Biostime pioneered the Supreme-tier category with the introduction of

>RMB300/can retail priced infant formula products and commanded 69%

market share in 2013. The company operates on a unique asset light supply

chain model with three key European OEM partners: Montaigu, Isigny

(Biostime owns 20% stake) in France and Arla in Denmark.

The company was successfully listed on the Stock Exchange of Hong Kong in

December 2010 under the ticker 1112.HK and raised HK$1.6bn in equity

capital. In February 2014, the company raised HK$3bn from the issuance of a

5-year zero-coupon convertible bond with a strike price of HK$90.84/sh.

Corporate governance and shareholding structure

Nine directors: two executive, four non-executive and three independent

Shareholding structure: 75% by co-founders (Biostime Pharmaceutical), 25%

free float. 5% potential dilution upon exercise of the 2019 Convertible Bond.

Auditor: Ernst & Young

Fig 1 Biostimes extraordinary growth in infant formula since2008


0%1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

01,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

2008 2009 2010 2011 2012 2013 2014E 2015E 2016E

Infant formula Others (probiotics, baby food) Infant formula market share

Revenue (RMB million) Market share %


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11 June 2014 25

Market share scenario: downside risk ismeaningfulDefend share in Supreme, capture share in Mid and High Tiers

Biostimes market share capture since the launching of infant formula in 2008 is remarkable.It went from just 1.1% total market share in 2009 to 7.6% share in 2013. This was

accomplished with Biostime capturing significant growth opportunities in the Supreme and

High Tiers.

With a 17% CAGR over the past five years and we estimate slowing to just 8% over the next

five, Biostime recognizes it may be difficult for them to replicate their earlier success. Instead

they will focus on defending market share in Supreme, hoping to continue gaining incremental

share in High and launching Mid Tier products to enter the fastest growing segment.

Supreme tier(>RMB300/can): Biostime pioneered the segment and maintains a

dominate market share of 55% (2013). Increasing competition from Mead Johnsons

new products in the segment poses the risk losing some market share

High tier (RMB200-300/can): Biostimes biggest earnings contributor tier. Accounts for60% of its revenue and it captured 12% market share as of 2013.

Mid tier (RMB100-200/can): Biostime previously didnt want to be in this segment due

to the lower margins, 56% vs. 62% and 69% for High and Supreme tier, but this is

where we expect the market growth will be: low tier consumption upgrade to mid will

drive an 11% CAGR, in our view, and this tier accounts for 42% of total industry sales.

Fig 2 Biostime is competitively positioned in the remaining growth tiers

% of sales (2013) Biostime GP margin

TierPrice

RMB/can Industry Biostime Industry growth outlookMarket share

(2013) Strategy FY13

Low 10% CAGR

0.0% Entering 2014 with domestic producedAdimil (Retail ASP RMB180)

56%

High 200-300 39% 60% Bright spot in the industry, couldcontinue to grow >10% CAGR,intensifying competition

11.8% Key driver for Biostime 62%

Supreme >300 5% 40% Slowing growth, but still hasopportunities, 7% CAGR

55.4% Maintain market share, and ward offcompetition from Mead Johnson

69%

Source: Nielsen, Euromonitor, Company data, Macquarie Research, June 2014

Fig 3 Market growth to shift to Mid-to-High Tier Fig 4 Base case projection of market share by tier

Source: Nielsen, Global Demographics, Macquarie Research, June 2014 Source: Company data, Macquarie Research, June 2014

13%

17% 18%

24%

17%

-8%

11% 11%

7% 8%

-10%

-5%

0%

5%

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15%

20%

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30%


09-13 13-18E


0%

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2009 2010 2011 2012 2013 2014E 2015E 2016E

Mid High Supreme

Biostime market share


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11 June 2014 26

Market share scenario analysis

We model three scenarios on Biostimes market strategy. Our effective market share

calculation excludes the declining Low Tier, given that this is a market Biostime avoids.

Fig 5 Biostimes market share scenario

Scenario Execution outcome 2013A 2014E 2015E 2016E

BASE CASE

Mid Slight market entry success with Changsha Yingke produced RMB180/can Adimil 0.0% 0.8% 1.8% 2.3%High Intensifying competition in high-tier is countered by the market success of the

RMB250/can Adimil and thus the company maintains market share11.8% 12.3% 12.3% 12.3%

Supreme lose some market share to Mead Johnson, but maintain >50% share 55.4% 53.4% 52.4% 51.4%Total market share 7.6% 8.2% 8.5% 8.8%Total market share (Ex-low tier) 8.8% 9.3% 9.6% 9.7%Effective market share gain/loss +0.7% +0.4% +0.3% +0.1%

BULL CASE

Mid Major breakthrough in capturing market share with new product introduction 0.0% 3.0% 6.0% 9.0%High O2O exceeds expectations, share gain from domestic players through Mama100 11.8% 13.3% 14.8% 16.3%Supreme Maintaining market share with the RMB350 Adimil 55.4% 55.4% 55.4% 55.4%

Total market share 7.6% 9.6% 11.5% 13.5%Total market share (Ex-low tier) 8.8% 10.9% 13.0% 15.0%Effective market share gain/loss +2.1% +2.0% +2.1%

BEAR CASE

Mid Fail to meaningfully launch mid-end product 0.0% 0.3% 0.6% 0.9%High Losing market share due to competition, weak O2O, imported brands steal share from

Biostime through ecommerce11.8% 10.8% 9.8% 8.8%

Supreme Little success with the more expensive Adimil, lose market share to Mead Johnson 55.4% 50.4% 45.4% 40.4%Total market share 7.6% 7.2% 6.6% 6.1%Total market share (Ex-low tier) 8.8% 8.2% 7.5% 6.8%Effective market share gain/loss -0.7% -0.7% -0.7%


Fig 6 Three scenarios on Biostimes total marketshare change

Fig 7 Adj. EPS are 10-33% above Base case for Bullscenario and 8-21% below for Bear scenario

Source: Company data, Macquarie Research, June 2014 Source: Company data, Macquarie Research, June 2014

Fig 8 Our bear case indicate a further downside of 8-21% on FY14-16 EPS

Adj. EPS RMB/sh % vs. base

2014E 2015E 2016E 2014E 2015E 2016E

Bull 1.78 2.34 2.96 10% 21% 33%Base 1.61 1.94 2.23 0% 0% 0%Bear 1.48 1.64 1.75 -8% -15% -21%


2.1% 2.0% 2.1%

2.6%

2.1%

0.7%0.4% 0.3%

0.1%

-0.7% -0.7% -0.7%-1.5%-1.0%

-0.5%

0.0%

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2011 2012 2013 2014E 2015E 2016E

Bull Base Bear

Change in Biostime market share (+/- %)

0.00

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3.50

2011 2012 2013 2014E 2015E 2016E

Bul l Base Bear

Adj. EPS


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11 June 2014 27

ValuationOur primary valuation is based on a PER; we then cross check against our DCF fair

valuation.

Biostime (Underperform) with HK$38.50/sh target, 16x FY15E PER

Our 12-month target price of HK$38.50/sh is based on a 16x FY15E PER, the average of its

since-listing average valuation. We like the 34% ROE, strong FCF generation and consistent

dividend payout of 70%, however we are cautious on the rich valuation given we expect

growth to slow down significantly to just an 11% earnings CAGR. Our FY14/15E earnings

forecasts are 16%/31% below Consensus. Founders lock-up expired on May 20thwhich may

also pose a sell-down overhang on the stock.

Fig 9 Infant formula valuation comps

Price TP Mkt Cap PER (x)EV/EBITDA

(x)

EPSgrowth

(%)EBIT

marginROE

(%)

Divyield

(%) P/BkTicker Company Rec lc lc % US$m CY14E CY15E CY14E CY15E 13-15E CY13 CY13 CY13 FY13

1112 HK Biostime UP 51.40 38.50 -25% 4,004 25.7 21.3 16.3 13.9 11.3 23.5 33.9 2.9 9.9Biostime at TP 38.50 19.2 16.0 11.5 9.8

Infant formula pure-playsMJN US Mead Johnson NR 87.39 17,662 23.6 21.1 15.6 14.0 7.6 23.9 418.4 1.6 51.1002570 CH Beingmate NR 13.10 2,152 13.4 11.0 13.7 11.4 28.2 13.3 16.8 2.0 3.41112 HK Biostime UP 51.40 38.50 -25% 4,004 25.7 21.3 15.7 13.4 11.3 23.5 33.9 2.9 9.91230 HK Yashili UP 2.87 1.45 -49% 1,318 34.4 29.8 18.8 14.0 -19.0 9.6 12.2 15.4 2.6Average 21.6 18.3 15.8 13.1 7.0 17.6 120.3 5.5 5.1

Diversified dairies2319 HK Mengniu UP 38.05 27.90 -27% 9,612 30.1 25.5 14.9 12.6 11.9 4.6 12.6 0.7 3.7600887 CH Yili NR 31.99 10,498 14.4 12.0 8.4 NA 21.0 7.4 20.3 2.0 3.8600597 CH Bright NR 16.27 3,200 21.4 17.6 NA NA 30.5 5.1 12.8 1.6 4.5NESN VX Nestl NR 69.55 249,344 20.0 18.6 13.5 12.5 5.3 15.8 16.2 3.3 3.5

BN FP Danone NR 54.76 47,750 19.8 17.9 12.3 11.2 6.8 13.2 12.4 2.8 3.2FSF NZ Fonterra N 5.95 6.65 12% 8,094 35.1 21.5 11.8 9.7 -31.3 3.1 3.5 2.1 1.4Average 21.6 17.9 11.7 11.4 7.4 8.2 13.0 2.1 3.0

China large cap staples151 HK Want Want OP 10.70 13.00 21% 18,237 23.1 19.9 15.6 13.2 15.4 23.0 37.9 2.9 9.4322 HK Tingyi OP 21.90 24.40 11% 15,817 32.6 27.0 11.7 10.3 19.7 7.4 16.0 1.5 5.51044 HK Hengan N 81.70 84.00 3% 12,945 22.9 19.2 16.4 13.5 23.3 20.2 25.2 2.6 6.12319 HK Mengniu UP 38.05 27.90 -27% 9,612 30.1 25.5 14.9 12.6 11.9 4.6 12.6 0.7 3.7168 HK Tsingtao Brewery NR 61.70 9,866 30.2 25.5 15.2 12.7 5.9 7.2 14.9 0.9 4.6Average 27.2 23.0 14.6 12.4 15.2 12.5 21.3 1.7 5.4Price date June 10, 2014. Valuations and forecasts for non-rated stocks are from Bloomberg.

Recommendation legend - OP: Outperform, N: Neutral, UP: Underperform, NR: not rated.

Source: Bloomberg, Macquarie Research, June 2014

With slowing growth, rising competition and government price caps, we believe infant formula

plays should trade at the low end of its historic valuation range of a 16-22x forward PER. We

think the price data over the past three years captures a fair representation of the infant

formula industrys risks and opportunities.

The three domestic infant formula pure plays were all listed in late-2010/early-2011. However,

their forward valuations fluctuated greatly in 2013, due to three major industry catalysts:

Positive: Mid-2013 Chinese government announces infant formula consolidation plans

Negative: July 2013 NDRC investigation which resulted in fines and price cuts

Positive: November 2013 relaxation of One Child Policy

Mead Johnsons average forward PER is also a good proxy, due to its global diversification

which limits short-term noise in the China market. MJNs forward PER has been steady in the

range of 18x to 25.5x since mid-2009.


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11 June 2014 28

Fig 10 Biostime forward PER band Fig 11 Currently trading on 23x forward PER


Mead Johnson the global comp, 18-25x PER range

We believe Mead Johnson is a good valuation comparable for Biostime, because:

31% of Mead Johnsons FY13 revenue comes from China.

China contributed to 62% of Mead Johnsons revenue growth over the past 4 years.

Both are market leaders gaining market share from the rest (Mead Johnson #1,

Biostime fast rising #4).

Both players command the highest margins among peers and have the highest ROIC.

Both players are leaders in product innovation and derive most of their profits from the

high-tier and supreme-tier infant formula category.

Both were investigated and fined by the NDRC in July 2013, hence they have a similar

policy risk profile (Mead Johnson received the highest absolute fine, Biostime the

highest in percentage of revenue).

However, we also note the crucial difference is brand awareness and channel exposure.

Mead Johnson is not only the #1 brand nationwide in China, but also the #1 in the fast

growing ecommerce channel, which is a competitive threat to Biostime. Thus, our target

valuation is 16x forward PER, a fair discount to MJNs.

Fig 12 Mead Johnson trades on 21.8x PER on average Fig 13 Biostimes margins more volatile

Forward earnings are based on Bloomberg Consensus estimates.


0.00

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Biostime Yash il i Beingmate Mead Johnson

EBIT margin


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11 June 2014 29

DCF fair value HK$40/sh

We cross check Biostimes valuation using a DCF model. Our fair valuation is HK$40/sh.

We like the 40% ROE, strong FCF generation capabilities and consistent dividend payout of

70%, however we are cautious in the near term given 16%/31% FY14/15E earnings downside

from Consensus. Founders lock-up expired on May 20thwhich may also pose a sell-down

overhang on the stock.

Fig 14 Biostime cash flow projection

RMB million 12A 13A 14E 15E 16E 17E 18E 19E 20E

Sales 3,382 4,561 5,417 6,308 7,090 7,793 8,440 9,148 9,920... Growth 54% 35% 19% 16% 12% 10% 8% 8% 8%Gross Profit 2,229 2,975 3,460 3,943 4,408 4,817 5,188 5,592 6,031... GP Margin 66% 65% 64% 63% 62% 62% 61% 61% 61%EBITDA 1,075 1,199 1,482 1,868 2,136 2,392 2,642 2,918 3,106 Margin 32% 26% 27% 30% 30% 31% 31% 32% 31%Less: Tax 244 345 367 419 448 518 442 509 565Less: WC -115 167 -47 33 -40 33 -40 32 -41Less: Capex 39 136 100 100 100 100 100 100 100

Less: Other 2 309 116 213 259 262 409 423 322Free Cash Flow 905 243 946 1,103 1,369 1,479 1,731 1,855 2,160... FCF Growth -73% 290% 17% 24% 8% 17% 7% 16%PV of FCF 881 906 992 945 975 921 946

Source: Company data, Macquarie Research, June 2014

Fig 15 DCF valuation metrics

ACC DCF Valuation

Risk Free Rate 5.0% Sum of PV of FCF 6,565Market Risk Premium 7.0% PV of Terminal Value (RMBm) 8,461Equity Beta 1.2 Enterprise Value (RMBm) 15,025Cost of Equity 13.4% Less: Net Debt -4,406Cost of Debt (Pre-tax) 9.0% Market Cap (RMBm) 19,431Cost of Debt (After tax) 6.8% No. of Ord shares (m), fully diluted 602Target Debt weight 0.0% Terminal as % total 56%Target Equity weight 100.0% Foreign exchange (HKD/RMB) 1.24Tax Rate 25% Market Cap (HKDm) 24,090

ACC 13.4%Terminal Growth 2.0% alue per share, HK$ $40.01



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O2O: killing two birds with one stoneProliferation of ecommerce threatening offline retail

Infant formula sales in supermarkets dropped by 4% for the first time in 2013, and companies

that had significant sales from supermarkets suffered. Despite the overall market still growing

at low-teens, sales of infant formula in super markets were largely flat over the past threeyears. We expect the shift towards maternity shops and ecommerce to accelerate and

winners will be those that can successfully capture this change in consumption habits.

The generation born after 1980 is typically technology-savvy and convenience-seeking

consumers. They were the first to develop habits of shopping online, and when they have

babies, they are increasingly buying infant formula from two emerging channels:

Maternity shops: neighbourhood Mom & Pop baby product shops, low-entry barrier,

very fragmented. Early mover brands secure advantage in shelf space.

Ecommerce: infant formula sold through Chinas leading B2C sites, a brand-driven

model where brand awareness attracts sales

Fig 16 Infant formula purchases are shifting fromsupermarkets to maternity shops and ecommerce

Fig 17 Supermarket sales on the decline, Ecommercegrowing rapidly

Source: Nielsen, June 2014 Source: Nielsen, June 2014

Biostime has been an early mover in the maternity channel and its phenomenal success in

recent years was attributable to its member store channel management system. However,

Biostime lacks in Ecommerce.

Fig 18 Biostime is strong in maternity channel, but negligible in ecommerce


20 21 20

1420 23

6

712

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Retail sales value (RMB billion)

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Bio stime Yash ili In dustry Bio stime Yash ili In dustry


2012 2013

% of infant formula sales


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11 June 2014 31

Proliferation of ecommerce threatening offline retail

Biostime launched its O2O sales model (online ordering to offline home delivery by member

shops) in September 2013 and targets deriving 10% of its FY14 revenue from O2O.

The initiative may at first appear as a defensive strategy against rapidly rising ecommerce

sales of imported infant formula brands (total sales up 60% in 2013). We think Biostime aims

to achieve two goals in one:

1) offering consumers the convenience shopping experience of online/mobile, and

2) strengthening relationships with its most important offline partners, the maternity shops, by

sharing value chain profits with participating stores.


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11 June 2014 32

Mama100 monetisationBiostimes success is instrumental to its Mama100 membership program, en tailing a point

reward program and a mobile app with maternity social media functions. With 1.8m active

members as of Dec 2013, Biostime hopes to develop Mama100 to reach 3m active users by

2016 and become a powerful ecommerce ecosystem of maternity products.

To fully unlock the potential of Mama100, Biostime looks to:

Immediately: launching an O2O sales model allowing consumers to place orders

online/mobile and receive offline delivery from member shops.

Near future: expand into other infant FMCG categories that it currently doesnt have a

significant presence. The company is searching for horizontal expansion M&A targets.

In the long run: Open Mama100 to third parties by charging a platform fee.

Fig 19 Mama100 active members to reach 3m by 2016 Fig 20 Already seeing strong cross-selling rates

Source: Company data, June 2014 Source: Company data, June 2014

Eyeing the lucrative yet underpenetrated diaper market

The Dec 2013 JV with Coco Health may be a major step in penetrating the lucrative diaper

market (penetration remains low at 47% vs. 85% for infant formula). Biostime intends to make

more horizontal acquisitions into other maternity-related FMCG categories, and the newly

issued RMB2.4bn CB puts it in a strong balance sheet position to do so.

Fig 21 Infant formula to reach 85% penetration Fig 22 Diaper penetration remains low at 40%

*based on 11kg/infant/year *based on three diapers per infant per day (conservative)

Source: Global Demographics, Nielsen, Macquarie Research, June 2014 Source: Euromonitor, CNHPIA, Macquarie Research, June 2014

0

500

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2010 2011 2012 2013 2016E

Mama100 active members (000's)

0%

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2009 2010 2011 2012 2013 2014E 2015E 2016E

Infant formula market (RMB billion) Penetration ratio*

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Baby diaper market (RMB bill ion) Penetration ratio*


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11 June 2014 33

Management and corporate governanceStrong shareholder return since IPO

Biostime was founded by Mr. Luo Fei and five co-founders, including his brother Luo Yun.

Collectively, the co-foundersholding company Biostime International owns 75% of listco

Biostime International with the remainder 25% as free float.

The company issued a HK$3bn 5-year zero coupon Convertible Bond with a conversion price

of HK$90.84/sh in February 2014. Upon full conversion, the CB will represent 5.36% of

enlarged shares outstanding.

Biostime Pharmaceutical entered into a voluntary lock-up for three years after the IPO. The

lock-up was further extended by three months after the 2019 CB issuance, and was expired

on May 20, 2014. Potential co-founder sell-down will pose an overhang on the shares.

Fig 23 Shareholding structure as of May 2014


Biostime International(1112.HK)

BiostimePharmaceutical

Free Float

75% 25%

LUO Fei

28%

WU Xiong

26%

LUO Yun

20%

CHENFufang

20%

ZHANGWenhui

10%

KONGQingjuan

4%


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11 June 2014 34

Fig 24 Biostimes Corporate history and major events

Date Event Note

Aug 1999 Company founding Biostime Guangzhou was founded by Luo Fei and Luo Yun to engage in the research,development and production of probiotic supplement products

2002 Lallemand partnership Partnership with Lallemand to develop probiotic supplement products

2003 Biostime launch Biostime brand of probiotic supplement was formally launched in China

2006 Mama100 Established the Mama100 Membership Program to provide catered customer service, amembership points accumulation program, a monthly magazine subscription and other exclusiveservices

2008 Infant formula launch Launched infant formula product line from supplier Montaigu with high quality French source

2009 BM Care Registered and launched BM Care line of infant care products, including baby diapers

Dec 2010 IPO Raised HK$1.6bn through successful initial public offering on the Hong Kong Stock Exchange,listing under the stock code 1112

Nov 2011 Share option scheme Board approves share option scheme to motivate and retain senior management

Jun 2012 Arla partnership Biostime enters a 10-year financing and supply agreement with Arla Foods and providedDKK81.5 million of financing to expand infant formula production facil ities

Jun 2012 CTO resignation Dr. Zhang Wenhui, the company's Chief Technology Officer, Executive Director and a

shareholder of Biostime Pharmaceutical resigned and was redesignated as Non-executiveDirector

Jul 2013 Isigny investment Biostime invested EUR2.5m for a 20% stake in its infant formula OEM partner Isigny SainteMre. The fund will be used for Isigny's capacity expansion and R&D spend

Jul 2013 NDRC investigation Biostime was found guilty of NDRC's investigation on monopolistic pricing behavior. Thecompany paid a total fine of RMB163m and cut prices on some of its prices up to 10%.

Sept 2013 Adimil and O2O The company introduced the nutritional fortification brand of infant formula Adimil. At the sametime, Biostime launched its Online-to-Offline (O2O) sales model.

Dec 2013 Changsha Yingke acquisition Acquired Changsha Yingke for RMB350m in cash. The acquired target will be used tomanufacture lower-end Adimil infant formula products.

Jan 2014 Diaper JV Established a joint venture with Hangzhou Coco Healthcare to manufacture baby diapers. JV60% owned by Coco, 40% by Biostime.

Feb 2014 2019 CB Issuance of HK$3.1bn 5-year zero-coupon Convertible Bond, conversion price HK$90.84/sh



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11 June 2014 35

Fig 25 Biostimes Board of Directors (as of April 2014)

Name Title Age Responsibilities and bio

Executive Directors

Mr. LUO Fei Chairman, CEO 50 Primarily responsible for overall strategies, planning & business development Founded Biostime in 1999 and served as general manager since Prior to 1999, Luo established Biohope, a personal care/household raw materials

trading company Graduated from South China University of Technology (1988) and EMBA from

CEIBS (2008)

Ms. KONG Qingjuan COO 52 Appointed Executive Director in May 2010, mainly responsible for overallprocurement, logistics, production, internal compliance & control

Prior to joining Biostime in 2000, Kong worked for hospitals and a bio-cosmeticcompany

Bachelor degree in medicine from Hebei Medical Institute (1985)

Non-executive DirectorsDr. ZHANG Wenhui Non-executive director 49 Redesignated to Non-executive Director in June 2012

Was previously a

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