光明乳业(600597)

Strong earnings growth on lower marketing expense and income tax savingsBright reported 2Q17 results with a 5.3% yoy increase in sales to RMB5,557mand 46.2% yoy increase in net profit to RMB179m. Sales and operating profitwere in line with our forecasts, while net profit was 14% higher than our forecastdue to a lower effective tax rate at 10.5% (vs. 26% in 2Q16), helped by a oneoffincome tax refund. On a semi-annual basis, sales increased 6.4% yoy and netprofit increased 52.2% yoy in 1H17. Specifically,

Sales increased 6% yoy in 1H17 (5% yoy in 2Q17 ), mainly driven by a39% yoy sales increase from its New Zealand subsidiary Synlait in 1H17.Its room temperature business declined by double digits in 1H17, whilepartly offset by incremental sales from the pasteurized milk segment.

Gross margin declined 670bps in 1H17 to 34.1% (down 780bps in 2Q17),mainly due to a declining gross margin in the room temperature segmenton increasing competition and a less favorite product mix.

SG&A/sales ratio declined 730bps yoy to 28.1% in 1H17 (decline 840bpsin 2Q17), helped by lower advertisement and promotion expenses.

Increasing investment in distribution network

Bright's room temperature sales declined by double digits in 1H17, even thoughit launched a few new products in this category from 2017, as its distributionnetwork is weaker than that of lead players such as Yili and Mengniu. Thecompany indicated that it is investing in the channels to increase penetration rateand POS sales. We think this could help to improve room temperature businesssales.

Implication on dairy sector: easing competition within cost inflationenvironment

We estimate that both pasteurized milk and room temperature gross margindeclined in 1H17, due mainly to rising packaging material cost in 1H17, whileraw milk price in Shanghai is flattish at Rmb3.78/liter. Within the cost inflatingenvironment, the company cut its advertisement expense and promotion expenseby 36% and 19% yoy in 1H17, indicating an easing competition environment (alsopartly because of a higher base in 1H17 due to Olympic Games).

Maintaining Hold on fair valuation

We maintain our TP unchanged at Rmb14 based on a DCF approach (factoringin 3.9% RFR, 5.6% equity premium, 1.0 beta and 2% TG). Near-term, we expectBright's growth to be under pressure due to its weaker distribution network inthe room temperature segment. The stock is trading at 23x 2017E P/E, which isfair compared to the peer average of 20x. Upside risk: successful new productlaunches. Downside risk: increasing competition.