Inner Mongolia Yili Industrial:Acquiring China Shengmu:kicking off M&A based growth and benefits the company's long-term value

Private placement to raise Rmb9.0bn and acquire Shengmu's (SM) 37% equity

    The private placement (587mn new shares @ Rmb15.33/shr) and the acquisition of SM(37% equity @HK$2.25/shr implying 9x EV/EBITDA; total consideration at Rmb4.6bn),which are not mutually conditioned, are in our view: 1) critical for the long-termstability of Yili's core management and thus shareholder value; and 2) the beginning ofYili's M&A growth, though earlier than planned. We expect both deals could close inH117, assuming i) the private placement is approved by the shareholders' meeting(>2/3 "yes" votes) and SEC; and ii) after buying SM's 37% equity (over 30%), Yiliwould tender a general offer to all shareholders at a price not less than HK$2.25/shr.Company mgmt. indicates the A-share and H-share listed platforms could see bettersynergies once the acquisition is completed. (More details on page 2-3)

    Acquiring SM for its organic dairy products and scarce organic raw milk

    Yili wants to buy SM as it expects organic dairy products (<2% volume share in China)to be a next star performer amid dairy consumption upgrade. We believe SM is unique:a) as an upstream name, it has a high self-sufficiency ratio of raw milk (40%, 2015) andlarge sales/net profit contribution from downstream business (53%/58%, 2015); and b)it has high entry barrier due to strict standards for natural environment to producingorganic raw milk. SM's farms in Ulan Buh Desert (one of the few places in China thathave both an organic environment and convenient traffic) produce c.60% of China'sorganic raw milk (Yili has c.20%). However c) SM's sales channel is less developed withweak control over distributors (normally relying on low pricing). Once SM is acquired,Yili could use its organic raw milk to add organic products in Satine and Ambrosial andenhance SM's distribution capability and profitability.

    Limited EPS dilution on SM's EPS accretion vs. enlarged share capital by 10.7%

    We estimate Yili's 2017E EPS could see an impact of –3% to +4% depending on theultimate no. of shares bought under the general offer (max. Rmb4.5bn of extra cash tobe paid). In addition, Yili will also launch a new share incentive scheme (relatedexpenses around Rmb970mn) mainly targeting its core technology/business staff (midlevelstaff), with vesting requirements of over 15% for its 2015-18E recurring earningsCAGR.

    Valuation: Neutral rating and PT of Rmb18.00 (WACC: 7.5%)

    Our financial model has not factored in the new share issuance and the consolidationof SM. Our PT is based on DCF method.