The Baltic Dry Index Revisited

I have been receiving a significant amount of email regarding an old entry I wrote back in March 2008 regarding the Baltic Dry Index (BDI). Back in March the BDI was recovering for an interim low it experienced in January on fears of a global economic slowdown, however, since then the situation has become far worse. The BDI is now trading at levels not seen since 2001. To help put this into perspective a recent article by “The Independent” noted that in the beginning of June the total cost of a shipment of coal from Brazil to China would have totaled USD15mn per voyage compared to USD1.5mn currently. At the same time, the article noted that the daily cost of chartering a capsize bulk carrier during this cycle's peak amounted to USD234.0K vs. USD5.6K presently. This is a drop of around 98%!

The Baltic Dry Index's recent plunge

Source: Bloomberg

Now on to what is important… Why has this happened? Unlike the drop the index experienced earlier this year, based primarily over concerns of a global economic slowdown; the current plunge also takes into account the ongoing liquidity crisis and commodity deflation. The shipping industry relies heavily on an instrument called “Letters of Credit” (LC), which is a guarantee issued by a bank that the buyers funds will be transferred to the seller at the completion of the transaction (i.e. traded goods properly received). As liquidity tightened around the world so has the issuance of these instruments, further slowing global trade. According to Trade Finance Magazine to cope with this, the market has begun to see a resurgence in export credit (i.e. the seller issues loan to the buyer via an export credit agency), but as the magazine pointed out this is a “relatively slim corridor”, and holds significantly more risk for the exporter compared to a traditional LC.

As if this alone were not bad enough it would appear that deflation in commodity prices has caused many companies to begin using up raw material inventories rather than importing new stocks. This is basic economics, why buy something today that will be cheaper tomorrow? Nonetheless, these industries will eventually run low enough on inventories where they will be forced to purchase more, which should put some upward pressure on shipping costs.

The CRY Commodity Index has also dropped significantly

Source: Bloomberg

If prolonged this ’suspension’ in global trade will have significant adverse effects for export oriented economies, and increase the likelihood of further reductions to 2009 growth rates . Nonetheless, I do believe that as companies run low on inventory and as global credit markets continue to unlock we will see a stabilization and marginal recovery in shipping costs. However, it is unlikely we will see BDI levels anywhere close to those at the beginning of this year anytime before the end of this decade. In the short-term yet another piece of negative news for the global economy...

As an aside I created a monthly market cap weighted shipping index starting in May 2005 to compare against the BDI. I used the following companies for the index 1) AP Moller - Maersk 2) Mitsui OSK Lines 3) China Shipping Development Co 4) Nippon Yusen 5) Kawasaki Kisen Kaisha 6) Evergreen Marine Corp 7) Orient Overseas International 8) Neptune Orient Lines 9) Hanjin Shipping Co. & 10) CSC Nanjing Tanker Corp. Maersk alone makes up roughly 50% of the total market vap of the index.

Global shipping companies could continue to face downward pressure until the BDI begins to moderate.
Source: Bloomberg

A Graphical Look at October's Senior Loan Officer Survey:

Back in January I did a piece discussing the predictive power of the Senior Loan Officer Survey, and found that there was some significance to the data. For the survey banks’ senior loan officers are asked to answer multiple questions based on their lending standards and demand for commercial/residential loans as well as consumer loans. The survey is conducted during the first month of the applicable quarter. (i.e. Q108 data is collected during Jan. 2008) This more or less implies the data has a forward looking aspect, since the applicable quarter has only begun when the data is collected. This data is reviewed by the Federal Reserve for conducting monetary policy.

Unfortunately, the October 2008 survey doesn’t look much better than it did back in January. Lending standards have continued to tighten and demand has diminished. Currently, the survey concurs with the view that US economy is in a recession, which shows no immediate signs of abating. Here is a quick outline on where the survey can be important in analyzing future trends:

Non-residential Investment:
We found that the strongest relationship exists between non-residential investment and the data in the survey related to the number of banks tightening lending standards to businesses , businesses' demand for lending, and the cost of lending. In fact, the correlation between this data and non-residential investment is strong enough to pass-through to overall real GDP growth, but as you would expect with a smaller magnitude. We found that the reason for the relationship is because the level of business lending drops when costs and lending standards increase and demand drops, all of which are measured in the survey. Presently, all of these indicators point towards continued deterioration of non-residential investment.

Residential Investment:
We also found that the lending standards and demand for mortgages data is correlated with residential investment, although not at the same significance as business lending with non-residential investment. We found the strongest result between residential mortgage demand and residential investment, but unlike the non-residential relationship it was not strong enough to pass-through to overall real GDP growth. Nonetheless, without a loosing in lending standards it is unlikely we can see a sustained recovery in the US housing sector.

Personal Consumption Expenditure:
Unfortunately, historically we did not find any significant relationships. However, there has never been an instance over the available time series where credit card and consumer loan lending standards have increased by the magnitude we are currently experiencing. With this said, I do expect this to continue having a negative impact on consumer spending.

Here is the Data:

Net Percentage of Domestic Respondents Tightening Standards for C&I Loans

Notes: This graph would imply a continued slowdown for non-residential investment. Also interesting to note but not represented in this data is that many banks not only increased lending standards, but also reduced the maximum size and maturities on loans to all sized of businesses.

Net Percentage of Domestic Respondents Increasing Spreads of Loan Rates over Banks' Cost of Funds

Notes: Like the graph above, this graph also implies a continued slowdown for non-residential investment.

Net Percentage of Domestic Respondents Reporting Stronger Demand for C&I Loans

Notes: This graph implies that demand for business loans has not collapsed bu has shown signs of slowing. This is likely due to businesses requiring less credit to finance equipment, plant, and inventory expansions: Again pointing to a slow down in the business sector.

Commercial Real Estate Market

Notes: This graph implies there could be further deterioration in the commercial real estate market.

Net Percentage of Domestic Respondents Tightening Standards for Mortgage Loans

Notes: Lending standards for the residential mortgage sector continue to tighten. However, we did see marginal improvement for the prime mortgage sub-component.

Net Percentage of Domestic Respondents Reporting Stronger Demand for Mortgage Loans

Notes: After showing some signs of recovery demand for residential mortgages has once again begun to drop according to the survey.

Net Percentage of Domestic Respondents Tightening Standards on Consumer Loans

Notes: This graph implies tighter lending standards for credit cards and consumer loans could have an adverse effect on consumer spending. I agree with this assumption and do not see US GDP growth to move above trend until post 2010, mostly due to a decrease on consumer spending.


All in all in my opinion the implications of this survey are that things will get worse before they get better. Not only are tough times at hand for consumers, but also for businesses and the real estate sector. Over the next couple months, I expect we will see disappointing holiday sales, which should lead to lower than currently anticipated 4Q08 earnings and a prolonged period of below trend economic growth. This will likely continue to stoke the current volatility we have seen in the worlds' financial markets.

The Age of Despondency…

One could argue we have moved from an age of exuberance to an age of despondency. Not long ago our major concern was sky rocketing commodity prices, and its effect on global inflation; enter the credit crisis. We are currently witnessing an unprecedented global sell-off with no regards to asset classes or quality, or as I like to call it the age of despondency. We have achieved capitulation. One positive result of this is this action is that it was a necessary step to bring us out of these uncertain times. In the end we should establish a clear bottom, and eventually stage a sustained comeback. Important to highlight is that in this age of despondency many assets, regardless of quality, have been pulled down to interim lows. For example right now, you can purchase the 30 stocks that make-up the Dow and receive a 3.8% dividend, plus of course any appreciation or depreciation of the assets. I won’t even begin to get into the credit market…

Looking ahead, what will happen? Global governments have made it clear they are willing to take significant action to stem the adverse effects of this current crisis. However, markets have been acting faster than these governments can react. Nonetheless, it is important to keep in mind that government and especially monetary policy tend to work on a lag. We still have not realized the effects of the recent rates cuts, and more importantly the Troubled Assets Relief Program (TARP). It is extremely likely we will see an additional set of global rate cuts sometime in the near future. This despite the fact the real effect of these cuts won’t be immediately realized, nonetheless, the psychological effect will be immediate. And of course, given the unbiased sell-off across all assets and qualities, investor psychology has definitely played a major role in this sell-off.

I believe that current and potential future government/monetary policies will eventually lead to stabilization in global markets over the next couple months. Prior to this however we face what could be a volatile earnings season, poor holiday sales in the US, and what will likely be worsening economic news from the US and Europe. Also, downgrades to either Morgan Stanley or Goldman Sachs could significantly extend the current market uncertainty, and this should be monitored closely. Nevertheless, unlike developed nations which are facing both the credit crisis and an economic slowdown, for the most part emerging markets are only facing the latter. What does this mean? I believe that once markets stabilize Russia, China, & Brazil will likely benefit the most over the mid-term. These markets are all significantly off their highs, yet domestically are still experiencing relatively strong GDP growth. What we want to monitor in these markets is the ability of domestic demand to make-up for slowing export markets. As for the developed nations, especially the US, there will be a critical shift from what were major consumers to major savers; given the importance of consumption in these economies we will likely see Real GDP growth remain below trend through the rest of this decade.

Here are some basic trading ideas, however, these are only suggestions; I in no way advocate undertaking them. I personally am hesitant to make any moves until I see some easing in the credit markets and proof that the TARP and other policies have begun to unlock credit markets… There is without question some great values out there on an individual equity basis, but the real question is whether or not you have the capital to stay in the market for as long as the market remains irrational…

Cash:
Overweight Cash! (at least until we see the credit markets stabilize)

Pair Trade:
Long US Staples / Short Luxury (short to mid-term idea)

Commodities:
Overweight Grain (long-term idea)
Overweight Livestock (long-term idea)

Countries:
Overweight Russia/China/Brazil (mid to long-term idea once credit markets settle)

Defensive:
You can always Long Gold, and potentially Short Platinum
Long Financial Ultrashort ETF (potential hedge against Goldman or Morgan downgrade)

**Please email me for further ideas or questions:
Email Me

A Blast From the Past... How the Housing Crisis Will End (Revisited)

This piece is simply an updated version to a piece I published back on March 5th 2008 titled 'How will it end'. Despite the fact we are much deeper into this financial crisis; the root of the problem has not changed, and that is the US housing market.

As an interesting exercise consider that in March 2007 the total value of US subprime mortgage market was estimated at USD1.3trn; now lets combine that with the fact that 12% of these mortgages have or are in the process of defaulting. What this implies is that the total value of subprime mortgages effected by these foreclosures equals USD156bn. Now compare that to the cost of write-downs (~USD517bn) and the Fed's bailouts (USD85bn just for AIG)... Of course no one, including the Fed, could have possibly predicted the detrimental wide-spread effect the housing crisis would have on the global economy; my point is solely to demonstrate how a small piece can have a very significant impact on the entire picture in an over simplified manner.

Here it is with updated data and some small changes!

We are continuously being barraged with mixed news concerning the housing crisis. One day we hear signs are pointing towards a bottom; the next housing numbers came in much lower than expectations. So we raise this question: What indicators should we be looking at to truly signal a recovery in housing?

With this question in mind our analysis focused on creating the stages we believe would be necessary to facilitate a recovery. We were able to define 7 chronological stages which need to occur in order for the crisis to end. Additionally, the progress for each of the stages can be measured by several key indicators. The stages we outline below are meant to help to average investor better understand how a recovery will most likely unfold, and includes indicator that anyone with a basic internet connection will be able to easily access.

Our stages and key indicators to watch:

1. The number of defaults from subprime borrowers needs to drop substantially. This will help to stabilize growing inventory levels. Key Indicator(s): RealtyTrac foreclosure data (monthly) & MBA foreclosure data (quarterly)

Subprime ARM mortgage resets continue to be the primary driver behind subprime foreclosures (July 2007-November 2009)

Foreclosures as a percent of total mortgages continue to rise...
Source: Bloomberg

2. Banks need to lower lending standards for home mortgages. This will allow existing and new home sales to increase and prices to stabilize. Key Indicator(s): Fed Senior Loan Officer Survey, mortgage rates, Case Shiller Home price index (monthly), & New and Existing home sale prices

However, lending standards have tightened across all mortgage types according to the Senior Loan Officer Survey

Source: FRB

30Y fixed mortgage rates have fluctuated but remain elevated especially when considering the recent rate cuts ...
Source: Bloomberg

3. Once people are again able to buy homes we will see a reduction in inventory levels. When this occurs demand will rise for new constructions. Key Indicator(s): New home sales data (monthly) & Existing home sales data (monthly)

But for now increased foreclosures and tighter lending standards have caused new home sales to drop

Source: Census

The recent crisis has begun to negatively effect the housing affordability index
Source: Bloomberg

4. The rise in demand for new construction will first show up in building permits. The rise in building permits will lead to our next step... Key Indicator(s): Building permits data (monthly)

But, building permits have shown no signs of a sustained recovery

Source: Census

5. Very soon after the rise in building permits we will see an increase in housing starts. Key Indicator(s): Housing starts data (monthly)

However, with permits still depressed, starts have shown no signs of recovery

Source: Census

6. The increase in starts will lead to an increase in construction spending. Key Indicator(s): Construction Spending (monthly)

As you can see from this chart, this is not yet the case

Source: Census

7. Finally, residential investment begins to rise and the housing crisis is over. Key Indicator(s): Residential Investment via GDP release (quarterly)

Residential investment continues to be a drag on real GDP growth

Source: Bloomberg

Conclusion:

Essentially, this crisis is occurring due to a substantial increase in the supply of houses through subprime foreclosures, and a decrease in demand to buy houses through harder to get mortgages. As more homes enter the market and less people are able to acquire mortgages to by them the price drops. Hence, the first major step in a recovery for the sector will be a slow-down in the number of foreclosures, which has likely been pushed back until second half 2009. Secondly, and equally important banks need to reduce lending standards to allow qualified buyers to purchase new homes. These two actions combined will begin to reduce the inventory of homes on the market and stabilize price. Once the amount of inventory of homes for sale begins to drop, we will see demand for new constructions begin to rise. This will first show up in the building permits index, followed by housing starts, and finally private construction spending. All in all, this will not be a fast process, with the reduction in foreclosures and lowering of lending standards being the hardest hurdle to overcome.

Currently, the primary driver for subprime foreclosures are interest rate resets. When these borrowers we first given their mortgages they were given low teaser rates which would eventually reset into higher adjustable rates. Meaning some mortgage holders who were paying USD1,200 a month for their mortgage in November could be paying USD3,200 a month in December. For a lot of these borrowers it has been nearly impossible to pay the new amount and they have been forced to default. On a positive note, based on available market information we should see the number of resets for adjustable rate subprime mortgages peak sometime in late spring/early summer. However, it is tough to estimate the lag time between mortgage resets and actual foreclosures, which prolong this situation. The deteriorating employment situation in the US will add additional downward pressure to this indicator. All in all there is no quick easy fix on the housing front, and we will likely have to deal with these conditions for quite some time.

Investment Idea:
Once a the market starts showing signs of a sustained recovery we feel that US home builders could significantly benefit. US homebuilder stocks have been pounded since the housing crisis first began, and will be poised to make a recovery as demand for new homes eventually rises. However, as we said this could take some time, but it will happen. I currently hold a long position in ITB, a US home builder ETF.

My Thoughts on the Next 24 Hours...

These are very interesting times... At this point in time, after passing up some deals which could have saved AIG, I wouldn't be surprised if we saw at least part if not all of AIG being bought at bargain basement prices by one of its major competitors. I think it will be tough for them to find financing any other way, especially after the recent downgrades. However, I haven't been following the industry too carefully, so it would be tough for me to speculate on an appropriate suitor (list could include ING, Allianz, AXA, etc...). Nonetheless, I am rather glad I haven't taken on any new long positions in the sector recently. Something else we should all be paying close attention to is the effect these failures have on the CDS market, this could open up a whole new bag of worms. I recently read an article which stated that PIMCO alone currently guarantees USD760mn of AIG debt.

As for the Fed, I would be surprised, but not shocked, if we saw the Fed move 50bps today, however they will almost certainly switch to an easing bias in the statement and very likely modify and extend some of the current lending schemes (i.e. changes to the discount window and/or TAF, accepting more assets as collateral, possibly even allowing the Fed funds rate to trade well below target over the next couple of weeks, etc...). I don't really believe a rate cut would be the right course of action, liquidity is the issue not price. However, psychologically it may help the market. All in all the Fed's announcement will likely bring some calm to the market, which could easily be undone by an AIG collapse. We will all get a much better idea within the next 24 hours, as it has been reported an AIG deal would need to be completed by Wednesday. Currently, I am staying on the sidelines, but monitoring the situation closely. Finally, I did notice that the financial sector ultrashort ETF is trading nowhere near its July highs, which I found somewhat interesting. I am not very familiar with this fund, so if anyone has some insight on this please feel free to email me.

As an aside, and as I mentioned was a possibility in my previous post, China has begun easing monetary policy. This could be an important factor once the market does start recovering. Many of China's issues were self-inflicted and reversing policy could have a big impact as investors (eventually) become a bit less risk adverse.

UltraShort Financials ProShares (AMEX:SKF)

Source: Bloomberg

A Quick Look at Global Sub-indices (& An Aside on China)

A while back I created an excel file that tracks the conditions of global sub-indices. Essentially, I took over 600 sub-indices from around the world and I broke them out by best and worst performing over the past 6 months, P/E and P/B ratios, and dividend yield. I extracted the 15 best and worst performing indices from each of these categories and consolidated them in the chart below . I am eventually planning on using this data to look at global trade ideas or to spot mis-pricings between markets. All in all I extracted this data form Bberg last week and I hope you enjoy the data. I will follow up with a more detailed analysis on markets that may look attractive after I conduct further research.

As an aside, given the recent economic data out of China (inflation, IP, exports, etc...), I anticipate the government is closer to moving towards a more accomodative monetary policy. The shift will likely include reductions in reserve requirements and an easing of lending standards. It is also possible, but unlikely at this point in time, that we could see a rate cut before the end of 2008. Any action by the government to stimulate the domestic economy should have positive effects on Chinese markets. I currently hold an upward bias towards some of China's housing, health care, and financial names. (Please see earlier posts for more details).

Top and Bottom 15 Global EQ Sub-Indices by 6M performance, PE, PB and dividend yield

*Source: Bloomberg

A Look at China’s P/E Ratios:

Quite a few readers have been wondering whether the relatively high P/E valuations of China’s equity markets were justified. This is my response: I would say that type of PE valuation is reasonable for most of the Chinese companies. As everyone knows, growth in China has been very robust over the past several years, and should remain strong over the next several, despite a slowdown in the rate of growth. To quickly quantify this argument we can take a look at the Shanghai SE Composite’s 2Q08 aggregate PE and divide that by China’s YoY GDP growth for the same period, and compare the data to against other markets (see chart below).

Select market PE's to underlying country's GDP growth

Source: Bloomberg

Looking at the chart above, despite China’s seemingly high PE valuations, in terms of PE to GDP they are actually the cheapest market in the set with a PE/GDP ratio of 2.1. Looking ahead, Chinese growth will continue outpacing its industrialized counterparts over the next several years, and this should help support its market. In fact, during this period we will likely see China’s domestic sector replace the export sector as the main engine of growth. This should partly be catalyzed by higher domestic incomes and growing domestic demand, coupled with a slowdown in consumption by industrialized nations. Of course from my experience, one of the big question marks for China’s market is the impact of any new government policies. However, given the expected weakness in the export sector, recent inflation moderation, and the slowdown of the GDP growth rate, I expect future policy to be accommodative to domestic growth.

Also, I will be traveling for the next couple of weeks, so I may be slow to post new entries. However, I will randomly be checking email.

Thanks!

Mengniu, A Look at A Chinese Dairy Company

Overview:

Chinese Mengniu Dairy: China’s Mengniu dairy was founded in 1999 by a group of seasoned dairy market professionals previously employed by the state-owned Yili Dairy. Mengniu began trading on the Hong Kong Stock Exchange in June 2004.

Our DCF based price target is currently HKD26.16: Given Mengniu’s historically strong growth, its ability to generate cash, and continued leading market position in the liquid milk industry we have decided to run a DCF model to value the company’s equity. Using a 10.6% WACC, based on our calculated cost of equity, and a terminal growth rate of 2% starting in 2019 we calculated a price target of HKD26.16. According to our calculations a price target of HKD26.16 would imply a 12 month forward P/E ratio of x26.79 and a 24 month forward P/E ratio of x19.95. This is in-line with Mengniu’s recent performance.

New high-value added products should help sustain Mengniu’s robust growth: We believe that Mengniu through its strong brand, innovative products, and efficient distribution network will be able to ride the wave on the transitioning

ASP should remain stable or see a slight increase as higher value products reach market: A recent increase in government price caps coupled with solid performance of Mengiu’s products should help sustain Mengniu’s ASP for the foreseeable future.

Higher costs should be offset by rising and eventually stable ASP coupled with falling raw milk prices: Higher costs via new product development, company branding and distribution could place downward pressure on Mengniu’s margins.

The Details:

China’s Mengniu dairy was founded in 1999 by a group of seasoned dairy market professionals previously employed by the state-owned Yili Dairy. Mengniu began trading on the Hong Kong Stock Exchange in June 2004. The company’s products include UHT milk, yoghurt, milk beverages, ice cream, milk powder and milk tablets. In 2007 Mengniu reported holding a market share of 40.7% in China’s liquid milk market. This is a significant increase from the 33.3% market share Mengniu held at the end of 2006. Mengniu has experienced significant growth since its creation, primarily through the introduction of UHT milk. As you can see from the chart below the majority of Mengniu’s revenue is derived from the liquid milk business.

Mengniu’s composition by product

Source: Company

Mengniu’s management has brought the company from an industry start-up in 1999 to a market leader in less than 10 years. They have achieved this by developing a strong brand and implementing an innovative business model that led to the successful introduction of new products, such as UHT. However, the biggest challenge for Mengniu’ management will be keeping up with the changing Chinese dairy sector. As we mentioned in the industry outlook section, the industry is undergoing an important transition, where UHT will likely no longer be the dominant force behind the industry’s growth. As it currently stands, management not only seems to be aware of this shift, but appears to once again be positioning itself on the cutting edge. They have started to invest more heavily in R&D projects aimed at designing higher-end products, and are training its raw milk suppliers on how to increase productivity and reduce disease. Nonetheless, it will be very important for management to maintain stable margins amid potential pricing pressure from increased competition and rising marketing costs. Unlike the western dairy market Chinese consumers are more brand conscience, so it will be essential for Mengniu to continue building its name. This notwithstanding, we believe Mengniu is well positioned to take advantages of the changes in the dairy sector given management’s strong track record of innovation, brand development, and efficient distribution networks.

Investment Thesis:

New high-value added products should help sustain Mengniu’s robust growth: We believe that Mengniu through its strong brand, innovative products, and ultra efficient distribution network will be able to ride the wave on the transition from traditional milk products to higher value dairy products. Mengniu has already demonstrated its ability to take advantage of new products and markets when it first introduced UHT milk to the Chinese market. Concurrently, we believe growing UHT sales to rural communities should help off-set someone of the growth slow-down from near saturated urban markets.

ASP should remain stable or see a slight increase as higher value products reach market: A recent increase in government price caps coupled with solid performance of Mengiu’s products should help sustain Mengniu’s ASP for the foreseeable future. We anticipate that despite some downward pressures Mengniu’s new higher value products and price cap increases should help maintain or slightly improve its 2008 ASP.

Higher costs should be offset by rising and eventually stable ASP coupled with falling raw milk prices: Higher costs via new product development, company branding and distribution could place downward pressure on Mengniu’s margins. Yet, we anticipate that in 2008 margin pressure will be more than off-set by reductions in raw milk prices and increases in the ASP for Mengniu’s products. We currently expect Mengniu’s gross margin to improve to 22.8% in 2008 vs. 22.5% in 2007 and to remain somewhat stable in 2009. Since Mengniu owns only a very small percentage of its own livestock and pastures, it remains extremely susceptible to changes in raw milk costs, both on the upside and downside. Meaning a continued moderation in raw milk prices could have a large positive impact on Mengniu’s bottom line. Based on the current inflation outlook we expect raw milk prices will continue to moderate, eventually stabilizing by year end.

Our DCF based price target is currently HKD26.16: Given Mengniu’s historically strong growth, its ability to generate cash, and continued leading market position in the liquid milk industry we have decided to run a DCF model to value the company’s equity. Using a 10.6% WACC, based on our calculated cost of equity, and a terminal growth rate of 2% starting in 2019 we calculated a price target of HKD26.16. Please take a look at the chart below for our model’s sensitivities to changes in WACC and the terminal growth rate. According to our calculations a price target of HKD26.16 would imply a 12 month forward P/E ratio of x26.79 and a 24 month forward P/E ratio of x19.95. This is in-line with Mengniu’s recent performance as can be seen in the chart below.

Mengniu's price vs. PE Ratio

Source: Bloomberg

DCF Sensitivities to Changes in WACC & Terminal Growth Rates

Source: My Calculations

As you can see from the performance chart above Mengniu’s share price has fallen significantly from its peak in October 2007. Year over year Mengniu is down 12%, while ytd the stock is down 26%. The primary driver behind this weak performance was escalating raw milk prices coupled with price controls in the dairy sector. Raw milk prices have begun to retreat over the past several months as overall food inflation in China begins to moderate. This should help alleviate some of the downward pressures the stock has been facing in the short-term. Also, on August 1st 2008 company employees sold 57mn existing shares into the market at a selling price of HKD22.02, or a 6.7% discount to the market price. This may have led to some downward pressure on the stock during that period. Important to note is that none of the company’s senior management sold shares during the swap.

Key Risks:

There are several significant risks to our forecast. First and foremost, any significant spikes in raw milk prices or supply constraints could have a detrimental impact on Mengniu’s business. Raw milk is the essential input for all of Mengniu’s products, and unlike some of its competitors Mengniu does

not own its own livestock or pastures making the company extremely vulnerable to price shifts or supply shocks in the raw milk market. With this said, given the current CPI outlook we believe raw milk prices will continue to moderating and remain flat by year’s end. Also important to note is that Mengniu has setup an extremely efficient supply chain in Inner Mongolia to source raw milk. It essentially holds a duopoly with Yili Dairy on all raw milk sources in Inner Mongolia, so a supply shock is unlikely.

Another risk is Mengniu’s new higher value added products failing to capture market share. This would significantly hamper Mengniu’s business given the expected slowdown in its core UHT milk sales. However, based on Mengniu’s prior track record of successfully developing and introducing new products we do not find this outcome to be very probable. However, there is a real possibility Mengniu may not meet our aggressive sales forecast.

A number of factors could put downward pressure on Mengniu’s ASP: We expect the higher value dairy products market to become increasingly competitive as China’s other dairy producers introduce new high-value products. We also anticipate higher penetration and sales volumes through China’s hypermarket/supermarket format retail chains. These format stores, given the large volumes purchased, tend to place considerable pricing pressure on producers, adversely effecting ASP. Mengnui’s strong brand name and innovative products should help buffer some of these negative effects on ASP. Lesser risks are potential changes to the 2008/09 effective tax rate, and any potential increase in sales and distribution costs effecting bottom line margins. Additionally, there is always a possibility new government policies related to the price caps of dairy products could adversely affect Mengniu’s future performance.

A Look at the Financials:

Turnover: We anticipate turnover will continue to grow at a healthy pace of around 33% for FY2008. This will be in response to a combination of higher sales volumes and better than market anticipated ASP. We expect yoghurt to experience the highest level of growth for the year at 44%. However, UHT will remain the dominant product consisting of 59% of Mengniu’s sales, but only growing 32%y/y. We believe the recent moderation in overall CPI should help benefit Mengiu as middle class consumers may be more inclined to spend as incomes and disposable income continue to rise.

Mengniu's Sales Growth by Product

Source: The Company & My Forecasts

Margins: We believe that given the increase in price caps for Mengniu’s products, coupled with the moderation in raw milk prices, gross margin should regain some footing lost in 2007. We are currently forecasting the gross margin to finish 2008 at 22.8% vs. 22.5% in 2007. For 2009, we expect the gross margin to remain relatively stable finishing the year at 22.9%. Mengniu’s gross margin will likely remain below that of its major competitors, primarily due to the company’s limited scope. On the plus side, if raw milk prices continue their current decline until year end, then we could see higher than anticipated margins, given Mengniu’s susceptibility to input prices. At the same time, given increased marketing and selling costs we anticipate operating and net margins to remain in-line with 2007’s level of around 5.3% and 4.4%, respectively.

COGS & Selling, Distribution Costs: A significant portion of Mengniu’s COGS is raw milk prices, which up until the beginning of this year have experienced a sharp rise. Raw milk prices have begun to moderate, but given the strong base increase at the beginning of the year we are anticipating COGS to increase around 33% for the year versus 31.2% in 2007. Compared to its competitors Mengniu maintains among the lowest selling and distribution expenses. This is primarily due to management’s ability to conduct concise and effective marketing and the company’s strong distribution network. We believe Mengniu’s strong distribution network and talented marketing team will off-set some of the costs pressures to the new Chinese dairy market dynamics leading to an increase in selling distribution of around 33% for 2008, permitting the company to maintain its competitive advantage vs. its competitors in this area.

Net Profit: We are currently forecasting net profit growth of 34.6% for 2008 and 32.7% in 2009. This would imply a net profit margin of 4.4% for both 2008 and 2009. We believe increased in the effective tax right will likely prevent these margins form realizing any significant upside.

An Overview of the Chinese Dairy Market

China’s robust economic growth has led to significant increases in wealth, which has ultimately led to a shift in consumer preferences. This shift has been especially realized in the food and beverage industry. Chinese caloric intake has increased substantially over the past decade, and will continue to climb likely doubling over the next decade. The Chinese dairy sector has been no exception to this trend. As you can see from the chart below, dairy consumption experienced a considerable increase over the past several years, and is showing no signs of diminishing. In 2006 Chinese dairy consumption stood at 0.012kg/capita, in comparison Japan’s per capita milk consumption totaled 2.08kg, implying significant growth potential as the Chinese market catches up to its peers. But what does this mean for the future of the industry?

Chinese Dairy Consumption 2003-10

Source: KPMG 'The milk and dairy market in China'

Over the past 8 years the bulk of the dairy sector’s growth came through liquid milk, specifically ultra high temperature (UHT) milk. However, we believe as consumer tastes become more sophisticated and income rises the primary growth engine will shift to higher value products such as ice cream, yoghurt, and milk based products, especially in China’s urban centers. Currently, studies imply that the CAGR 2005-2010 of cheese desserts (38%), milk beverages (22%), infant formula (17%), and yoghurt (31%) will all match or exceed that of milk (17%). (Please see the chart below for a more detailed breakout). These growth rates are congruent with bringing China’s dairy distribution in-line with that its major Asian peers. China’s increased consumption of dairy products is also being assisted by the government’s ‘500 Gram Declaration’ which essentially is the government’s hope that every Chinese citizen, especially children, are able to drink 500 grams of milk on a daily basis. This initiative was primarily motivated by the potential health benefits of dairy products. One of the major roadblocks for the dairy industry is the dispersion of Chinese consumers between urban areas with easy access to a wide variety of dairy products and rural sections with limited access and infrastructure challenges. Nevertheless, infrastructure in China is slowly being developed and the large untapped potential of China’s rural areas should continue to be unlocked.

Chinese dairy industry revenue distribution

Source: McKinsey 'China's booming dairy market'

In 1998 only 29% of China’s milk sales were made at modern supermarket/hypermarket stores, but by 2005 this number totaled 58% and is expected to reach 2/3’s of total sales by the end of the decade. China’s entry into the WTO, among other things, significantly reduced barriers for foreign retailers to start or expand operations in China. Based on this fact and the continued development of rural infrastructure we expect the penetration of foreign and domestic supermarket/hypermarket style retail chains to continue growing sharply in China. However, this can be a double edge sword for the Chinese dairy industry. While sales volumes are likely to increase dramatically through higher consumer access to super/hypermarkets, we anticipate greater pricing pressures on dairy manufacturers as these companies tend to have strong bargaining power. This could potentially place stress on dairy products ASP, leading to a reduction in margins. To counter this, dairy companies will need to increase spending on brand recognition and developing new innovative products. Chinese consumers, unlike western consumers, tend to be very brand conscience in relation to the dairy industry.

Key players in the Chinese dairy market:

In 2006 China’s four largest dairy companies represented 44% of the total dairy market share. The largest of these was Mengniu with a market share of 16% during the period followed by Yili with 15% market share. Market share for both of these companies has been increasing over the past several years, while China’s other top two companies by market share Bright (5%) and Sanlu (8%) have been decreasing. The remaining 56% of market share is split between over 1000 other smaller dairy companies. (See chart below for further details). Mengniu and Yili were the first companies to introduce UHT milk into China, which was an important driver behind their substantial market share growth. However, we have already begun seeing a

Chinese companies market share in 2006

Source: China Dairy Yearbook 2006

A major challenge for China’s dairy producers is the distribution and price sensitivity of raw milk (the sector’s primary input). Throughout 2007 raw milk prices grew substantially as food inflation rose. Raw milk prices were further exacerbated by droughts, the EU’s removal of milk powder export subsidies, and livestock being slaughtered due to higher feed costs. Making matters worse for Mengniu and Yili, neither own significant cattle ranches, forcing them to source raw milk from third parties, making these companies even more susceptible to increases in raw milk prices and supply disruptions. Mounting raw milk prices coupled with the government’s dairy price controls have placed significant pressure on the industry. Nevertheless, on a positive note food inflation has begun to moderate, and the government recently approved price increases for a number of dairies. All in all this should help alleviate some of the pressure the sector has experienced over the past year.

Foreign competition has been somewhat limited in the Chinese dairy sector, primarily existing only in the powdered milk segment. Given entry barriers to the sector and China’s, in many cases, inefficient raw milk suppliers we do not expect foreign competition to increase significantly in the short-term. Moreover, we expect to see considerable consolidation in the domestic Chinese dairy industry. Many of China’s smaller dairies are regionally focused in China’s rural areas. As China’s larger dairies continue accessing these areas, smaller producers will likely be unable to compete in terms of costs, and could be forced out of business our acquired by bigger names. Furthermore, given the increased competition amongst domestic players and the likely shift to higher value added products in urban areas dairies will need to increase spending on R&D and marketing to for product development and brand recognition. Only those companies with strong cash flow and significant market share will likely be able to cannibalize these necessary extra expenses.

Chinese Healthcare Sector ADRs

As an additional follow-up to my ADR series, I am going to take a look at the Chinese and Hong Kong healthcare sector. There are 6 key Chinese and Hong Kong ADRs within the GICS healthcare sector: Mindray Medical International (MR), Chine Medical Technologies (CMED), Wuxi PharmaTech (WX), Simcere Pharmaceutical (SCR), 3SBio (SSRX), and Tongjitang Chinese Medicines (TCM)

Chinese & HK Helathcare Sector ADRs

Source: Bloomberg (Closing prices 8/7)

The Companies:

Mindray Medical International (MR, Outperform): Mindray Medical International Limited develops, manufactures, and markets medical devices. The Company offers patient monitoring devices, diagnostic laboratory instruments, and ultrasound imaging systems. (Bloomberg)

MR’s outlook in a nutshell: Unlike the other companies discussed in this piece MR has significant exposure to both Chinese and ex-China markets; it is also the country's largest medical device company. The medical devices sector is still in its infancy in China, and MR is well poised to benefit from an expanding market. MR specializes in patient monitors, diagnostic lab equipment, and anesthesia & ultrasound machines. Earlier in 2008 MR acquired a U.S. patient monitoring business from Datascope (DPM). MR is currently in the process of integrating DPM's operations; it will likely take 1.5 to 2 years for the full synergies of this deal to be unlocked. Nonetheless, unlike MR, DPM's sales were mostly targeted around hospitals in the U.S. and Europe, this should prevent most sales cannibalization, and give MR good exposure to new markets and technologies. This acquisition adds significant upside potential to MR's future growth potential. Looking at the immediate impact, MR just received FDA approval for DPM’s next generation AS3000 anesthesia delivery system, which is a strong entry into a USD250mn a year market. On the home front, MR has been partially supported by public healthcare reforms, and an initiative to provide medical equipment to rural hospitals; this trend will likely not let up anytime soon. Additionally, MR's robust pipeline should continue supporting the companies bottom line. MR's pipeline includes digital radiography equipment, a digital defibrillator, and various other patient monitoring and chemical analysis equipment. The digital radiography system is a high-res X-Ray machine utilizes digital vs. traditional film, allowing for simpler analysis and digital storage. I see significant upside for MR given its strong domestic position, and growing international presence. This together with stronger medical device demand in China, a successful integration with DPM, and its innovative product line MR should continue to experience strong growth for the foreseeable future. (Expected Q208 Earnings Report 8/20/08)

Events which could improve outlook:

• Exceeding 2008’s company guidance of USD560-580mn in revenues and USD132-134mn for income.
• Successful integration of DPM, with stronger than anticipated synergies (i.e. cross-selling)
• Stronger domestic and international demand for MR’s product line.

Events which could deteriorate outlook:

• Higher costs and potential FX risk.
• Increased competition in both the domestic and foreign markets.
• Changes in government policy reducing domestic sales or prices.

MR vs. Hang Seng

Source: Bloomberg

China Medical Technologies (CMED, Outperform): China Medical Technologies, Inc. is a medical device company that develops, manufactures, and markets products using high intensity focused ultrasound, or HIFU, for the treatment of solid cancers and benign tumors in China. (Bloomberg)

CMED’s outlook in a nutshell: CMED has a unique characteristic when it comes to Chinese healthcare companies; it is the only company in China certified to conduct FISH testing. FISH testing (fluorescence in situ hybridization) is a genetic test that can detect chromosome abnormalities, and can be used prenatally to detect Down’s syndrome among other genetic conditions. Given CMED’s currently monopoly and China’s untapped potential, this segment should help support CMED in both the short and long term. CMED’s other primary segments include ECLIA (electrochemiluminescence immunoassay) and HIFU (high intensity focused ultrasound). These segments should also continue to demonstrate growth, but at a slower pace than the company's FISH business. It is expected CMED will be granted further approvals by the SFDA that will permit it to increase FISH advertising, and and widen the scope of the testing. Additionally, we seen significant improvements in the company’s margins, primarily due to an increased emphasis on high margin reagent products, and limiting the sale of low margin equipment, such as microscopes. This strategy has led to a non-GAAP margin increase to 79.1% from 72.3% for 1Q08 vs. 1Q07; I anticipate this growth rate will moderate, yet remain slightly above current levels. Recently, the company initiated a new business model where by it gives free ECLIA equipment to new customers, who in turn end up purchasing high-margin reagent products to operate the machine. In the short-term this may add some pressure onto CMED's bottom-line, but will be more than offset via longer-term reagent sales. All in all, I believe CMED is a great play in the Chinese healthcare industry given its unique position regarding the FISH test, and new strategy emphasizing higher margin products. (1Q08 Earnings Report 8/04/08 Est: 0.52 Act: 0.42)

Events which could improve outlook:

• Further SFDA approvals for new FISH probes.
• Continued growth in company margins.
• Reaching or exceeding expectations of 500 hospitals with FISH capabilities by the end of 2008.

Events which could deteriorate outlook:

• Increased competition.
• Lower than anticipated FISH sales.
• Changes in government policy adversely affecting the sector.

CMED vs. Hang Seng

Source: Bloomberg

Wuxi PharmaTech (WX, Neutral): WuXi PharmaTech Cayman Inc. provides pharmaceutical and biotechnology research and development outsourcing. The Company's services include discovery chemistry, service biology, analytical, pharmaceutical development, and manufacturing. (Bloomberg)

WX’s outlook in a nutshell: While the CRO business should remain robust in China, WX's recent acquisition of AppTech, a biologics manufacturing company raises some concerns. WX is a market leader in China’s CRO industry, and this portion of its should remain strong over the next several years. In fact, on June 24^th 2008 WX announced a memorandum of understanding to create a 50-50 joint venture for contract research with Covance. The joint venture will be located at WX’s Suzhou facility; specific financial terms are expected to be released once the deal is complete. This deal should help bolster WX’s CRO business over the next several years. However, WX’s USD169mn acquisition of U.S. based Apptech add a cloud of uncertainty over the company's overall outlook. It is likely this deal will create significant cost pressures, and lead to higher earnings variance due to the volatility of biologics manufacturing. All in all, given the recent Apptech acquisition and the potential for increased costs and compressed margins we do not see much upside potential for WX. (Expected Q208 Earnings Report 8/13/08 Post-market)

Events which could improve outlook:

• Strong demand for biologics manufacturing.
• Significantly higher CRO business in China.
• Streamlined integration of Apptech combined with successful cross-selling initiative.

Events which could deteriorate outlook:

• Increased costs from Apptech acquisition.
• Decrease in biologics demand.
• Slow-down in CRO business

WX vs. Hang Seng

Source: Bloomberg

Simcere Pharmaceutical (SCR, Neutral): Simcere Pharmaceutical Group manufactures and supplies branded generic pharmaceuticals to the China market. The Company's products include antibiotics, anti-cancer medications and anti-stroke medications. (Bloomberg)

SCR’s outlook in a nutshell: SCR and the Chinese generic drug sector in general face strong competition. SCR’s sales suffered in Q208, primarily due to shifting to a lower margin sales model in the face of potential competition. I expect SCR will continue to face growing competition in many of its existing lines, further compressing margins. Nonetheless, SCR has at least one first-to-market generic expecting approval during 2H08, which could help bolster sales and sustain margins. Given China's untapped potential in the healthcare industry, SCR should continue experiencing sales growth in its generic markets. SCR will likely continue to target the large potential in small & medium sized hospitals and pharmacies, which should help sales volumes. Nonetheless, increased volumes may not be enough to off-set the impact of lower prices in an environment of increased competition. Looking at 1Q08 we can already see some of the potential impact on margins. Furthermore, a SCR competitor that manufactures a Yidasheng rival, is selling its drug slightly below Yidasheng’s current price, which could lead to further pricing pressure. SCR noted on its 2Q08 earnings call that it is considering acquisitions given its strong cash base. All in all, despite the fact that we believe SCR’s sales volume will continue to expand, it will likely be at least partially off-set by lower prices due to increased competition. (2Q08 Earnings Report 8/05/08 Est: 1.44 Act: 1.48)

Events which could improve outlook:

• Stronger than anticipated drug sales.
• Competitors bringing rival drugs onto market slower than expected
• Approval and eventual ability to market drugs in SCR’s pipeline including Biapenem, Palonosetron, Iguratimod, and Levamisole.
• Any significant acquisition that could improve SCR’s bottom line.

Events which could deteriorate outlook:

• Continued pricing pressure from competitors.
• Lower than anticipated drug sales.
• Rejection of drugs in SCR’s pipeline.
• Any government regulation regulating drug costs.

SCR vs. Hang Seng

Source: Bloomberg

3SBio (SSRX, Outperform): 3SBio, Inc. is a biotechnology company. The Company researches treatments in the areas of nephrology, oncology, supportive cancer care, inflammation, and infectious diseases. (Bloomberg)

SSRX’s outlook in a nutshell: SSRX is a growing company in a Chinese growth sector. SSRX’s two main products are EPIAO and TPIAO, experienced record sales increases in 1Q08 of 42% and 104%, respectively. EPIAO is an EPO drug, which helps stimulate the body’s red blood cell production that can be prescribed to patients with anemia, or who are undergoing chemo-therapy. According to the company, in Europe roughly 17% of chemo-patients are prescribed EPO, while in China the ratio stands at 2%, implying significant growth potential. TPIAO is a THPO treatment, which increases the body’s production of platelets; this drug can also be prescribed to oncology patients. Looking ahead SSRX has a potentially strong pipeline, with its high dosage EPIAO treatment and second generation IL-2 treatment, both finishing Phase III trials. SSRX expects to file with the SFDA regarding both these drugs during 2H08. By the end of 2008, SSRX also intends on filing with the SFDA in order to be granted permission to use TPIAO as a treatment for ITP, a bleeding disorder. Management expects to continue investing heavily into the company's core business, increasing sales force and expanding capacity. Despite the potential for rising costs due to managements expansion plans, I foresee SSRX further penetrating China’s oncology market while maintaining strong and stable margins. All in all given SSRX’s growth and future pipeline, I believe SSRX is a good play in the Chinese healthcare industry. SSRX is a growth company with a management team who appear to be making wise investment decisions towards long term sustainable growth. Interesting to note is that SSRX has the right to buy-back company shares through March of 2009. Lastly, I expect the company could upwardly revise its 2008 guidance during its Q208 earnings call, this of course depending on 2Q results. (Expected Q208 Earnings Report 8/12/08 Post-market)

Events which could improve outlook:

• Improved 2008 company guidance.
• Stronger than anticipated EPIAO & TPIAO sales.
• Approval of new treatments by the SFDA.

Events which could deteriorate outlook:

• Strong competition from other market players, which could reduce market share or add pricing pressures.
• Any pipe-line drugs failing to get approval from the SFDA.
• Higher than anticipated costs reducing margins.

SSRX vs. Hang Seng

Source: Bloomberg

Tongjitang Chinese Medicine (TCM, Neutral): Tongjitang Chinese Medicines Co. is a pharmaceutical company. The Company develops, manufactures and markets modernized traditional Chinese medicines. (Bloomberg)

TCM’s outlook in a nutshell: I am hesitant on TCM’s outlook for several reasons 1) nearly 80% of TCM’s revenue comes from its Xianling Gubao product alone, which is used to treat osteoporosis; 2) the traditional Chinese medicine industry is extremely competitive; & 3) canceling its privatization due to what was reported as a deteriorations in the credit market. All in all, if it were not for this equities recent sell-off after the cancellation announcement I would have rated them ‘underperform’, but given the sell-off and challenges the company still faces I don’t see much upside or downside for TCM.

Events which could improve outlook:

• Higher than expected earnings.
• Re-initiating privatization.
• Creating a more robust product base.

Events which could deteriorate outlook:

• Slower than anticipated sales of Xianling Gubao.
• Earnings below expectations.

TCM vs. Hang Seng

Source: Bloomberg