Slaughtering capacity expansion based on LT view of industryconsolidation comes at expense of low ST utilization rate and marginerosion: The most important consideration for continuous capacity expansionis the benefit of industry consolidation, as the MOC aims to control slaughteringlicenses and pushes for a potential consolidation from 17,000 slaughters ofvarious scales to 3,000. Sector leaders Yurun Foods and Shuanghui currentlyhave total capacity of 70M heads (~10% of domestic hog demand). Base on itsnew slaughtering facilities 15% ROIC, we therefore believe the company ispositioning for future market share at a short‐term cost of low utilization ratethat drives down production efficiency (reversed EOS effect) and higher D&A(as shown in figure 1 & 2), both of which result in margin erosions and concernover financial stability.
Connected transaction concerns: Yurun Foods started sourcing hogs fromYurun Group in May 2012, with total purchase to potentially rise significantly toRMB 17.1B during 2013‐15. The parent company’s 30 farms supply 3M headsannually. Yurun Foods management explained that the procurementarrangement is in line with its strategy of increasing sourcing from scaled andwell‐organized farms (accounting for less than 30%) to uphold meat qualityand reduce quarantine inspection fees. By 2015, hogs purchased from parentgroup will amount to 15% of total procurement.
Savvy management, however no share repurchase plan: The company’sreverse roadshow (first of its kind this year) was hosted by both CEO Li andChairman Yu, who were articulate and provided detailed explanations of thecompany’s operation. However, the management indicated there are no plansfor either a share repurchase or increases of management/large shareholders’holdings, which would have boosted market confidence in the stock.
A mismatch between Yurun Foods’ LT goal and investors’ focus on a STturnaround: The company is mainly focusing on slaughtering business andchannel building, and positioning for market share in the long term, and weexpect government efforts to limit slaughtering licenses will play a critical rolein industry consolidation and therefore the success of Yurun’s overall strategy.
Although we are comfortable with more stringent control in 1st‐tier cities, thedifficulty of reducing a sum of 17,000 slaughters to 3,000 is explicit. Wetherefore believe the mismatch of company’s LT goal and investors’ focus of SToperating results turnaround will continue to weigh on the sentiment towardthe stock.
Sales growth to pick up in 2013: Due to weak macro economy and fluctuatingconsumer behavior, management does not expect sales growth and margins toreturn to normal levels until mid FY13. Furthermore we expect its FY12 5%upstream volume growth target will come under pressure. Nonetheless, we findthat slaughtering volume and downstream GPM improve in QoQ terms.
Management is targeting 20% growth in slaughtering volume during FY13. Asales recovery is to be driven by an increase in the utilization rate, saleschannels development (e.g. restaurant chains) and strengthening macro.