Feihe’s 2023 earnings were far below our expectations, as 2H23 OP/NP were down 28%/37% YoY respectively due to sales being below expectations and hence an operating deleverage. While there are positives in recent development, such as a slight uptick in the number of pregnancy, initiatives to stabilise retail prices, and higher dividends, we believe these may not be sustainable beyond 2024 or longer term.
　　We believe Feihe will be particularly vulnerable to unfavourable changes in demographics and intensifying competition. We expect Feihe would eventually face the dilemma on sacrificing either margins or market share. We expect the former is more likely, as reflected in its latest guidance. Downgrade to SELL amid a sector structural de-rating.
　　Key Factors for Rating
　　2023 NP 23% below our estimates as 2H23 pressure escalated. Feihe’s 2H23 revenue was down 16% YoY (1H23: +0.6% YoY) as pressure mounted amid inventory dumping by distributors and smaller peers. SG&A ratio of 43% in 2H23 is also higher than what we expected and 2H22 of 36.8%, reflecting Feihe’s ongoing spending to maintain brand power and investments on channels.
　　In 2H23, Feihe also suffered from higher non-cash fair value loss related to raw milk of RMB340m. Hence, 2H23 OP/NP were down 28%/37% YoY respectively, far below market expectations and its previous guidance. However, Feihe also raised the dividend payout ratio to 70%, which met its commitment to increase the dollar amount of dividends back in Aug 2023.
　　2024: a temporarily better year. Feihe set a baseline target for 2024 of at least 5% revenue YoY growth, with similar or even higher NP growth. We agree these circumstances would allow a temporary pick up and make these targets seemingly achievable: (1) pent-up demand of IMF as the number of pregnancy could recover slightly after the end of the pandemic; (2) a very low base in 2023, due to inventory dumping of other peers after the implementation of new GB standards in Feb 2023, and (3) Feihe’s aggressive initiatives to reach more customers, such as more offline events for consumer education.
　　Long term outlook challenging, especially margins. Still, we believe the long term outlook of Feihe beyond 2024 could face tremendous pressure: (1) a structural decline of newborns due to lowering birth rate beyond 2024; (2) more intense competition, especially from foreign brands; (3) commoditisation of dairy products, especially infant formula which could limit long term growth, and (4) Feihe’s own struggle to diversify from the reliance on infant formula. Hence, we believe Feihe would eventually face sluggish top-line growth, and it would need to sacrifice its margins for maintaining its market share and in the meantime diversifying its business, which is not as profitable as infant formula.
　　Key Risks for Rating
　　Upside risks to our SELL rating include: better-than-expected birth rate in China, strong performance of Astrobaby and other super premium products and an effective control of SG&A leading to strong OPM expansion.
　　Valuation
　　We cut our FY24/25E EPS forecasts by 21%/25% to reflect: (1) 2H23 performance far below expectations, and (2) the latest guidance of mid-S.D. revenue growth in 2024. We believe the likelihood of earnings beating the baseline guidance may be slim, due to challenging demographics and market landscape.
　　We also introduce our FY26E forecasts which expect revenue & NP to decline by 4%/11% YoY after the mild recovery in 2024 & 2025, as the challenges from fewer newborn babies could kick in again.
　　Downgrade to SELL. Our TP is lowered to HK$3.10, based on 6.5x 2024 P/E (previous: 8x). The target multiple is equivalent to 0.4x 2024 PEG. While we believe higher dividends in 2024, as reflected by an expected 2024 dividend yield of 9%, could be attractive in the short run, we believe shareholders’ return in the long run could be trimmed by the significant long term downside risks of earnings, especially shrinking industry volume due to falling birth rate.