Falling raw milk prices in China have squeezed margins and pushed up debt leverage of China Modern Dairy Holdings Ltd. (CMD). As a result, S&P Global Ratings revised down the stand-alone credit profile (SACP) of the company to 'b' from 'b+' in September 2023. CMD is a large supplier of raw milk in China.
Raw milk prices have since kept dropping, to Chinese renminbi (RMB) 3.6 per kilogram (kg), and have slid 2% in the past four months. We see few signs of stabilization. Investors are asking if a weak market for raw market will trigger further revisions to the SACP on CMD, and how that might affect the issuer credit rating (BBB/Stable/--).
Here, we answer the most frequently asked questions by investors about CMD.
Frequently Asked Questions
If the 'b' SACP on CMD further weakens, will it trigger a downgrade of the company?
A weakening of the SACP on CMD will not cause us to lower the issuer credit rating. Our group rating methodology assesses the potential for extraordinary support from the group for the particular rated entity. Our final rating on CMD (BBB/Stable/--) is derived using a top-down approach from parent China Mengniu Dairy Co. Ltd. (BBB+/Stable/--). Our approach accounts for CMD's highly strategic status within the group.
CMD's status is based on its strategic importance to Mengniu group's business position, and a history of Mengniu supporting CMD during downturns. So long as our assessment of CMD's group status is unchanged, we believe CMD will receive timely and strong extraordinary support from parent Mengniu. That means the group is likely to support CMD under almost all foreseeable circumstances, in our view.
Accordingly, although we revised the SACP on CMD to 'b' from 'b+' in September 2023, our downside trigger for the entity stays constant:
- We would lower the rating on CMD if we downgraded Mengniu.
- We could also lower the rating if there were signs of CMD's reduced importance to its parent, such as a decrease in Mengniu's interest in CMD to 40% or below, or a reduced share of raw milk supply to Mengniu.
What are the new upside/downside triggers for the SACP on CMD after the revision to 'b' last September?
The downside risk for the SACP on CMD is limited. We have incorporated a negative view for raw milk prices and high raw material costs, which captures most of the downside. For example, we've baked in a ratio of debt-to-EBITDA of 5x-6x and negative free operating cash flow (FOCF) of Chinese renminbi (RMB) 1.0 billion-RMB1.4 billion for 2023-2024.
There isn't a specific downside trigger for our SACP on CMD. What could cause a revision in the SACP would likely be:
- A longer-than-expected decline in raw milk price into 2025, resulting in even higher leverage and negative FOCF; or
- Liquidity pressure.
Having said that, liquidity shortfall is likely not an imminent risk because CMD's capital structure is quite healthy, with short-term loans accounting for 26% of reported debt as of June 2023 . The company still has access to a RMB1 billion credit line from its parent, Mengniu.
On the upside, we could consider revising our assessment of the SACP if the company's leverage (debt to EBITDA) fell below 4x, while its FOCF narrowed.
Why doesn't Mengniu use more imported milk powder if it's cheaper than raw milk produced in China?
Fresh milk and milk powder are not used identically in dairy products. Fresh milk is mainly used in liquid milk (including ultra-high temperature treated milk) and more premium dairy products. Milk powder is mostly used in dairy drinks, lower-end ice cream, yogurt or cake (largely that made in bakeries and factories).
Also, growing demand from high-end dairy products such as Telunsu, Satine and high-end infant milk formula all require fresh milk--not milk powder--as raw materials.
Even if imported powdered milk is at times cheaper than locally produced raw milk, Mengniu cannot easily switch to cheaper milk powder without compromising on product quality or tarnishing its brand.
However, to avoid use of imported milk power, Mengniu must first secure dependable sources of quality local dairy. Downstream entities snatched up large dairy farms during 2018-2020 through mergers and acquisitions, or long-term supply contracts.
During market downturns, downstream dairy producers tend to prioritize use of local dairy sources rather than imported whole milk powder to support the entities through an industry trough. This is what we observed during the pandemic for both Yili Holding Investment Ltd. and Mengniu. Such thinking also underpinned Mengniu's support of CMD during the last downturn in 2017.
Chart 1
What is the breakdown of CMD's unit milk costs? How does the company control costs?
Feed costs and direct materials accounted for over 80% of CMD's cost of goods sold, followed by labor, utilities, and other expenses. Corn and soymeal make up for 50%-60% of CMD's feed costs. CMD's margins are therefore sensitive to price volatility in grains such as corn and soymeal.
CMD tries to control the cost of its milk by locking in the supply of volatile feed commodities at fixed costs, and by enhancing the unit yield of cows.
Over the past decade, CMD has improved its average yield by 4% annually to 12.2 tons a head in 2022, from 8.4 tons a head in 2013. Its yield rate is better than average in China and largely in line with average yield in the U.S. There is still room for improvement to above 13 tons a head.
The company has historically hedged between 40% and 60% of its raw material costs, and adjusted the portion depending on price expectations. The company will likely adjust down its hedging percentage, on an expectation that the price of key materials--such as corn and soymeal--will soften in 2024. The firm will continue to enhance unit yield per cow to rein in the unit cost of milk.
Chart 2
What is our forecast for raw milk prices?
Milk prices will remain low in 2024, in our view. Prices will likely linger at levels set in the second half of 2023, of RMB3.6/kg-RMB3.9/kg. It should recover to about RMB3.8/kg-RMB4.0/kg in 2025, in our estimation. Milk prices probably won't fall below RMB3.5/kg--the level set during the last trough--for sustained periods, given the high prices for corn and soymeal prevailing now.
Excess supply of raw milk in China will likely continue into 2024. However, demand and supply will swing into equilibrium in 2025, in our view. This would help to push up raw milk prices in 2025. Meanwhile, CMD's unit cost of milk production should decline on continued yield increases, and its efforts to cut costs by locking in lower-cost raw materials.
We assume a ratio of debt to EBITDA of 5x-6x for CMD in 2023 and 2024, improving toward 4x-5x in 2025. Its FOCF will deteriorate to negative RMB1.4 billion from negative RMB1 billion in 2023, before improving to negative RMB 0.5-1 billion in 2025.
Chart 3
Editor: Jasper Moiseiwitsch
Related Research
- China Modern Dairy SACP Revised Down On Weak Profitability; Ratings On Company, Parent Mengniu Affirmed; Outlooks Stable, Sept. 18, 2023
- China Modern Dairy Holdings Ltd., June 5, 2023
- A Closer Look At Our 'BBB' Rating On China Modern Dairy And Its Relationship With Parent Mengniu, July 13, 2021
This report does not constitute a rating action.
Primary Credit Analyst: | Flora Chang, Hong Kong + 852 2533 3545; flora.chang@spglobal.com |
Secondary Contact: | Aras Poon, Hong Kong (852) 2532-8069; aras.poon@spglobal.com |
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