HK Food &Beverage Sector Outlook 2017:Expect short-term rebound but not turnaround,Stock selection hinges upon cost transfer

Core views

    Short-term improvement mass consumer demand is expected, product mix upgrade to continue in mid-to-long run: In 3Q16, the beverage and beer industry improved while dairy products continued to see a mild recovery due to the hot weather in summer, in particular the high-end instant drinking tea, mid/low-end water beverages, and energy/sports drinks showing improvement. Since consumption was already hovering at bottom for three years coupled with improving construction infrastructure investment, short-term expectation to be slightly better while product mix upgrade to continue in mid-to-long run. We continue to be positive on dairy products entering the recovery cycle as well as the development prospects of energy drinks and health products in China.

    2017E risk-cost pressure and price hikes: As of Nov-end, PET prices rose 6% YoY, Fonterra milk powder auction prices surged 56% YoY, while sugar and palm oil prices rebounded by more than 19% YoY. We believe the FMCG generally benefited cost advantage in 2016, but no more in 2017.

    Stock selection strategy: We are optimistic about the brand companies with strong capability of cost transfer in the backdrop of inflation expectation: 1) downstream dairy companies: e.g. the improving competitive landscape could result in less price competition; 2) red wine: this business is discretionary in nature and has a strong capability for price hikes, less affected by the negative impacts of rising costs; 3) health products: since these products possess the health property, consumers are not sensitive to terminal price hikes; and 4) infant formula: driven by the second child policy and infant formula registration system, 2H17 will improve YoY with industry recovery. We see little possibility of the market leaders of instant to raise prices next year, as the industry demand is weak overall.

    Catalysts: ASP hikes and innovations of new products·Our key recommendations:Mengniu Dairy (2319 HK, BUY) - Strong pricing power in high-end dairy products, limited impacts from the rising raw milk pricesChina Foods (506 HK, BUY) - Red wine business to continue recovery, stable growth for beverage businessBiostime (1112 HK, BUY) - Destocking of health products nearing the end, 2017E offline deployment and milk powder industry recoveryTingyi (322 HK, BUY) - Short-term sales to continue improving, 2017E earnings to resume strong growthOther companies under our coverage: Uni-President China (220 HK, NEUTRAL) & Hengan International (1044 HK, NEUTRAL) - Eye on trading opportunities amid volatility brought by the contribution of new products and the stabilizing performance of old products