Huachuang Securities: Improvement logic gradually unfolding Neutral view 25 Q3 milk prices expected to reverse

Huachuang Securities released a research report stating that since 2022, the net cash flow of the ranch including capitalized expenditures has been continuously negative, and the net debt ratio may have exceeded the previous high point. It is expected that the direction of capacity elimination is still clear. In the subsequent observation points, the off-season destocking after the Spring Festival is expected to accelerate, and the milk price cycle in the third quarter of 2025 is expected to reverse. Currently, as the company gradually clears inventory and various upstream impairments gradually converge as destocking progresses, and the operation of the enterprise becomes more rational and practical, the sector has bottomed out. With the reversal of the milk price cycle, demand recovery, and even price increases catalyzing, the sector is expected to see opportunities for both performance and valuation growth. Key Points of Huachuang Securities are as follows: Milk Price Cycle: Where is this cycle heading? The net cash flow of ranches is continuously negative, and the net debt may exceed the previous high point. Neutrally watching for a milk price reversal in the third quarter of 2025. Fresh milk demand-supply growth rate differential is a better indicator of milk price trends. The current negative growth rate differential is narrowing, and it is expected that the supply side will be a key factor for future milk price changes. Due to the consecutive decline in milk prices since October 2021, with a cumulative decrease of nearly 30%, the industry is currently experiencing losses, leading to a decrease in inventory levels since February 2024. Although the short-term destocking speed is relatively mild due to enhanced risk resistance of large-scale ranches, the introduction of various policies, and a slowdown in forage cost reductions, combined with the increase in seasonal calves, the actual net cash flow of ranches has been continuously negative since 2022, and the net debt ratio may have exceeded the previous high point, indicating a clear direction for capacity elimination. In the future observation points, first look at the acceleration of destocking in the post-Spring Festival off-season, then look at the potential reversal of the milk price cycle in the third quarter of 2025. Demand Outlook: Does the positioning of "essential needs" weaken? Sales in the past two years have not declined, with price drops being the main reason, and penetration is increasing against the trend, leaving room for both quantity and price. Despite the overdrawn epidemic and weakening consumer purchasing power causing a slowdown in sales growth, the calculations based on production, inventory, and quantity-price analysis indicate that sales in the past two years have remained stable and not declined. The key factor affecting the industry scale is the decrease in unit price due to excess milk leading to passive promotions and an increase in demand for cost-effective products among consumers. Additionally, despite the external pressure, there has been an increase in the penetration rate of dairy products in the past two years, indicating that the industry will return to an upward trajectory once the economy improves, milk prices rise, and companies introduce new products. Dairy Enterprise Perspective: Consolidating barriers amid the cycle. Enterprise profit: From competition to situational dominance in the milk price cycle, the entire industry chain shares both prosperity and adversity. In fact, the impact of the milk price cycle on dairy enterprises cannot be directly compared to historical data. In the past, sales volume and structure were core factors for income growth, and the competitive landscape was a key driver of profit changes. Since 2020, due to accelerated reverse integration, there has been a trend of shared prosperity and adversity between the upstream and downstream sectors. Even without considering pressure from promotional giveaways, various depreciation losses related to excess milk in the first half of 2024 accounted for more than 10% of pre-tax profits for Yili and Mengniu, making milk prices a key factor for future profit recovery. Barriers strengthening: A new reshuffle in the cycle will enhance the control of upstream activities by leading dairy companies. Firstly, under the tiered management system of leading dairy companies, smaller suppliers are under significant pressure to survive, and in the future, ranches may prefer to maintain long-term stable relationships with leading companies. Secondly, considering that it takes more than 2 years for a calf to grow into a milk-producing cow, during this round of destocking, small and medium-sized ranches that have been forced to close due to economic pressures are increasing the proportion of cows in their herds to 80% or even 100%, which means that future growth potential is compromised. Once the milk price cycle reverses, the capacity of milk-producing cows will lag behind, and leading ranches will accelerate the harvest of market share, strengthening the barriers to milk sources and providing potential profit elasticity. Operational Strategy: Actively addressing competition, accelerating deep processing layout, and smoothing the long-term operation cycle. Since 2023, leading dairy companies have been under continuous pressure due to the dual impact of active inventory reduction and declining market share under the premise of stabilizing the entire industry chain. Looking ahead, during the surplus milk phase, leading companies will introduce high-quality and cost-effective products and expand into emerging channels to actively respond to competition. Similarly, with the reversal of milk prices, market share will also accelerate recovery. External pressures are forcing companies to think more long-term, prompting leading companies to accelerate their business-to-business operations and deep processing capacity layout. By referring to the nearly 30 billion yuan revenue of Heng Tai Natural in the Greater China region in the 2024 fiscal year and a net profit margin of around 10% in the catering-to-business sector, business-to-business operations are expected to contribute beneficial growth, while deep processing is expected to enrich the utilization of raw milk and increase product added value, thus enhancing overall competitiveness and smoothing the operational cycle. Investment advice: Improving logic gradually unfolds, sector allocation value highlighted. Huachuang Securities believes that there is still room for growth in the industry in terms of quantity and price, and the supply-side barriers are strengthened amidst the fluctuations in the milk price cycle, maintaining the long-term logic of the industry. As companies gradually clear inventory and various upstream impairments converge as destocking progresses, and business operations become more rational and practical, the sector has bottomed out. With the reversal of the milk price cycle, demand recovery, and even price increases catalyzing, the sector is expected to see opportunities for both performance and valuation growth. The suggested targets are Yili and Mengniu, while New Hope Dairy is recommended, and attention should be paid to small and medium-sized dairy enterprises and leading ranches, including Xinjiang Tianrun Dairy, YOURAN DAIRY, and CH MODERN D. Risk warning: Unexpectedly lower feed costs may hinder inventory destocking; demand recovery may be slower than expected.