Hua Chuang Securities: The upturn in the dairy sector has been established; it is recommended to allocate along three main lines.

Huachuang Securities released a research report stating that the price of raw milk has declined from its peak in October 2021 for over four years, with a cumulative drop of about 30%. The duration and extent of this adjustment have exceeded the previous two cycles. However, since mid-July, dairy prices have shown a year-on-year increase earlier than the market's neutral expectation for the second half of 2026. An upward cycle has been established, and a sector-wide recommendation for the dairy industry is suggested, with three main lines of investment: first, the reversal and elasticity of raw milk; second, sector-wide improvement; and third, the growth of deep processing. Key points from Huachuang Securities include: Raw Milk Cycle: Demand Improves First, Supply Accelerates Later, and an Upward Cycle is Established 1) Demand improves first: The C-end liquid milk base is gradually stabilizing, forming the foundation of demand. Over the past five years post-pandemic, the compound growth rate of dairy products has remained positive, and China's dairy product output in the first half of 2026 has increased by 5.8% year-on-year, showing accelerated improvement. The B-end demand for deep processing is thriving, and domestic replacements are accelerating. According to our analysis, major dairy companies and specialized processing enterprises are currently planning to consume over 5 million tons of raw milk annually, accelerating production, and it is expected that the price gap between domestic and international milk will continue in 2026-2027, with the replacement process unlikely to reverse. At the same time, leading dairy companies are turning to full-volume acquisition and providing price incentives, further pushing the milk price upward. 2) Supply accelerates to relieve pressure: In the short term, increased milk production offsets the reduction of stock numbers. The output of fresh milk is still growing, but the cow herd structure indicates that starting in 2027, the number of breeding cows is expected to decline significantly, and the contraction in supply will continue at least until 2028. 3) It is expected that milk prices will rise in three stages: first, recovery to the breakeven line of 3.2-3.3 yuan/kg, then closing in on the normal profit level near 3.5 yuan/kg. If the reduction accelerates in 2028, it may further unlock upward elasticity. Upstream Farms: Cash Flow and Profitability Improve Sequentially, Valuation Unlocks Elasticity Under the dominance of declining costs, leading farms have seen profits grow year by year since 2024, excluding fair value losses. Free cash flow has turned positive, and interest-bearing debt has declined from its peak, entering a self-repair phase in the financial reports. However, the reported profits have been overshadowed by fair value losses, with YouRan's fair value loss in 2025 reaching 4.31 billion, resulting in a net profit reported as a loss of 430 million. Further breakdown of fair value losses shows: first, the depreciation of breeding cows occurs rigidly with the number of stock, and after the slowdown in herd expansion, the growth rate naturally declines, making it a slow variable; second, the loss from culling cattle depends on the disposal price difference and the quantity culled, which narrows as meat prices rise and excessive culling slows; third, the valuation reassessment of the herd will follow adjustments in milk price expectations, with an overall upward adjustment once a turning point is confirmed, representing a major elastic component. The bank estimates that for every 0.1 yuan/kg increase in milk price, YouRan/Modern (after consolidating Shengmu) can see profits increase by at least 1 billion/500 million to 1 billion. Downstream Dairy Enterprises: Two Major Switches Affect Transmission Intensity, Differentiation in Financial Reports The same upward movement in milk prices affects downstream dairy companies differently due to two major factors: first, the self-sufficiency rate of milk sources in business operations. During the downturn, the price difference between scattered milk and contracted milk once exceeded 2 yuan/kg, with small dairy companies consuming market share at lower prices. Market leaders internalized excess milk supply and recorded impairment in their reports, with pressure peaking in 2023-2024 and easing significantly in 2025. After the reversal, recovering shares, reducing promotions, and narrowing impairments will be realized simultaneously. Second, the financial aspect of accounting standards is different. Unlike IFRSs two-way fair value revaluation, the CAS cost model allows for one-way provisions, creating a firewall, resulting in YouRan reporting a loss of 1.05 billion under IFRS in 2023, while Yili recognized only 0.07 billion in actual investment income under CAS. Mengniu fully absorbed the losses of Modern. Additionally, Junlebaos internal consolidation under CAS and cost fluctuations have been recognized, while New Hope Dairy accounts using FVOCI, isolating its results from the profit statement, leading to distinctly different report forms reflecting the same cycle. Full Industry Chain Elasticity Spectrum: Elasticity Observed in Transmission and Rhythm In terms of elasticity strength, the degree of transmission from rising milk prices to financial reports determines it, with farms directly benefiting and having the greatest elasticity, while dairy companies realize indirect returns through self-sufficiency and joint ventures, showing much smaller magnitudes. Based on a calculation of a 0.1 yuan/kg rise in milk prices, leading farms can see increases of nearly 1 billion; Mengniu, while absorbing Modern (post-consolidation), may recover around 170 to 450 million, and Yili may only recognize an increase of about 140 million in cash profits from YouRan. In terms of realization rhythm, fair value revisions and joint venture profits can immediately impact financial reports, while recovering shares and reducing promotions require gradual realization in accordance with changes in the competitive landscape. Therefore, in the raw milk reversal cycle, the direct elasticity of representative dairy companies financial reports (fair value recovery and joint venture profit transmission) is expected to rank as follows: YouRan > Modern > Mengniu > Tianrun > Junlebao > New Hope Dairy > Yili > Miaoke, while recovering shares and narrowing impairments will contribute additional increases (Yili, Miaoke, and New Hope Dairy are expected to benefit mainly from these factors). Risk Warning: The reversal of raw milk prices may fall short of expectations, significant rises in feed costs, a steep decline in international milk prices dragging down domestic replacement processes, a drop in beef prices causing cattle culling losses to be less than expected, calculation errors, etc.