rating company buy biostime -...

Deutsche Bank Markets Research

Rating

Buy Asia China

Consumer Food & Beverage

Company

Biostime

Date 4 December 2013

Initiation of Coverage

Building a parenting and childcare platform; initiating with Buy

Reuters Bloomberg Exchange Ticker 1112.HK 1112 HK HSI 1112

Forecasts And Ratios

Year End Dec 31 2011A 2012A 2013E 2014E 2015E

Sales (CNYm) 2,189.0 3,381.9 4,695.8 6,206.0 8,211.8

EBITDA (CNYm) 709.6 1,031.5 1,383.3 1,766.0 2,365.9

Reported NPAT (CNYm) 527.4 743.1 820.4 1,241.4 1,642.3

Reported EPS FD(CNY) 0.88 1.23 1.36 2.05 2.71

DB EPS FD (CNY) 0.88 1.23 1.63 2.05 2.71

DB EPS growth (%) 50.3 40.9 31.8 26.2 32.2

PER (x) 11.7 12.0 30.1 23.8 18.0

EV/EBITDA (x) 5.9 6.3 19.7 15.1 11.0

DPS (net) (CNY) 0.62 0.87 0.95 1.44 1.91

Yield (net) (%) 6.0 5.9 2.0 3.0 3.9

Source: Deutsche Bank estimates, company data 1 DB EPS is fully diluted and excludes non-recurring items 2 Multiples and yields calculations use average historical prices for past years and spot prices for current and future years, except P/B which uses the year end close

From 'Small is Beautiful' to 'Bigger is Better'

________________________________________________________________________________________________________________

Deutsche Bank AG/Hong Kong

Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 054/04/2013.

Price at 3 Dec 2013 (HKD) 62.20

Price target - 12mth (HKD) 69.30

52-week range (HKD) 69.60 - 21.76

HANG SENG INDEX 23,910

Winnie Mak

Research Analyst (+852) 2203 6178 [email protected]

Price/price relative

0

15

30

45

60

75

12/11 6/12 12/12 6/13

Biostime

HANG SENG INDEX (Rebased)

Performance (%) 1m 3m 12m

Absolute 0.6 30.5 165.7

HANG SENG INDEX 2.8 6.8 9.8

Source: Deutsche Bank

Biostime’s visionary and return-focused management and its proven track record in monetizing vendor and customer relationship are driving the company's transformation from a brand to a platform. Our DCF-based target price of HKD69.3 is equivalent to 26.4x 2014E PE, a premium to peer average, as we expect Biostime to tap the mass market and become a comprehensive platform for parenting and childcare in the long term. Initiating with Buy.

Two winning decisions Biostime’s decision to expand into infant formula and focus on baby special stores are the key growth drivers of a 30% NPAT CAGR in 2013-15E. We believe its new specialty formula (ADiMIL) and continuous network expansion (20% CAGR to 26,200 POSs) will engage new customers (34% CAGR of member customers) and enhance cross-selling.

More winning decisions We expect Biostime’s new O2O channel to bring in 8% new customers by 2015, and bolster shopping convenience, enhancing cross-selling. In our view, the company plans to start a child psychology programme to help attract moms-to-be, who have a triple cross-selling potential than moms. Separately, we expect the company to be sitting on HKD4.3/share of cash (2013E) for M&As of baby product brands.

Premium to peers justified; initiating with Buy Our DCF-based target price of HKD69.3/share factors in a 3.1% RFR, 5.6% ERP, 1.3 beta, debt-free structure and 2% TG, all of which are in line with our valuation methodology for Chinese staple companies. The valuation implies 26.4x 2014E PE, the high end of its baby products peers and is justified by high 53% ROE and 0.9x PEG. We initiate coverage with a Buy rating. Key downside risks: government policy to curb growth of non-state-owned infant formula brands and overhang on expiration of major shareholders’ lock-up period.

4 December 2013

Food & Beverage

Biostime


Model updated:04 December 2013

Running the numbers

Asia

China

Food & Beverage

Biostime Reuters: 1112.HK Bloomberg: 1112 HK

Buy Price (3 Dec 13) HKD 62.20

Target Price HKD 69.30

52 Week range HKD 21.76 - 69.60

Market Cap (m) HKDm 37,463

USDm 4,832

Company Profile

Biostime sells infant formula, probiotic supplements, nutrition supplements and dried baby food and baby care products under its own brands. The company also maintain a VIP membership programme, which offers customer service, information sharing, nursing consulting to members.

Price Performance

0

15

30

45

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75

Dec 11Mar 12Jun 12Sep 12Dec 12Mar 13Jun 13Sep 13

Biostime HANG SENG INDEX (Rebased)

Margin Trends

2627

29303233

10 11 12 13E 14E 15E

EBITDA Margin EBIT Margin

Growth & Profitability

010203040506070

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40

60

80

100

10 11 12 13E 14E 15E

Sales growth (LHS) ROE (RHS)

Solvency

-120-100

-80-60-40-20

0

10 11 12 13E 14E 15E

Net debt/equity (LHS) Net interest cover (RHS)

Winnie Mak +852 2203 6178 [email protected]

Fiscal year end 31-Dec 2010 2011 2012 2013E 2014E 2015E

Financial Summary

DB EPS (CNY) 0.58 0.88 1.23 1.63 2.05 2.71Reported EPS (CNY) 0.58 0.88 1.23 1.36 2.05 2.71DPS (CNY) 0.17 0.62 0.87 0.95 1.44 1.91BVPS (CNY) 2.6 2.8 3.2 3.6 4.2 5.0

Weighted average shares (m) 456 602 602 602 602 602Average market cap (CNYm) 3,983 6,161 8,917 29,440 29,440 29,440Enterprise value (CNYm) 2,254 4,187 6,466 27,208 26,701 26,102

Valuation MetricsP/E (DB) (x) 15.0 11.7 12.0 30.1 23.8 18.0P/E (Reported) (x) 15.0 11.7 12.0 36.0 23.8 18.0P/BV (x) 3.35 3.80 6.03 13.66 11.65 9.75

FCF Yield (%) 9.1 7.9 10.1 1.4 3.6 5.2Dividend Yield (%) 1.9 6.0 5.9 2.0 3.0 3.9

EV/Sales (x) 1.8 1.9 1.9 5.8 4.3 3.2EV/EBITDA (x) 6.7 5.9 6.3 19.7 15.1 11.0EV/EBIT (x) 6.8 6.0 6.4 20.1 15.5 11.4

Income Statement (CNYm)

Sales revenue 1,234 2,189 3,382 4,696 6,206 8,212Gross profit 877 1,456 2,229 3,054 3,921 5,051EBITDA 339 710 1,031 1,383 1,766 2,366Depreciation 7 13 22 27 42 86Amortisation 0 0 0 0 0 0EBIT 332 697 1,009 1,357 1,724 2,280Net interest income(expense) 2 17 41 34 35 48Associates/affiliates 0 0 0 0 0 0Exceptionals/extraordinaries 0 0 0 -163 0 0Other pre-tax income/(expense) 0 0 0 0 0 0Profit before tax 334 714 1,051 1,227 1,759 2,328Income tax expense 68 187 307 407 518 685Minorities 0 0 0 0 0 0Other post-tax income/(expense) 0 0 0 0 0 0Net profit 266 527 743 820 1,241 1,642

DB adjustments (including dilution) 0 0 0 165 2 2DB Net profit 266 527 743 986 1,244 1,645

Cash Flow (CNYm)

Cash flow from operations 380 527 943 554 1,153 1,588Net Capex -18 -39 -39 -150 -108 -64Free cash flow 363 488 903 405 1,045 1,524Equity raised/(bought back) 1,372 12 -57 0 0 0Dividends paid -146 -180 -404 -624 -538 -925Net inc/(dec) in borrowings -1 0 271 0 0 0Other investing/financing cash flows 7 -233 -858 -65 -91 -45Net cash flow 1,594 86 -145 -285 416 555Change in working capital 83 -77 115 -382 -242 -307

Balance Sheet (CNYm)

Cash and other liquid assets 1,728 1,814 1,669 1,384 1,800 2,355Tangible fixed assets 31 59 77 200 265 243Goodwill/intangible assets 1 1 1 1 1 1Associates/investments 0 160 1,053 1,118 1,209 1,254Other assets 141 403 734 1,113 1,581 2,108Total assets 1,902 2,438 3,533 3,817 4,857 5,961Interest bearing debt 0 0 271 271 271 271Other liabilities 344 754 1,354 1,391 2,060 2,670Total liabilities 344 754 1,625 1,662 2,330 2,941Shareholders' equity 1,558 1,684 1,909 2,155 2,527 3,020Minorities 0 0 0 0 0 0Total shareholders' equity 1,558 1,684 1,909 2,155 2,527 3,020Net debt -1,728 -1,814 -1,399 -1,114 -1,530 -2,084

Key Company Metrics

Sales growth (%) nm 77.5 54.5 38.9 32.2 32.3DB EPS growth (%) na 50.3 40.9 31.8 26.2 32.2EBITDA Margin (%) 27.5 32.4 30.5 29.5 28.5 28.8EBIT Margin (%) 26.9 31.8 29.8 28.9 27.8 27.8Payout ratio (%) 29.0 70.5 70.9 70.0 70.0 70.0ROE (%) 17.0 32.5 41.4 40.5 53.1 59.3Capex/sales (%) 1.4 1.8 1.2 3.2 1.7 0.8Capex/depreciation (x) 2.5 3.0 1.8 5.6 2.6 0.7Net debt/equity (%) -110.9 -107.7 -73.3 -51.7 -60.5 -69.0Net interest cover (x) nm nm nm nm nm nm

Source: Company data, Deutsche Bank estimates

4 December 2013

Food & Beverage

Biostime


Investment thesis

From ‘Small is Beautiful’ to ‘Bigger is Better’

Biostime’s visionary and return-focused management has made two winning decisions: 1) expanding into infant formula; and 2) focusing on baby special stores. Supported by proven vendor and customer relationship management (VRM and CRM) as illustrated by high POS productivity, rising cross selling rate and vibrant product pipeline, the result is a 67% NPAT CAGR over 2011-12.

In the near term, we believe Biostime’s new products (ADiMIL brand specialty formula, diapers, etc.) and additional POSs (20% CAGR to 26,200) will engage new customers (34% CAGR to 3.4m member customers) for more cross-selling, and thus we forecast a 30% NPAT CAGR over 2013-15.

We think Biostime’s next winning decisions could be 1) an online-to-offline (O2O) platform leveraging on productive VRM and CRM; 2) the launch of a child psychology and education programme to engage customers from the pregnancy stage to over seven years compared to three years currently (i.e. child aged 0-3); and 3) M&A of other baby product brands.

To quantify the immediate impact of these decisions, we expect the new O2O platform to engage 8% additional active members in 2015. We think the child psychology programme could help engage moms-to-be. Based on Biostime’s 1H13 cross-selling rate, every RMB100 sales to a mom-to-be could bring additional RMB47 sales of infant formula and other baby products to Biostime;this compared to RMB15 additional sales from cross-selling for every RMB100 sales to a mom-to-be for infant formula. Separately, we expect the company to hold RMB2bn (including long-term deposits) or HKD4.3/share in net cash) in 2013E for M&As.

Management’s philosophy is to scale up a profitable model, instead of scaling up to achieve profitability. As such, the company starts from a niche market. In the long term, we think Biostime could leverage on the by-then-established O2O platform and enter the mass market without heavy investment in the channel. It could also open its platform to third-party brands, making it a comprehensive parenting and childcare platform.

Valuation and risks

Our DCF-based target price of HKD69.3/share factors in a 3.1% RFR, 5.6% ERP, 1.3 beta, debt-free structure and 2% TG, all of which are in line with our valuation methodology for Chinese staple companies. The valuation implies 26.4x 2014E PE, which is at the high end of its baby products peers in China and the rest of the world. This premium to peer average is justified by visionary management, sophistic VRM and CRM, scalable business model and good corporate governance practice. We initiate coverage with a Buy rating.

Key downside risks: government policy to curb growth of non-state-owned infant formula brands, and overhang on expiration of major shareholders’ lock-up period.

4 December 2013

Food & Beverage

Biostime


Valuation and risks Figure 1: Baby product brands/producers comparison (3 December 2013 closing price) Company Code Curr Price Mkt cap Rec TP (local

curr)PE (x) EPS change ROE (%) Yield (%)

(USDm) CY14E CY15E CY14E CY15E CY14E CY15E CY14E CY15E

Hengan 1044.HK HKD 95.7 15,233 Buy 92.5 23.3 20.0 27% 17% 34.0 34.6 2.5 2.9

Yili 600887 CH CNY 39.9 13,583 NR NA 25.0 20.1 18% 24% 20.3 20.7 1.0 1.3

Biostime 1112 HK HKD 62.2 5,026 Buy 69.3 23.8 18.0 26% 32% 53.0 59.2 3.0 3.9

Beingmate 002570 CH CNY 31.1 3,228 NR NA 20.6 16.5 26% 25% 21.0 21.6 1.6 1.8

Yashili 1230 HK HKD 4.7 2,176 NR NA 20.7 16.2 18% 28% 18.5 22.0 2.7 3.2

Goodbaby 1086 HK HKD 4.2 547 NR NA 16.2 13.1 21% 23% 12.4 14.0 1.8 2.2

HK/China listed baby product brands/producers avg 21.6 17.3 23% 25% 26.5 28.7 2.1 2.6

Danone BN FP EUR 52.4 46,082 Hold 50 17.6 16.1 26% 9% 13.6 14.0 3.2 3.5

Mead Johnson MJN.N USD 85.2 17,126 Buy 86 23.1 NA 8% N/A 610.2 NA 1.9 NA

Unicharm 8113 JP JPY 6,450 13,076 NR NA 30.2 26.1 14% 15% 12.6 12.9 0.6 0.7

Pigeon 7956 JP JPY 5,010 1,992 NR NA 27.1 23.7 19% 14% 19.8 20.5 1.7 1.9

Synutra SYUT US USD 8.6 492 NR NA 14.7 12.9 42% 15% NA NA NA NA

Synlait SML NZ NZD 3.8 451 NR NA 24.1 20.4 32% 19% 13.8 13.3 NA NA

Les Enphants 2911 TT TWD 23.5 172 NR NA 26.9 NA 2259% NA NA NA NA NA

Pumpkin Patch PPL NZ NZD 0.8 112 NR NA 14.0 10.9 21% 28% 17.9 20.9 2.2 4.4

Tung Ling 2924 TT TWD 57.9 62 NR NA NA NA NA NA NA NA NA NA

Other listed baby product brands/producers avg 22.2 18.4 303% 17% 114.7 16.3 1.9 2.6 Source: Bloomberg Finance LP, Deutsche Bank

Figure 2: % of baby products and China revenue comparison (latest full-year report) Company % of baby products % of China % of emerging mkt Remarks

Hengan 15% 92% 92%

Yili 11% 100% 100% Milk powder sales include adult milk powder

Biostime 100% 100% 100%

Beingmate 100% 100% 100%

Yashili 86% 100% 100% Other products include cereal, soybean milk powder

Goodbaby 100% 29% >43%

Danone 20% NA >36%

Mead Johnson 98% 30% 69% % of emerging mkt refers to Asia and Latin America

Unicharm 43% 15% NA

Pigeon 91% 17% c. 27%

Synutra Intl 100% 100% 100%

Synlait 100% NA NA 39% owned by Bright Dairy (600597 CH, NR)

Les Enphants 71% NA NA Children’s wear and accessory supplier

Tung Ling 100% NA NA A children’s wear producer

Yih Dah 99% NA NA A children’s wear producer and distributor

Pumpkin Patch 100% NA N/A A children’s wear and accessory retailerSource: Bloomberg Finance LP, Company data

4 December 2013

Food & Beverage

Biostime


Trading at 23.8x 2014E PE, fair PEG and high ROE

Biostime is one of the most geared plays to China’s two-child policy. At current price, Biostime is trading at 23.8x 2014E PE, or 10% and 7% premium to the average of peers listed in HK/China and rest of the world (RoW), respectively, but at 0.82x PEG (CY14E PE/14-15E EPS CAGR), it is trading at a slight discount to the average 0.89x PEG of HK/China listed peers. In addition, its asset-light model warrants a relatively high ROE.

Figure 3: CY14E PE/14-15E EPS CAGR comparison

HK/China avg = 0.89x RoW avg = 1.13x


DCF-based target price of HKD69.3/share

Our DCF model for Biostime factors in Deutsche Bank’s China COE (3.1% risk-free rate and 5.6% equity risk premium), 1.3 beta (to reflect the policy risks on import infant formula), debt-free structure and 2% terminal growth at the end of our 10-year explicit forecast period, all of which are within the range of assumptions we use for Chinese staple companies. We set our DCF-based target price at HKD69.3/share, equivalent to 26.4x 2014E PE and 0.9x PEG, which is at the high-end of other listed baby product brands/producers.

We think it is justified by: 1) strong 30% NPAT CAGR over 2013-15E, which is reflected in a 0.9x PEG (based on our target price ), comparable to HK/China listed peers; and 2) a relatively high ROE, which is partly by nature following its light-asset model and is also a report card which illustrates a successful return-focused management. Note also that Biostime’s relatively high ROE is primarily operational, as it would hold HKD4.3/share of net cash (including long term deposits) as of end-2013E (82% of 2013E BV). We believe it is highly likely that future M&A(s) will not dilute its ROE. We initiate coverage on the stock with a Buy recommendation.

4 December 2013

Food & Beverage

Biostime


Key downside risks and sensitivity analysis

What if the government implements measures to limit infant formula import? We believe the PRC government aims at 1) promoting domestic infant formula brands/producers, in particular state-owned brands, although we have been waiting for new policies that will promote the consolidation of local brands since June 2013; and 2) a stable infant formula price, as illustrated by the result of anti-trust investigations in July 2013. To achieve its targets, we look into the opportunities arising from the government’s initiatives to:

limit the volume of infant formula import to promote domestic brands. It could be detrimental to Biostime, but we believe that: 1) infant formula imports are crucial to feed the babies, as China does not have competitive advantage in milk powder production given the supply shortage of raw milk; 2) Chinese companies have been actively investing in milk powder production outside of China. Hence, it is difficult for the government to impose restrictions on selective infant formula import without triggering trade dispute(s). However, the government has tightened inspection and quarantine of import infant formula. This is the major reason behind our assumption of a lengthening inventory cycle for Biostime (from 130 days in 2012 to 189 days in 2015E). Assuming volume sales of infant formula is 5% lower than our forecast, our 2014-15E NPAT forecast will be adversely affected by c. 7%.

limit price increase of infant formula. We believe prices will be under government’s scrutiny, and hence we do not expect Biostime to hike prices on a like-for-like basis (after the price cut following the anti-trust investigation) in 2013-15E. On the contrary, due to dilution by lower-margin high-end infant formula, we expect its ASP of infant formula to decline at 4% CAGR over 2013-15E. Assuming ASP of infant formula is 5% lower than our forecast, our 2014-15E NPAT forecast will be adversely affected by c. 7%.

Figure 4: Chinese companies’ overseas milk powder investment Company Date Investment/cooperation

Yili Nov-13 Forms strategic partnership with Italy's largest dairy producer Sterilgarda Alimenti S.p.A., allowing Yili to upgrade its technology and improve the quality of its liquid milk.

Yashili Aug-13 Approval from New Zealand government to build a milk powder processing plant with total investment at RMB1.1bn.

Yili Jul-13 Signs memorandum on strategic cooperation with Dairy Farmers of America (DFA), the largest milk company in the US with 8,500 dairy farms.

Yili Dec-12 Announces acquisition of Oceania, which will build a 47,000 tonne-infant formula project in New Zealand for RMB1.1bn (completion scheduled in phases starting June 2014).

Synutra Sep-12 Signs JV agreement with Sodiaal, with Synutra investing EURO90m for a 90% stake in the JV, for a 100,000 tonne infant formula plant in France (completion scheduled for 2015).

Bright Dairy Nov-10 Acquires 51% stake in New Zealand milk processor Synlait for RMB382m.

Source: Company data; Deutsche Bank

4 December 2013

Food & Beverage

Biostime


Figure 5: Sensitivity analysis on infant formula volume sales 2014E 2015E 2014E 2015E

Change from base case (RMBm) (RMBm) (%) (%)

+15% 1,505 1,987 21.2% 21.0%

+10% 1,417 1,872 14.2% 14.0%

+5% 1,329 1,757 7.1% 7.0%

Base case NPAT (RMBm) 1,241 1,642

-5% 1,154 1,527 -7.1% -7.0%

-10% 1,066 1,413 -14.2% -14.0%

-15% 978 1,298 -21.2% -21.0%Source: Deutsche Bank estimates

Figure 6: Sensitivity analysis on infant formula ASP 2014E 2015E 2014E 2015E

Change from base case (RMBm) (RMBm) (%) (%)

+15% 1,532 2,025 23.4% 23.3%

+10% 1,430 1,890 15.2% 15.1%

+5% 1,333 1,762 7.3% 7.3%

Base case NPAT (RMBm) 1,241 1,642

-5% 1,157 1,533 -6.8% -6.7%

-10% 1,081 1,434 -12.9% -12.7%

-15% 1,014 1,349 -18.3% -17.9%Source: Deutsche Bank estimates

During the China National Development and Reform Commission’s (NDRC) anti-trust review of the infant formula industry’s resale pricing practices in June/July 2013, Biostime was not the only company under investigation, but it was the first company to inform the public of the investigation. While Biostime’s action complied with the Listing Rule in Hong Kong (the Inside Information Provisions, which imposes statutory obligations on issuers and their directors to disclose inside information as soon as reasonably practicable after the information has come to the listed issuers’ knowledge), the company was heavily penalized by the NDRC with a fine of RMB163m, equivalent to 6% of its 2012 infant formula revenue, thus eating up 17% of 2013E core NPAT. It nevertheless demonstrates Biostime’s good corporate governance practices.

Food safety concerns, whether real or perceived, regarding Biostime’s products could result in product liability, damage reputation and reduce sales, and could subject the company to regulatory action. Other operational downside risks include intensified competition, unit cost hike, failure to expand distribution network.

Expiration of three-year lock up period may create any overhang in the stock. Biostime listed on HKSE main board on 17 December 2010, with Biostime Pharmaceuticals (BP – owned by founders of Biostime) holding 74.7% of the company. The breakdown of the effective stake is listed in Figure 7. BP is subject to a three-year lock up period. The expiration of the lock-up period could create an overhang on the stock, although we think it will not affect the company’s long-term value. Meanwhile, Biostime’s recent share price performance has been relatively weak (see Figure 8).

4 December 2013

Food & Beverage

Biostime


Figure 7: Major shareholders of Biostime Name Eff stake Current position with Biostime Remarks

Luo Fei 21.0% Chairman, CEO and Executive Director

Wu Xiong 19.4% Non-executive Director Not participating in the day-to-day management

Luo Yun 14.6% Non-executive Director Not participating in the day-to-day management

Chen Fufang 8.9% Non-executive Director Not participating in the day-to-day management

Zhang Wenhui 7.5% Non-executive Director Was CTO and Executive Director before Jun 2012

Kong Qingjuan 3.3% COO and Executive Director Source: Company data; Deutsche Bank

Figure 8: Peer group total return comparison Total return (%)

Company 1 week 1 month 3 month 6 month YTD

Hengan 2.8 2.8 14.8 14.5 42.5

Yili 0.6 (1.5) 4.8 39.3 78.8

Biostime (9.8) 1.5 36.4 46.3 166.9

Beingmate (3.7) (6.0) (10.3) 7.1 110.3

Yashili (7.1) 30.7 30.7 44.7 168.1

Goodbaby (3.3) 8.4 14.7 (2.8) 49.3

Danone (2.8) (1.7) (5.9) (5.9) 9.7

Mead Johnson 0.8 3.2 13.2 5.2 30.1

Unicharm (1.5) 7.3 24.3 14.3 44.8

Pigeon (1.2) (0.1) 8.9 21.9 145.1

Synutra Intl 14.2 41.0 100.6 104.9 108.0

Synlait (0.5) 4.9 18.2 NA NA

Les Enphants - 1.5 10.0 19.1 9.0

Tung Ling 0.7 6.0 10.9 16.2 (0.4)

Yih Dah 1.6 2.7 NA (21.8) (33.4)

Pumpkin Patch - (11.5) (8.6) (22.7) (36.6)Source: Bloomberg Finance LP

In addition, Biostime has had a track record of providing conservative guidance, and the market has therefore adjusted itself by putting a mark-up over management projection. As a result, it is increasingly difficult for Biostime to beat market consensus. For instance, management guidance for 2013 revenue growth is 30% compared with our forecast of 39% and market consensus of 42%. On the contrary, risk is building up as expectation could be too high, e.g. our 2014 forecast is RMB1,241m, comparable to the market consensus of RMB1,285m, but 22% lower than the highest forecast of RMB1,585m.

4 December 2013

Food & Beverage

Biostime


Competitive advantages

Partnership, not just distributorship

Major consumer brands in China, after spending decades to build scalable nationwide distribution network, are now working hard to build partnerships with distributors, e.g. Tsingtao (168 HK, Hold), shortening distribution hierarchy, installing POS system to accelerate response time and improving channel inventory management, e.g. Tingyi (322 HK, Hold), Want Want (151 HK, NR) and Belle (1880 HK, Hold). Biostime has taken the other way round, i.e. after building a partnership with distributors and retailers and a sophisticated real-time POS system, it is now scaling up.

In China, most of infant formula and baby product brands have a multi-tier distribution system, leaving room for malpractices, e.g. distributors selling products online at a discount and competing directly with retailers are leading to destructive competition. Biostime’s partnership, which is built on a transparent and consistent incentive scheme, timely reimbursement, effective anti-channel conflict measures and alignment of benefits between brand and distributor, is one of the few proven solutions to deal with such malpractices.

Productive vendor relationship management Such a partnership is rewarded by high productivity. Based on 1H13 reported results, Biostime’s average monthly revenue/POS was RMB20,690, 9x that of Yashili’s and 3.8x that of Goodbaby’s.

Figure 9: POS productivity comparison (1H13) Biostime Yashili Goodbaby

Baby specialty stores 11,402 13,592

Modern channel 4,382 5,789

Others 822 Online

Total POSs (end Dec 12) 16,606 105,000 19,381

2012 revenue (RMBm) 2,062 2,153 635(China rev)

Monthly revenue/POS (RMB) 20,690 3,417 5,461 (based on offline stores only)


The high productivity is also partly due to the active replacement of non-performing POSs. Based on the stores available for same-store sales growth (SSSG) comparison, loss of POSs joined in or before 2010 was only 3-7%, but higher at 9-10% for stores joined in 2011. Part of such losses was due to stores shutting down or dropping out, but most of such losses was due to Biostime’s proactive move to replace non-productive stores, in particular in early years. As it keeps only the crème de la crème in the camp, old stores are still growing, reporting 9.8-21.4% SSSG in 1H13.

4 December 2013

Food & Beverage

Biostime


Figure 10: POSs for SSSG comparison Baby specialty stores Supermarkets

Joining year Jun-12 Jun-13 yoy change Jun-12 Jun-13 yoy change

2008 or before 1,812 1,708 -6% 481 466 -3%

2009 788 756 -4% 451 428 -5%

2010 1,199 1,113 -7% 608 582 -4%

2011 2,221 2,022 -9% 888 799 -10%Source: Company data; Deutsche Bank

Figure 11: SSSG comparison Baby specialty stores Supermarkets

Joining year Avg monthly points SSSG Avg monthly points SSSG

In or before 2008 43,686 13.6% 40,034 19.4%

2009 36,576 9.8% 37,875 27.6%

2010 30,853 21.4% 26,900 33.0%

2011 25,111 51.3% 21,031 67.9%

2012 17,488 115.7% 12,061 229.5%

2013 6,057 NA 3,936 NASource: Company data; Deutsche Bank

Favourable to new product launch We expect Biostime’s POSs to reach 26,200 in 2015, including 18,000 baby specialty stores. In the near term, we believe such partnership enhances success rate of new product launches, or else distributors/retailers usually have reservation on stocking new products. Biostime launched a new ADiMIL brand infant formula in September 2013. We expect ADiMIL to account for 12% of its total infant formula sales in 2014.

We also expect ADiMIL to become a RMB1bn brand (by retail sales value) in three years. Note that it took three years for Biostime’s brand infant formula (launched in 2008) to become a RMB1bn brand (by retail sales value). Although competition is intense now than three years back, Biostime has a much stronger distribution network than in 2008 to combat competition.

Figure 12: Biostime’s network expansion plan End 2012 As of 30 Sep 2013 2013E 2015E

Baby specialty stores 10,404 12,014 13,000 18,000

Modern channel 4,174 4,477 4,800 6,200

Pharmacies 744 867 1,000 2,000

Total 15,322 17,358 18,800 26,200Source: Company data; Deutsche Bank estimate

4 December 2013

Food & Beverage

Biostime


Figure 13: Biostime’s network expansion (2010-September 2013)

3,687

6,277

10,404 12,014

1,716

2,968

4,174

4,477

301

545

744

867

‐

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

20,000

2010 2011 2012 30‐Sep‐13

Mama 100 Member's Zones (pharmacies)

Retail sales organizations

VIP baby specialty stores

9,790

15,322

17,358

Source: Company data

Proven track record of monetizing data, not just analyzing

VRM and CRM on one common Mama100 platform Biostime’s two-tier management system seamlessly covers both vendor level (vendor relationship management VRM) and end customers/members (customer relationship management CRM) through one common platform, Mama100.

Biostime adopts a Mama100 points system as an incentive scheme to enhance customer loyalty. The Mama100 membership is free, and for each purchase members get points, which can be used to redeem products or services. Members can also use the Mama100 hotline for product information and nursing consultancy services. All calls to Mama100 hotline are documented. In 2012, its Mama100 call centre handled 226,291 calls on average on a monthly basis/7,500 calls daily, up 22% yoy.

Over 80% of Biostime’s POSs are connected by Mama100 points POS system, through which the company gets real time information regarding members’ transactions. The points system applies to vendors as well, and store operators get incentives for each recorded transaction. In addition, the company started installing payment system to Mama100 points POS machine in 1H13, thus combining payment and points crediting/redemption and easing the workload of store operators.

4 December 2013

Food & Beverage

Biostime


Figure 14: Active members and % of sales by members

1,854,607

91%

-

200,000

400,000

600,000

800,000

1,000,000

1,200,000

1,400,000

1,600,000

1,800,000

2,000,000

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2007 2008 2009 2010 2011 2012 1H13 9M13

Active members (end of period)

% of sales by active member

Source: Company data

On productivity and cross-selling While we believe strong partnership helps ensure productivity, it is the company’s active management driving high productivity, e.g. Biostime keeps inventory count on members and sends daily reminders to store keepers/promoters (also through the points POS machine), urging them to call specific members for replenishment.

Biostime uses personalised marketing based on members’ data to drive cross-selling. To illustrate, from June 2011 to June 2013, Biostime’s cross-selling rate 1) from infant formula (the largest revenue contributor) to baby cereals and probiotic sachet increased from 13-14% to 15-18%; and 2) from all other products to probiotic sachet (the second largest revenue contributor) increased from 13-16% to 18-21%. While the cross-selling rate from mother formulas to all other categories is the highest, reflecting pregnancy stage as a critical customer engagement period, Biostime has been conducting a study on a child psychology programme since 2012, partly as it will help in engaging moms-to-be, and in the long run help extend their lifecycle to beyond three years (i.e. child age of 0-3).

Figure 15: Cross-selling rate for the six months ended 30 Jun 2013 (A to B)

B A Mother

formulas Infant

formulas Baby cereals Probiotic

sachetBaby diapers

Mother formulas 2.5% 2.9% 2.9% 3.8%

Infant formulas 30.1% 13.4% 14.2% 14.5%

Baby cereals 16.3% 14.8% 13.0% 17.8%

Probiotic sachet 19.6% 18.0% 17.8% 20.6%

Baby diapers 7.9% 4.6% 5.9% 5.4%Source: Deutsche Bank

Figure 16: Cross-selling rate for the three months ended 30 Jun 2011 (A to B)

B A Mother

formulas Infant

formulas Baby cereals Probiotic

sachetBaby diapers

Mother formulas 2.1% 2.1% 2.3% 2.3%

Infant formulas 24.1% 15.8% 15.1% 10.0%

Baby cereals 15.3% 12.7% 11.5% 13.9%

Probiotic sachet 13.9% 13.8% 16.2% 12.6%

Baby diapers 8.3% 6.0% 7.9% 6.2%Source: Deutsche Bank

4 December 2013

Food & Beverage

Biostime


On pricing The price gap between Biostime’s Stage 1 and 3 infant formulas (1-9%) is narrow as compared to its peers (mostly 11-31%). We understand from management that it is a result of consumer survey and data analyzing, that Biostime consumers are indifferent to the price difference between Stage 1 and 3, as long as they (together with the babies) are satisfied with the quality.

Figure 17: High-end infant formula retail price of leading infant formula companies (RMB200-300/900 can) Company Brand Series Price (RMB/100g)

Stage 1 Stage 2 Stage 3 Price diff

Mead Johnson Enfa A+ 28 23.7 21.4 31%

Nestlé Wyeth S-26 25.6 24.8 22 16%

Danone Dumex Precigro 25.8 23.9 22 17%

Nutricia Karicare 24.4 23.3 21.1 16%

Nutricia Nutrilon 24.4 24.4 22.2 10%

Hangzhou Beingmate Beingmate Love+ 27.7 26.3 25.3 10%

Biostime International# Biostime Golden Care 26.4 25.3 24.2 9%

Biostime Premium 32.2 32.0 30.9 4%

Yashili International Yashili Ambery 27.6 25.8 23.9 15%

Yashili a-Golden Stage 24.2 23.1 20.9 16%

Abbott Laboratories Abbott Gold High Q+Shield 27.9 24.7 21.8 28%

Inner Mongolia Yili Yili Pro-Kido 25.4 22.9 20.7 23%

Wonder Sun Dairy Wondersun Gold 25.3 24.2 22 15%

Wondersun Zhenyi 26.4 25.1 23.8 11%

Wondersun Shiji Beibei 23.9 23.6 23.3 2%Source :Respective Tmall flagship, #Mama 100; all price on 28 Nov 2013

Figure 18: Supreme infant formula retail price of leading infant formula companies (>RMB300/900 can) Company Brand Series Price (RMB/100g)

Stage 1 Stage 2 Stage 3 Price diff

Nestlé SA Wyeth Illuma 45.3 43.1 40.9 11%

Nan Super Nan 43.6 41.1 37.3 17%

Hangzhou Beingmate Group Co Ltd Beingmate Golden Love + 35 33.3 32.3 8%

Biostime International Holdings Ltd Biostime Supreme 40.9 39.8 38.7 6%

Biostime Supreme Care 51.1 50.9 50.7 1%

Yashili International Holdings Ltd Scient Merla 37.2 35.0 35.0 6%

Yashili a-Golden Stage Super 37.3 35 32.8 14%

Yashili Ambery Gold 42.3 39.8 37.3 13%

Abbott Laboratories Inc Abbott Essence 52.2 50 43.3 21%

Abbott Gold Total Comfort 42.9 40.1 38.5 11%

Wonder Sun Dairy Co Ltd Wondersun Anlicong 36.4 34.2 32 14%Source: Respective Tmall flagship, #Mama 100; all price on 28 Nov 2013

This is proven by Biostime’s stable market share across the three different stages. This is one of the many examples of Biostime monetizing on the information collected from members’ transactions (products, frequency, preferred POSs, etc.) and communication with consultants through Mama100 service hotline/website, by applying on product development and pricing. We compared Biostime’s infant formula sales breakdown by Stage 1 to 3 with China’s total infant formula sales (based on Euromonitor estimates), and confirm that Biostime’s pricing strategy does not affect the sales of its Stage 2 and 3 products.

4 December 2013

Food & Beverage

Biostime


Figure 19: Market share of Stage 1-3 infant formula 2008 2009 2010 2011 2012 2013E^

Stage 1

Nestlé SA# 11.4 11.4 10.8 10.6 11.0 11.3

Danone, Groupe 10.0 9.5 8.9 8.5 9.1 10.0

Mead Johnson Nutrition Co* 8.8 9.2 9.6 11.5 9.4 9.3

Yashili International Holdings Ltd 11.4 8.2 7.7 6.3 6.7 6.9

Biostime International Holdings Ltd 0.2 0.9 2.4 4.0 5.3 6.6

Stage 2

Danone, Groupe 11.2 10.3 10.3 10.2 11.0 12.2

Hangzhou Beingmate Group Co Ltd 6.6 9.4 10.2 11.7 12.0 11.9

Nestlé SA# 8.5 8.2 8.3 8.4 9.0 9.5


Biostime International Holdings Ltd 0.2 0.7 2.0 3.5 4.8 6.2

Stage 3


Hangzhou Beingmate Group Co Ltd 7.6 10.7 10.9 11.9 11.6 11.0

Nestlé SA# 9.5 9.9 9.7 9.5 10.2 10.7

Danone, Groupe 11.1 10.5 9.9 9.3 9.3 9.3

Biostime International Holdings Ltd 0.2 0.8 2.0 3.6 4.7 6.1Source: Euromonitor; * incl. Bristol-Myers Squibb Co; # incl. Pfizer and Wyeth ^Euromonitor forecast

Figure 20: Biostime’s infant formula sales (2013E) Figure 21: China infant formula sales (2013E)

Stage 130%

Stage 227%

Stage 343%

Stage 128%

Stage 227%

Stage 345%

Source: Euromonitor Source: Euromonitor

On product development Biostime’s new ADiMIL brand is tailored to 1) recruit new customers with minimal cannibalization with its core brand; and 2) enhance cross-selling. Based on the company’s survey, in the first two months 1) 70% of ADiMIL buyers were new customers; and 2) 30% buyers were Biostime’s existing infant formula customers (i.e. cannibalization). In April 2013, the company had launched a food-class probiotic powder for children, which is a major driver of the 39% yoy revenue increase from probiotic supplements in 1H13.

Separately, Biostime’s cross-selling rate from all other products to diapers fell across-the-board from June 2011 to June 2013. According to management, diaper consumers are price sensitive (unlike infant formula), and Biostime’s diapers at RMB2.8-3.1/piece are not competitive. In 2014, Biostime plans to re-launch its own brand diaper at a more competitive price, which we expect will help drive cross-selling rate.

4 December 2013

Food & Beverage

Biostime


Figure 22: Diaper retail price (RMB/piece) Brands Series S M L

Biostime* BM Care Premium 2.81 2.67 3.12

Pampers Premium Care 1.27 1.60 1.98

Huggies Platinum 1.96 2.5 3.02

Gold 1.21 1.76 2.21

Merries Pants 2.33 3.16 4.45

Super premium 1.5 1.71 2.00

Mamypoko Moony 1.42 1.86 2.20

Super dry 1.06 1.13 1.37

Normal dry 0.65 0.81 0.98

Hengan Flexi 1.33 1.68 1.84

Super absorption 1.01 1.42 1.49

Q-Mo 0.76 0.90 NASource: JD.com price on 3 Dec 2013, except *Mama 100

Visionary and return-focused management

Two winning decisions Looking into Biostime’s history, the company made two winning decisions: 1) launching infant formula; and 2) focusing on baby special stores.

Biostime started a joint R&D with Laiterie de Montaigu on infant formula in 2006. In July 2008, the company officially launched its Biostime brand infant formula in China. Also, in July 2008, the melamine scandal broke after 16 infants in Gansu Province, who had been fed on Sanlu brand milk powder, were diagnosed with kidney stones. While the timing was a coincidence, opportunities favoured the prepared mind, i.e. Biostime.

In 2008, Biostime lacked resources (politically and financially) to scale up as a new brand and a small private company. Given the limited resources, the company started with a sustainable business model focusing on return, which includes:

a light asset model, and therefore does not face the pressure to ramp up utilization;

a focused channel strategy, primarily on baby specialty stores due to the following reasons: 1) the channel allows cross-selling; 2) it has established relationship with baby specialty stores through probiotic supplement sales starting 2003; 3) reading the potential of baby specialty stores, which has evolved as a mainstream baby product channel over the past few years; and 4) baby specialty stores settle by cash on delivery, more favourable to Biostime;

careful working capital management, including channel inventory and cash on delivery; and

leveraging on a cross-selling platform. To begin with, Biostime is not an infant formula brand, and does not mean to be only an infant formula brand.

Baby specialty stores have grown to a mainstream distribution channel after 2008, as: 1) baby product consumers started looking for reassurance from specialty stores due to general food safety concerns; and 2) the Post-80s’ (the generation born in the 1980s) parents prefer baby specialty stores as a one-stop shop for baby products and also seek advice from storekeepers.

4 December 2013

Food & Beverage

Biostime


More winning decision(s) Biostime has a track record of making a well-thought product and marketing plan before a launch. For example, it started R&D on probiotic supplement in 2000 and launched the product in 2003; it started R&D on infant formula in 2006 and launched it in 2008. Also, after years of study, Biostime recently launched its O2O channel and plans to launch “Parenting Power” educational programme, both of which could become Biostime’s next driver(s).

O2O platform to leverage on productive vendor and consumer relationship In 2012, Biostime inaugurated its Mama100 mobile app, which enables its members to obtain information about parenting, make inquiries and redeem points through the app. In September 2013, the company upgraded the app to an O2O channel, as management believes mobile commerce will be mainstream commerce in future. At this stage, Biostime’s main focus is to switch more members to its O2O channel and bolster shopping experience to enhance cross-selling. We expect the new channel to recruit 8% additional active members in 2015.

We talked to a Biostime distributor, who is also a major childcare product distributor in Guangzhou. Apart from Biostime products, the distributor is the regional exclusive agent of baby cereal, baby nutritional supplement, toys, etc., for various local and foreign brands. The distributor started his own Tmall store two to three years back. He uses the Tmall store to clear inventory now, as well as to prepare for the potential change in consumer behaviour. This is because he believes that when the Post-90s (the generation born in the 1990s) become parents, e-commerce/m-commerce will become the mainstream distribution channels (compared with c.20% of total China infant formula sales in 1H13, according to Biostime).

While the O2O channel is a new channel to Biostime, we believe it is the beginning of the next chapter. As the O2O channel is built on its Mama 100 platform, or its well-built VRM and CRM system, we think Biostime is capable of converting O2O channel into a platform in the long run, through which, Biostime can also cover the mass market (e.g. infant formula < RMB200/900 can) without heavy investment in the channel, and vendors can also sell non-Biostime brand baby products. We think the competitive advantages of Biostime’s O2O model (compared to other vertical baby product platforms) are its well-established brand equity and productive vendor and customer relationship.

Given that the online competitive landscape has been changing rapidly, Biostime will only scale up when it develops a sustainable business model.

Education to extend member lifecycle The company plans to offer child psychology and early childhood courses 1) for free as part of promotional campaign when needed; and 2) for a fee; members can also redeem using their points, starting late 2014/early 2015. We think the child psychology courses, in particular, will help engage consumers as early as pregnancy stage, and based on Biostime’ high cross-selling rate from mother formulas (to all other products), we believe the early engagement will contribute positively to Biostime. In the long term, we expect Biostime to continue developing parenting and educational programmes to cover children aged 4-7, thus extending its member lifecycle (usually for parents with babies aged 0-3 now) further.

4 December 2013

Food & Beverage

Biostime


Company overview

Since 1999

Established in August 1999, Biostime launched the ’Biostime’ brand in 2003. It started as a probiotic supplement vendor and later diversified to dried baby food. It launched ‘Biostime’ brand infant formula in July 2008 and ‘BMcare’ brand baby care products in May 2010. The company’s product offerings cover four main categories: 1) infant formula (81% of 2013E revenue); 2) probiotic and nutrition supplements; 3) baby care products; and 4) dried baby food; under its own brands. The company produces probiotic supplement itself, and outsources manufacturing of all other products.

Figure 23: Key milestones Brand/product/service launch Corporate and others

1999 Established

2000 Starts probiotic supplement co-development with Lallemand

2003 Biostime brand probiotic supplement

2006 Starts infant formula co-development with Montaigu

2007 Biostime brand baby food

Mama 100 services launched

2008 Biostime brand infant formula GMP certification of Guangzhou production facility; Montaigu OEM contract signed

2009 Biostime brand baby cereal

2010 BMcare brand baby care products IPO

2011 Biostime brand nutrition supplement products Signs ISM OEM contract

2012 Signs Arla 10-year agreement, opens laboratory in France

2013 ADiMIL brand infant formula ISM equity and bond investment Source: Company data; Deutsche Bank

Figure 24: Biostime’s key product portfolio Products/brands Unit retail price (RMB) Launched Manufacturing

Infant formula

Biostime Supreme 348-368/900g 2008 OEM agreement with Cooperative Isigny Sainte Mere Biostime Premium 278-290/900g 2008

Biostime Supreme Care 456-460/900g 2008

Biostime Golden Care 218-238/900g 2010

Adimil Supreme 348-368/900g 2013

Adimil Premium 248-268/900g 2013

Probiotic and nutrition supplements

Probiotic sachets, tablets and capsules 63-296 2003 Owned facility

Milk calcium tablets and DHA soft chews/capsules, etc 48-296

Baby care products

Diapers; shampoo, bath gel and baby oil 58-88l 2010

Dried baby food

Baby cereals, dried fruit and vegetable powder, etc 40-98 2007Source: Deutsche Bank; Mama 100 on 29 Nov 2013

4 December 2013

Food & Beverage

Biostime


30% NPAT CAGR over 2013-15E

Infant formula continues to be near-term driver We expect Biostime’s revenue to grow at 34% CAGR over 2013-15E, mainly driven by 36% revenue CAGR from infant formula (81% of 2013E revenues). We expect revenues from baby care products to grow at 32% CAGR during the forecast period, largely due to the planned re-launch of own-brand diapers at a competitive price in 2014. NPAT will grow at 30% CAGR during the period, reflecting margin contraction after a price cut of supreme infant formula products following the government’s anti-trust investigation in July 2013, and change in the product mix.

Figure 25: Biostime – P&L estimate RMBm 2011 2012 2013E 2014E 2015E 3-yr

CAGR

Revenue

Infant formula 1,685 2,715 3,810 5,119 6,906 36%

Probiotic and nutrition supplements 359 426 578 702 838 25%

Baby care products 48 106 138 188 242 32%

Dried baby food products 97 135 170 197 227 19%

Total 2,189 3,382 4,696 6,206 8,212 34%

Product mix

Infant formula 77% 80% 81% 82% 84%

Probiotic and nutrition supplements 16% 13% 12% 11% 10%

Baby care products 2% 3% 3% 3% 3%

Dried baby food products 4% 4% 4% 3% 3%

Gross profit

Infant formula 1,104 1,769 2,447 3,187 4,182 33%

Probiotic and nutrition supplements 278 325 439 529 625 24%

Baby care products 19 58 73 96 118 27%

Dried baby food products 56 77 96 110 126 18%

Total 1,456 2,229 3,054 3,921 5,051 31%

Gross margin 66.5% 65.9% 65.0% 63.2% 61.5%

EBIT 697 1,009 1,357 1,724 2,280 31%

EBIT margin 31.8% 29.8% 28.9% 27.8% 27.8%

Interest income/exp 17 41 34 35 48

Exceptional Item 0 0 -163 0 0

Pre-tax profit 714 1,051 1,227 1,759 2,328 30%

Taxes -187 -307 -407 -518 -685 31%

Net Profit 527 743 820 1,241 1,642 30%

Source: Deutsche Bank estimates

4 December 2013

Food & Beverage

Biostime


Infant formula remains the key contributor

33% GP CAGR over 2013-15E Infant formula accounts for 81% and 80% of Biostime’s 2013E revenue and GP, respectively, in our estimate, and remains a key contributor in our forecast horizon. We expect GP to grow at a 32% CAGR over 2013-15E, as a combined result of:

a 41% CAGR in volume growth driven by organic Biostime core brand and new ADiMIL brand launched in August 2013, supported by continuous network expansion (a 20% CAGR of POSs), including the O2O channel development (launched in September 2013);

a 5% price cut in supreme products (retail price>RMB300/900g-can) following the government’s anti-trust investigation in July 2013, together with product mix dilution due to stronger growth of high-end products (RMB200-300/900g-can). As a result, we expect ASP to decline by 4% CAGR over 2013-15E, and blended gross margin to come down to 60.6% in 2015E from 65.1% in 2012.

Figure 26: Biostime – Infant formula segmental estimate (RMB) 2011 2012 2013E 2014E 2015E 3-yr

CAGR

Sales volume (tonne) 7,239 12,004 17,610 24,894 34,836 43%

ASP (RMB/kg) 189 183 175 167 161 -4%

Revenue (RMBm) 1,685 2,715 3,810 5,119 6,906 36%

Product mix

High-end <RMB300/can 54% 59% 66% 73% 79%

Premium >RMB300/can 46% 41% 34% 27% 21%

Gross profit 1,104 1,769 2,447 3,187 4,182 33%

Gross margin 65.5% 65.1% 64.2% 62.3% 60.6%

Source: Company data; Deutsche Bank estimates

Contracted capacity to reach 48,000 tonne by 2016 from 30,000 tonne now The growth is supported by capacity expansion. Biostime engages OEM suppliers for production of its infant formula on cost-plus basis. Its total capacity is around 30,000 tons at present, and will grow to 48,000 tons by 2016, based on OEM agreements with three infant formula OEM suppliers, namely:

1) Cooperative Isigny Sainte Mere (ISM) currently produces 10-20% of Biostime’s infant formula and has been a supplier since 2011. In July 2013, Biostime sealed a deal with France-based ISM, under which Biostime will invest EUR20m in ISM for a 20% equity stake and EUR17.5m bonds (5% coupon p.a.). ISM is composed of 683 milk producers as cooperative shareholders. In 2012, the company had a turnover of EUR250m, with 250m litres of milk processed, of which around 42% is exported, making EUR2.5m in NPAT.

ISM will use the proceeds to build a new infant formula production and packaging industrial facility, therefore increasing its total capacity to 50,000 tons by 2016, of which Biostime will take up at least 18,000

4 December 2013

Food & Beverage

Biostime


tons p.a. starting from 2016. Apart from securing steady and quality supply, Biostime will be able to strengthen its R&D as it can extend its research to the milk source.

2) Laiterie de Montaigu (LdM) produces 60-70% of Biostime’s infant formula at present and has been a supplier since 2006. In March 2013, Biostime renewed an OEM agreement (for no less than 10,000 tons) with France-based LdM for three years from 1 January 2014 to 31 December 2016.

3) Arla produces 10-20% of Biostime’s infant formula at present. In June 2012, Biostime signed a 10-year agreement with Denmark-based Arla, under which the two companies agreed to co-finance a DKK163m capacity expansion project (c. HKD216m). Each party contributes 50% of the investment. About 20,000 tons of capacity will be dedicated to Biostime, upon completion by 2015.

Two- to three-year product launch cycle Biostime started R&D on infant formula in 2006 and launched a series of Biostime brands – Supreme, Premium and Supreme Care – in 2008. In 2010, it launched Biostime Golden Care. In less than three years, Biostime launched the new ADiMIL brand ADIMMUN and ADIGEST series in August 2013, and will add new series under the ADiMIL brand in 2014.

The ADiMIL brand is specialty formula tailored for specific nutritional and dietary needs. According to Mead Johnson, sales of specialty formulas in Asia accounted for only 6% of total infant formula sales in 2012, significantly lower than 43% in the US. We believe it shows the growing penetration of specialty formula in China.

We believe Biostime will keep a 2-3 years product launch cycle, i.e. launch new brands or re-launch existing brands in 2016. In the long term, we think Biostime could leverage on the by-then-established O2O platform and enter the mass market, i.e. <RMB200/can, without heavy investment in the channel.

Figure 27: Mix of routine vs specialty and solutions by region

57% 63%

94%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

US Latin America Asia

Specialty & solutions

Routine

Source: Mead Johnson

4 December 2013

Food & Beverage

Biostime


Baby care products – eyeing on diapers

Biostime launched BMcare branded baby care products (primarily diapers, baby skin and hair care products) in 2010. According to Euromonitor, the market size of diapers together with baby and child personal care products in China totalled RMB47bn in 2013, up 20% yoy, and is a major category to cover if Biostime wants to leverage on its brand equity, in particular diapers.

Figure 28: China 2013E baby product market (by retail sales value)

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

0102030405060708090100 Retail sales value (RMBbn)

yoy change

Source: Euromonitor

Euromonitor forecasts that diaper and baby personal care products in China will grow at 20% and 17%, respectively, over 2013-15, in terms of retail sales value. Again, we believe the additional 17% newborns due to the potential policy change could drive more rapid growth (Euromonitor forecast). We expect Biostime’s baby care products (including diapers) to grow at a 32% CAGR in revenue terms, outpacing the market growth with diapers re-launch. Biostime is considering to acquire foreign baby product brand(s) to further leverage on its distribution network. Including long term deposit, we estimate Biostime to sit on RMB2bn as of end 2013, and based on the non-infant formula listed comparables’ average 22.9x CY14E PE (average of Goodbaby, Unicharm, Pigeon, Les Enphants and Pumpkin Patch based on consensus forecast), Biostime could spend RMB2bn to buy additional RMB87m NPAT, equivalent to 7% of our 2014E NPAT forecast for the company.

4 December 2013

Food & Beverage

Biostime


Figure 29: China’s diaper market size Figure 30: China’s baby personal care market size

15%

17%

19%

21%

23%

25%

27%

0

10

20

30

40

50

60

2011 2012 2013 2014 2015

Retail sales value (RMBbn)

yoy change

15%

16%

17%

18%

19%

20%

21%

22%

0

2

4

6

8

10

12

14

16

2011 2012 2013 2014 2015


yoy change

Source: Deutsche Bank Source: Deutsche Bank

Figure 31: Cross-selling from infant formula Unit price

(RMB) 1H13 cross selling rate

Sales (RMB)

Rebased Adj price (RMB)

Adj cross selling rate

Adj sales (RMB)

Rebased Adj cross selling rate

Adj sales (RMB)

Rebased

Infant formula 260 260 100 260 100 260 100

Probiotic sachet 140 14.8% 21 8 21 8 21 8

Baby cereal 65 18.0% 12 5 12 5 12 5

Diapers 118 4.6% 5 2 94.4 10% 9 4 15% 14 5

298 115 302 116 307 118Source: Company data; Deutsche Bank

Based on Biostime’s cross-selling rate in 1H13, 15% of its infant formula customers also buy its baby cereals, 18% buy its probiotic sachet and 5% buy its diapers, i.e. every RMB100 infant formula sales will bring in RMB15 sales of other baby products based on unit price of the respective item. The company will re-launch diapers in 2014, and assuming that it will cut price by 20% following a jump in cross-selling rate to 15% from 5%, the spending on other baby products will rise to RMB18.

Education – a potential driver for sustainable growth

In late 2012, Biostime published the Chinese edition of ’What Every Parent Needs to Know’ (licensed by Dorling Kindersley, the book won First Prize in the British Medical Association Medical Book awards 2007 Popular Medicine section) in November 2012. Mama 100 members can redeem the book using their points.

This only marks the beginning of Biostime’s commitment to make educational programme its future growth driver. Starting 2012, Biostime has been collaborating with:

The Centre for Child Mental Health (CCMH), which is co-founded by Dr Margot Sunderland, the author of ’What Every Parent Needs to Know’. CCMH offers conferences and trainings in key interventions, tools, techniques and theory in healing conversations with children and a wide range of child mental health topics. The co-development project focuses mainly on psychological care of babies and toddlers; and

4 December 2013

Food & Beverage

Biostime


Zero-to-Three, a US-based non-profit organization that provides parents, professionals and policymakers the knowledge and know-how to nurture early development, in particular in the areas of infant mental health and reflective practice and programme development.

Biostime’s planned ’Parenting Power’ programme will offer 1) child psychology courses to parents and parents-to-be; and 2) early childhood development courses to parents and children, in phases starting late 2014/early 2015.

The company plans to offer the courses 1) for free as part of promotional campaign when needed; and 2) for a fee; members can subscribe using their points. We think child psychology courses will help engage consumers as early as the pregnancy stage, and based on Biostime’ high cross-selling rate from mother formulas (to all other products), we believe the early engagement will contribute positively to Biostime. Based on Biostime’s 1H13 cross-selling rate, every RMB100 sales to a mom-to-be could bring additional RMB47 sales of infant formulas and other baby products to Biostime.

Figure 32: Cross-selling from mother formula Unit price (RMB) 1H13 cross selling

rate Sales (RMB) Rebased

Mother formulas 260 260 100

Infant formulas 260 30% 78 30

Probiotic sachet 140 16.3% 23 9

Baby cereal 65 19.6% 13 5

Diapers 118 7.9% 9 4

383 147 Source: Company data; Deutsche Bank

In the long term, we expect Biostime to develop programmes for children aged 4-7 targeting at both parents and/or children to help extend their member lifecycle (usually for parents with babies aged 0-3 now) further.

Probiotic and nutrition supplement

Biostime started as a probiotic supplement brand and producer, and diversified to other nutrition supplement starting 2011. Upon completion of the new R&D centre by early 2015, we believe the company will develop more nutrition supplement to leverage on cross-selling.

In 2013, the company merged the two marketing teams with the ADiMIL brand specialty formula team with an aim of creating synergy between skill and knowhow and driving cost efficiency.

Distribution and marketing

20% CAGR of POSs over 2013-15E Biostime distributes through baby specialty stores, hypermarket/supermarket, and pharmacies. As of 30 September 2013, it has 17,358 POSs. We expect it to expand to 26,200 by the end of 2015. In the near term, Biostime plans to beef up coverage and will continue to increase penetration into tier-3 cities, in particular southern China.

4 December 2013

Food & Beverage

Biostime


Figure 33: Geographical breakdown of 2013E revenue

Eastern China

Southern China

Central China

Western China

Northern China


Baby specialty stores contributed to 70% of Biostime’s revenue in 1H13, significantly higher than the market average of 40%, according to Biostime. In future, Biostime will remain focused on the development of baby specialty store channel, because 1) modern channels ask for high listing and promotional fee, but offer unfavourable payment terms and limited display flexibilities for cross-selling, therefore the return on modern channel development is lower; and more importantly 2) it copes with its O2O channel development.

Figure 34: Breakdown of 1H13 sales by channel Total (Biostime est) Biostime

No. of stores Mkt share No. of stores (30 Jun 13) % of 1H13 sales

Baby specialty stores 50,000 40% 11,402 70%

Modern channel 15,000 40% 4,386 24%

e-commerce NA 20% NA NA

Pharmacies 2,500 Negligible 822 6%Source: Deutsche Bank

Figure 35: Biostime penetration estimate Biostime POSs

Total 2013E Penetration 2015E Penetration

Baby specialty stores 50,000 13,000 26% 18,000 36%

Modern channel 15,000 4,800 32% 6,200 41%

Pharmacies 2,500 1,000 40% 2,000 80%Source: Deutsche Bank

We estimate O2O channel to engage additional 8% active members Biostime lagged behind the market in e-commerce sales, but we expect it to catch up quickly. Gome (493 HK, Buy) says it has 100m registered members, including 30m online members and 70m offline members. While 50% offline members are active, only 10% of online users are active. That said, the online platform helped Gome recruit an additional 8% of active members. In general, brand loyalty of baby products is higher, but for conservative purpose we expect Biostime’s O2O channel to recruit an 8% additional active members.

In September 2013, Biostime started its O2O channel, through which its members can shop Biostime products using Mama100 mobile app, and the

4 December 2013

Food & Beverage

Biostime


transactions and delivery will be taken up by its committed POSs (as of November 1023, c. 40% of its existing baby special store-POSs had joined the O2O channel). The company will connect its O2O platform to its Tmall flagship (to be opened) and other B2C platforms with an aim of recruiting new customers. All online and offline prices are aligned.

The new channel provides convenience to consumers. We think it will enhance the cross-selling rate as its entire product portfolio is literally at one’s fingertips. The model also solves the common problems of costly logistic expenses and channel conflicts. At this initial stage of operation, Biostime encountered issues like insufficient stock level at certain POSs and was therefore unable to fulfil customer orders; however, we think it is a minor hiccup. We estimate the current average daily run rate at c. RMB1m.

We believe distributors and retailers in China are well aware of the challenges from e-commerce, but not all of them have the capabilities to deal with it. In the long term, Biostime is capable of putting its valuable vendor and customer relationship onto a virtual market place, wherein Biostime will sell its own brand products and services and partnering distributors/retailers will sell their non-Biostime child care products, and deliver from offline stores.

We expect Biostime’s average spending per active member to decline 3-5% yoy in 2013-14 taking into account the price cut and product mix change, before a mild pick up in 2015, as we expect improved cross-selling capabilities due to the development of the O2O channel and as new education services will start contributing from 2015.

Figure 36: Average member spending 2011 2012 2013E 2014E 2015E

Active offline members 825,230 1,400,781 1,880,000 2,475,000 3,144,000

Active member/POS 84 91 100 110 120

Active online members 9,400 123,750 251,520

Total active members 825,230 1,400,781 1,889,400 2,598,750 3,395,520

Avg active members 645,383 1,113,006 1,640,391 2,244,075 2,997,135

% sales by active members 78.0% 84.7% 89.0% 89.0% 89.0%

Avg sales/active member (RMB) 2,646 2,574 2,548 2,461 2,438

yoy change -4.4% -2.7% -1.0% -3.4% -0.9%

Source: Deutsche Bank estimates

4 December 2013

Food & Beverage

Biostime


Industry overview

Two-child policy

According to our China strategy update ‘Beneficiaries of reforms post 3rd Plenum’ published by Dr Jun Ma on 18 November 2013, the number of newborns will rise by 1.6m per year during 2014-16 as a result of the reform.

The mega reform package approved by the 3rd Plenum in November includes the easing of one-child policy by allowing a couple to have two children if either the husband or the wife has no sibling. The ’Decision on Major Issues Concerning Comprehensively Deepening Reforms’ (Decision) mentions that the government will further adjust and improve its population policy, implying that a genuine two-child policy will only become possible in a few years. In the short run, we expect the reforms will benefit sectors such as infant formula, diaper, baby care products, strollers, clothing and education. (For details, refer to our China strategy update ‘Beneficiaries of reforms post 3rd Plenum’ published by Dr. Jun Ma on 18 November 2013.)

China infant formula market

20% CAGR by value over 2013-15 Euromonitor forecasts that China’s infant formula market will grow at a 20% CAGR over 2013-15 by volume, based on increasing consumption per birth. According to Mead Johnson, China’s infant formula consumption per birth was 18kg/birth in 2012, 18% below Asia average of 22kg. In value terms, Euromonitor forecasts a 20% CAGR over 2013-15.

Figure 37: China infant formula market value Figure 38: China infant formula market volume

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4 December 2013

Food & Beverage

Biostime


Figure 39: Consumption per birth comparison Figure 40: China infant formula sales by grade

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2008 2013

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Source: Mead Johnson, including infant formula and growing up milk powder Source: Mead Johnson

Note that Euromonitor forecasts were released before the two-child policy endorsement. We believe the additional 11% newborns due to the potential policy change in 2014-18 will drive more rapid volume growth (from current Euromonitor forecast). According to Mead Johnson, consumers continue to shift to premium products in China, but we believe that as parents will become more sophisticated under the two-child policy, demand growth for supreme class infant formula will underperform that of non-supreme. The growth of average price of infant formula will therefore be curbed.

According to Euromonitor data, Mead Johnson is the largest infant formula company in China, and Biostime is the fifth largest infant formula company (by retail value sales) in China in 2013.

Figure 41: Top 5 infant formula companies (by retail value sales) 2008 2009 2010 2011 2012 2013

1 Mead Johnson Nutrition Co* 10.6 11.0 11.7 13.9 11.3 11.1

2 Nestlé SA# 9.8 9.9 9.7 9.5 10.1 10.6

3 Danone, Groupe 10.9 10.2 9.8 9.4 9.8 10.3

4 Hangzhou Beingmate Group Co Ltd 6.2 8.9 9.2 10.3 10.2 9.9

5 Biostime International Holdings Ltd 0.2 0.8 2.1 3.7 4.9 6.3Source: Euromonitor; * incl Bristol-Myers Squibb Co; # incl Pfizer and Wyeth

Regulations

On production The State Administration of Food and Drug issued a notice on 3 December 2013 regarding the prohibition of delegation, OEM or repackaging production of infant formula, to further clarify the requirements of infant formula production. According to the notice, an infant formula producer shall not produce products on behalf of others under a contract manufacturing (CMO) arrangement, or products under a brand owned by others under an OEM arrangement. It also shall not produce products domestically under a trademark or brand registered by itself outside of China. Repackaging production is not permitted; the producer must not produce products with the same formula but under different product names or brands, and shall not use raw materials other than cow and goat milk powder.

4 December 2013

Food & Beverage

Biostime


The ‘new’ regulations echo the draft guidelines and regulations on infant formula production published in August 2013, including

a draft Review Guidelines for Conditions for Infant Formula Production License, under which the producers will assume the primary liability for the product safety. The producers are required to establish the quality control departments with qualified quality control professionals. They will need to implement the Hazard Analysis and Critical Control Point (HACCP) system and Good Manufacturing Practices (GMP) to control the product quality. The producers should ensure the traceability of their products and establish and implement the product recall system, including voluntary recalls, as well as mandatory recalls.

a draft Regulation on Prohibition of Infant Formula Production under CMO, OEM, or Repackaging Arrangements;

a draft Administrative Measures on Registration of Infant Formula, under which infant formula producer must register with the provincial Food and Drug Administration at least 60 days prior to its production; and

a draft Regulation on Supervision and Inspection of Quality and Safety Management of Infant Formula Producers.

On import infant formula On 27 September 2013, Administration for Quality Supervision and Inspection and Quarantine (AQSIQ) issues a notice – Strengthening Supervision of Imported Infant Formula, under which,

Foreign infant formula processors exporting to China are required to register locally in line with the Administrative Measures for Import and Export Dairy Products’ Inspection, Quarantine and Supervision;

The import infant formula’s shelf life must be more than three months from the date of inspection;

Import infant formula must be pre-packaged for retail to avoid repacking and redistribution; and

From 1 April 2014, import infant formula packs must have pre-printed Chinese labels. Any such formula without Chinese labels or with labels that fail to meet Chinese laws will be returned or destroyed.

On consolidation According to Ministry of Industry and Information Technology (MIIT), the government hopes to consolidate the domestic infant formula industry, in aim of top ten domestic brands to account for 80% of infant formula sales in China. Nevertheless, we have been awaiting for more policies/regulations to promote the planned consolidation since June 2013.

4 December 2013

Food & Beverage

Biostime


Appendix 1

Important Disclosures Additional information available upon request Disclosure checklist

Company Ticker Recent price* Disclosure

Biostime 1112.HK 62.25 (HKD) 3 Dec 13 1,6,7,14 *Prices are sourced from local exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies

Important Disclosures Required by U.S. Regulators

Disclosures marked with an asterisk may also be required by at least one jurisdiction in addition to the United States. See Important Disclosures Required by Non-US Regulators and Explanatory Notes.

1. Within the past year, Deutsche Bank and/or its affiliate(s) has managed or co-managed a public or private offering for this company, for which it received fees.

6. Deutsche Bank and/or its affiliate(s) owns one percent or more of any class of common equity securities of this company calculated under computational methods required by US law.

7. Deutsche Bank and/or its affiliate(s) has received compensation from this company for the provision of investmentbanking or financial advisory services within the past year.

14. Deutsche Bank and/or its affiliate(s) has received non-investment banking related compensation from this company within the past year.

Important Disclosures Required by Non-U.S. Regulators

Please also refer to disclosures in the Important Disclosures Required by US Regulators and the Explanatory Notes.

1. Within the past year, Deutsche Bank and/or its affiliate(s) has managed or co-managed a public or private offering for this company, for which it received fees.

6. Deutsche Bank and/or its affiliate(s) owns one percent or more of any class of common equity securities of this company calculated under computational methods required by US law.

7. Deutsche Bank and/or its affiliate(s) has received compensation from this company for the provision of investment banking or financial advisory services within the past year.

For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at http://gm.db.com/ger/disclosure/Disclosure.eqsr?ricCode=1112.HK Analyst Certification

The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s) about the subject issuer and the securities of the issuer. In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Winnie Mak

4 December 2013

Food & Beverage

Biostime


Historical recommendations and target price: Biostime (1112.HK) (as of 12/3/2013)

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Previous Recommendations

Strong Buy Buy Market Perform Underperform Not Rated Suspended Rating

Current Recommendations

Buy Hold Sell Not Rated Suspended Rating

*New Recommendation Structure as of September 9,2002

Equity rating key Equity rating dispersion and banking relationships

Buy: Based on a current 12- month view of total share-holder return (TSR = percentage change in share price from current price to projected target price plus pro-jected dividend yield ) , we recommend that investors buy the stock. Sell: Based on a current 12-month view of total share-holder return, we recommend that investors sell the stock Hold: We take a neutral view on the stock 12-months out and, based on this time horizon, do not recommend either a Buy or Sell. Notes:

1. Newly issued research recommendations and target prices always supersede previously published research. 2. Ratings definitions prior to 27 January, 2007 were:

Buy: Expected total return (including dividends) of 10% or more over a 12-month period Hold: Expected total return (including dividends) between -10% and 10% over a 12-month period Sell: Expected total return (including dividends) of -10% or worse over a 12-month period

56 %

36 %

8 %26 %

22 %15 %

050

100150200250300350400450

Buy Hold Sell

Asia-Pacific Universe

Companies Covered Cos. w/ Banking Relationship

4 December 2013

Food & Beverage

Biostime


Regulatory Disclosures

1. Important Additional Conflict Disclosures

Aside from within this report, important conflict disclosures can also be found at https://gm.db.com/equities under the "Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing.

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David Folkerts-Landau

Group Chief Economist Member of the Group Executive Committee

Guy Ashton

Global Chief Operating Officer Research

Marcel Cassard Global Head

FICC Research & Global Macro Economics

Richard Smith and Steve Pollard Co-Global Heads Equity Research

Michael Spencer Regional Head

Asia Pacific Research

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Deutsche Bank Research, Germany

Andreas Neubauer Regional Head

Equity Research, Germany

Steve Pollard Regional Head

Americas Research

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