RMBPrev.2014APrev.2015EPrev.2016EPrev.2017ERev. (MM)--2,132.0--3,437.0--4,799.0--6,228.0Core Earnings(MM)--624--942--1,294--1,776Chg (% YoY)--96.4%--51.0%--37.3%--37.2%BV/Share--0.71--0.90--1.17--1.50P/B2.4x1.9x1.4x1.1xDividend--0.00--0.00--0.00--0.03Div. Yield0.00%0.00%0.00%1.79%Core EPSFY Dec--0.10--0.16--0.22--0.30P/Core EPS16.7x10.4x7.6x5.6xPrice PerformanceJUL-14OCT-14FEB-15JUN-152.62.42.221.8COMPANY NOTEInitiating CoverageChina | Consumer | China Consumer8 June 2015Shengmu (1432 HK)The Pearl in Desert; Initiate with BuyEQUITY RESEARCHBUYPrice target HK$3.20Price HK$2.09Bloomberg: 1432 HKReuters: 1432.HKFinancial SummaryBook Value (MM):Rmb4,255.0Book Value/Share:Rmb0.70Net Debt (MM):Rmb733Return on Avg. Equity:23.9%Net Debt/Capital:12.8%Long-Term Debt (MM):Rmb150.0Cash & ST Invest. (MM):HK$751.0Market Data52 Week Range:HK$2.55 - HK$1.89Total Entprs. Value (MM):HK$13,494.2Market Cap. (MM):HK$12,577.8Insider Ownership:56.6%Shares Out. (MM):6,018.1Float (MM):2,199.2Avg. Daily Vol.:18,126,560Jessie Guo, PhD *Equity Analyst+852 3743 8036 jguo@jefferies.comKevin Chee, CFA *Equity Analyst852 3743 8022 kchee@jefferies.comJeffrey Zeng *Equity Associate+852 3743 8009 jzeng@jefferies.com * Jefferies Hong Kong LimitedKey TakeawayWe expect demand for organic food to see rapid growth. Shengmu is the firstlarge-scale organic milk producer in China with a vertically integrated valuechain. Its farms’ unique location in desert and experienced team offer entrybarriers, and it enjoys high growth and margins. We initiate at Buy with at PTof HKD3.2.Positive on organic milk demand. Organic milk refers to pollution-free and additive-free milk products. As middle class pays more attention to food safety and is willing to paypremium for high-quality foods, we expect rising demand for organic food. Production oforganic raw milk grew rapidly at CAGR of 79% in 2009-13, notwithstanding the small scale.Frost & Sullivan forecasts this to grow at 51.5% CAGR in 2014-17e, accounting for 2.5% of2017e market. Organic raw milk production is undersupplied currently in China with highentry barriers. We expect huge market potential for this sector.First mover advantage with large scale. Shengmu is, so far, the only largest organicdairy company in China with a fully integrated value chain. Its products meet EU standardsfor organic milk and have received international awards for premium quality since 2011. Itsmarket share in 2014e organic raw milk production was 62%. All organic farms are located inUlan Buh desert (Inner Mongolia), creating high entry barriers for potential competitors. Itsown-branded liquid milk targets high-end market and is in a fast growth stage. Shengmu’smargins and turn ratios are higher vs other key dairy companies.Earnings forecasts. We forecast sales of Rmb3.4bn in 2015e (+61% yoy), and Rmb4.8bnin 2016e (+40% yoy); and group GP margin to remain stable at 50-51% in 2015-16e vs.50.2% in 2014. We assume high marketing expenses and promotion to expand the liquidmilk business. We forecast core net profit (excluding gain/loss from changes in fair value) ofRMB942m (+51% yoy, NM 27.4%) in 2015e and RMB1.3bn (+37% yoy, NM 27.0%) in 2016e.Valuation/RisksOur PT of HKD3.2 is based on 13.5x 1-year forward PE, slightly higher than 12x for CMD (1117HK, Buy) due to Shengmu’s unique organic positioning, fast growth and high returns. Thestock trades at 9.5x forward P/E (historical median of 12x) and 0.3x forward PEG. Valuationlooks compelling. Its share price has outperformed the HSCEI and dairy sector by 11% in thepast 1M. Catalysts: significant improvement of dairy cows’ productivity; faster expansion ofmarket share in liquid milk. Key risks: Self-supply feeds shortage; strong competition.Jefferies does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Jefferies may have aconflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investmentdecision. Please see analyst certifications, important disclosure information, and information regarding the status of non-US analysts on pages 43 to 46of this report. Long Term Financial Model Drivers LT Earnings CAGR 42% Organic Revenue Growth 43% Acquisition Contribution 0% Operating Margin Expansion -4.0 to 1.8ppt. Other Considerations Self-supply feeds shortage Strong competition in liquid milk business Potential food safety issue Potential outbreak of cow disease 1 Year Forward P/E Source: Jefferies estimate Shengmu is the largest organic dairy company in China with a vertically integrated value chain that meets EU organic standards. It supplies organic raw milk to major dairy players in China and also produces own-branded liquid milk for the market, with a dominant market share in the organic milk industry. Pullback in feed costs Faster-than-expected improvement of dairy cows’ productivity 