Is widely-held liquor producer a risk for Chinese funds?

Kweichow Moutai is the world’s largest liquor company measured by market capitalisation. It produces baijiu, a strong white liquor distilled from sorghum. It is a staple at most weddings and business celebrations in China.

Even though foreign wines and whiskies have been gaining popularity, especially among the younger generation, baijiu still accounts for 98% of China’s spirit consumption, according to Allen Cheng, equity analyst at Morningstar. “That number has been steady for the last 20 years,” he told FSA.

Kweichow Moutai is the biggest and best known of baijiu producers. The company’s name is derived from the town of Maotai in the Guizhou province in China’s southwest. A bottle of the company’s flagship liquor Feitian, which sells for around RMB 1,500 ($230), has become a traditional prestigious gift, prized above other baijiu brands.

Steady popularity and demand for its products has allowed Kweichow Moutai, a state-owned enterprise whose shares trade on the Shanghai Stock Exchange, to reach a market capitalisation of RMB 926bn. It is the third largest component of the MSCI China A Index and the FTSE China A50 Index, accounting for 2.1% of the former and 5.7% of the latter.

Around 50 mutual funds available for sale in Hong Kong and/or Singapore (approximately a third of the category) have Kweichow Moutai among their top ten holdings, according to data from FE. Four of them hold more than 8% of their assets in the company’s stock. Does such high concentration in a highly-specialised company with a narrow product line represent a risk for the funds’ holders?

Kweichow Moutai has recently announced that it would raise the ex-factory price of Feitian by 18% to RMB 969 per bottle. The last time the company raised the price it charges distributors was in 2012, before the anti-corruption campaign that Chinese president Xi Jinping started late that year. The ex-factory price rose then to RMB 819 per bottle from RMB 619.

The 28 December announcement, which came earlier than the market expected, has prompted analysts, including Cheng, to raise their price targets for the company.

The current retail prices of the company’s products translate to around 30% margin for the distributors, according to Cheng. “Given their pricing power and the brand power, it is very reasonable for the company to increase their ex-factory price,” Cheng told FSA.

“The market consensus was that the price hike would happen before the mid-autumn festival (25 September) in 2018,” Cheng said. After the announcement, he raised his fair value estimate for the company’s stock price by 8.2%, to RMB 660, from RMB 610.

The fair value estimate represents the future forecast of the stock price discounted to its current value. According to Cheng’s model, the 2018 year-end target price of the stock is RMB 700 and the 2019 is RMB 750.

The Kweichow Moutai stock saw its price rise by 108% in 2017, and traded as high as RMB 718.6 on 3 January 2018. The surge reflects the market’s bullish expectations on the company’s growth, according to Cheng. It was exacerbated by the broad holdings of the company in many mutual funds, including passive ones, which has made the trade quite crowded.

Although the company and its brand are well established and not significantly threatened by domestic or foreign competition – a view reflected in Morningstar’s “wide-moat” classification – some risks remain.

The company is projecting only a 10% increase in sales in 2018. Most analysts, including Cheng, consider it too conservative, with the consensus estimate around 30%. Should the company, however, fail to meet the expectations of the sales increase, its stock price would likely suffer.

The risk does not lie with the demand for its products, which remains robust, according to Cheng. While the anti-corruption campaign has curbed the consumption of the luxury liquor by military personnel and government officials, the demand has been growing from businesses and individuals, as their disposable incomes increase.

The potential constraint to growth comes on the supply side, according to Cheng. Even at the current prices, the liquor is at times hard to find, he noted. And though the company increased its shipments by 30% in 2017, it is not likely to do so again in 2018, he added.

Kweichow Moutai remains a good long-term investment, according to Cheng, with sustainable growth prospects for the next five years, although following the recent rally, now may not be the best entry point. He projects a growth of around 17% on average in 2018-21, despite the already high valuation. The stock’s price-to-earnings ratio was 38 at the end of 2017.

Although China’s younger generation is developing a taste for other beverages, Cheng maintains that in the short and medium term, the consumption of baijiu is not likely to decrease. The strong liquor is popular with more mature drinkers, between 40 and 60 years old, and that population is likely to remain stable in the next 10 years. As they become richer, many drinkers will likely switch to the more prestigious brand from lesser ones.

Kweichow Moutai is also expanding its line of products, to appeal to more budget-conscious consumers, leveraging its strong brand to penetrate the mass market. The sales of such products, although still less than 5% of the company’s total, more than doubled in the past year, Cheng noted.

Mutual funds with highest exposures to Kweichow Moutai