August 9, 2012 / 9:08 PM / 5 years ago

China's downturn-proof booze makers hit government wall

A labourer packages baijiu at the Shanghai Shenxian Rice Winery in Shanghai May 11, 2012.Aly Song

HONG KONG/SHANGHAI (Reuters) - The makers of China's fiery liquor baijiu, a pricey, potent drink that is a staple at state dinners, say it inspires poets and can even ward off dementia.

For investors in the largest baijiu makers Kweichow Moutai Co Ltd and Wuliangye Yibin Co Ltd, the appeal is more mundane: the companies paid out huge dividends and raised earnings forecasts when a slowing economy had prompted dozens of Chinese firms to issue profit warnings.

Demand for high-grade liquor at state banquets and premium pricing helped Moutai post an operating profit margin last year that was more than double that of tech giant Apple Inc, the world's most valuable company, Thomson Reuters data shows.

Moutai is even a partner of the Chinese Olympic Committee, pushing out a commemorative brew for the London 2012 games.

But the stellar first-half results that these companies are expected to report this month -- Moutai on Friday and Wuliangye on August 20 -- may mark the high point if Beijing cracks down on lavish baijiu-drenched banquets.

Premier Wen Jiabao pledged in March to ban the use of public funds for luxury items including baijiu, which retails for about $300 per standard bottle and well into the thousands for rare, aged varieties.

"It really depends on how strongly the government would like to execute this policy," said Melinda Zhang, a manager in the consumer and retail practice at the consultancy Booz & Co, who has studied the baijiu sector.

"In the long term, we see the China baijiu market keeping stable growth," she added. "The demand is there. Consumption behavior of businesses and the government will not have significant change."

DRYING UP

At the five-star Okura Garden Hotel in Shanghai, a top banquet venue, the beverage manager, surnamed Liao, said baijiu sales had dropped more than 20 percent since March.

In Tianjin, a bustling port city near the capital Beijing, Moutai sales were down by as much as 50 percent over the past half year, the official China Daily reported in late July.

Some localities have introduced their own rules, like prohibitions on drinking at lunch, to improve the image of government officials. In Jiangsu province's Siyang county, public expenditures on receptions had been cut by two-thirds, the Shanghai-based Oriental Morning Post reported.

The clamp-down on government profligacy, a hot-button issue in China where ordinary people sometimes associate officialdom with boozy banquets and corruption, comes ahead of the sensitive once-in-a-decade political transition later this year.

Yet fund managers and sell-side analysts have remained almost uniform in their bullishness on Moutai and Wuliangye, in part premised on the companies' ambitious earnings guidance. Wuliangye is predicting a 51 percent jump in first-half profit.

Of the 22 analysts tracking Wuliangye, 21 rate it a 'strong buy' or 'buy,' according to Thomson Reuters StarMine. For Moutai, 17 of 18 have a 'buy' or 'strong buy' rating.

While onshore Chinese stock markets have tanked 33 percent over 2010 and 2011, Moutai has been a standout outperformer, surging 25 percent. Wuliangye rose a more modest 3.6 percent.

In 2012 so far, Shanghai-listed Moutai is up 35 percent, while Shenzhen-listed Wuliangye is up 14.2 percent. This compares with a 2.8 percent gain in the CSI300 Index of the top Shanghai and Shenzhen listings.

"In the awful (stock) market conditions of the last two-and-a-half years, the outperformance of baijiu stocks has got to do with their earnings visibility," said Cao Xuefeng, head of research at Huaxi Securities in Chengdu. "Growth for the sector will stay high, but rates of growth will slow down."

Moutai and Wuliangye currently trade at 16.6 and 13.2 times their respective forward 12-month earnings, at the low end among shares of companies classified as "consumer staples" in China.

Wuliangye did not respond to repeated interview requests and Moutai declined to comment for this story.

BRIDGE TO THE WORLD

Baijiu, which translates to "white spirits," traces its roots back centuries and is made from a mixture of grains including rice, wheat and corn. It packs a punch similar to vodka, with an alcohol content typically above 50 percent, and is normally downed fast and neat in tiny shots.

On their websites, Moutai and Wuliangye both boast of their firms' long histories. Moutai also claims health benefits, saying moderate drinking "keeps the dementia away" and even helped a 92-year-old man re-grow his teeth.

But it is demand from the Communist Party that drives sales.

"As liquor for state banquet, Wuliangye has become an envoy and bridge between China and the outside," Wuliangye said on its website, adding that "many famous scholars, poets (and) generals in history have got addicted to the marvelous flavor."

That bridge to the outside has reached investors including BlackRock Asset Management, which is listed among the top 10 shareholders in both Wuliangye and Moutai.

But the alcohol itself has found few foreign fans. Some 98 percent of Wuliangye's 20.35 billion yuan ($3.19 billion) in revenue last year was domestic. For Moutai, 97 percent of its 18.4 billion yuan in revenue last year came from within China.

"There is almost no export market. 'Laowais' (foreigners) don't drink that thing," said Hong Hao, chief equity strategist at Bank of Communications International Securities.

Indeed, some foreigners have likened drinking baijiu to swallowing razor blades or jet fuel. That suggests China will struggle to follow the lead of Japan, which succeeded in making sake a popular global drink.

British drinks company Diageo Plc is trying. Last year, Diageo bought a majority stake in Sichuan Swellfun Co Ltd, maker of Shui Jing Fang baijiu, a deal that the company said would "enable us to bring one of the leading Chinese white spirits brands to international markets."

So far, those international markets are limited to places such as San Francisco and London, where wealthy Chinese tourists snap up baijiu because it is cheaper overseas and buyers believe they run less of a risk of picking up a counterfeit bottle.

Paul Mathew, a British bar owner and drink consultant living in Beijing, said he did some baijiu experimenting for Diageo. One example was the Shui Jing Fang Grapefruit Sour, which mixes a shot of baijiu with pink grapefruit juice, lemon juice, cinnamon syrup and an egg white.

Derek Sandhaus, an American living in Chengdu, Sichuan, who chronicled his conversion from baijiu hater to enthusiast in a blog entitled "300 Shots at Greatness," said he developed a taste for the liquor after 75 attempts. The title of his blog, however, refers to one study that estimated it takes 300 shots to start to enjoy the stuff.

"There's definitely a cultural barrier in terms of cocktails," Sandhaus said.

HOME SHOPPING NETWORK

That leaves domestic consumption as the main driver.

But as demand slows, supply is building. Credit Suisse analysts said inventory growth hit a record high of 35 percent in 2011, outpacing sales growth.

"It doesn't matter if you have superior pricing power like Moutai does right now. That will disappear when there's oversupply," BoComm International's Hong told Reuters.

With an operating margin of 67 percent last year -- triple the industry median according to Thomson Reuters data -- Moutai can afford to lose a little pricing power. Wuliangye's margin was a relatively modest 42 percent, still double the industry median.

"In terms of margins, Kweichow Moutai has the advantage because most of what they produce is higher-quality liquor," said Yi Yangfang, a fund manager at Guangzhou-based GF Fund Management, which manages $7.9 billion worth of assets that includes stakes in both Kweichow Moutai and Wuliangye.

Some long-time China watchers said the government's crackdown on lavish banquets may not last long.

Paul French, a veteran Shanghai-based market consultant with the firm Mintel, said campaigns like the one launched by Wen, who is due to retire early next year, have tended to be cyclical and easy to circumvent.

"Every time they try to do anything like this people find a way around it... If you sit around long enough you'll come up against that story again in a few years," he said.

Editing by Emily Kaiser and Ryan Woo

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