Nongfu Spring – The Value Investors

Industry Overview

Packaged drinking water growth:

The scale of bottled water market exceeds 180 billion yuan, and both volume and price have room for expansion. Packaged drinking water consists of four subcategories: natural water, natural mineral water, drinking pure water and other drinking water. Drinking pure water is the largest category and the retail sales in the Chinese market account for packaged drinking water in 2019, and the market proportion of drinking pure water is around 60.4%. Natural water and natural mineral water have requirements for the water source. Natural water comes from wells, mountain springs, reservoirs, lakes, mountain glaciers or underground spring water, etc. Only the raw water is required to be treated; natural mineral water is from deep underground naturally gushing or collected by drilling, it contains a specific content of minerals or trace elements with the growth of people’s health awareness and the enhancement of consumption power, these two categories are currently growing fastest.

According to Frost & Sullivan, the industry’s compound growth rates for 2019-2024 are 15.4% and 14.2%, respectively. At present, the per capita consumption of bottled water in China is still far lower than that of other countries in the world. There is a large room for improvement in the sales volume and unit price of bottled water in the future. From the perspective of sales: With the enhancement of residents’ health concepts, low-sugar consumption habits are expected to drive bottled water to replace other soft drinks; the increase in consumption scenarios such as tourism is expected to bring increased consumption of bottled water; the expansion of new channels such as vending machines and convenience stores boost bottled water sales; occasional water pollution incidents drive bottled water sales growth. From a price point of view: enterprises directly raise prices to drive the unit price of packaged water; with the improvement of residents’ consumption power, the demand for health, quality and personalization continues the proportion of mid-to-high-end packaged water is expected to increase.

No matter from the perspective of the total amount or per capita, the current market size of China’s bottled water is relatively low. The main reasons include consumption habits need to be cultivated as residents still tend to boil water for drinking, the single consumption scenario as consumer consumption mainly drink packaged water when going out or meeting; Substitution effect which consumers are more willing to choose beverages in meals or leisure scenes; Product prices are low and the terminal price of packaged water sold in the market is mainly concentrated at about 2 yuan compared with other countries and regions, there is still a gap. The future growth points of the packaging water industry are mainly due to volume increase with the change in the consumption structure of soft drinks, the increase in consumption scenarios, the development of new channels, and the occasional incident of water pollution; price increase when companies directly increase prices 3 yuan. Also, products continue to be upgraded to mid- to high-end.

Benefiting from the increase in the rate of urbanization is expected to achieve rapid growth. In recent years, as China’s urbanization rate has increased, the demand for drinking water in convenient scenarios has increased and the packaging drinking water industry has shown a medium-to-high-speed development trend. While the output continues to climb, the market size has also maintained steady growth. With the further increase in the urbanization rate and the continuous expansion of consumer groups, the packaged drinking water market is expected to continue to expand.

Company Overview

Packaged drinking water consists of four subcategories: natural water, natural mineral water, drinking pure water and other drinking water. Drinking pure water is the largest category, and the retail sales in the Chinese market account for packaged drinking water in 2019. The proportion is 60.4%, and drinking pure water has no restrictions on the water source. Natural water and natural mineral water have requirements for the water source. Natural water comes from wells, mountain springs, reservoirs, lakes, mountain glaciers or underground (spring) water, etc. Only the raw water is required to be treated; natural mineral water is from deep underground naturally gushing or collected by drilling, it contains a specific content of minerals or trace elements with the growth of people’s health awareness and the enhancement of consumption power, these two categories are currently growing fastest.

The bottled water industry is highly concentrated, with the top six manufacturers occupying approximately 80% of the market. According to AC Nielsen statistics, CR3 and CR6 of China bottled water industry reached 57.9% and 80.5% respectively in 18 years. Nongfu Spring, C’estbon, Ganten, Master Kong, Binglu and Wahaha accounted for 80% of the share. Judging from the evolution of the market share of the six major manufacturers, the market shares of Nongfu Spring, C’estbon and Ganten has increased steadily which shows that during the consumption upgrade process, mid-to-high-end products and natural mineral water are more likely to be recognized by consumers. The market share of the lower end of the product line has declined to varying degrees, and the proportion of low-end bottled water has gradually declined. “Packed drinking water” dual-engine driven steady growth results. Nongfu Spring is one of the top 20 beverage companies in China and a leading beverage company with both scale, growth and profitability. The company has formed a “packaged water beverage” product matrix, and its main products cover packaging and drinking water, tea beverages, functional beverages and fruit juice beverages. From 2012 and 2019, Nongfu Spring maintained the No. 1 market share of China’s packaged drinking water for eight consecutive years (20.9% in 2019). The market share of tea beverage, functional beverages and juice beverages are the top three in the Chinese market, respectively, 7.9%/7.3%/3.8%. By establishing a dual-engine development pattern for packaged drinking water beverages, the company has built a unique competitive advantage. With the construction of the category product matrix, the company’s coverage continues to expand. Relying on the company’s strong channel advantages, the performance has achieved steady growth. Under the multi-category strategy, the consumption scenario has expanded several times, and the product matrix is ​​evenly distributed. The company’s packaged drinking water contributed 80% of its gross profit, and its revenue accounted for 59.7%. As a necessary consumer product, the packaged drinking water category meets the basic drinking needs of consumers. The company has improved the coverage of drinking water through marketing and channel construction, creating a moat for the company. The beverage category satisfies consumers’ diverse and personalized drinking demands. The company continuously expands its product line and enriches its product matrix by laying out industries such as tea beverages, functional beverages, coffee beverages and juice beverages. The diversity of products allows the company to carry out flexible product portfolios based on the characteristics of different markets and channels, forming a differentiated advantage in channel competition; the multi-product layout provides more space for the company’s business growth and effectively reduces the risk of performance fluctuations.

Nongfu Spring implement a multi-brand strategy. It has long-term plans for strong brand communication capabilities. The company convey the spirit and the proposition of brands to consumers through diversified marketing methods. The company have established a nationwide sales network with in-depth market penetration. As of December 31, 2019, it covered more than 2.37 million retail points of sale across China through 4,280 distributors. The company achieved digitalization of distributors and frontline sales personnel management through the NCP system which is available on mobiles and personal computers. From 2017 till 2019, Nongfu Spring beverage retail sales rank at the top 10 list globally in comparison with other foreign listed beverage companies. The growth rate of Nongfu Spring is the fastest among global beverage listed companies. China packaged drinking company are concentrated into few main companies, during 2019 Nongfu Spring has a highest market share of around 20.9%, in the same time the company is also the second largest packaged drinking company in the world. The company has 10 strategically located water resources all over China which forms a strong competitive advantage. In 2019, the company’s packaged drinking water revenue accounted for 59.7% and gross profit margin was 60.5%, which was the category with the highest gross profit margin. In recent years, the company has launched specific packaged drinking water for different scenarios and groups of people, and differentiated upgraded products may become a new growth point.

Benefiting from the increase in the rate of urbanization is expected to achieve rapid growth. In recent years, as China’s urbanization rate has increased, the demand for drinking water in convenient scenarios has increased, and the packaging drinking water industry has shown a medium-to-high-speed development trend. While the output continues to climb, the market size has also maintained steady growth. At present, packaged drinking water has become one of the largest sub-industries in the drinks industry. Nongfu Spring accounted for about 20% of China’s packaged drinking industry revenue in 2018. Nongfu Spring is the leader in the packaged drinking water and beverage business in the PRC with devotion to providing consumers with high-quality products. The company’s major products include packaged drinking water, tea beverage, functional beverage and juice beverage.

According to the Prospectus, Nongfu Spring ranked first in the packaged drinking water market in China in terms of market share for eight consecutive years from 2012 to 2019. The company were among the top three players in tea beverage, functional beverage and juice beverage markets in China in terms of retail sales value in 2019. The business developments of the company’s beverage products and packaged drinking water products are well-balanced. In 2017, 2018 and 2019, the revenue from the beverage products accounted for 40.0%, 40.1% and 38.4% of our total revenue, respectively. According to the F&S Report, the packaged drinking water market in China is relatively concentrated. The top five players occupied an aggregate market share of 56.2% in terms of retail sales value in 2019. The largest player, Nongfu Spring, had a distinctive leading position. Its retail sales value was more than one and half times of the retail sales value of the second largest player in 2019. The chart below sets forth the details of market concentration, market shares and retail sales value of the top five players of the packaged drinking water market in China in 2019.

Tea beverages: According to the F&S Report, the market size of the tea beverage market in China was RMB78.7 billion in terms of retail sales value in 2019 and the industry concentration is relatively high, CR5 has a total market share of 86.5%, of which Nongfu Spring is ranked third. Sugary tea beverages accounted for 94.8% of retail sales, and the product “Tea Pi” is owned by Nongfu Spring. “Tea Pi” created sales of more than 1.6 billion yuan in the year of its launch. It was also the Chinese beverage product with the highest retail sales in the first 12 months of listing in the decade from 2010 to 2019, reflecting the company’s strong ability to introduce new products. Compared to sugar-containing tea beverages, sugar-free tea beverages represent the future trend of the industry. The company’s “Oriental Leaf” has become the brand with the largest market share of sugar-free teas in China. Tea beverage is divided into sugar-free tea beverage and sugar-sweetened tea beverage. The market size of sugar-sweetened tea beverage is greater, with the retail sales value accounting for 94.8% of the aggregate retail sales value of tea beverage in 2019. Driven by the increasing awareness of the health of Chinese consumers and the retail sales value of sugar-free tea beverage has grown rapidly. Sugar-free tea beverages are growing rapidly, optimistic about the company’s ability to promote new products. Its market share is expected to increase to 12.3% in 2024. Nongfu Spring continuous expansion of categories, such as the newly launched tea Π series in 2019 and continuous cultivation of mature categories, such as the enrichment of the product taste and packaging are expected to achieve healthy growth in the tea beverage business.

Fruit juice beverages: According to the F&S Report, the market size of the juice beverage market in China was RMB143.5 billion in terms of retail sales value in 2019, with low market concentration and Nongfu Spring ranked third. In 2019, CR5 is only 25.1% of which Nongfu Springs ranks third with a market share of 3.76%. Juice beverage has three levels of concentration: pure juice (with 100% juice concentration), medium concentration juice (with juice concentration from 30% to 99%) and low concentration juice (with juice concentrations from 5% to 29%). Medium-concentration juice and pure juice with high juice content are expected to have a higher compound growth rate in the future. Medium-concentration juice and pure juice benefit from the enhancement of people’s health awareness and income, the compound growth rate in 2014-2019 far exceeded that of low-concentration juice.  Nongfu Spring has launched the “17.5°” series and the “Nongfu Spring” NFC series of non-concentrated reduced pure juices outside the “Nongfu Orchard”. Low-concentration juice has the largest market share, with a market share of 75.3%. The retail sales value of low concentration juice accounted for 75.3% of the aggregate retail sales value of juice beverage in 2019. According to the F&S Report, driven by the rising disposable income and increasing awareness of the health of consumers, the retail sales value of pure juice and medium concentration juice grew at a CAGR of 12.9% and 9.4%, respectively, from 2014 to 2019, which were far higher than the CAGR of 0.4% of low concentration juice during the same period. It is expected that the growth rate of retail sales value of pure juice and medium concentration juice will further increase. The market size of pure juice and medium concentration juice is expected to grow at a CAGR of 9.8% and 6.6%, respectively, in terms of retail sales value from 2019 to 2024.  In recent years, the proportion of the company’s juice business has continued to increase. Become one of the business sectors that the company strives to cultivate. Through the selection of high-quality fresh fruit production areas and intensive cultivation of product lines, the company’s juice beverage business is expected to gradually develop its strength.

Functional beverages: Rapid growth period, the company firmly grasps consumer trends. In recent years, with the increase in demand for younger consumer groups and personalized drinking, China’s functional beverage market has grown rapidly. In 2019, the scale of China’s functional beverage market reached 111.9 billion yuan, the market was relatively concentrated, and Nongfu Spring ranked third. The functional beverage market is still in a stage of rapid growth. The compound growth rate of each category in 2014-2019 is more than 10%, and the overall industry’s projected compound growth rate in 2019-2024 is 9.4%. The company owns the sports drink brand “Scream” and the nutritional supplement drink brand “Vitamin Water”. According to the F&S Report, the market size of the functional beverage market in China was RMB111.9 billion in terms of retail sales value in 2019. Functional beverage mainly includes energy beverage, sports beverage and nutritional beverage. The market size of energy beverage is the largest. The retail sales value of energy beverage accounted for 70.2% of the aggregate retail sales value of functional beverage in 2019. According to the F&S Report, the retail sales value of energy beverage, sports beverage and nutritional beverage grew at a CAGR of 14.4%, 15.1% and 11.1%, respectively, from 2014 to 2019. The trend is expected to continue from 2019 to 2024, with the market size of energy beverage, sports beverage and nutritional beverage growing at a CAGR of 9.7%, 9.6% and 7.6%, respectively. The company also regularly upgrades the taste and packaging of functional beverage products to firmly grasp the consumption trends of the target group.

Competitors in Industry

Packaging beverage competitors

China Resources entered the industry earlier and has rich experience, mainly benefiting from multi-category layout, nationwide sales network, and accurate marketing. The company’s revenue growth rate and its profitability is steadily improving. In 1984, China Longhuan Beverage Co., Ltd. (predecessor of China Resources Yibao) was established, headquartered in Shenzhen High-Tech Industrial Park, mainly selling carbonated beverages. In 1990, China Resources took the lead in launching the “C’estbon” brand water in China, becoming one of the earliest domestic enterprises specialized in the production of packaged drinking water. As of the end of 2017, China Resources C’estbon headquarters had 18 functional departments, 8 branches, 37 factories, more than 12,000 employees, and 15 product SKUs. The company has become an important part of the consumer products business segment of China Resources Group. In 2017, the company’s revenue exceeded 12.6 billion yuan, an increase of 9.6% year-on-year. In the past few years, the growth rate of the company’s operating income has slowed down. The slowdown of the company’s revenue growth rate is on the one hand a natural decline and the core products are gradually entering a mature period. In addition, according to the company’s 2017 social responsibility report, from 2015 to 2017, the company’s return on net assets were 14.17%, 16.86%, and 20.51%, respectively, and profitability continued to improve. In 2011, China Resources C’estbon put forward the strategy of “national multi-category beverage business” and began to expand the beverage product categorization line. At present, in addition to its own brands, China Resources C’estbon also holds many well-known brands authorized by Japan, such as “Afternoon Milk Tea” and “Fire Coffee” series. In addition to pure water and mineral water, the company’s products have been successfully extended to milk tea, coffee, functional drinks and other categories to meet the diverse needs of consumers. The strong channel construction has steadily increased its market share. China Resources C’estbon’s production base covers the whole country, effectively reducing the transportation cost of products. In 2017, the company’s market coverage of terminal outlets exceeded 1.7 million, and the high coverage rate promoted the continuous increase of the brand’s market share.

Jingtian Ganten products have accurate positions, outstanding cost-effective advantages, healthy positioning of natural mineral water, enjoy consumption upgrade dividends, and superimpose high-quality brand marketing to jointly increase product added value. In 1992, Jingtian Food & Beverage Co., Ltd. was established in Shenzhen, focusing on the production and operation of packaged drinking water. The company has more than ten independent subsidiaries and multiple large-scale production bases, distributed in Shenzhen, Guangzhou, Huizhou, Yichun, Putian, Xiamen, Nantong, Tangshan Qianxi and other places. The factory is equipped with a number of integrated filling equipment imported from Germany, and its production products include mineral water, purified water and soda water. The company has hundreds of distributors around the world, and its products are sold overseas, and has a good reputation worldwide. Jingtian Company launched Ganten mineral water in 2004. In 2018, Ganten mineral water’s share in the bottled water market has reached 9.6%, ranking third in the industry and its export volume ranks first in the drinking water industry. Ganten success is mainly due to the following two aspects. Product card positioning is accurate, cost-effective, and natural concepts enjoy consumption upgrade dividends. With the trend of consumption upgrade and the awakening of residents’ health awareness, the public’s preference for bottled water gradually changed from pure water to healthier natural mineral water. Jingtian Ganten is positioned at the mid-end in the drinking water market, but it is priced lower in the natural mineral water category. Compared with higher-end mineral water brands, Jingtian Ganten has outstanding cost-effective advantages. Impressive advertising videos and advertising slogans cooperated with high-frequency TV and Internet delivery, and successfully introduced the impression to consumers, and won the success of media communication. Combined with the simple and elegant outer packaging, it brings a good consumer experience to consumers. In addition to ingenious advertising design, Ganten continues to increase sports marketing.

On December 15, 2018, Yili announced that it planned to invest 744 million yuan to build a new Yili Changbaishan natural mineral water drink project in Changbaishan Natural Mineral Water Industrial Park, Jilin Province. The dairy giant entered into bottled water shows its ambition to expand. The project is expected to be officially completed and put into production in 2021. The company expects the project investment payback period to be 5.7 years. Yili’s move reflects the company’s optimistic outlook for the development of bottled water, and intends to get a slice of the bottled water market scale of 100 billion; and it is also an extension of the main product line, which helps the company to build a new product. Yili takes natural mineral water as an entry point and positions it in the middle and high end. In terms of product attributes, natural mineral water contains certain mineral salts and trace elements, which have higher requirements on the quality of water sources, and are more beneficial to health than pure water and mineral water. Limited by the distribution of water sources, the pressure on the product cost end may lie in transportation. Since natural mineral water has high requirements for water sources, the water sources are basically distributed in remote areas with good preservation of original ecology, inaccessible and unpolluted. Therefore, the water sources are far away from the market, resulting in higher logistics costs. At the initial stage of product launch, the scale effect was not fully exerted, and Yili may have difficulty with high transportation costs. With the expansion of production scale, the profitability of the project is expected to gradually improve. Yili’s advantages and challenges are brand + channel to build core competitiveness, to seize the consumer’s mind or the biggest challenge. As a leading dairy enterprise in China and even Asia, Yili has strong brand power and complete channel construction. With Yili’s brand endorsement, product quality can be guaranteed, and the bottled water channel has a high degree of overlap with the company’s existing liquid milk channel. It can be reached by circulation, supermarket, convenience store, and e-commerce. However, there are certain challenges in how to deal with brand positioning and seize the minds of consumers because the image of Yili dairy products is deeply rooted in people’s minds, consumers may not be able to quickly accept non-dairy products when operating across categories. Therefore, how to balance the relationship between pricing, region and marketing is also worth further thinking. All in all, Yili’s strategic layout of choosing to enter the natural mineral water industry at the current time reflects the unique vision of the company and its management, and the long-term benefits outweigh the disadvantages.

Peer company in the industry

Nongfu Spring best benchmarks in the Hong Kong stock market are Master Kang (322 HK) and Uni-President (220 HK). Master Kang and Uni-President are both engaged in beverage and convenience food businesses, while Nongfu Spring focuses on beverages. Healthy and high-end are two major trends in beverage consumption emphasis on natural ingredients, low sugar, no sugar, no addition; pursuit of function and face value; focus on product segmentation and diversification for different enjoyment scenarios. Relative to Master Kang’s who seek more stability than innovation, the Nongfu Spring, which is based on 2-yuan natural spring water and 5-yuan ready-to-drink tea, is more active and decisive in investing in trendy new products and trend categories, and the product configuration is closer to market demand. Therefore, in the wave of beverage consumption upgrades in recent years, Nongfu Spring has been able to achieve growth and profitability that is superior to its peers.

Master Kang is one of the few local full-service beverage companies, covering all mainstream beverages. The company product category included ready-to-drink tea, bottled water, milk tea, carbonated, energy drinks, and lactic acid bacteria drinks. Nongfu Spring is mainly based on packaged drinking water, as well as tea, juice and sports drinks. In recent years, Nongfu Spring has outperformed both Master Kong and Uni-President in terms of revenue growth and market share expansion. Benefit from Nongfu Spring’s advance layout and decisive investment in high-growth beverage categories, including high-end bottled water, energy drinks and high-concentration fruit juices. Master Kong’s carbonated drinks performed well, but the bottled water business fell into a negative situation due to the lack of timely high-end sales (2017-19 sales declined by 26%, not only losing its position as the leader, but also falling out of the top three). The milk tea segment has been recovering well, and it has reproduced double-digit growth, but the former star products “Classmate Xiaoming” are still weak.

Nongfu Spring has the highest profit margin among the three beverage businesses, thanks to high-margin water accounting for 60% of revenue, and its product mix is positioned at the mid-to-high end. Master Kang’s beverage gross profit margin and operating profit margin are the lowest, because the company’s layout of high-end products has been lagging in recent years. The proportion of medium-priced products in the product matrix is relatively high, and it has been in a period of adjustment in recent years. Nongfu Spring has a double-digit ratio cost of logistics and warehousing over total revenue, Master Kong and Uni-President are on the lower side. Master Kong’s factory network layout is the best through the cost effectiveness of the cost of logistics and warehousing. Nongfu Spring staff costs and advertising ratios are lower than both Master Kong and Uni-President. In terms of administrative cost ratio, thanks to scale advantages, Master Kong’s administrative expenses accounted for the lowest proportion of revenue, and Nongfu Spring was the highest among the three companies.

Although Nongfu Spring revenue is less than 40% of Master Kang, the net profit of Nongfu Spring is around 1.5 times that of Master Kang. The main reason is that Nongfu Spring’s product portfolio although also aimed at the mass market, is positioned and priced at the mid-to-high end, so it enjoys a higher profit margin of around 20.9%. The operating cash flow of the three companies and the quality of profit is in great condition. This is due to the dealership model of prepayment after delivery. Master Kang maintains a leading net cash position of its operating activities, and its financial position has also changed from net debt to net cash. The company has pursued the overall strategy of “cash is king” in recent years, controlling capital expenditures, activating idle assets, and constantly replacing borrowing with free funds. Nongfu Spring’s rate of return is higher than that of its peers. The root cause is the high gross profit margin brought by its advanced layout in the mid-to-high-end beverage market. Working capital turnover days of Master Kang’s are negative, because its inventory days are much shorter than its peers, and the company’s accounts payable days are as long as two months, mainly due to bargaining advantage with suppliers. Nongfu Spring has the longest cash turnover days. Nongfu Spring’s accounts receivable days are only 4 days because 95% of the company’s revenue comes from first-level dealers (first payment after delivery).

Master Kang and Uni-President have passed the peak period of capital expenditures for beverage business. In recent years, the proportion of beverage company capital expenditures has dropped to single digits. New capital expenditures are more used for new product categorization, refrigerators and heating cabinets. Therefore, Master Kong and Uni-President have paid dividends of 100% for two consecutive years in 2018-19. Nongfu Spring is still in the investment period, with capital expenditures exceeding RMB 3 billion in the past two years (accounting for double-digit revenues mainly for new factory construction. The company guidelines are estimated to be around RMB 3 billion and RMB 2 billion in 2020 and 2021, respectively. The Chinese beverage market is a trillion-scale market with a compound annual growth rate of approximately 6% over the next five years. By category, water is the largest category by channel. Although the traditional market selling channel still occupies the most, e-commerce, and other emerging channels are growing faster due to diversified and fragmented consumption scenarios. In terms of concentration, carbonated drinks and tea drinks have the highest concentration, while juice drinks are the most dispersed. Beverages are impulsive consumption, with high trend risks, constantly changing consumer preferences, and many demands for products such as health, beauty, and taste. Companies that produces full range of beverage selection have the advantage and greater ability to counter changing consumer trend risks.

Due to general industry barriers and high product profit margins, in the short term, some food and beverage giants may enter the bottled water sector and become new entrants, causing a slight decrease in concentration. In the long run, under the trend of consumption upgrades, mid- to high-end companies with good quality, high brand recognition and strong channel marketing strength are expected to stand out and gain a higher market share. Leading mid- to high-end companies benefit from quality and brand advantages, and market share is expected to increase further. The technical barriers in the bottled water industry are not high, the tastes are similar, and the homogenization of products is more obvious. At present, the median price-to-earnings ratio of Hong Kong stocks, A shares and global mainstream food and beverage companies in 2019 is 25 times, 41 times and 21 times respectively. In terms of a 30x 2019 price-to-earnings ratio, Nongfu Spring valuation is about 150 billion yuan.

Management and Shareholders

The company’s history can be traced back to the Xin’anjiang Yangshengtang Drinking Water Company founded in 1996 by the founder Mr. Zhong Shan Shan. According to the prospectus information, as of April 2020, Mr. Zhong Shan Shan, the founder of Nongfu Spring, holds 87.4% of the company’s equity, including about 17.9% of the direct interest and about 69.6% of the indirect interest held through Yangshengtang. Zhong Shan Shan holds 100% equity in the entire registered capital of Yangshengtang, including 98.4% direct interest and 1.6% indirect equity held by Hangzhou Youfu wholly-owned by Zhong Shan Shan. By having a majority of shares in hand, the management will be having the alignment of interest with the minority shareholders in the future.

Company’s competitive advantage

Correct strategic positioning focus on producing natural water.

From the perspective of product attributes, Nongfu Spring focuses on health. In 1999, after discovering that pure water is not beneficial to the human body, Nongfu Spring began to aim at natural and healthy properties. The transformation only produced natural water, and the pH value showed weak alkalinity, which once again strengthened the concept of health. From the perspective of pricing strategy, the middle and high-end card positions of Nongfu Spring conform to the trend of consumption upgrade. Nongfu Spring is positioned in the mid-to-high-end market from the beginning. Wahaha and Master Kang took a relatively low-end route. During the upgrade process, consumers tend to choose Nongfu Spring with higher prices and better quality. From the packaging point of view, the bottle body of Nongfu Spring is thicker, the red packaging paper is more conspicuous, and it is easier to stand out from the competition.

Comprehensive layout of sales channels as a competitive advantage

Nongfu Spring has established a deep nationwide distribution sales network. By the end of 2019, the company had covered more than 2.37 million terminal retail outlets nationwide through 4,280 dealers, of which approximately 78.9% were located in third-tier cities and below. In addition, the company also has large direct sales customers, mainly including national/regional supermarkets, chain convenience stores, e-commerce platforms, restaurants, airlines and group customers. According to Frost & Sullivan, the number of terminal outlets covered by Nongfu Spring accounts for about 11% of all terminal retail outlets in China. The company is executing continuous improvement of marketing network construction and continuous improvement of sales management efficiency. At present, China’s beverage industry is still dominated by traditional distribution channels, accounting for around 44%. In the future, the proportion of emerging channels such as e-commerce is expected to gradually increase. In terms of channel construction, the company mainly focuses on distribution channels, supplemented by direct sales channels. The company’s strong business network has established business moat for the company. At the same time, the company will continue to devote itself to the construction of channels, increase the market penetration rate, and strengthen the construction of modern channels.

The company has an industry-leading channel network, supplemented by efficient personnel management. Channel advantages continue to be highlighted, laying a good foundation for the volume of new products. Nongfu Spring adopts a single-layer distribution system: distributors directly sell products to supermarkets, convenience chain stores, small retail stores, e-commerce platforms, restaurants, etc. Distributors do not exclusively sell Nongfu Spring products, and usually the same distributor will distribute other packaged drinking water and beverages at the same time. Distributors directly purchase products in the form of advance payment followed by goods. When they cannot directly cover remote markets, they will sell products to secondary distributors. From 2020, in order to further promote the market, Nongfu Spring signed agreements with about 64 sub-distributors. Sub-distributors still need to purchase goods through the distributors. The company does not solely rely on a single distributor, only two of the top five customers are distributors, and the revenue generated by any single distributor does not exceed 1% of the overall turnover.

The company have established a nationwide sales network with in-depth market penetration, covering all provinces, municipalities and prefecture-level administrative divisions across China. In 2017, 2018 and 2019, the revenue from the distribution to distributors accounted for 95.0%, 94.6% and 94.2% of our total revenue, respectively. Among them, in 2019, traditional channels accounted for 44%, and modern channels accounted for 22.3%. From 2017 to 2019, the proportion of all channels except traditional channels has increased. Among them, modern channels have increased from 20.4% to 22.3%, and e-commerce channels have increased from 4.5% to 6.1%. From the picture above, we can conclude that Nongfu Spring tries to expand its e-commerce channel in Taobao to expand the presence online. Nongfu Spring and Ganten (only sells drinking water) set up e-commerce platform in Taobao, however C’estbon doesn’t set up a platform and relies on Tmall Mart to help sell its beverage. From the follower’s data (approx.744,000 followers the highest in comparison to peers) in the e-commerce page we can see that the contribution of e-commerce into revenue will increase for Nongfu Spring. In addition to direct customers, Nongfu Spring provides in-depth coverage of different channels through a comprehensive dealer network. Nongfu Spring’s direct customers mainly include national/regional supermarkets, convenience chain stores, e-commerce platforms, restaurants, airlines and group customers. Also, the company is equipped with Nongfu Spring brand image freezer in more than 360,000 terminal retail outlets, which can effectively increase the product’s brand display and shelf share in the terminal, and the sales volume is particularly significant in summer during the peak sales season. As of the end of 2019, Nongfu Spring has about 200 direct customers, and 3 of the top five customers in 2019 are direct customers. In 2017-2019, the direct sales channel realized revenue of 881 million yuan/1.113 billion yuan/1.398 billion yuan, accounting for 5.0%/5.4%/5.8% of the same period. In addition, the company is also actively expanding new retail channels represented by vending machines, catering channels, online channels, etc., and has launched nearly 60,000 smart terminal retail equipment represented by vending machines in nearly 300 cities across the country, and gradually establish a matching team and information system distribution service model. Considering the high transportation costs, the soft drink industry has a huge economies of scale. The nationwide production and sales network layout not only helps to reduce unit costs, but also helps to increase product coverage. There is an empirical theory of “500 kilometers” in the bottled water industry. If the transportation radius exceeds 500 kilometers, the transportation cost may eat up profits, and it is difficult to make profit for packaging water priced at 1, 2 yuan. Relying on the ten high-quality water source bases, Nongfu Spring has established a distribution network all over the country, and has done a more thorough job in channel sinking.

Room for product pricing improvement

Japan and Taiwan as the benchmarks for upgrading, there is about 60% room for improvement in the unit price of bottled water in China. The current per capita consumption of bottled water in China is still far lower than that of other countries in the world. There is much room for improvement in the future of bottled water sales and sales. From the perspective of sales, the per capita sales of bottled water in China in 18 years was US$20, which was lower than the global average of US$29.6. In the same period, the per capita consumption of bottled water in Japan, South Korea, Hong Kong and Taiwan, which also belong to Asia, reached US$66.5 and US$23.1, $99.9 and $29.8. From the perspective of sales volume, the per capita sales volume of bottled water in China in 18 years was 32.1 liters (calculated according to 550ml/bottle, which is about 116.7 bottles, and the daily average is only 0.3 bottles), which is only higher than that of Taiwan (19.7 liters) and lower than the global average (43.9 Liters), also lower than the United States (129.6 liters), Japan (66.5 liters), South Korea (58.0 liters) and Hong Kong (55.2 liters). For countries and regions with comparable standards, my country’s bottled water consumption has huge growth potential. According to Euromonitor International statistics, the average unit price of bottled water in China in 2018 was 4.1 yuan/liter, a year-on-year increase of 1.8%. According to the calculation based on the capacity of 500ml/bottle, the average terminal price of a single bottle is about 2 yuan, which is at a low level. The CAGR of bottled water is maintaining low- to mid-single-digit growth and expected to continue to increase in the future.

Affected by the rising costs of packaging materials and labor, the price of bottled water has risen significantly in recent years, and major manufacturers such as Nongfu Spring, Wahaha, Master Kong and others all have price adjustments. With the improvement of residents’ consumption power, the demand for health, quality and personalization continues to heat up. From the perspective of category, higher-priced soda and natural mineral water grow faster than lower-priced pure water and drinking water, driving the overall average price increase; from the brand point of view, among domestic brands, Master Kong, Wahaha, the low-end and middle-end bottled water represented by Binglu etc. has gradually given way to middle and high-end products such as Nongfu Spring, C’estbon and Baisui Mountain. On the other hand, some foreign manufacturers continue to introduce high-end bottled water with high-quality water sources, novel packaging design, and fascinating brand stories, such as Evian, VOSS, Fiji, Perrier, Saint Pelou, Puna, etc.

Compared with other countries and regions in the world, China current bottled water prices are still low. If Japan and Taiwan are used as benchmarks for upgrading, the unit price of bottled water in China has about 60% room for improvement, that is, corresponding to 6 yuan/liter, corresponding to 3 yuan/bottle (assuming a single bottle capacity of 500ml). Due to differences in product brands, manufacturer pricing strategies, price levels, and residents’ purchasing power, the average price of bottled water in China was lower than the world average, and lower than that in the United States, Japan, Hong Kong, and Taiwan. Bottled water in Japan and Taiwan is about 60% higher than that of Mainland China, that is it reaches the level of 3 yuan/500ml or more. Taking into account the similarity of diet and consumption habits, Japan and Taiwan are used as a reference. China’s bottled water is also expected to gradually move towards the “3-yuan era” as some developed coastal areas such as Shanghai has its bottled water priced at 3 yuan.

Geographically strategic water resource as an advantage

The natural water source is a scarce resource and a strong barrier for the industry. Nongfu Spring laid out ten high-quality water sources in advance. The water sources are scattered in different regions of China, which can not only cover the global market, but also effectively shorten the transportation radius, control the delivery time of logistics and transportation costs. The company water resource layout is the only one of the top five domestic packaging drinking water companies that uses natural water sources as raw materials for products. Since its establishment in 1996, the company has begun to plan the layout of water sources, and has now formed the top ten high-quality water sources in the country, which fully covers the national market supply and can be easily and efficiently accessed. The forest coverage rate of the company’s water source location is more than 85%-85%. The ecological environment is superior. The high-quality water is rich in natural mineral elements such as potassium, sodium and calcium. The health concept has won the favor and trust of consumers. The company’s natural water source guarantees the stability of product quality and long-term sufficient supply, and it is also a strong industry barrier against foreigners. With that, Nongfu Spring can improve its factory network layout to improve the cost effectiveness and the cost of logistics and warehousing.

Categorization of creative new products to the market

In recent years, the company has developed different types of packaging water for different scenarios and groups of people. Differentiated upgraded products have become a new growth point for the category. Different groups mainly targeted the introduction of sterile natural water containing minerals needed by infants and young children, and lithium-containing mineral water that is more friendly to middle-aged and elderly consumers. Different usage scenarios for consumers who love sports, one-handed bottle-opening, leak-proof design of sports-covered mineral water was introduced; glass bottles are also specially designed for meetings and banquets. Beverage products under Nongfu Spring include tea beverages, functional beverages, fruit juice beverages and other categories. Each beverage brand has its own brand positioning and focuses on health. It meets the dietary requirements of people who prefer healthy selection. For the research and development of new beverage brands and the maintenance of brand power, on the one hand, the company actively pays attention to the new changes of consumer groups and new trends in consumer habits, and develops innovative categories in a timely manner; for listed brands, it will also launch new packaging, new SKUs, brand promotion and other ways to maintain the vitality of each brand, so that a variety of beverage brands can have a longer life cycle, such as the “Farmer Orchard” series launched in 2003, “Scream” series launched in 2004 still maintain a certain competition force. With the company’s differentiated product strategy effectively meets diverse consumer needs, expands consumption scenarios and crowd coverage, and continues to increase brand stickiness. The company launched medium and large-scale drinking natural aquatic products from 1.5 liters to 12 liters, which effectively increased the penetration rate of household drinking water scenarios, and successfully created several packaged drinking water products for subdivided consumer groups. New customer groups, increased sales stickiness, and created new growth points for the packaged drinking water business. Nongfu Spring is also a highly innovative enterprise, and new products have been released in recent years. The company’s new products all focus on the “healthy” routes, the outer packaging with full of artistic design, in line with the oriental aesthetic, attracting the attention of consumers. For example, the company incorporates natural elements such as flowers, leaves, snowflakes, and elk in high-end glass bottled water, which is very interesting and echoes the company’s natural product characteristics; the company uses the image of frog, deer, bear, raccoon cat, etc. The natural scene of Changbai Mountain depicts the scenery in the fairy tale world.

Technology innovation in implementing data analysis through in-house NCP system

With the help of NCP system, the company can manage dealers and front-line salesmen through mobile phones and personal computers. It is beneficial to track and analyze the distribution activities of dealers, and improve the operation level and sales team efficiency of terminal outlets in terms of goods distribution, display and promotion. In terms of new retail, as of the end of 2019, Nongfu Spring has launched nearly 60,000 smart terminal retail equipment represented by vending machines in nearly 300 cities across the country. Vending machines can help Nongfu Spring to better reach end customers, further expand the sales network, and meet the needs of consumers in multiple scenarios.

In addition, the company conducts business activities through the digital system, which can monitor the operating conditions of terminal inventory, display, promotion, etc. in real time, which has significantly improved the management efficiency of the sales team. “Water source layout pushes new capabilities, brand building channel network” to jointly build the company’s competitive advantage. According to the prospectus and research of the company and the industry, the company has digital management system helps to continuously improve marketing efficiency. The company’s sales management team and all cooperative dealers use the NCP system to conduct business activities, analyze the service performance of first-line sales staff and dynamic inventory of dealers through big data, and automatically generate inventory warnings based on historical data and distribution performance. Refined and targeted guidance of distribution activities has significantly improved the company’s sales management efficiency. In 2019, the company’s sales expense ratio was 24.2%, a year-on-year decrease of 1.2 pcts, with continuing the trend of continuous decline in the past three years. In the future, with the increasingly perfection of the company’s information system construction and the terminal, it’s control is further strengthened, and the company’s marketing efficiency is expected to continue to improve.

Focuses into building long lasting brand power

A series of advertisements of Nongfu Spring are as follows: Nongfu Spring is a bit sweet (1997). We are just porters of nature instead of producing water (2008). It has long been deeply rooted in the hearts of the people and has established consumers’ trust in the brand. At the same time, the company continuously maintains communication with young consumers through various means such as star endorsement, variety show implantation, sports marketing, and cooperative promotion. Through the replacement of brand packaging and cooperation with programs such as hip-hop and idol trainees in China, the compound growth rate of “Vitamin” from 2017 to 2019 exceeded 47%. At the same time, the company and NetEase Cloud Music’s “Music” and “Forbidden City” bottle and other joint activities generated a hot topic among consumer groups by displaying selected music reviews, ancient paintings, interesting text and other content on the water bottle label. With strong creative ability, several classic cases of brand marketing have appeared in recent years which fully proves that the company is well versed in brand marketing and has cultivated many well-known brands such as Nongfu Spring, Tea Pi, and Oriental Leaf. The industry barriers are mainly resources, brands and channels. Leading mid- to high-end companies benefit from quality and brand advantages, and market share is expected to increase further. The technical barriers in the bottled water industry are not high, the tastes are similar, and the homogenization of products is more obvious. Existing manufacturers mainly rely on water resources, brand recognition and channel advantages to build barriers. Nongfu Spring are also trying to expand its brand presence not only in China but also internationally by becoming the sponsor of packaged water in high level events such as the 2016 G20 Conference that was held in Hangzhou which is also similar to the strategy used by Kweichou Maotai during the old days of China’s famous international conferences.

Consolidation of the company’s leading position

The moat is constantly widening. China’s packaging drinking water market is relatively concentrated. Nielsen data shows that in 2018, China’s packaging water industry CR5 was 75.20%, Nongfu Spring ranked first in the industry with a market share of 26.50%, followed by China Resources C’estbon with a market share of 21.30%, also Baisui Mountain, Master Kang and Binglu, with a market share of 10.10% 9.90% 7.40% respectively. In 2017, the company’s drinking water revenue increased from 10.120 billion yuan to 14.346 billion yuan, with a CAGR of 19.06%. It has maintained a leading position in the industry. On the one hand, it has established strong barriers by laying high-quality water sources to ensure product quality, consumer groups and consumption scenarios create differentiated categories and enhance user stickiness.

Well position to capitalize future consumption upgrade of the Chinese consumer by creating new products

The beverage industry has low user stickiness and diversified consumer demand, which requires companies to have a strong ability to promote new products. The company has a strong ability to promote new products, on the one hand, it is reflected in the continuous expansion of categories, on the other hand, it continues to cultivate mature categories, such as Tea Pi and the latest sparkling beverage Taste of Time (TOT). Nongfu Spring launched a new coffee beverage “charcoal”, soda drinks and plant yogurt products in 2019. In addition, the company also sells agricultural products, including “17.5°” fresh oranges, “17.5°” apples, and northeast jasmine rice, which helps to enhance the company’s brand awareness. Thanks to the forward-looking layout of the mid-to-high-end product matrix, Nongfu Mountain Spring has become the obvious beneficiaries of consumption upgrades, especially in bottled water, ready-to-drink tea and energy drinks class.

Provide quality drinking water to consumers in China

Occasional incidents of water pollution may cause residents to worry about the quality of drinking water and drive the growth of bottled water sales. For example, a phenol tanker leakage accident occurred in Hangzhou in 11 years, and some phenol leaked and flowed into Xin’an River, causing water pollution and Hangzhou citizens to snap up pure water. Besides that, a cadmium pollution incident occurred in Longjiang, Guangxi, affecting the 300km river section. Due to panic water pollution, Liuzhou citizens hoarded and bought supermarket bottled water. Similar incidents of water pollution trigger residents’ concern about drinking water safety. Bottled water is safe and convenient, and its unit price is not high. Such incidents will drive the local area’s demand for bottled water to surge in the short term. Continuation of increase demand for natural and mineral water due to increased consumer health awareness. The company launched medium and large-scale drinking natural aquatic products from 1.5 liters to 12 liters, which effectively increased the penetration rate of household drinking water scenarios, and successfully created several packaged drinking water products for subdivided consumer groups or special drinking scenarios. New customer groups, increased sales stickiness, and created new growth points for the packaged drinking water business.

Increasing consumption scenarios such as tourism and entertainment increase consumption for bottled water. In recent years, China’s tourism industry has maintained rapid growth. In 2018, the number of domestic tourists exceeded 5.5 billion, with a revenue of 5.13 trillion yuan. The CAGR of domestic tourism in the past ten years was as high as 19.3%, and the CAGR of tourism in the same period was 12.5%. Considering the health, safety and portability of bottled water, tourists usually choose bottled water as drinking water, and consumption during the travel process increases the demand for drinking water. Based on this, the rapid development of the domestic tourism industry will bring about a larger market increase in bottled water consumption. The number of domestic tourist arrivals will maintain a growth rate of about 10% in the future, and the annual number of new tourist arrivals will be about 550 million. Assuming that the proportion of people drinking bottled water is 70%, the average number of tourist days per person is 2 days, and the average daily consumption is 1 Liters of bottled water, due to the growth of tourism scenes, the annual increase in bottled water was 770 million liters, accounting for 1.7% of total bottled water sales in 2018.

Strategic opportunities for growth through successful IPO

Through the upcoming IPO in Hong Kong, Nongfu Spring can take advantage of the capital raised to accelerate market expansion. Optimistic about the company’s continuous consolidation of the moat’s advantage in the field of packaging water, and by continuously enriching the product matrix to expand consumption scenarios and crowd coverage thus the company’s future performance will develop steadily. The listing of Nongfu Spring which has abundant operating cash is that the larger purpose may be the realization and inheritance of wealth as company management are going to distribute large dividend of around RMB 9.598 billion in 2019 back to the major shareholders and also the possibility of strategic acquisitions for expansion. Global food and beverage giants such as Nestlé and Coca-Cola (a full-category beverage company that had acquired, Monster Drinks etc.) are through continuous mergers and acquisitions to capture the evolving trend of product categorization thus helping in continuing to consolidate its moat in the overall consumer market. Nongfu Spring may follow the example of global giants to extend categories and channels by acquiring suitable niche emerging beverage companies and established companies, and shorten internal R&D time, especially in its own weak categories.

Continue to build the brand image and quality to young consumers. The company has launched a number of leading drinking water and beverage brands including “Nongfu Spring”, “Tea Pi”, “Eastern Leaf”, “Scream” and so on. At the same time, some new categories and new brands such as “17.5°”, “Taste of Time” and “Charcoal” that have been launched in recent years have gradually been recognized by consumers. In the future, the company will increase product development based on natural raw materials such as fruits, tea, natural plants, coffee, and vegetable proteins, and continue to promote functions that meet health requirements. Another reason is to improvise the research and development of drinks. By successfully integrating online and offline marketing, strategically combine and use various media tools and communication methods to further enhance brand influence and reputation.

To steadily promote the construction and optimization of dealer networks. The company will continue to support dealers to strengthen their operational capabilities and improve the level of management of terminal retail outlet coverage. Continue to lay out high-growth sales channels, including new retail channels represented by vending machines, catering channels, etc. By covering different consumption scenarios and enhancing consumer reach, thereby successfully expanding the breadth of distribution. Continue to increase investment in terminal retail outlets to increase the influence of products in terminal retail outlets and increase the frequency of consumers’ purchases by placing freezers, warming cabinets, optimizing shelf display and conducting offline market activities in terminal retail outlets, as a result, the sales of terminal retail outlets increased.

Further expand the total production capacity. Even with the total capacity of current production at around 52%, the company plans to further expand its production capacity strategically, by upgrading existing equipment and building new production facilities, purchasing new production equipment, and improving production technology to seize market growth opportunities and consolidate the company’s leading position in the beverage industry in China. The key plan is to expand the production capacity of the production bases located in Qiandao Lake, Zhejiang, Wanlv Lake, Guangdong, and Changbai Mountain, Jilin.

The company will increase investment in basic capacity building, which will help the company/ Optimize operational efficiency and enhance long-term development of core competitiveness. The company plans to continue to invest in information system construction which connects different dimensions of sales data to better analyze big data and enhance the company’s adaptation towards market change. The speed of response to the trend of improvement has promoted the improvement of operational efficiency. Continuously strengthen the company’s applied research, product innovation, new capabilities, continue to strengthen project cooperation with universities at home and abroad. R&D capability building helps the company to continue to develop products that meet consumer demand and lead market trends.

Explore overseas market opportunities. The company is working hard to explore overseas markets, planning to set up production bases overseas. Form complementary business opportunities and strategic acquisition opportunities. The company hopes to acquire New Zealand bottled water brand Otakiri Springs, as to apply the company’s manufacturing capabilities, supply chain management capabilities and sales channel expansion capabilities to overseas market. Through research, Nongfu Spring has started to expand its business to overseas market such as the introduction of its successful product “Tea Pi” with the collaboration with 7-Eleven Malaysia.

The company’s listing is expected to start a new journey of development, as investors are optimistic about the company’s future development. Nongfu Spring is about to conduct an IPO in Hong Kong, and raises 10 billion US dollars. It is mainly used for brand building, steadily promoting the construction and optimization of dealer network, expanding production capacity, increasing basic capacity building and explore overseas market opportunities. Believe that after the company’s listing, it can use its capital advantage to accelerate market expansion, optimistic about the company’s continuous consolidation of the moat’s advantage in the field of packaging water, and by continuously enriching the product matrix to expand the consumption scene and the coverage of the crowd, the company’s future performance will develop steadily.

Company’s financials

For the company to continuously increase the use of packaging drinking water products, while improving channel coverage, to achieve a stable packaging water business, through continuous innovation to help the rapid development of the beverage business. Nongfu Spring maintained healthy business growth. In 2017, 2018 and 2019, revenue was RMB17,491 million, RMB20,475 million and RMB24,021 million, respectively. From 2017 to 2018 and from 2018 to 2019, revenue increased by 17.1% and 17.3%, respectively, which were much higher than the growth rates of 5.0% and 6.6% in the PRC soft beverage industry, and the growth rates of 2.7% and 3.4% in the global soft beverage industry in the same periods, according to the F&S Report. In addition, Nongfu Spring are one of the most profitable companies in the PRC soft beverage industry. In 2017, 2018 and 2019, net profit margin was 19.4%, 17.6% and 20.6%, respectively, which was much higher than the average net profit margins of 6.9%, 7.1% and 9.6% in the PRC soft beverage industry and 3.9%, 7.6% and 8.5% in the global soft beverage industry during the same periods, according to the F&S Report.

Beverage business: In 2017-2019, the company’s beverage product revenue was 7.01 billion yuan/8.213 billion yuan/9.228 billion yuan, a year-on-year increase of 17.31%/12.36%. The company adopts a multi-brand development strategy to give beverage brands a unique positioning. The company has extensive experience in managing the life cycle of beverage products, through formula optimization, packaging update, new SKU launch, and brand promotion activities and other ways to keep the brand young and vibrant. The company’s “Scream” launched in 2004 and revenue in 2019 is still up 10.2% year-on-year. The tea beverage “Tea Pi” launched in 2016 had revenue of more than 1.6 billion yuan. Through the replacement of product packaging and cooperation with Chinese programs such as hip-hop and idol trainees, ” Vitamin Water” has renewed its vitality, with a CAGR of over 47% in 2017 and 2019. Profitability remained high, and packaged drinking water contributed significantly to gross profit. From the profit side, the gross profit margin fluctuated slightly, from 56.1% in 2017 to 53.3% in 2018, 53.3%, and then increased by 2.1% to 55.4% in 2019.

The fluctuation in gross profit margin is mainly due to the average purchase of raw materials PET. The price is constantly fluctuating. The principal raw material use in the production of products is PET, which is used in manufacturing bottles. In 2017, 2018 and 2019, the costs arising from PET amounted to RMB2,228 million, RMB3,044 million and RMB3,382 million, accounting for 29.0%, 31.9% and 31.6% of total cost of sales, respectively. Apart from raw materials, the company also need packaging materials such as cardboard boxes, labels and shrink wraps to produce our products. In 2017, 2018 and 2019, the costs of packaging materials accounted for 31.4%, 31.1% and 31.5% of total cost of sales, respectively. Nongfu Spring have maintained stable and long-term relationships with our major suppliers only procure raw materials and packaging materials from the suppliers already listed on our supplier catalogue. Consider several factors in the evaluation and selection of suppliers, including but not limited to the supplier’s background, reputation, industry experience, and most importantly the quality and price of their supplies. All new suppliers must go through our internal supplier admission process before entering into supply agreements with the company. Some of them are subject to an onsite inspection conducted by us on their production plants on an as-needed basis to test the raw material and packaging material samples and evaluate their production processes and quality management.

In 2018, water resources fees will be changed to water resources taxes, which will become part of business taxes and surcharges, and will not be included in the main business costs. At the same time, because many of the company’s water sources are located in the western development area, local tax incentives are often given, and the actual tax costs of the company are relatively low, which are not considered as raw material costs. In the future, the company will strategically reserve more PET inventory when prices are lower based on expectations of PET purchase prices, which will ensure the stability of raw material supply prices and the level of profitability will tend to be stable.

The net margin is volatile due to the impact of the gross profit rate. In 2019, the net margin was 20.6%, a year-on-year increase of 3.0%. On the one hand, the company granted employee share incentives of 157 million yuan in 2019 to affect the company’s management costs. On the other hand, the company’s logistics and storage expenses, employee costs and advertising and promotional expenses offset each other, and overall operating efficiency increased, making the sales expense rate decline year by year. In the future, with further improvement in management efficiency, and the improvement of transportation cost that’s higher than peer companies, Nongfu Spring’s profitability is expected to increase.

At present, the median price-to-earnings ratio of Hong Kong stocks, A shares and global mainstream food and beverage companies in 2019 is 25 times, 41 times and 21 times respectively. In terms of a 30x 2019 price-to-earnings ratio, Nongfu Spring valuation is about 150 billion yuan.

Risks