Analyzing Illi's (600887.SH) half-year report requires a dual perspective. On the surface, total revenue reached 64.49 billion yuan, a year-on-year increase of 4.13%, setting a new record. Core operating profit hit 8.38 billion yuan, up 10% year-on-year, also a historic high, with the profit margin expanding by 66 basis points. However, net profit attributable to shareholders stood at 5.759 billion yuan, a decline of 20.02% year-on-year. One report presents two very different narratives, and the release on August 26 provided ample material for both praise and criticism.

Let's first highlight the commendable aspects. Illi's most impressive metric isn't just revenue, but the quality of its profits. The gross margin improved to 36.3%, up 25 basis points, while selling expenses as a percentage of revenue decreased by 57 basis points. The difference between gross and selling expense ratios widened by 80 basis points to 18.6%. In simple terms, for every drop of milk sold, the company retains more profit. Cash flow from operations surged 229% year-on-year to 9.759 billion yuan, with the company describing its channel inventory as being in an optimal state.

The cold beverage division was the biggest surprise, generating 9.073 billion yuan in revenue, a 10.26% increase, maintaining its industry-leading position for 31 consecutive years. Brands like Zhenxi, Qiaolezi, and Binggongchang all saw double-digit growth. In the powdered milk sector, Infant formula secured the top national market share, with the Jinlingguan first-stage series achieving the number one position globally, and the organic series experiencing retail sales growth exceeding 50%. International expansion also accelerated, with cold beverage revenue in Indonesia climbing around 20% and doubling in the Philippines.

A favorable industry wind is also blowing: in the first half of the year, the national dairy cow inventory decreased by 3.8% year-on-year to 5.772 million heads. After a six-month period of price consolidation for raw milk, prices rose 1% year-on-year in July, marking the first positive turn since 2021. This cyclical turning point for raw milk prices provides a solid foundation for the financials. Shareholder returns are also being enhanced: on the day of the report, Illi announced a 1 billion to 2 billion yuan share buyback and cancellation plan, with a commitment to a dividend payout ratio of no less than 75% in the coming years. Since its listing, it has cumulatively distributed 67.295 billion yuan in dividends, the highest in the industry. Some calculations suggest that, factoring in the buybacks, the effective payout ratio for 2026 could reach as high as 85% or even 95%.

After highlighting the positives, we must address three unavoidable issues. The first is the -20% net profit decline, a hole that was dug seven years ago. The primary cause of the net profit drop is AUSNUTRIA. In the first half of the year, Illi recorded an impairment of 2.461 billion yuan related to AUSNUTRIA's asset groups, including 1.547 billion yuan in goodwill impairment and 907 million yuan in inventory write-downs. AUSNUTRIA's own performance was grim: revenue fell 18.62% year-on-year to 3.163 billion yuan, and it posted a net loss of 705 million yuan, its first loss since its 2009 listing, dragging down Illi's net profit by approximately 430 million yuan. A look at the total picture: when Illi made its high-profile investment in AUSNUTRIA in 2019, goodwill stood at 5.134 billion yuan, which has since been reduced to around 600 million yuan, with cumulative impairments exceeding 4.5 billion yuan. The company describes the impairments as non-cash items that allow it to move forward with a leaner balance sheet, but investors are wondering when this acquisition lesson will finally be learned, especially as AUSNUTRIA continues to lose money seven years on. To add to the woes, some of its products were reclassified as deeply processed items by tax authorities, leading to a one-time supplementary tax payment of approximately 630 million yuan.

The second issue is that the industry leader's growth has been surpassed by the runner-up. Comparing the two half-year reports shows a less favorable picture for Illi. In the first half, Mengniu's revenue rose 7.8% to 44.795 billion yuan, with net profit attributable to shareholders growing 15.9% to 2.37 billion yuan, and liquid milk sales increasing 5.2%. Illi's revenue grew only 4.13%, with liquid milk sales up a mere 1.28%. Mengniu has upgraded its full-year growth target from mid-single-digit to high-single-digit, while Illi maintains its mid-single-digit guidance. While Mengniu benefited from a lower comparison base last year, the image of the industry leader being outpaced by its competitor is a significant concern for management. Illi's liquid milk segment has seen positive growth for two consecutive quarters, which is good, but the 1.28% growth rate is hardly indicative of a strong recovery.

The third issue questions the sustainability of the powdered milk segment's success. Infant formula was the brightest spot in this report, with top market share, the Jinlingguan first-stage series leading the industry, and organic products growing over 50%. However, this growth curve is clearly a story of gaining market share. With declining birth rates, the overall infant formula market is shrinking, so Illi's gains are coming at the expense of its competitors. As the pie gets smaller, the question becomes what happens next. A supporting indicator is that the overall growth rate for the powdered milk and dairy products segment was only 1.61%, highlighting the contrast between a strong product line and a weaker overall segment. As for adult powdered milk, which already holds a 26.8% market share, the potential for further growth is uncertain.

In summary, Illi's half-year report is multi-faceted. The 8.38 billion yuan core operating profit is genuine, as are the improvements in gross-to-selling expense margins, cash flow, and the strengths in cold beverages and powdered milk. The -20% net profit is also real, along with the burden from AUSNUTRIA, the challenge from Mengniu, and the potential ceiling in the powdered milk market. The core profit has maintained appearances, but the three key challenges test the company's underlying substance. Whether liquid milk can turn its 1.28% growth into double digits in the second half, whether AUSNUTRIA can stop its losses, and whether powdered milk can continue to take market share—these answers will carry more weight than the title of the largest player in Asia.