Challenges of China's milk industry

Milk in Global Markets

Challenges of China's milk industry

Pin-insights

The Chinese dairy industry offers unvarnished views on strategic  central planning. With food quality concerns on edge after the 2008 milk poisoning scandal, the leading dairy companies have been implementing quite distinct forms of collaboration with foreign milk producers

A review of the associations, partnerships and buy-outs led by the Chinese dairy companies paints a coordinated effort to explore alternative options with an open mind, but with unequivocal purpose - to secure the milk resource for Chinese demand and to gather the best expertise in premium dairy products

The anticipation of potent growth in China's medium term milk demand is the underlying rationale 

Although dairy farming does not have the seductive potency of the tech sector, the industrial policy of its leading firms could be seen as a blue print shedding light in the patient build-up of a central-command economy

 

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Milk, rivers of milk are a red thread of the most unusual and the most significant sort, tying issues of equal access to quality food in China to collapsing water quality in New Zealand to deforestation in the Amazon to land use and environmental strategies world wide

 

The conglomerates riding the ever expanding wave of international trade in agricultural products have contributed to soothing perceptions of ‘business as usual’ in the dairy industry

But food-related political tensions have been spreading around the world and commentators will be paying more and more attention to these flickering shadows of tomorrow’s ‘hot’ conflicts…

 

Access to food may be a given in the more advanced economies but the entitlement is rightly seen as a proof of responsible government in developing countries

China stands out with its 1.4 billion people (18.4% of world population) and its freshly minted buying power but the country is by no means unique in the food-race

Milk is special in the sense that its consumption has a strong emotional dimension and is seen as a symbol of national economic achievement in the face of past Western dominance, when milk was reserved to the privileged few

But, at the same time, the fast expanding dairy industry reverberates intractable environmental risks around the world

Like the dying canary singing in the coalmine, it could be that milk, prefigures complex international relations in a no-so distant future around water and food

The warning signs around growing demand and production constraints of milk are worth paying attention

 

A potent symbol

Seen with good reason as an essential component of a balanced diet, milk is edging towards center stage in every country’s effort to secure reliable food supply

Nowhere more so than in China has safe milk supply become a critical stake intertwining domestic and global trade considerations

As so often when a nation’s sense of identity is in play, history weighs in, influences and, on occasion, distorts political policies

 

The devastating years of the Great Famine, 1959-1961, and the resulting deaths of tens of millions, have scarred generations – those who were old enough to remember the hardship and those who have become moral custodians of the suffering of their fathers

Neither has the Chinese Communist Party forgotten the tragic mismanagement of the ‘Great Leap Forward’ and the policy mistakes of drastic changes in farming policy and agricultural techniques; as of this day, no guiding principle supersedes the deeply felt responsibility to secure safe food supply for every Chinese

This vital issue sheds light on the sensitivity of food poisoning which, in a very large country, still in the process of structuring its regulatory framework and its enforcement of safety rules, was bound to occur occasionally

Although much has been made of the fact that ethnic Hans are lactose intolerant, making milk hard to digest, its aura of social progress and its promise of a healthy life growing up in an affluent nation encouraged parents to feed their infant child with milk, maintaining the child’s capacity to make the lactase enzyme in the process

Widely publicizing its nutritional benefits, large access to milk also marked a clean break with the earlier days of Communist China, when milk was rationed and reserved to infants and the elderly, athletes and party cadres above a certain grade – giving a true sense of equality to many

 

Aftermath of a Chinese scandal 

The scandal, which blew up in 2008, was about more than poorly monitored quality controls – it was about shredded illusions of a better future for one’s child, it was about endemic corruption in the ranks of middle- and lower-management, it was about deep-seated inequality which healthy food would eradicate but did not

The milk poisoning resulted from adding melamine, an industrial chemical, to watered-down milk to cheat the protein tests on which the price paid to farmers was based. It is estimated that 300 000 children fell ill from kidney stones and 6 babies died. The reputation of China’s dairy industry collapsed overnight

credit - interest.co.nz

While the scandal – and further incidents – bewitched the domestic dairy industry, efforts to regain lost credibility injected new urgency in long-term trends industrializing milk production on a large scale,  integrating raw milk supply and encouraging in-house research, international exchange and acquisition of foreign stakes

 

Back on track, China's dairy majors

The strategic importance of the Chinese milk industry is highlighted by the growing international presence of the 3 major industry players

  • Inner Mongolia Yili Industrial Group (not listed on OTC any longer - Shanghai stock exchange ticker 600887) 
  • China Mengniu Dairy - Hong Kong listed ticker 2319 - and its subsidiaries China Modern Dairy Holdings (not quoted on OTC any longer - Hong Kong ticker 1117) and Yashili (Hong Kong ticker 1230)
  • Bright Dairy & Food (Shanghai stock exchange ticker 600597)

 

logo of Yili  Industrial Group

Yili Industrial Groupwith a 22% market share, ranked as largest Asian dairy conglomerate and n°9 on the 2018 Rabobank global survey with a turnover of $9.9 billion. With 2018 sales of $11.8 billion (¥ 79.6 billion), the company will be gaining in world rankings

As new M&A options beckon, Yili could soon count amongst the world's top dairy food conglomerates (along with Nestlé , Lactalis and Danone of France , Dairy Farmers of America (DFA) and Fonterra of New Zealand - ticker FCG)

In 2013, Yili acquired New Zealand Ocean Dairy and expanded its production capacity in milk powder in 2017/2019

In 2014, the company announced a partnership with DFA to build a new milk powder plant in Kansas but Yili withdrew its commitment in 2015 because of milk price volatility. The plant was inaugurated in 2017 with a daily production target of 250 tons (550 000 pounds) and Yili may have become a customer

In 2018, Yili strengthened its international presence in Asia with an Indonesian venture (2015), a Thailand-based investment in frozen foods and ice cream and a 51% stake in a Pakistan juice and dairy processor

Following the announcement in late 2018 by Japanese Kirin of the sale of Australia-based subsidiary Lion Dairy & Drinks, Yili has expressed interest ... as did Chinese competitor Mengniu, Canadian Saputo and most other dairy conglomerates (although Coca Cola Amatil withdrew...)

As of April 2019, Lion Dairy had entered into an agreement to sell the Dairy & Drinks Specialty Cheese business to Saputo

In 2019, Yili hopes to acquire 100% of New Zealand based Westland Dairy Products from the shareholder farmers whose response remains cautious. The takeover offer is attractive (at more than twice the share price and with a farmgate milk price aligned on the higher Fonterra price for 10 years) and the terms highlight what ails mid-sized cooperatives : poor investment capacity, inability to develop and compete in value-adding premium milk  products and - as a result - poor payout to the farmers

In the later case, the response of the New Zealand Overseas Investment Office will be of interest

 

logo China Mengniu Dairy Company

Mengniu is the second largest integrated dairy producer in China with a 17.3% market share (est. 2017)

The company has controlling stakes in  China Modern Dairy - 61.25%  (HK - 1117), a large upstream raw milk provider and in Yashili - 51% (HK - 1230) - specialized in infant milk formula product

In a joint venture with Mengniu to develop the high end chilled yoghurt market (2013), Danone acquired  a 4% stake in Mengniu and boosted its holding to 9.9% in 2014, following through with a 25% stake in  Yashili the same year and selling its China infant formula brand to Yashili (allocating the proceeds to increase its stake in Mengniu). In early 2019,  Danone finalized a 49% JV in Yashili New Zealand

A 51%-49% joint venture with WhiteWave Foods, US-based and acquired by Danone in 2016, purchased Yashili Zhengzhou, a subsidiary of Yashili International Holdings and further tightened shared interests with Danone

Swedish-Danish dairy co-operative Arla Foods is Mengniu's second foreign shareholder (with a 6% stake since 2012) and key partner in developing premium products

The tighter partnership pursued with Danone is focused on infant formula unit Yashili to regain footing in the premium market dominated by Nestle SA, Mead Johnson (bought by Reckitt Benckiser ) and local firms Beingmate Baby & Child Food Co Ltd (listed in Shenzhen - 002570) and Health & Happiness (formerly called Biostime and listed in Hong Kong -1112)

Mengniu's 2018 profit rose 49% on a product mix focused on premium products but listed-subsidiary Yashili had another year of negative (-4.39%) operating margin - a development which, undoubtedly, draws attention at Danone 

 

                   logo Bright Dairy & Food

Bright Dairy & Food  is the third largest dairy company with offerings of fresh milk, yogurt (est 15% market share), probiotic beverages, UHT milk butter and cheese

Bright Dairy stands out with a strategy of majority stakes in foreign partners

  • a 51% stake in New Zealand based Synlait, an infant dairy formula producer, reduced to 39.04% with the listing of Synlait on New Zealand (ticker SML) and Australia exchanges, which proved to be remarquably successful (+350% over 2014/2019)
  • a 77% stake in the largest Israel's dairy major Tnuva, acquired in 2015, was hard hit by the double negative of price controls and the market opening to foreign imports

The drastic fall in Tnuva's value, only two years after the acquisition, has forced Bright Dairy to rebalance the share collateral provided against the loan taken on to acquire Tnuva in the first place and to provide strong bank guarantees against short-term loans needed to make-up the shortfall 

The strategy of Bright Dairy of controlling stakes in foreign players with credible business strategies has been hit and miss

  • A hit - Synlait has, in its own right, distribution agreements in China with Bright Dairy, Sichuan New Hope Nutritionals (25% controlled by Synlait) and New Zealand based a2Milk (listed on NZ exchange - ticker ATM) and itself is a major infant formula marketing firm and distributor on the Chinese market (also a Synlait shareholder with a 17.39% stake)
  • A miss - Tnuva - as it turned out - had no strong market approach outside Israel, exposing the company to regulatory shift on the domestic market and requiring diversification on foreign markets (including China...), a slog for years to come....

 

A brief recap

Putting the milk poisoning scandal of 10 years ago in its historical context of the Great Famine, we stressed the utmost sensitivity of the Chinese Communist Party to food security and universal access.  Anything less would unfailingly tax the Party of gross incompetence

The fullest attention paid to the industry has led to a national long-term strategy, encompassing all the key Chinese companies engaged in downstream milk processing, to which distinct 'roles' appear to have been assigned

  • Yili reached out on the international market, targeting 100% control of additional resources and possibly expertise from its acquisitions and implementing a marketing policy in South East Asia
  • Mengniu's association with international conglomerates concentrated on expertise - and probably technology transfer - at the high end of the Chinese consumer markets - with carefully monitored foreign stakes, preferably in a subsidiary (such as the 25% Yashili share of Danone)
  • Bright Dairy has taken the reverse approach with majority stakes in foreign firms seen as successful in their own markets and facilitating access of these firms - under their own brands - to the Chinese market

All three strategies, profiling different rapports with foreign dairy companies, have merit and it is fair to assume that the various angles explored are not haphazard

To a foreign observer, the Chinese milk industry makes the case for the long view, indispensable to gain an understanding of any, and in fact all, Chinese policies

Looking ahead, the real test resides in anticipating the challenging times of exploding domestic demand, with a critical environmental fallout, coming none too soon as we will discuss in "Global milk demand - keeping pace ?"