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Radical shifts in China's milk market
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By Ethel Lu

The recent melamine scandal has bitten deep into China's milk industry, smearing a number of reputed domestic names and ruining the companies. Sanlu, the principal company implicated in the scandal, now faces bankruptcy. It is, however, a rule of the market that as some players fall, others rise. So in the wake of the turmoil, China's diary market is undergoing an extensive shake-up.

Winners and Losers

Beijing-based Sanyuan is without doubt the biggest winner in the tainted milk scandal. Once the news came out that its milk was free of melamine, a noxious chemical detected in products of many prominent domestic companies such as Sanlu, Mengniu and Yili, the demand for Sanyuan milk skyrocketed. Overnight demand reached eight times the firm's production capacity. Its stock price rose by 64.4 percent in six days, from RMB 3.4 to RMB 5.59, in contrast to the sharp drops experienced by competitors.

Little known outside Beijing and its environs, Sanyuan had long lived under the shadow of giants like Sanlu, Yili, Mengniu and Bright, whose sales networks cover the whole nation. Now Sanyuan also enjoys national fame. Another rising star is Guangzhou's Kowloon Dairy Food Products Co., Ltd. Its four production lines have been running at full capacity since the melamine scandal. What's more, it was selected as the new supplier for Starbucks in China.

The situation of the former dairy giants is a stark contrast. Mengniu and Yili saw their orders shrivel by more than 80 percent in ten days following the disclosure of melamine contamination on September 11. Though later batches of their products tested negative, it seems customers will not be won back easily.

Dairy consumption is still a recent phenomenon in China. Ten years ago only babies and older people drank milk, mainly in powdered form. Starting in 1999 the sales of UHT milk grew at an annual rate of 89 percent for five years straight, so that in urban areas liquid milk consumption is now greater than powdered consumption. According to 2006 statistics, China's urban residents each imbibed an average of 22.54 kilograms of dairy products per year, comprising 22.04 kilograms of liquid (including 18.32 kilograms of fresh milk and 3.72 kilograms of yogurt) and 0.5 kilograms of powder. But this has not changed China's status as the world's largest powered milk market, where annual consumption still exceeds 1 million tons.

Prior to the melamine contamination scandal, Sanlu, founded in 1956, held the leading spot in China's powdered milk sector for 15 years, with a market share well above 18 percent by 2007. Emerging from a tiny factory of merely 32 cows and 170 sheep, the company evolved into a conglomerate with dozens of branches all over China, in partnership with the Fonterra Co-operative Group of New Zealand. But the company now seems doomed to be bought out and split up.

Negotiations are underway for Sanyuan to purchase seven plants from Sanlu, whose RMB 10 billion in sales in 2007 far outweighed Sanyuan's modest takings of RMB 1.1 billion. But it appears unlikely the former giant will survive the melamine scandal, given government support for Sanyuan's takeover bid and an offer of assistance from the CITIC Group to finance the deal.

Foreign Companies Sense Opportunities

Untarnished local dairy companies are not the only beneficiaries of the melamine scare. Until very recently, 80 percent of the liquid milk market in China was occupied by Mengniu, Yili and Bright. But all have been hit badly by the melamine crisis, and their market share is coveted by a horde of eager foreign competitors. While major Chinese dairy producers were occupied with recalling products and attempting to salvage damaged reputations, the Japanese brewery Asahi launched its first milk brand in China on September 21, 2008, conspicuously labeled as a "green" product. It has consequently sold like hot cakes, despite carrying a price more than twice the market average, although for the moment Asahi Green Source only produces three tons of fresh milk daily. The company mainly supplies hotels, restaurants and major supermarkets in big cities such as Beijing, Shanghai and Qingdao.

Asahi Green Source was established in April 2008 and obtained its operation license in August. The company insists that the fortuitous timing of its debut was not calculated, but it could not have arrived at a better time.

In the powdered milk sector international brands have always reigned at the upper end of the market. Statistics from 2007 show that one-quarter of the high-grade baby formulas sold in China that year came from U.S. company Meadjohnson, who raked in RMB 1.6 billion that year. They were followed by U.S. company Wyeth, with a 20 percent market share, and French company Dumex with 12 percent.

As domestic powdered milk is largely abandoned by customers, foreign brands are taking up the slack. Wyeth, for example, plans to build the world's largest powdered milk factory in Suzhou, Jiangsu Province, producing high-end baby formula. According to Xi Qing, the company's public relations chief, orders from large chain stores soared three-fold after the melamine scandal. Danone, the world's second largest dairy food group, merged with Miaoshi, a private dairy company, back in February 2008, and is working on similar deals with other home-grown companies.

Surging demand for better-quality powdered milk has also spurred imports. Customs figures show that in the first quarter of 2008 China imported 31,000 tons of powered milk, at the value of US $140 million, an increase of 5.5 percent and 95.9 percent respectively over the same period in 2007.

Huge Potential to be Tapped

The per capita annual milk consumption of urban residents in China was merely 27 kilograms in 2008 - the figure was even lower in rural areas. This is far below the world average of 80 kilograms, or the 200 kilograms per head in developed countries. In the U.S. the figure consumed is 260 kilograms per capita, almost ten times the rate of consumption in China. It is estimated that only 300 million of the 1.3 billion people in China regularly drink milk, leaving a vast virgin market to be explored by dairy companies.

Since 2006 the government has launched a campaign to promote dairy consumption in an effort to enhance citizens' nutrition, under the slogan, "A glass of milk every day can make people stronger." Meanwhile, a local baby boom is taking place, lending momentum to the formula milk sector. Dairy companies see these conditions as offering an unprecedented chance to expand their business. Mengniu, for example, offered free milk to 500 rural primary schools under the "one glass of milk a day" movement, before the melamine scandal cast a shadow over the ardor for dairy products.

One of the few domestic brands unscathed by the crisis, Sanyuan ensures its quality control by running its own dairy farms. At present it has 27 dairy farms with 35,000 cows, producing 160 million kilograms of good-quality raw milk every year. Their model, though more costly, has been copied by other companies in the wake of the melamine scandal. Mengniu merged its small, dispersed farms, and placed them under direct supervision. Bright dispensed with supplies from individual dairy farmers, which previously accounted for five percent of its raw milk supply, and has instead incorporated individual operators into standard farms.

Kong Xiangzhi, a professor with the School of Agricultural Economics and Rural Development at Renmin University, predicts that it will take two or three years for China's dairy industry to recover from the blow of the melamine scandal. For companies like Mengniu and Yili, it will be an uphill battle regaining the trust of customers.

For all businesses, in the dairy sector and beyond, an old lesson has been proven true once again: quality is the cornerstone of a strong, long-term market presence.

(China Today January 14, 2009)

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