Cash cows

Dairy products and pop culture television are not obvious bedfellows but this didn’t stop dairy firm Mengniu sponsoring Hunan Television’s Supergirls series, the Pop Idol-style program that saw the public vote on which unknown had the looks and larynx to make it as a professional pop star.

For series winner Li Yuchun, a place at the top of the charts awaited. The prize for Mengniu wasn’t all that different; brand recognition generated in no small part by association with Supergirls has turned it into a major player in China’s dairy industry. The company was only founded in 1999 but now seems to have the strength to stay at – or close to – the summit long after Li disappears into obscurity.

"The company has engaged in very aggressive advertising and promotion around China," said Yang Xu, a research analyst at Euromonitor International. "Before Mengniu sponsored the Supergirls TV series, its Suansuanru brand sold 700 million; after the series, it sold 2,500 million."

Despite developing from a comparatively small base, China’s dairy industry is becoming a significant moneymaker. Consultancy McKinsey estimates it will double in size to US$20 billion by the end of the decade, and growth rates cited by other analysts tally with this projection. Euromonitor puts it at 19% a year between 2007 and 2011; agriculture specialists Rabobank say 25% a year over the next decade; and Nomura quotes growth estimates of 20-25% year-on-year through to 2010.

Well trod path

China is following trends set by its Asian neighbors. The country’s dairy industry may be the second-largest in Asia after Japan’s, but it is at a much earlier stage of development. Dairy products have traditionally played a relatively small role in the Chinese diet: annual dairy consumption currently stands at 15-20 kilograms per capita, a sixth of the global average.

According to a recent McKinsey report, value-added dairy products such as milk beverages and yoghurt make up 25% of the China market as opposed to 60% in Japan. The next five years are likely to see some serious catching up, with milk beverages, cheese and yoghurt sales increasing by 22%, 38% and 31% respectively.

"Increasing dairy consumption is correlated to income," said Lillian Lou, senior manager for strategy, advisory and research at Rabobank China. "In the big cities it’s getting more westernized, so it will follow what happened in Japan and Korea."

For the time being, though, liquid milk remains the principal seller and its strong position is backed up by various government efforts to promote milk consumption for health reasons. Mengniu and rival group Yili – both based in Inner Mongolia near grasslands conducive to cattle-rearing – have been granted tax breaks for teaching farmers how to raise and keep cows.

In Yang’s view, this easy access to raw milk supplies, as well as good product focus, gives Mengniu and Yili a big advantage over their main competitors, Shanghai Bright and Beijing Sanyuan.

"Mengniu and Yili have huge production bases and focus on UHT [ultra-high temperature processed] milk. Shanghai Bright is mostly doing fresh milk."

The continuing dominance of non-refrigerated UHT products in a consumer market that is putting ever more emphasis on quality, says a lot about the unique nature of China’s dairy industry. Rabobank’s Lou cautions that, while parallels can be made with the likes of Japan and Korea, it is wrong to push the comparisons too far.

"You can’t look at China in exactly the same way because it is so big." Basically, delivering a fresh product nationwide remains a challenge, despite the supply networks that the major players have built.

Logistical problems

"When the big chain stores become the dominant force in retailing, the process will be much simpler as dairy manufacturers can talk directly to the chain stories, with no need for distributors," said Nomura analyst Wu Rui. "But this will take some time to happen. At the moment, groceries are still the main distribution channels."

This has a profound effect on the nature of demand and supply in the dairy market. The demand side is skewed towards the major cities which offer easy access, better refrigerated storage systems and consumers that can pay more for premium products.

On the supply side, the market is incredibly fragmented. There are between 1,000 and 1,500 dairy companies, most of which make little or no money. Consolidation by the four largest companies – which already account for about a third of the market – is very much on the cards. Yang points to Mengniu’s purchase of Wuhan-based dairy Youzhiyou and Yili’s acquisition of Changfu dairy in Fujian province as an indication of the companies’ plans to expand their fresh milk supply chains into central and southern regions.

But he’s keen to stress the difficulty involved in moving to new areas where local players may already have a stranglehold.

"Nanjing Weigang is doing fresh milk and its brand is strong amongst consumers as it does home delivery," Yang explained.

Arrivals from overseas

This is the mass market – knotted by logistical challenges and regional nuances – that the multinational dairy companies entered in the 1990s. Kraft, Danone, Nestl? and Parmalat all arrived with big plans but, by the early 2000s, several of them had scaled back their investment.

"They tried to do everything on their own," said Rabobank’s Lou. "They tried to establish production and source raw materials by themselves. This is hard in China because backyard farming is prevalent."

Now, though, foreign-invested joint ventures are making a comeback. Having given up its yoghurt operation with Shanghai Bright in 2001 in exchange for a tiny stake in the Chinese company, Danone has scaled up its interest. It boosted its stake to 11.55% last November and has spent US$3 million on an R&D center in Shanghai.

Meanwhile, New Zealand’s Fonterra has paid US$107 million for 43% of Sanlu and Mengniu has teamed up with Arla to produce milk powders. Kraft sold off its yoghurt joint venture with Beijing Sanyuan in 2001 as it was deemed incompatible with the firm’s other China businesses. However, Tod Gimbel, Asia Pacific director for corporate and government affairs at Kraft, refused to rule out a return to dairy.

"We would never close the door on anything," he said. "China has been designated one of our top five emerging markets."

For the foreign players, these joint ventures offer access to distribution networks they could never hope to establish on their own – Patrick Kwok, general manager at Fonterra China talks of "full integration along the supply chain" with Sanlu.

But these partnerships are also driven by the needs of the domestic firms. As the likes of Mengniu and Yili try to develop their business beyond low margin liquid milk towards more value-added products, they need foreign expertise.

"A lot of pro-biotic products are provided by foreign companies as the domestic companies don’t have the technology to develop these products on their own," said Euromonitor’s Yang. "That’s why, now the Arla partnership is in place, Mengniu will launch premium baby formulas this year."

In an ever more competitive market, it is this ability to differentiate that will separate winners from losers. "Differentiation is crucial," said Kwok. "If everyone produced the same things, we’d just end up with a price war."