Don’t be deceived by the name American Dairy (ADY.NYSE). Feihe, the most prominent of the company’s 100% China-focused brands, has a near 50-year pedigree dating back to its inception in 1962 in the country’s northeast. Since then, both the company and the brand have traveled far. This culminated in American Dairy listing on the main board of the New York Stock Exchange in June 2009, while the brand has seen its popularity spread across the nation – helped rather than hindered by China’s catalogue of milk safety crises. Jonathan Chou, CFO of American Dairy, spoke to CHINA ECONOMIC REVIEW about the company and the industry.
Q: How do you define American Dairy’s market niche and what are its main competitors?
A: Our strength is in milk formula, with the majority of our revenue coming from infant milk powder. Our direct competitors in terms of international players would be Mead Johnson, Wyeth, Abbott Laboratories and Dumex, which is now owned by Danone. The domestic firms are Yili, Yashili, Beingmate, Wandashan, and Synutra, which is probably our closest comparable in that it is NASDAQ-listed and does infant and adult milk formula.
Q: How is American Dairy positioned compared with the other companies?
A: Our high-end premium product offering is a 900-gram can priced at about RMB200 (US$29.30) – the domestic national players are generally positioned lower than that. The imported brands have a premium brand with a similar price and then a super-premium brand – RMB300 for a 900-gram can. However, some imported brands such as Dumex are now launching lower-end products to compete more with the domestic brands.
Q: In other consumer goods segments foreign firms run a premium brand as well as lower-level brands designed to generate sales volume. Does this apply to dairy?
A: Infant milk formula is a staple consumer product – there is less price elasticity and it’s hard for parents to consider substitute goods or lower price. With shampoo and toothpaste people may be willing to go lower and try something new. Our space has high barriers to entry because you can’t create a new brand overnight and expect it to be accepted by consumers. Parents do research by talking to friends and family, talking to their doctor, and, increasingly, through the internet. Based on this research, they identify two or three brands worth consideration.
Q: How does this affect how you market your products?
A: The general theme is that we are the first infant milk formula company with a vertically integrated business model. It’s not just quality and safety, it’s freshness as well. Through our two company-owned organic farms in Heilongjiang province as well as by sourcing from contract farmers, we can go from raw milk to milk formula production to warehouse and to store shelves in a shorter timeframe than the other brands.
Q: A vertically integrated supply chain must have been handy during the tainted milk scandal in 2008…
A: Generally, when a crisis happens we have done better due to a flight to quality. Before the melamine crisis we had a 2% market share; since the crisis our market share has risen to as high as 7%. We have grown our distribution network from 50,000 points at the start of last year to 90,000 now and we have repositioned our brand to enter first-tier cities. Before the crisis we were in the second-, third- and lower-tier cities, where we generate most of our profit. Because of the crisis we have been able to go into tier-one cities nationwide.
Q: Have you been surprised by the reemergence of melamine-tainted dairy products in recent months?
A: I am surprised. Following the examples set by the government last time – the chairwoman of Sanlu was jailed for life and there were two executions – you wouldn’t expect people to take chances and that contaminated formula would be dumped.
Q: To what extent are China’s intermittent dairy scandals attributable to fragmented supply chains?
A: Since 2005 we have imported equipment from Europe and put fully-automated pumping machines in all our collection stations. These are company-owned collection stations of which there are now over 200. This model bypasses the purchase of raw milk from intermediaries or consolidators, which is the source of 70% of China’s raw milk.
Q: But is this also being done on an industry-wide level?
A: I’ve heard that larger firms like Mengniu and Yili have automated pumping equipment on their larger farms. Nestle is only the foreign brand that sources raw milk in China and I understand it has facilities in Heilongjiang with its own collection stations.
Q: Will consolidation of supply chains lead to integrated dairy firms?
A: There is a trend toward large-scale imported cattle dairy farms similar to what we have. For example, Kohlberg Kravis Roberts has invested in Modern Farm Group, which was founded by the chairman of Mengniu, and they are building farms in different parts of the country. Additionally, in Heilongjiang, you will likely see a number of family-owned farms, each with about 300 head of imported cattle, come together to form cooperatives. This family-owned model is embraced in Hokkaido, Japan’s dairy region. The Chinese government has been very supportive in terms of land grants, tax incentives and finance. It costs about RMB3 million (US$440,000) to start one of these farms and if the farmer can come up with one-third of the equity the government will finance the rest.
Q: What about consolidation at the retail end of the market?
A: Consolidation has been pushed out because there is so much interest from an investment perspective. The industry is projected to grow 20% a year for the next five years, which would take it from US$5.5 billion now to US$12 billion by 2015. It’s very attractive, especially if you look at the gross margins. Many of the players that were implicated in the melamine crisis are still surviving because investors are interested and willing to take a risk, get in at a decent valuation and try to turn around the brand.
Q: How will American Dairy’s portfolio change as the industry evolves?
A: Infant milk formula is our core focus now, and we will eventually introduce products like water targeted at babies in their first 6-12 months. Another product we envision is a kind of children’s cheese product. China has a high percentage of people with lactose intolerance, but the generations of infants being fed infant milk formula may develop a tolerance level. Accordingly, they will consume other dairy products over time. That’s why the penetration rate for dairy products in China will go from 15 kilograms per person per year to 70 kg, like in Japan.