Trouble in dairyland

China has proved a welcoming place for offshore computer and garment makers, shipbuilders, plane builders, all sorts of builders and makers, even food processors like Kraft, France's Danone, Switzerland's Nestle, not to mention the noodle giants of Taiwan. But woe to the next outsider who tries to foist another dairy on the country.

Dutch dairy Friesland Coberco, of Dutch Lady brand fame, became the last foreigner to hang up its pasteurizers, announcing in November that it was withdrawing from China to focus more on its other Asian markets, namely Vietnam, Thailand, Malaysia and Indonesia. It certainly wasn't the first to quit. Kraft and Danone had both pulled the plug on their dairy operations, and Italy's Parmalat withdrew after bankers pulled the plug on it.

It wasn't for want of trying, in Friesland Coberco's case. It had spent eight years trying to make a go of it, climbing to third place in the South China dairy league table. But each year it lost money.

In their 2003 annual report released early last year, management spoke cryptically of "repositioning" the China operation. And by November the public learned what that meant, the company announcing that it was transferring its production and sales assets to its joint venture partner, Tianjin Sino-Finnish Dairy Research and Training Center.

Friesland Coberco and Tianjin Sino-Finnish Dairy formed Friesland Tianjin Dairy Foods and started production in 1996. Dutch Lady milk had arrived in China, and other products would follow. Friesland Coberco used the JV as a conduit for Dutch Lady milk powder, its Friso branded infant foods and other imported items (which continue to be imported now).

What went wrong – or kept going wrong? Agence France-Presse quoted a Friesland Coberco official blaming a crowded market. "Owing to the overproduction of dairy products in the country, margins are continually being eroded? with no prospect of real change for the medium term," Long before the pullout, management had expressed concern over currency fluctuations having a debilitating effect on the bottom line.

But others said it was more complicated than that, citing the JV's high operating costs and a shaky raw milk supply chain. Its competitors had home advantage, for one thing. According to a China Daily report, locals had lower operating costs, thanks in part to better access to milk supplies.

And everything just seemed to move the venture closer to the edge: A recent price war exacerbated an already difficult situation for the JV, Wang Ding, a senior official at the Guangdong Dairy Association, told the Nanfang Ribao newspaper, known in English as Southern Daily. Prices can vary wildly. According to one state media report, the price of a liter of milk in Xinjiang can be as little as half that of Zhejiang province and Shanghai.

As irony would have it, Friesland Coberco's exit came just as the dairy market was growing like gangbusters. Per capita consumption of milk in China nearly doubled in just over 10 years – from 4.8kg in 1993 to 10kg today. That's peanuts compared to average consumption elsewhere – the world average is 98kg and Europeans average 200kg – but China has a lot of people. That would imply higher distribution costs for Chinese producers, but also fantastic growth potential.

Like China's people, China's cows are concentrated in dense pockets. Around 70% of the country's 3.75m cows (2002 data) call Xinjiang, Inner Mongolia, Heilongjiang and Hebei home. The rest are scattered around, but many of these are congregated around large cities like Beijing, Shanghai and Tianjin. Indeed, some are feeling a little crowded in by all the company: In May, for example, Shanghai's municipal government put out orders to move some of its 90,000-strong population out of town.

By world standards, China is very under-cowed. According to the Danish Dairy Board, China's entire population of dairy cows produced just over 9m tons in 2002 – and this tells another story: Chinese cows are lackluster performers. The US cow population runs to just over 9m, roughly two and a half times the China bovine count, yet its milkers produce over eight times the milk China's do. US projected yield for 2004: 77.2m tons.

With the American dairy industry going back 300 years or so, and China's going back only 60 or 70 years – about the time Mme Chiang Kai-shek started up Nanjing Dairy – some might dismiss US-China comparisons. But China's milk output is only a tenth that of India's 91m tons.

So there is lots of growing to do and locals are investing. China's two big dairies, North China-based Yili Group and Mengniu Milk Co Ltd, both claim to be No. 1 milk producer. Yili last year announced it would invest US$35m solidifying its milk supplies. Guangming (Bright) Dairy and Foods, which owns much of Shanghai, China's biggest single dairy market, has been investing, too. Its Shanghai Guangming unit poured US$24m into Shanghai Holstein Technology to buttress milk supply. Shanghai Holstein's empire runs to 21 big dairies across 17 provinces. "What concerns us most is the quality of the raw milk from other places," a Bright official told the Shanghai Star in June.

To scale up, the big players buy smaller dairies or use others as OEM producers who brand their products accordingly.

Chinese milk production was projected to increase by 20% this year, which is more or less in line with the growth track established over the last two years. China's spreading consumer culture is helping growth, but so are health concerns. Calcium is increasingly seen as an essential ingredient of healthy living, so milk and milk byproducts like calcium supplements are promoted in schools.

That's certainly true of the cities. But in the countryside, where the cows moo, it is a very different story. Indeed, one state media report quoting government figures revealed that city dwellers consumed 13 times on average what China's rural population consumed.

Milk products come in a variety of forms, of course – from basic milk and milk powder to butter and cheese, yogurt and so on. In China, industry data suggest 90% of raw milk ends up as milk, much of that used in making yogurt. That means there is not much left for higher margin products like butter and cheese, which are still years away from being even moderate sellers in China. Indeed, China consumed just 81,000 tons of butter in 2000, compared to 570,000 tons in the US that year. Chinese did indeed eat more cheese – 196,000 tons of it – but then Americans ate cheese like heart attacks were going out of style: 3.75m tons.

China's milk supply lines suffer from a sparse population of underperforming cows, poor transport infrastructure and other factors, but also from badly under-mechanized dairy farms. State media reports indicated that fewer than a third of China's cows are drained by milking machines.

But when China is of a mind, things can move very quickly. And since China is always about growth, optimism keeps driving the industry forward whatever the occasional stutters and stumbles. Indeed, Friesland Coberco's departure may only be a tactical retreat. As one official told the China Daily, "We will watch the market closely and re-invest when we feel it is becoming healthy."