Safety scandals give foreign dairies a boost in China

BEIJING/SHANGHAI (Reuters) - Global food and dairy companies are making another round of big bets on China's fast growing dairy sector, hoping to position themselves as safe alternatives even after a lethal baby formula scandal burned many of them the first time around.

They are lured by a projected 10 percent annual growth and by Chinese consumers' willingness to pay a nice premium for foreign brands as they remain wary of local brands' safety records.

Just last week, China's top-selling dairy firm Inner Mongolia Yili Industrial Group Co recalled six months' worth of one brand of infant formula after government tests found it was tainted with mercury, a heavy metal that can cause neural damage if ingested [ID:nL3E8HF0MP].

As if on cue, Danish-Swedish dairy group Arla announced on Friday it would pay 1.7 billion Danish crowns ($289 million) for what amounts to a 6 percent stake in Yili's main competitor, China Mengniu Dairy Co, a deal that will also enable it to expand the Arla brand in China.

"If you have an international brand, then there's a premium in the market, because food safety is a concern," said Kevin Bellamy, dairy analyst at Rabobank in the Netherlands.

For some global milk producers, finding new markets is also crucial as they consolidate and expand production faster than their traditional, and mature, milk markets can grow.

Arla and its competitors are hoping that they can tap the thirst for quality among a Chinese consumer base weary with wondering whether the milk they buy for their families is safe.

But in doing so, they have to defend themselves against reputational risk. In 2008 Arla, which already has a formula joint venture with Mengniu, had to reassure its international customers that it does not sell Chinese-produced products elsewhere, after production at the Chinese plant was temporarily suspended after the melamine scandal.

Milk and formula safety became a deep concern for Chinese parents after the 2008 scandal. At least six babies died and 300,000 became ill from drinking milk formula contaminated with melamine, a chemical used in fertilizer and plastic.

Mengniu last year destroyed milk tainted with aflatoxin, a carcinogenic mould found in corn grown in humid climates.

"To be a minority shareholder in a food company in China, regardless of the quality of your partner, you're still exposed to the supply chain," said dairy consultant David Mahon, head of Mahon China Investment Management. "The lesson from melamine would not have been learned, and that would be a pity."

SUPPLY CHAIN

China is the world's largest formula market and is expected to overtake the United States as the largest dairy market by 2020. Leading global food companies are jockeying to make sure they benefit from the rise in demand.

Nestle's sales in China are about to expand significantly, pending approval by the commerce ministry to incorporate the China operations of Pfizer Inc, which would boost its market share in infant formula to 12 percent. The Swiss food giant agreed in April to buy Pfizer's infant formula division for $11.85 billion.

Greater China accounted for only 3 percent of Nestle's global sales in 2011, but sales in the region grew by 23 percent last year.

To keep up with that growth, it and other firms are looking to expand their production in China, but are taking pains to guard against quality problems.

Foremost in those efforts is the need to control the supply chain for raw milk.

Nestle buys milk directly from thousands of small dairy farmers in the flat green fields of northeast China. But it has already cut its small suppliers from nearly 30,000 to under 12,000, and plans to rehouse the rest in big dairy bases.

This month it broke ground on a 2.4 billion yuan ($377 million) project invested with U.S. dairy and feed cooperative Land O'Lakes and other partners. It will house a training center and two huge modern dairy farms, one with 2,400 cows, the other with 8,000.

"A model where you have small farmers having a few cows is not really sustainable any longer," Nestle's China chief executive Roland Decorvet told Reuters at the ground-breaking in Shuangcheng, near the northeastern city of Harbin.

"The farmers are moving into the cities, the system is getting consolidated, so we are moving towards more middle-to large-sized farms."

New Zealand dairy cooperative Fonterra, which sells $2 billion a year of imported milk products in China, is also building large dairy bases near Beijing, the milk from which it sells at a premium to other dairies.

In 2008, Fonterra lost almost all its $150 million investment in Sanlu Group, the state-owned Chinese dairy at the heart of the melamine scandal.

COMING FLOOD

Another driving force for foreign firms to ramp up their presence in China is a coming surplus of milk in Europe.

The expiration in 2015 of national production caps in the European Union is expected to lead to a 6 percent jump in European milk production, bringing an additional 9 billion liters a year onto the market, said Bellamy of Rabobank.

"They could supply more to European cheese, but that's pretty saturated. The Asian and Chinese markets are very attractive because of the percentage of growth we are seeing," he said.

With its latest investment, Arla estimates its turnover in China will grow five-fold by 2016, from $119 million in 2011.

"It will contribute positively to our cooperative owners' milk price from day one, as we are able to add more value to milk that we otherwise would have to sell on the global bulk trading market, where the profit is lower historically," Arla Foods CEO Peder Tuborgh said in a statement.

Chinese brands also hope to benefit from the influx of foreign money and expertise.

In some cases, any foreign association can help.

Wandashan, a Chinese dairy partly owned by Taiwanese conglomerate Uni-President, is marketing its new infant formula line made only from domestic milk by emphasizing that the product was developed together with an American food technology institute. ($1 = 6.3651 Chinese yuan)

(Editing by Jason Subler and Ron Popeski)

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