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China’s Milk Rush (Part 2): There’s Gold in Them, Thar….Cows

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Milking China's Demand for Dairy

 A number of key factors have precipitated China’s huge demand for imported dairy (particularly infant formula) which can be boiled down to 3 key points

  • Food scandals involving domestic producers

  • Changes in family planning policy allowing couples to have a second child (under certain conditions)

  • New dairy regulations requiring all foreign manufacturers exporting to China to undergo CNCA audit

However as speculators clamor to find CNCA audited manufacturers to act as OEMs for their brands, is there any cause for pause? Will this demand continue? I hesitate to speculate on complexities like future demographic and economic trends which invariably lead to the unenviable outcomes of looking smug while saying “I told you so” or getting it spectacularly wrong and having to backtrack or issue retractions. For this reason the best advice I can offer to would be investors is to arrive to the party early. Historical precedents have shown us, that it’s usually a case of first come first served and after the chaos has subsided and everyone’s belly is full the only thing left is the scraps from the table. So the big questions still remain. What factors are likely to influence market demand and retail prices and will the demand for imported milk continue? 

China’s Government Looking to Address Market Balance and Trade Deficit

If we refer back to the 3 factors providing the impetus for this infant formula demand, the most likely factor to change is the integrity and reputation of domestically produced infant formula. This is the Chinese government’s ultimate goal and it is attempting to achieve this end using a twofold strategy, firstly by controlling the influx of foreign produce (see *1) and secondly repairing the reputation and increasing the quality of domestic produce (see *2).

  1. Technical barriers to trade: Neww regulations make it a lengthy and difficult process for foreign dairy produce to gain market entry

  2. Natural selection by regulation: This is a term I coined to describe a common legislative strategy adopted by the Chinese government to cull the industry herd by removing the weakest manufacturers and only allowing the fittest to continue. The Chinese government has insititued very stringent domestic dairy regulations with the aim of consolidating milk manufacturing into the hands of China’s larger more reputable dairy companies. These regulatory selective pressures target China's smaller, financially unstable domestic dairy manufacturers forcing them to modernize, amalgamate or close. This also has the knock on effect of allowing greater control over pricing.

So how are domestic interests fairing at the moment in comparison to foreign competitors?

Foreign companies hold the lion’s share of the market boasting over 60% control. However China’s economic climate is changing. Inflation has meant that consumers are feeling the pinch and looking to find ways to save money. Foreign milk powders retail at a significantly higher price than domestic produce usually in the region of 30%-40% more expensive, a fact domestic producers are keenly aware of and eager to exploit. Several major domestic and foreign companies including Dumex, Erie, San Yuan Yubo and Abbott have made price reductions ranging from 3-50%. These recent price reductions have been completely market driven with no coercion from government.

So what are the reasons for these price reductions and are they a sign of things to come?

The Chairman of China's dairy advisory body told reporters that formula companies have had to cut prices due to the increasingly fierce market competition. This situation has been in the making since the "production license renewal" and "domestic milk mergers restructuring plans were instituted and is very likely the early signs of an impending price war. While foreign brands are still in the ascendancy and those with solid reputations are likely to sustain a sizable market share, for those would be investors still sitting on the fence it is advisable to strike while the iron is hot and not wait for the market to reach saturation point. From 2008 to 2012 milk prices in China have seen a steady year on year increase of 10%. This rapid inflation was unlikely to be sustainable and what we are seeing now is likely the inevitable bursting of the bubble. International giants are not excluded from these pressures reflected in Abbotts 10% price cut on its flagship formula range and Dumex’s more modest 3% reduction on its “Ying Yang” product range

Domestic Low Cost Retail Models

Just two months before the June price cuts, dairy company Junlebao, China’s newest entrant to the infant formula market preempted the price reduction by entering the market with an unprecedented low price, retailing their single pot infant formula (900g Specifications) for only 130 yuan which is two or even three hundred Yuan cheaper than many of its rivals. The move has generated huge interest in the industry and certainly started its marketed campaign with a bang. The timing of the move was not a coincidence and more likely based on savvy market forecasts. Junlebao’s low cost model utilizes the low cost marketing strategies allows them to pass these savings onto consumers and enter the market with enticingly cheap products. The most interesting aspect of this strategy is that according to Junlebao Chairman Sammy Liu net profits will still range between a healthy 3-4%.

The Fonterra Scandal is Proving Fertile Pastures for US and EU Brands

Before last year, China's imports from New Zealand milk powder accounted for 70% -80% of total imports, but since the Botulism product recall incident Europe's milk exports to China surged. Companies such as Danone, Wyeth and other first-tier manufacturers are keen to take up the slack and have begun marketing in earnest. New Zealand milk powder export prices reduced from $ 5,005 / ton in February 2014 down to $ 3,877 at its lowest point in May. In addition to the Botulism incident there are other reasons for the price reduction such as an increase in global milk supply, a general economic downturn in the Asian Pacific region and outstanding raw material supplies remaining after over purchasing during the spring festival seasonal demand.

Profit Margins Faltering but Demand Increasing:

Data show that China imports more milk powder than is domestically produced. Imported price fell from an average of 44000 yuan / ton in April 2013 to 34,000 yuan / ton in April 2014 (down 22.7 percent) while domestic prices decreased by 21.9% in the same period.While prices are dropping the overall demand for imported milk powders is still increasing. From April 2013 to 2014, research institutes reported an increase of 69% in foreign imports (an annual increase of 500,000 tons) bringing the total import volume to some 1.2 million tons. With the upcoming cessation of EU quotas and the largest proportion of audited and CNCA accredited dairy manufacturers cleared for import to China coming from Europe, it is likely that prices will take a further hit post 2015 when European supplies increase and production capacities are geared up (How much prices will take a hit is still unclear). What new investors should realize is that high priced infant formula is likely to be the sole purview of established companies like Danone’s Dumex and Abbott. Adopting lean marketing and sales strategies is a feasible way to keep profits high and continue to reap the benefits of China’s markets.

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