November 28, 2013

 

Dairy industry's consolidation intensifies in China

 

 

Driven by higher demand, tighter raw material supply and stiffer competition, China's dairy industry will be forced to further consolidate, though buyers might face higher pricing and execution risks as the number of quality targets shrink.

 

Buoyed by a series of food safety breakdowns, including the highly publicised incident in 2008 where several babies died after consuming infant milk formula contaminated by melamine, restructuring in the industry was initially spurred. However, consolidation did not take place immediately after the 2008 melamine incident until last year.

 

According to statistics from Capital IQ, there were 44 initial public offering/merger and acquisition (IPO/M&A) deals in the China dairy industry in 2012, compared with 39 deals in the year to end-August 2013.

 

In June 2013, Chinese government aimed to reduce the number of domestic milk powder manufacturers to 50 from 127 and nurture 10 large-scale dairy entities with an annual income of over RMB2 billion (US$328 million) to take over 70% of the market in five years.

 

This move demonstrated the government's resolve to clean up the Chinese dairy industry's reputation, avoid more food safety lapses at smaller players and fend off competition from foreign companies, who now account for more than 60% of the market compared with less than 30% before the 2008 scandal.

 

The recent consolidation in the infant formula milk powder sector highlights the government's broader plan to enhance food safety standards and boost consumption of local products, although the dynamics of the milk powder segment are slightly different from the broader dairy sector.

 

Apart from policy-driven consolidation, the severe shortage of raw milk in China will also likely force companies to step up consolidation along the industry value chain. In 2013, the supply shortage will exceed four million tonnes compared with 1.7 million tonnes in 2010.

 

According to MINTEL, a leading market research firm, growth in dairy consumption, estimated at compounded annual growth rate (CAGR) of 8.2% for 2012-17, will continue to outpace the increase in raw milk supply, which is estimated at only 1.2% CAGR for 2012-17.

 

Therefore, to secure high-quality raw milk supply, Chinese dairy players must move upstream either through acquisitions of mature dairy farms or nurturing their own ranches, which usually takes years. Dairy companies will also seek M&A activity to tap the growing demand from consumers who are more aware of the benefits of milk, who have more spending power and as the government relaxes its one-child policy.

 

Consumer confidence in domestic producers is also gradually returning thanks to enhanced quality control by manufacturers and the government's closer supervision.

 

Big national dairy names such as China Mengniu Dairy, Inner Mongolia Yili Group and Shanghai Bright Dairy will be the ultimate winners in the consolidation process, based on the solid execution of their on-going acquisitions.

 

There could however, be a short-term impasse in the dairy industry because the smaller number of quality acquisition targets in the industry and the expected demand growth will widen the gap between sellers' and buyers' expectations on pricing.