china-cries-over-poisoned-milk

China cries over poisoned milk

The contaminated milk scandal may force China's food and beverage sector to clean up its act and could become a trigger for M&A activity.
Little over a month ago, melamine was known as the material used to make unbreakable plates and as an industrial additive. But since then it has gained considerable fame as a chemical which, when added to milk, boosts its protein level at the cost of damaging the consumerÆs kidneys. China's dairy farmers, eager to boost their milk sales, have been watering down their milk and then lacing it with melamine so that tests show the same protein content as unwatered milk.

Products laced with the chemical are directly responsible for the death of four babies and for putting more than 10,000 in hospital, at last count. And the impact is mushrooming û not only have more and more companies been found guilty of selling contaminated milk, but it has now spread beyond milk to other products that include dairy, such as chocolate. And the ramifications seem set to shake the foundations of China's food and beverage sector.

One potential outcome, observers say, is a renewed consolidation in the food and beverage sector that will benefit the larger producers. And having watched the damage done to its reputation by the latest scare, the Chinese government may also become less averse to the involvement of foreign investment in the industry.

According to a recent J.P. Morgan research report, melamine-contaminated milk has been present in China's dairy industry for the past three to four years and has contributed to the rapid development of the market. It estimates that the production of liquid milk grew at a compound annual growth rate of 45% from 2000 through 2006, while production volumes of raw milk increased by a CAGR of only 20% in the same period. "When fake raw milk is eliminated from the system, the decline in raw materials itself should reduce production volume by at least 50% in the sector, in our view," the report says.

The companies directly involved have already been hit hard. Hebei-based Shijiazhuang Sanlu Group, the company at the centre of the scandal, is facing bankruptcy, and it could be taken over by Sanyuan Foods Company, a dairy company based in nearby Beijing. It was originally thought that the Sanlu brand would die away, and Sanyuan would cherry pick from the company's facilities. But now there seems to be some competition as reports yesterday revealed that soft drink producer, Wahaha, is also interested in a piece of the company.

The other companies that have been implicated in the scandal is a roll call of some of China's biggest dairy companies: China Mengniu Dairy, Shanxi Yashili Dairy and Inner Mongolia Yili, and it should come as no surprise that as consumer confidence in dairy products has tanked, so have the related stocks. Since the news broke in early September, Hong Kong-listed Mengniu is down 65% and Shanghai-listed Yili has lost 51%. And while stockmarkets have tumbled overall due to the financial crisis, dairy stocks have underperformed.

One factor that has added to the severity of the sell-off is that many of China's big food companies are heavily reliant on one product, unlike many international food companies which have a diversified portfolio of products that help manage the risks.

This newfound cheapness in share prices should not be viewed as attractive, argues Citi in a separate report. The bank says investors should not be worried about missing the opportunity to go bottom-fishing for dairy plays in the near term. "We see earnings and [return on equity] downside risks for the Chinese powdered milk sector and would wait for tangible signs of recovery, such as industry consolidation, stricter quality control, and better regulation."

However, Yang Fan, senior research analyst for packaged food at Euromonitor's Shanghai office, notes that Chinese consumers are used to this kind of scandal and predicts that consumer confidence will come back relatively soon û in two or three months for liquid milk products, and around six months for infant milk. "A minority of consumers are highly sensitive to food safety, the majority however are just trying to make a living and are very price sensitive," he says.

On the other hand, the fact that the scandal has been so large and has harmed mostly babies, has made the Chinese public more vocal about their anger.

And while Chinese consumers might start buying milk again, that doesn't mean dairy companies are going to see good times for awhile. Last week for example, Mengniu announced that it had invested approximately Rmb80 million ($11.7 million) in melamine testing equipment, and given 8,000 employees, over 25% of the company's staff, the duty of monitoring milk. Putting in place its so called "three-tier" monitoring regime will definitely bump up costs.

"The only way that you can sort out the food problem in China is by consolidation so that the little companies are forced out of the market," says Matthew Crabbe, managing director of market intelligence company Access Asia, who suggests that the larger companies will benefit from better management as well as greater efficiency. "The problem is that this needs to be happening more quickly."

Crabbe predicts that consolidation will be driven by both Chinese and foreign firms buying up food companies. He expects that a lot of foreign companies could be doing this over the next year. "I think that the Chinese government is going to welcome it," Crabbe says.

He thinks the current review of Coca-Cola's takeover of Huiyuan Juice under the new monopoly law will be the turning point. "If that deal goes through, it will give the signal that itÆs good to go."

The outcome of the milk scandal, combined with the ongoing attempt to purchase Huiyuan by Coca-Cola, could therefore be a flurry of mergers and acquisitions in the food and beverage sector.

In the dairy industry itself, this could be a good opportunity for foreign companies to get back into the sector. Most have abandoned earlier joint ventures û for example, Danone's yoghurt joint venture with Mengniu was terminated last year when it failed to acquire government approval; and Danone also sold its 20% stake in Bright Dairy to Shanghai Industrial. Nestle is one of the few foreign companies that still offers a full range of dairy products in China.

A mergers and acquisition strategy would allow foreign companies to avoid the troublesome joint venture structure and take control of dairy companies completely, using their size to enforce higher standards in upstream raw milk production.

If larger, more efficient food conglomerates take over China's food and drink landscape, then the Chinese consumer may well benefit in the long run û but it will have been at the cost of an immense, avoidable tragedy.
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