Will These Dairy Suppliers Be Spoiled by China?

Source: Mead Johnson Nutrition.

From poor quality and negligence to contamination and price fixing, the Chinese dairy market has witnessed the gamut of impropriety for this essential nutrition source. Worse, the lapses and criminality have led to numerous deaths of infants and adults and the sickening of thousands more.

Last summer's botulism scare at New Zealand's Fonterra facilities was just the latest, but it may have been the one with the broadest implications, as China enacted sweeping reforms that touch on all infant formula importers, including those from the European divisions of Abbott Labs (NYSE: ABT  ) , Mead Johnson Nutrition (NYSE: MJN  ) , and Nestle (NASDAQOTH: NSRGY  ) , requiring they register with the government their products, manufacturing, and storage facilities before bringing the products to market.

Foreign formula and dairy producers rode the wave of fear that followed in the wake of the scandals. Brands of international producers saw their share of the market soar from 30% in 2008 to 50% in 2012 with international manufacturers enjoying a 70% share in the high-end powdered milk market. According to Beijing Orient Agribusiness Consultants, New Zealand accounts for up to 80% of China's imports of milk powder, much of it used in infant formula. Fonterra, the world's biggest dairy exporter, has caused an upheaval that is having a big impact on its peers as the dairy industry accounts for about one-fourth of the country's total exports.

The New Zealand Infant Formula Exporters Association says less than half of the country's infant formula suppliers were approved by China, meaning exports to the country may be halted at port. New Zealand has about 60 milk powder makers and over 100 brands, but only a handful have made the cut. With some 41 suppliers from 13 countries registering so far, that may give global rivals a chance to gain even more ground, the recent price-fixing scandal notwithstanding.

Chinese consumers have proved willing to pay as much as three times the cost of locally produced dairy products, going so far as having relatives in foreign countries buy cases of formula and ship them back to China. Analysts say gross margins on global brands sold in China can run as much as 50%.

Nestle, though, is spending $396 million to expand its capacity in Shuangcheng to produce formula, along with creating a dairy farming institute to educate farmers and modernize methods with the goal of becoming the premier infant nutrition company on the mainland. In 2010, it had just a 2% share, well behind Mead Johnson at 12% and Danone's 10%. But the market was expected to continue to grow at a torrid pace, reaching 136 billion yuan by 2015, or around $860 million.

Mead Johnson is also looking to capitalize on the situation and build on its leading market share, which has since grown to 16%. Like Nestle, Abbott, and others, it was fined by the Chinese government for its role in the price-fixing scheme, paying $33 million in penalties. It intends on expanding from the tier 1 cities it currently focuses on to tier 2 and tier 3 cities, with immediate prospects best for cities such as Hangzhou, Nanjing, Chongqing, and Wuhan.

For its part, Abbott was tainted by Fonterra's contamination even though it didn't use any of the whey powder that was recalled, but out of an abundance of caution, it recalled some of its own product last year. That was reflected in its earnings report last month where infant formula sales tumbled 7% to $909 million. Like its rivals, it also expects to increase its global capacity by opening new manufacturing facilities in China by the end of the second quarter.

The dairy producers can't cry over spilled milk but need to look ahead. While analysts say parents in major cities in China continue to limit the number of children they're having to just one because of high costs, those in outlying cities and towns are now having more children. That means China is still a major growth opportunity, and for those like Mead Johnson that specifically target those regions, it's a chance to gain ground on New Zealand's lead.

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Rich Duprey

Rich has been a Fool since 1998 and writing for the site since 2004. After 20 years of patrolling the mean streets of suburbia, he hung up his badge and gun to take up a pen full time.

Having made the streets safe for Truth, Justice and Krispy Kreme donuts, he now patrols the markets looking for companies he can lock up as long-term holdings in a portfolio. So follow me on Facebook and Twitter for the most important industry news in retail and consumer products and other great stories.


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