30 November 2009

8 minute read

Before the massive scandal that unravelled last September which killed six infants and sickened some 300,000 children, the use of melamine to artificially boost protein content in milk products was a common industry practice and an open trade secret in China. Sanlu Group, the leading seller of milk powder in China, was discovered to be the main culprit in the incident. As it failed to repay outstanding debts including compensations to the victims, Sanlu declared bankruptcy in February this year.

The exposure of Sanlu's contaminated milk products has brought along a domino effect to China's dairy industry. In all, a total of 22 companies including some of the major domestic dairy firms, were also found to be guilty of producing melamine-tainted milk products. The resultant financial loss in the fourth quarter of last year was so overwhelming that strong sales posted in the first three quarters was struck off in a stroke. Mengniu Dairy, the largest liquid milk producer in China, registered an annual loss of RMB948.6 million in 2008. While Yili and Bright Dairy reported losing RMB1.69 billion and RMB286 million respectively. Amidst the troubled scenes, Sanyuan Group, which was not implicated in the scandal and had since taken over Sanlu's core assets, survived the ordeal with an 87.2 per cent on-year jump in net profits to reach RMB40.76 million.

Meanwhile, dairy shares also plummeted as the confidence of both consumers and investors was shattered. In China's stock exchange, Yili's shares plunged from RMB17 to RMB6 last August while Bright Dairy shrunk from RMB7.60 in September 2008 to RMB3.20 last December. Mengniu, listed in Hong Kong in 2004, saw its shares fell from HK$24 to HK$6.40 last August as well.

The domestic and international reactions to the event were also unanimously furious with the Chinese citizens livid that their children were being fed with a poisonous industrial chemical while many countries banned all imports of China's dairy products upon hearing the news.

Who is responsible?

The devastating ramification from the milk scandal was unprecedented in China's food history and the Chinese government and dairy firms knew they had to react fast to salvage whatever confidence the people had left in them.

Following rounds of thorough investigations, the Chinese authorities identified the raw milk collection phase as the source of pollution with farmers and middlemen adding melamine to watered-down raw milk supplies gathered at milk collection stations, before passing them on to the dairy companies.

As they were deemed to have superior quality controls, some of the major Chinese dairies had long been exempted from government inspections. Consequently, their contaminated products filtered through the loopholes and landed in the market and the unsuspecting parents snapped them up for their children. In order to correct this management lapse, China revoked this special status of food companies on 18 September last year and ordered the current holders to cease citing the privilege in their advertisements.

The Chinese government also clamped down hard on the trouble origin by shutting down 3,908 substandard milk collection stations as of 3 June this year as they were found to lack testing equipment or the sanitary conditions were unsatisfactory. The remaining 16,485 stations that are still in operation are now subjected to rotating inspections by provincial and regional agriculture departments.

In a bid to further strengthen its determination to curb the repeated food scandals that had plagued China for so long, the Chinese authorities implemented a new Food Safety Law that went effective on 1 June this year to intensify the monitoring and law enforcement on the country's food industry.

The new law, approved by China's legislature, was designed to replace the previous Food Hygiene Law which was deemed outdated and inefficient and one that oversaw many scandals that rocked China's food industry. With the aim of enhancing the efficiency of the food safety monitoring network, the new law will introduce tougher standards and strict supervision, a recall system for substandard products as well as stiffer punishment for offenders.

Despite introducing several measures to regulate the dairy industry, there were still lingering doubts over their effectiveness. For years, there were too many organisations responsible for the supervision of the dairy sector, resulting in a confusion of duties and loopholes were aplenty in the entire management system. The Chinese government's lax inspection and slack enforcement of rules further worsened the situation. Therefore, one can only tell the true success of the measures over a period of time.

While the Chinese government was busy establishing the overall framework to revive the dairy industry, there were also major shakeups in the enterprise sector.

With the ousting of Sanlu from the industry, it leaves an additional RMB10 billion worth of market share up for grabs. More importantly, China still has a hugely untapped dairy market.

On average, every Chinese citizen consumes 30kg of dairy products annually, falling way behind the world average of 120kg and 300kg for developed nations. The entire 1.3-billion Chinese population is estimated to require 117 to 351 billion kg of dairy products yearly. This staggering statistic clearly indicates the enormous potential of China's dairy industry and there is vast capacity for further companies' expansion and consolidation in the sector.

Beijing Sanyuan Group was undoubtedly the biggest winner in the milk scandal as the demand for its melamine-free dairy products skyrocketed in the immediate aftermath. Moreover, with its successful acquisition of Sanlu for RMB616.5 million, Sanyuan has emerged as a top player in China's dairy industry. Not resting on its laurels, Sanyuan announced in June this year that it plans to further expand its milk capacity by establishing a RMB680 million industrial park in Beijing, one that is able to process 1,200 tonnes of fresh milk daily. Sanyuan will also set up a subsidiary in Shanghai in a bid to accelerate its business expansion in eastern China. In addition, the doubling of distributors outside Beijing to more than 1,500 and the launching of a series of high-end products have helped Sanyuan to a 138 per cent increase in net profit to RMB36.73 million in the first half of this year.

In order to ensure complete quality control over its products, Sanyuan runs its own dairy farms. Currently, it has 27 dairy farms with 35,000 cows that are capable of producing 160,000 tonnes of good-quality raw milk annually. Although this operation model is more costly, it has been duplicated by other companies in the wake of the melamine scandal for its better control of milk quality.

For instance, Yili is developing a new cow community model and it plans to establish 20 such communities by the end of 2009. Each community is designed to accommodate 1,000 cows that are collected from local farmers. Yili is also entrusting a professional company with the task of breeding the cows to ensure the safe quality of the milk. Earlier in May this year, Yili announced that it had been appointed by the Shanghai World Expo Business Coordination Bureau as the sole dairy sponsor for the 2010 event, signalling a return in belief in the company. In addition, Yili signed an agreement with Tianjin City in July to set up a dairy firm in Tianjin's New Coastal District. Being the first expansion project following its involvement in the tainted milk scandal, Yili plans to make this latest investment the largest dairy company in northern China, one that is projected to generate an annual revenue of RMB2 billion.

Meanwhile, Mengniu has also taken steps to improve its business operations. It plans to increase the number of its mega-sized pastures, which is able to house 10,000 cows each, to 20 in the next three years from the current nine. The company has also tightened its milk production process with every carton of milk going through nine working procedures, 36 inspection points and 105 standard examinations before entering the market, and only those that meet the safety standard can be put on the market shelves.

Sensing the huge opportunity in China's dairy industry, COFCO, the largest oils and foods importer and exporter in China, together with Hopu Investment Management Co agreed to buy a 20 per cent stake in Mengniu in a deal valued at HK$6.1 billion, giving the embattled company a major boost in the arm.

A long, hard battle

As the dust settled, consumers have seemingly resumed their confidence in China's dairy industry.

In the first five months of this year, the country's accumulated production output for dairy products reached 7.5 million tonnes, an on-year increase of 3.3 per cent. Meanwhile, the dairies' revenues have also grown 4.87 per cent compared to the same period last year while their profits and gross profit margins rose 17.55 per cent and 25.5 per cent respectively. The Dairy Association of China also maintained a positive outlook for the country's dairy sector by estimating a 90 per cent recovery by the end of this year.

However, all is not well as Chinese consumers still shun domestic dairy products. According to statistics from Euromonitor, the world's leading independent provider of business intelligence and market analysis, the market share of higher-priced imported milk formula in China's high-end market had risen to 70 per cent since the melamine scandal. Also, the simultaneous large imports of cheaper milk powder further heighten the enormous inventory pressure that domestic manufacturers are facing. Statistics from the Chinese Customs showed that China's export of dairy products for the first four months of this year dipped by 63.7 per cent on-year while imports grew 68 per cent.

Moreover, just as the dairy industry embarks on its long, arduous rebuilding process, it suffers another blow when Scient's milk product was discovered to contain melamine 130-times above the permitted standard in June this year. The local dairy later admitted that its formula milk produced last year did not use imported milk as claimed on its website and product containers. It also confessed that US Scient International, one of its purported shareholders, was a company registered by its parent company, Yashili, in the US and not an actual overseas investor.

Although China's dairy industry is a large goldmine, the fierce competition and the single-minded profit gaining motive of dairy firms have proven once and again to be the stumbling block to its development. The continual betrayal of consumers' trust has caused the dairy industry to reach its boiling point, a situation that China must use all the powers within its means to rectify before it implodes.