A Government-imposed shakeout on China's dairy industry will radically alter the way both its domestic firms and international competitors - like Fonterra - operate in the world's second largest economy, writes Alexander Speirs.
Beijing is anointing National Champions as it sponsors a reform wave to consolidate an industry cluttered with too many players into a stronger dairy sector with fewer and higher quality firms.
The changes will drastically reduce the number of market players as the Chinese Government leads the introduction of new efficiencies to restore confidence in the scandal-plagued dairy sector.
The National Champions identified (so far) are six of China's strongest dairy businesses, singled out by the Ministry of Industry and Information Technology to spearhead the consolidation. Some of the details still remain as "opaque as milk" as respected Chinese financial magazine Caixin points out. But it appears the national champions will be able to access funds worth as much as $5.65 billion earmarked for the acquisition of smaller firms and the creation of transparent supply chains.
This new-look industry has the potential to radically alter the opportunities available for New Zealand with our largest trading partner. Already foreign firms face a slew of new import regulations as China looks to wipe from the supermarket shelves some hundreds of brands which have dubious credentials and lack traceability.
The new policies followed a crackdown by the National Development and Reform Commission - a top economic regulator - which levied fines of nearly 670 million RMB (NZ$124.2 million) on six foreign milk powder companies (including Fonterra) after it investigated them for price-fixing and anti-competitive practices.
Chinese consumers lost confidence in their own domestic dairy products - particularly infant milk formula - after the 2008 melamine scandal which resulted in six babies dying and more than 300,000 being made sick. The crisis of confidence sharpened as, one-by-one, even the most reputable domestic players such as Mengniu, Yili and Yashili were implicated.
The upshot was a "White Gold Rush" as foreign companies - including Fonterra and myriad small New Zealand firms - filled market gaps, and domestic producers began taking some processing offshore to rebuild their tainted reputations.
Restoring confidence in Chinese milk starts at the source. The Chinese authorities are prioritising large-scale farm developments to reduce the reliance on small-time farmers who are difficult to regulate. These, often family-run, farms with fewer than five cattle are a weakness in the current supply chain.
At the time of the melamine crisis, it was common practise to water down milk (milk is priced on the basis of volume in China). Eventually melamine was added to "artificially inflate protein levels".
In the wake of the crisis demand for domestic dairy plunged, diminishing prices and sending demand for foreign dairy products skyrocketing. The lower prices for domestic milk made smaller-scale Chinese farms unviable and resulted in many sending their cows to the slaughterhouse.
Herald inquiries in Beijing confirm there is strong government support for major processors to invest in their own farms to force vertical integration of supply chains.
Fei Pei, who is Senior Investment Officer at IFC World Bank based in Beijing, says for industrialised farms with at least 1000-2000 cattle, the government will provide land, grant direct subsidies from high-value imports and reimburse loan interest. "There are a lot of incentives available".
The policy is already proving effective. JP Morgan research reveals scaleable farms with a herd size of at least 1000 cattle now account for 16 per cent of all dairy cattle in China; up from only 9 per cent in 2008.
"The government would like all downstream dairy processors to have 70 per cent of their milk coming from big dairy farms, which they control. Realistically, that's difficult to do as it is an extremely capital-intensive business and will take time," says Pei.
The hope is that by having major dairy companies running own dairy farms the standard of practice will rise, industry-wide.
For a sector, which is still plagued by biosecurity threats including foot and mouth disease, that is a definite need.
There was a major outbreak in 2005 as the disease spread through eastern China, including to Beijing and Hebei where Fonterra's first farming hub has recently been completed.
Dairy herd numbers collapsed last year, as the population dropped from a high of 8-10 million in 2012, down to 6-8 million in 2013.
The plunge in livestock numbers has been attributed to high feed prices and further outbreaks of foot and mouth and has caused a 20 per cent drop in domestic milk production.
The need for cattle feed as industrial scale farming ramps up will continue to escalate. The Chinese Government is aiming for 95 per cent self-sufficiency in overall grain production but output is struggling to catch up and China continues to look overseas to meet the shortfall.
In 2012, more than 460,000 tonnes of alfalfa was imported to China - 95 per cent from the United States at a cost of $200 billion.
For a sense of scale, China's largest dairy feed company Wellhope Ruminant produces 96,000 tonnes per year. There is a shortage of arable land suitable for growing crops and a looming water crisis further compounds matters.
Four hundred cities in China face water shortages, 100 of which are facing serious scarcity. Rampant economic growth has driven water requirements, with agriculture accounting for 62 per cent of demand for water resources.
An increase in scaleable farming should at least see a more efficient use of scarce local resources while a long-term solution is sought.
"The purpose of the industry consolidation is to maximise the resources we have here," says Paul Wang, vice-president at Mengniu Dairy - China's largest dairy firm and one of the six selected National Champions. "With consolidation, there is going to be a larger resource pool, with higher efficiency and an increased ability to invest in quality, traceability and monitoring. It makes the process more transparent to consumers and helps to build confidence in our domestic product.
"The Government is actively encouraging major dairy companies to build their own dairy farms, because your own farm is very controllable and the requirements in terms of quality can happen from the farm to the factory to the market.
"They are trying to show the consumer that we have very high and strict quality controls for our products".
Major dairy processors will look to take control of their entire value chains, not only improving the overall efficiency of an industry previously ridden with surplus players, but also introducing traceability and accountability from "grass to glass". Mergers and acquisitions in the dairy sector have increased significantly as competition for high quality targets intensifies.
Fitch Ratings reports 2012 saw 44 IPO's/M&A deals take place and 39 completed in the first half of 2013, as firms prepare to stake their claim on newly opening segments of the market.
"This is the first time there has been a national push for the dairy sector," says Li Ke, vice-president and head of marketing at Bright Dairy.
"The purpose of this consolidation is to raise the standard of the dairy sector and also raise the difficulty for new companies looking to enter the market."
Rehabilitating the domestic industry is a step towards ensuring China retains a larger share of the profits generated by rapidly increasing demand for dairy products, while simultaneously trying to reduce its reliance on foreign products to meet demand shortfalls. Despite the surging demand for dairy products, China remains well below the global average in terms of consumption on a per capita basis.
There is a direct correlation between increases in income and demand for high quality, nutritionally rich foods. China's middle class is predicted to grow substantially over the coming years off the back of social changes and wage increases, with 75 per cent of families expected to surpass the income threshold by 2022, up from only 6 per cent in 2002 according to McKinseys.
Further spurring on that growth is the Government's recent relaxation of the one-child policy, allowing families to have a second child if one of the parents is an only child.
Macquarie Group are forecasting an overall growth rate in total dairy consumption of 13 per cent per annum over the next five years and most importantly for New Zealand, a 20 per cent growth rate at the premium end of the market.
New Zealand businesses have already started to feel the impact of the changing market dynamics.
Synlait Milk, in which Bright Dairy is a major shareholder, is poised to miss its export target of 10,000 tonnes of infant formula to China this year. Uncertainty around the tighter controls on foreign products has also prompted Chinese customers to halt orders of New Zealand dairy products as clarification is sought on what was permitted to be sold.
"It is going to be harder for international firms to compete here," concedes Kelvin Wickham, Fonterra's Managing Director for China and India.
"The big dairy companies here are already highly credible businesses. It's competitive, they're growing fast and they've got big funds to invest in A&P (agriculture and pasture)."
The consolidation seems set to force some of New Zealand's minor players out of the market. With costs of compliance set to intensify and a government crackdown on the number of dairy brands available on the shelf, the prospects for small-scale NZ producers are dimming.
For the lucrative infant formula market, speculation suggests China may allow a maximum of 10 New Zealand brands, a far cry from current levels which exceed 100 brands.
New Zealand exports of infant formula boomed in the aftermath of the melamine crisis, growing from $515,000 worth in 2003 before reaching $107 million in 2012 and $200 million in 2013.
The improvements in regulations and quality for Chinese milk do come with an increased price tag - an important factor New Zealand can look to exploit says Wickham.
"You find that as you do improve, your cost structure increases.
"To produce high-quality milk and to have all the controls in place, it's not cheap. We can do that more cost-effectively in New Zealand and produce milk cheaper than you can in China."
Those advantages are mitigated by the import tariffs China continues to impose on New Zealand dairy products.
The 2008 China New Zealand Free Trade Agreement gradually lowered dairy tariffs to prevent New Zealand products from flooding the market and negatively impacting Chinese producers.
A preferential rate was introduced in the interim, with that rate decreasing from 5 per cent to 4.2 per cent in 2014. That rate applies to a set quota of imported products each year, before a full 10 per cent charge is imposed. The growth in exports has seen that quota reached faster and faster each year, and the preferential limit was drained by January 17 this year.
China is due to eradicate all tariffs on New Zealand dairy products by 2019, when the full potential of NZ's cost efficiencies should be able to be realized. In the interim though, protecting the New Zealand brand and leveraging the reputation of NZ's "safe" products remains critical to ensuring the NZ price premium remains sustainable.
Says Wickham: "You've got to have a reason why you would buy New Zealand milk over Chinese milk and our branded proposition and differentiation justifies that."
Prime Minister John Key and a delegation toast the opening of the China-New Zealand Dairy Exchange Centre (with milk).
Overseas firms asked to play their part
China has given foreign dairy companies the message that if they want to be a part of the new industry landscape they will have do to their part in helping to improve it.
"You see a number of international farming operations setting up here now and they can provide great support to our dairy industry," says Professor Li Shengli from China Agriculture University.
"We have many many dairy farms in China and we need to be able to rely on the experts to help us with farm training and raising our standards.
"They can share their valuable experiences and expertise to help us improve Chinese dairy."
Fonterra's Kelvin Wickham stresses the pivotal role that business partnerships with Chinese players will play in the future of Fonterra's development in China.
But the crucial partnership is the one that the big dairy companies have with the Chinese Government to transfer vital "know-how".
"It's very important that we look at the role we can play to help support the dairy industry," says Wickham.
"We bring our farming upstream technology, we invest and we've got a relationship with the Ministry of Agriculture.
"They arrange for us to do farmer training in different venues throughout the year".
Fonterra launched the China-New Zealand Dairy Exchange Centre in Beijing during the Prime Minister's visit to Beijing last month.
A joint initiative between Fonterra and China's National Dairy Industry and Technology system, the venture will support the sustainable development of the dairy industry. It will feature policy development in the China and New Zealand dairy sectors, academic exchanges, industry promotion, dairy technology research and personnel training.
What's the Chinese dairy market consolidation about?
10 National Champions by 2015 each with sales exceeding
RMB 2 billion.
Chinese consumers have little confidence in their domestic industry and pay heavy premiums for international products. This over-reliance is unsustainable in the face of surging demand.
Six National Champions (so far) - dairy giants Yili and Mengniu, Heilongjiang Wondersun, Feihe International, Wissun International and Treasure of Plateau Yak Dairy.
RMB 30 billion Government support package to foster consolidation.