Fonterra Co-operative Group Ltd, a New Zealand-based multinational dairy company, is expected to buy nearly 39 per cent of Chinese dairy producer Shijiazhuang Sanlu Group Co Ltd, suggest industry insiders.

Many multinational companies are trying to re-enter the fast-developing Chinese milk market ?through mergers and acquisitions (M&As) ?after having backed away from the market due to poor business, the insider told China Business Weekly.

The insider, a leading expert in the sector, refused to be named.

Last November, Danone Asia Pte Ltd, a subsidiary of French food giant Groupe Danone, paid Shanghai's municipal government 121.03 million yuan (US$14.59 million) for 3.58-per-cent stake in Bright Dairy & Food Co.

The deal increased Danone's holding in the dairy to 7.7 per cent. Danone becomes the firm's third-largest shareholder.

Sanlu is negotiating with Fonterra, a public relations executive told China Business Weekly.

Discussions, the source said, are in the initial stage.

Fonterra's efforts to secure a stake in Sanlu is part of a long-term investment initiative, company Chief Executive Officer Andrew Ferrier was quoted as saying on Fonterra's website.

"We have a good track record in the (Chinese) market, and we have achieved good sales,?Ferrier said.

"So, our experience gives us confidence we can achieve long-term growth through the Sanlu investment, if we are successful in our negotiations.?

Sanlu is based in North China's Hebei Province.

It is presently unclear if a a joint venture will be established by Fonterra and Sanlu, or if Fonterra will invest directly into the Chinese firm.

Insiders predict the co-operation between Fonterra and Sanlu will mainly involve liquid milk rather than milk powder.

Several international companies have established joint ventures with Chinese milk powder producers, but few have created joint ventures to produce liquid milk.

The world's top 20 milk brands had entered China's market by the end of 2002, indicates the Dairy Association of China (DAC).

Many have performed well while producing and selling milk powder, but few have done well producing and marketing milk, even though the sector has grown rapidly in recent years.

During the first 11 months of last year, China's milk industry's production value was 45.66 billion yuan (US$5.5 billion). Profits rose to a combined 2.79 billion yuan (US$336.9 million), up 51.89 per cent year-on-year.

Yet, foreign dairy firms have retreated from China's burgeoning market.

Before Parmalat, the Italian food firm, filed for bankruptcy last December, the company's China branch transferred control of its joint venture in Nanjing to its local partner.

Parmalat also leased its outlet in Northeast China's Heilongjiang Province to Yili Group, China's leading dairy producer.

When foreign dairy firms entered China in the mid-1990s, the country's milk consumption was just beginning to take off.

Those firms had a tough time promoting in China the benefits of drinking milk, said Dou Ming, director of the editing department of China Dairy Yearbook.

Some firms, such as Parmalat and Kraft, which were not familiar with China's market, decided to sell their products at higher prices to attract high-end consumers.

That benefited domestic milk producers, such as Yili, Bright, Sanyuan and Sanlu, to rapidly expand their shares of the market.

These domestic players have their own dairy farms, which guarantee them stable milk supplies. In comparison, few multinational dairy companies, with the exception of Nestle, established dairy farms in China.

Even Nestle, which helped Shuangcheng, in Northeast China's Heilongjiang Province, become China's largest dairy-raising county, did not pour its money into dairy farm infrastructure.

Increased milk consumption in China resulted in an undersupply of fresh milk. Foreign milk producers, because they did not have their own dairy farms, could not guarantee stable supplies of fresh milk.

Jin Biao, a senior official with Yili Group, said high operation costs of many foreign milk producers also contributed to some firms dwindling shares of the market.

"The industry's profit margin is quite thin, while the salaries of foreign general managers (of foreign dairy companies) compose half of the profits,?Jin said.

But foreign milk producers did not necessarily fail in China's market, Jin and Dou suggested.

The market value of a major international milk and food company might be higher than the total production value of China's milk industry, and, with huge capital, foreign players can easily return to the Chinese market, Dou said.

For example, Fonterra earned NZ$5.6 billion (US$3.86 billion) in sales revenues for the six months ended November 30. That was more than half of the production value of China's milk industry last year.

In comparison, Sanlu earned 2.36 billion yuan (US$284.67 million) in sales revenues in 2001.

International dairy producers might choose not to build infrastructure, such as dairy farms, as they re-enter China's market.

"They can seek re-entry through the capital market. The increasing foreign shares in Chinese milk companies is an example,?Dou said.

By investing in Chinese milk firms, they can avoid the difficult problem of developing dairy farms, which can take several years.

Besides Fonterra and Danone, Morgan Stanley, CGU-CDC China Capital Partners Ltd and Dinghui Investment have invested a combined US$26 million in Inner Mongolia-based Mengniu Dairy in late 2002.

Those firms hold a 33-per-cent stake in Mengniu.

Mengniu, which has grown more than 1,000 per cent in recent years, has been the fastest growing player in China's milk industry.

(Business Weekly 02/17/2004 page1)