Profit from China's rediscovered love for dairy

Last year, China was gripped by a milk scare that caused widespread panic, and resulted in death penalties for two convicted milk suppliers.

It began with the news that Chinese baby formula laced with the industrial chemical melamine had caused the deaths of four infants. As thousands of children showed up in hospitals with kidney stones, supermarket shelves were cleared. Milk exports were banned. Government officials raced to the country's 20,393 milk collection stations (where farmers bring their milk to be processed and sold to suppliers) to seize tainted products.

But this was no accident. An investigation found that mixing melamine in milk had become common practice in the Chinese dairy industry. Melamine is high in nitrogen, which means that products made with it appear to be high in protein. So suppliers trying to cut costs added it to watered-down milk to cover up the protein deficiency. Of China's 109 dairy groups, 22 were implicated in the scandal. Unsurprisingly, for a while China's parents took their children off milk, giving them rice water instead.

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Not for long, however. The Chinese soon rediscovered their taste for milk. Dairy sales rose 12.4% in the first quarter of 2009, according to agribusiness analysts Rabobank. The milk groups that were not implicated in the scandal profited handsomely. But this is only the start. The Chinese are becoming a nation of milk drinkers. Twenty years ago, the Chinese regarded cheese with revulsion it was what gave Westerners their smelly breath. But rising incomes and growing fridge ownership have brought with them a taste for all things dairy from flavoured milk to sweetened yogurts. China will consume 25 million tons of milk this year, putting it ahead of both France and Germany, according to KPMG. That's a 76% increase since 2000. The infant milk formula market alone is expected to grow from $5.5bn today to $12bn by 2014.

And the government is moving to cement the position of the big dairy groups. It is estimated that two-thirds of Chinese dairy farmers have fewer than 20 cows each, says Kit Gillet in China International Business. Between these farmers and the supermarkets is a swamp of local milk suppliers and wholesalers. With only 17%-18% of the market under the control of the dominant six or seven milk groups, quality control is a logistical nightmare.

So in the six months following the scandal, the authorities shut down 3,908 milk collection stations. The plan is to move towards an industry where the dominant players control 60%-70% of the market, says Jonathan Chou, chief financial officer of China-focused American Dairy. To this end, the government is offering huge subsidies to the larger companies so that they can expand their operations.

That's lit a fire under the big milk groups, who've been matching government money to buy milk stations and expand this year. In the last few months, expenses have soared as they ratchet up spending on advertising in an effort to win over customers at a time when they are flitting between brands. But these groups have already carved out a much larger share of a growing market this year. Meanwhile, the price of milk is recovering strongly last week, leading New Zealand milk producer Fonterra forecast a price of $5.50/kg of milk solids, up 21% on last season's value. Few dairy producers will have a bigger market to sell to than the brands that Chinese consumers still trust. We have a look at one such brand below.

The best bet in the sector

Beijing-based American Dairy (NYSE: ADY) has been producing high-end milk powders in China since 1962 under the brand names Feihe and Firmus. It was one of the few big producers to escape the tainted milk scandal.

The company has 200 milk-collection stations, two dairy farms and six production facilities. But unlike its rivals, American Dairy controls its own production instead of buying from other brokers. As its competitors were forced to halt production, the company saw its market share grow from 2% to 7.3% in the past 12 months. It now expects to have 15% of the Chinese milk-powder market by 2014.

Operating expenses grew 58.3% year-over-year to $33m in the last year, due to the rapid growth of the firm's distribution network and rising advertising costs. In the past year, it has grown the number of sales outlets it owns from 50,000 to 80,000. The share price took a hit recently as it cut its full-year revenue forecast to $290m from $360m fourth-quarter revenues may not be as strong as had been expected, particularly as last year's were boosted by the melamine scare.

But that's still a huge jump on the $193m seen last year, while gross third-quarter profit almost trebled year-on-year to $37m. Cash and equivalents stood at $43m at the end of the quarter. The stock trades on a forward p/e of 8.9.