Given the increase in food safety awareness, China’s dairy sector has attracted renewed interest as the reality takes hold that scandals will push consumers toward buying products from larger, branded players.

In seeking out attractive consumer businesses, we have looked at a number of dairy companies. Many have had challenging histories. Consumer spending patterns for milk products have historically favored cheap products, making it uneconomical to implement the necessary quality control process to ensure safety. Smaller private companies also lack scale, geographic reach beyond their home market. However, the dynamics of the industry must change. Dairy producers eager to succeed must provide safe products, avoid scandal, and scale up while addressing low profit margins. The alternative is to become an acquisition target, which will inevitably result in mergers, acquisitions and buyouts, often with the seller being forced to negotiate from a position of weakness.

In anticipation of growing demand for safe branded products, larger companies have begun to expand vertically or enter into off-take contracts to ensure supply. This has resulted in the rapid expansion of commodity raw milk suppliers. However, we remain cautious about these businesses. Unlike branded producers that focus on UHT milk, premium raw milk suppliers suffer from weak cold chain logistics that make it difficult, and expensive, to distribute beyond their local region. Premium raw milk suppliers are also growing in response to the anticipated desire for higher-end products. However, these producers require large capital expenditure and advanced technology to succeed, and while the demand looks anecdotally promising, it is uncertain. As more premium raw milk suppliers come on line, the most likely near term result is that they contribute to overall margin pressure.

We prefer instead to focus on branded producers with established distribution channels for compelling products. Strong premium branded producers are likely to be acquisition targets for larger industry players. Flavored milk in particular is intriguing, in that it is a higher margin business with attractive growth rates. We estimate that flavored milk generates 30% gross margins on average, versus 25% for UHT milk, and that demand will grow 20% annually for the foreseeable future. Companies with strong flavored milk products will become desirable acquisitions and have the ability to negotiate from a position of strength as larger dairy businesses look to address to this fast growing niche market. Specific to our portfolio, we believe this creates potential for Joysun, our business focused on walnut-flavored beverages. By most measures, walnut is currently the most popular flavored milk due to its strong association with health and intelligence amongst Chinese consumers.

So as we continue looking at the dairy industry, we anticipate seeing (i) acquisition, consolidation and distress amongst raw milk producers, (ii) challenges to scale and safety in the mid-sized diversified branded players; (iii) expansion vertically amongst the larger, listed players; and (iv) a strong desire by all players for products with higher value-add, an established brand, and efficient distribution channels.