Dairy Sector

The ongoing modernisation of China’s dairy sector

The ongoing modernisation of China's dairy sector -2 - The ongoing modernisation of China’s dairy sector

Content

Introduction 4

Dairy farming sector 6

Stagnating growth and farm consolidation 7

Dairy farm modernisation 11

High production costs 13 Geographic and seasonal mismatch 16

Ambitious growth target 17

Future dairy farm modernisation 18 Dairy processing sector 19

Consolidated industry structure Vertical 20 integration and cross-border expansion 22

Product mix 23

UHT milk 24

Fresh milk 24

Yogurt 25

Ice cream 27

Cheese 29

Infant milk formula 30

Government policies for the dairy industry 34 Keys to success 36 The ongoing modernisation of China’s dairy sector Introduction

China has long aimed to increase dairy consumption in Between 1980 and 2006, China’s raw milk production order to improve public health and nutrition. In 2006, increased by more than 2000% from 1.4 million tonnes Prime Minister Wen Jiabao said “I have a dream that to over 30 million tonnes. Production peaked at 33 every Chinese person, especially children, can drink million tonnes in 2012. Consumption has continued to one jin of milk per day” (note: one jin is equal to 0.5 increase, but dairy production has declined. More than kg).1 The 2009 Dairy Industry Policy stated that per 30% of China’s dairy products (measured in raw milk capita milk consumption was a key indicator of the equivalents) now come from imports, compared to country’s standard of living.2 China’s per capita dairy about 5% in 2007.6, 7 consumption is currently less than 100 grams3 per day, compared to the national daily recommendation of 300 grams.4 With these goals in mind, government policies aim to increase domestic production by nearly 50% by 2025.5

China dairy production and net imports (tonnes of raw milk equivalent)8

45,000,000 45 millions

30 30,000,000

15 15,000,000

- - 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Domestic rawDomestic milk production raw milk (tonnes) production Dairy importDairy (raw milkimports equivalent))

Dairy production growth has stagnated since 2008, but consumption has continued to increase. China now relies on imports for about about 30% of its dairy raw materials (as measured in raw milk equivalents.)

4 | The ongoing modernisation of China's dairy sector The ongoing modernisation of China’s dairy sector

During the past 10 years, the entire value chain has UHT and chilled categories. Infant milk formula (IMF) been modernising, but the sector’s transformation is is still dominated by foreign brands, but government not yet complete. The industrialisation of dairy farming, policies aim to increase the market share of Chinese vertical integration by processors and upgrading of brands to 80%.11 Dairy companies are looking to e- genetics and technology will continue. These trends will commerce, expanding chains of supermarkets, continue to deliver better food safety and quality, and a convenience stores and maternity stores, as well as proliferation of new dairy products. China’s top three third- and fourth-tier cities for revenue growth. dairy processing companies account for nearly 50% China’s government has been issuing new plans, market share9, and they will continue to drive policies and regulations to modernise production, modernisation and innovation throughout the value improve food safety and quality, and reduce chain. dependence on imports. Dairy manufacturers are The most difficult challenge to China’s ambitious encouraged to build or acquire controlling stakes in growth plans is the high cost of domestic production.10 dairy farms. Government policies actively encourage Imported dry dairy products are cheaper than domestic the establishment of strong domestic dairy brands and products. Limited domestic forage and feed crops are increased consumption of pasteurised milk and dry an important driver of the cost difference. China’s large- products such as cheese. Because babies and children scale dairy farms depend on imported alfalfa and soy, are the most vulnerable of all consumers, dairy products and manufacturers often depend on imported milk – especially IMF – are among the most strictly regulated powder. Increasingly stringent environmental and food of all food and beverage products in China. safety regulations, as well as rising labour costs, also China is has been one of the world’s largest dairy contribute to production costs. producers for more than a decade. In terms of Growth and new product development will be driven by modernisation, it is now far ahead of major developing cold chain expansion and rising disposable income. countries, and its large corporate farms and factories UHT milk was the first dairy product to achieve increasingly resemble those of modern industrial dairy widespread consumption, but fresh milk is becoming countries. popular as cold chain distribution capacity grows and This report will look at dairy industry trends in China as consumers look for products viewed as more across the entire supply chain, and will highlight some nutritious. Yogurt sales recently surpassed liquid milk keys to success in this dynamic environment. sales, and this trend is likely to continue as competition drives new yogurt product development in both the

1. China Daily, 25 Feb 2006, 《温家宝：让每个中国人每天都能喝上一斤奶》, http://www.chinadaily.com.cn/hqsy/2006-04/25/ content_578567.htm 2. 乳制品工业产业政策（2009 年修订） 3. As calculated by the China Dairy Association, using the formula of 1 kg of dry milk products is equivalent to 8 kg of milk. 4. 中国营养学会，声明：关于《中国居民平衡膳食宝塔（2016）》官方版本,18 May 2016, http://dg.cnsoc.org/ article/04/8a2389fd54b964c80154c1d781d90197.html 5. 农业农村部等九部委联合印发《关于进一步促进奶业振兴的若干意见》, 26 Dec 2018, http://www.moa.gov.cn/xw/zwdt/201812/ t20181226_6165640.htm 6. Raw materials as measured in raw milk equivalents. 1 kg of dry dairy product imports estimated to equal 8 kg of milk as per the China Dairy Association methodology, 7. China Dairy Data Report 2019; 2019 China Dairy Statistical Summary 8. 2019 China Dairy Statistical Summary, 1 kg of dry dairy product imports is estimated to equal 8 kg of milk as per the China Dairy Association methodology 9. Dairy Association of China, White paper of China Dairy Industry 10. USDA, China Dairy and Products Annual, 15 Oct 2018 11. National Dairy Industry Development Plan (2016-2020), Jan 2017

5 | The ongoing modernisation of China's dairy sector The ongoing modernisation of China’s dairy sector

Dairy farming sector Dairy farming sector

Stagnating growth and farm consolidation

Between 1980 and 2008, China’s annual raw milk Since 2008, raw milk production has practically stopped production incredibly grew from 1.4 million tonnes to growing, but the government and China’s leading dairy over 32 million tonnes. The introduction of UHT companies have been focused on modernising the processing and aseptic packaging technology in the industry and on improving food safety and product late 1990s enabled longer shelf life and distribution quality. In December 2018, the government announced without refrigeration, launching a period of rapid dairy plans for a new period of rapid growth. The Opinions on industry growth. This made China one of the largest Further Advancing Dairy Industry Rejuvenation set a dairy producers in the world. production target of 45 million tonnes for 202513, an The fragmented structure of China’s raw milk increase of nearly 50% over 2018. This growth will be production has made supervision over safety and driven by increasing China’s dairy herd, farm scale and quality challenging. Growth in raw milk production productivity, as the number of dairy farms continues to prior to 2008 was delivered by a vast increase in the fall. number of dairy farms. In 2002, China had less than Driven by government policy and increasingly strict 1.4 million farms with dairy cows, of which 1.1 million regulations, the number of small dairy farms has been had fewer than 5 cows. At the time of the melamine rapidly shrinking, while the average farm scale has crises in 2008, China had nearly 2.6 million dairy been steadily increasing. The number of dairy farms farms, of which nearly 2 million had fewer than 5 has fallen by nearly 75%, from over 2.6 million in 2007 cows. These small farm owners generally lacked the to 660 thousand in 2018. The decrease was especially resources and expertise to implement best practices steep between 2016 and 2018 when the number of for efficient production, raw milk quality and food dairy farms fell by nearly 50%, largely due to new safety. Nearly half of all raw milk was extracted by environmental restrictions on livestock farming. hand.12 Compared to today, there was relatively little oversight for dairy farms and the collection and trading of raw milk.

China raw milk production and number of dairy farms14

tonnestonnes of numbernumber of of raw milk dairy farms raw milk farms 30,000,000 2,500,000 30 2.5 25,000,000 2,000,000

millions 25 2.0 millions 20,000,000 1,500,000 20 15,000,000 1.5 15 1,000,000 10,000,000 1.0 10 5,000,000 500,000 5 0.5 0 0 0 0.0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 Raw milkRaw milk production (left axis) production (left axis) NumberNumber of farms with d of farms with dairyairy cows (right axis) cows (right axis)

The number of farms with dairy cows has fallen by nearly 75% since 2007, even as raw milk production has remained steady.

7 | The ongoing modernisation of China's dairy sector Dairy farming sector

In addition, large dairy processors are increasingly purchasing milk from large commercial dairy farms that they control or with whom they have long-term purchase agreements. The trend in China since 2007 is similar to developments in the US and Western Europe during the past 30-40 years. Between 1987 and 2017, the number of US dairy farms fell from about 200 thousand to 40 thousand while annual raw milk production increased from about 65 million tonnes to over 95 million tonnes.15 The number of farms with dairy cows in the ten original EU member countries fell from 1.5 million farms in 1983 to about 290 thousand farms in 2013, an 80% decrease.16

Number of dairy farms and average number of cows per farm in China17

number of cows per farms farm 18 2.5 16 millions 2.0 14 12

1.5 10

8 1.0 6

4 0.5 2

0.0 0 2008 2010 2012 2014 2016 2018 Number of farms with dairy cows (left axis) Average number of dairy cows per farm (right axis)

As the number of dairy farms in China fell by about 75%, the average number of dairy cows per farm more than tripled.

12. National Dairy Industry Development Plan (2016-2020), Jan 2017 13. 九部委印发《关于进一步促进奶业振兴的若干意见》, 26 Dec 2018 14. 2018, 2019 China Dairy Data Report; 2019 China Dairy Statistical Summary; PwC estimates 15. USDA 16. Eurostat, “Milk and Milk Products – 30 years of quotas”, https://ec.europa.eu/eurostat/statistics- explained/index.php/Archive:Milk_and_milk_products_-_30_years_of_quotas 17. 2012, 2014, 2018, 2019 China Dairy Data Report 18. National Dairy Industry Development Plan (2016-2020), Jan 2017; 2018 China Dairy Industry Quality Report 19. National Dairy Industry Development Plan (2016-2020), Jan 2017 20. Sina Finance, 第十届中国奶业大会暨2019中国奶业展览会天津开幕, 15 July 2019, https://finance.sina.com.cn/roll/2019-07-15/doc- ihytcerm3748841.shtml. 21. China Animal Husbandry and Veterinary Yearbook

8 | The ongoing modernisation of China's dairy sector Dairy farming sector

The government has been encouraging and incentivising the construction of larger dairy farms. The average dairy farm scale has increased from almost 5 to nearly 16 cows. The number of professional dairy farming cooperatives has grown from about two thousand in 2008 to over 16 thousand in 2017.18 The percentage of China’s dairy cows on scale farms, (i.e. farms with more than 100 dairy cows,) has increased from 20% in 200819 to over 60% in 201820. The number of farms with more than 1,000 dairy cows has grown from 112 in 2002 to more than 1,350 in 2017.21

China dairy herd distribution by size of farm22

size of China’s dairy herd 12

8 millions of cows millions 6

0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 20172018

Dairy farm size: 1‐49 cows 50‐99 cows 100‐499 cows 500‐999 cows 1000+ cows

China’s dairy herd shrunk by nearly 20% between 2008 and 2018, but the percentage of cows on farms with more than 100 cows increased from 20% to over 60%.

9 | The ongoing modernisation of China's dairy sector Dairy farming sector

In spite of this ongoing consolidation, China’s dairy farm sector is still highly fragmented compared to the most modernised dairy countries, such as New Zealand and the US. In 2018 the US had only about 37,500 dairy farms with an average size of 251 cows.

Number of dairy farms23 Average number of cows per farm24

661,760 431

400

600,000.00 350

500,000.00 300 251 400,000.00 250

300,000.00 200

150

200,000.00

100 64

100,000.00 65,782 37,468 50 11,590 16

0.00 0 China Germany US New China Germany US New Zealand Zealand

China’s dairy farming sector is still highly fragmented, with over 660,000 farms raising dairy cows and an average size of nearly 16 cows per farm.

22. 2019 China Dairy Statistical Summary; Dairy Association of China, White paper of China Dairy Industry; PwC estimates 23. 2019 China Dairy Data Report 24. 2019 China Dairy Data Report

10 | The ongoing modernisation of China's dairy sector -10- Dairy farming sector Dairy farm modernisation

China’s dairy industry has made great progress in modernisation. Government policies have increased the percentage of milk obtained by mechanical milking from 51% in 2008 to 95% in 2015. On China’s scale farms, 100% of milking is mechanised.25 The use of total mixed rations (TMR) for feeding is another indicator of modernisation. The share of scale dairy farms in China using TMR increased from 30% in 2008 to over 90% in 2018.26

Raw milk obtained by mechanised milking27 Share of scale dairy farms using TMR technology28

99% 90% 95%

51%

30%

2008 2015 2020（planned） 2008 2018

The share of raw milk obtained by mechanical milking increased from 51% in 2008 to 95% in 2015, substantially improving China’s food safety and quality.

25. National Dairy Industry Development Plan (2016-2020), 2018 China Dairy Quality Report 26. National Dairy Industry Development Plan (2016-2020), Jan 2017; Dairy Association of China, White paper of China Dairy Industry 27. National Dairy Industry Development Plan (2016-2020), Jan 2017 28. National Dairy Industry Development Plan (2016-2020), Jan 2017; Dairy Association of China, White paper of China Dairy Industry 29. China Dairy Data Report 2019

11 | The ongoing modernisation of China's dairy sector Dairy farming sector

Modern farming techniques, large-scale industrial farms, and improved genetics have all contributed to the steady increase in productivity. Average annual production for Holstein cows increased from just under 4000 kg per year in 2005 to 7,400 kg in 2018. China’s leading dairy farming company, while accounting for less than 5% of total production, had already achieved annual production of more than 10,000 kg per dairy cow by 2018. Some companies have achieved annual production of more than 11,000 kg per dairy cow.29

China’s average milk production for 2017 average milk production per cow by Holstein cows (kg/year) 30 scale of farm (kg/year) 31

7,534 7,400 7500

5,950 6,000 5,507 5,221 4,760 5000 3,891

2500

0 2005 2010 2015 2018 1-10 11-50 51-500 500+ cows cows cows cows

China’s average dairy cow productivity has nearly doubled since 2005. Farms with more than 500 cows achieve a significantly higher level of productivity than other farms.

30. China Dairy Data Report 2019 31. NDRC, 全国农产品成本收益资料汇编2018

12 | The ongoing modernisation of China's dairy sector Dairy farming sector High production costs

There has been a shift from small farms to larger-scale farms, but China’s overall production costs appear to not improve with scale. NDRC estimates indicate that economies of scale reduce per-unit labour costs on dairy farms. But these savings are offset by other costs, including commercial fodder, electricity, veterinary services and management fees.32 Small and backyard dairy farms can often graze their cattle in nearby fields or gather their own forage. Large-scale farms must purchase alfalfa or other fodder for delivery to their farms.

2017 estimated raw milk production cost by farm size (CNY/kg)33

2.5

1.5

0.5

0 1-10 cows 11-50 cows 51-500 cows 500+ cows

Concentrate Fodder Labour Depreciation Others

According to NDRC estimates, larger farms have lower labour costs per unit of milk compared to backyard and small-scale farms. But these savings are offset by the cost of commercial fodder, electricity, veterinary services and management fees.

32. NDRC, 全国农产品成本收益资料汇编2018 33. NDRC, 全国农产品成本收益资料汇编2018

13 | The ongoing modernisation of China's dairy sector Dairy farming sector

During the period from 2006 to 2014, the shift to larger Prior to 2008, China did not import significant amounts scale dairy farms improved labour productivity and of fodder. But as the number and scale of large dairy average production per dairy cow. But the feed farms grew, so did demand for commercial fodder conversion ratio, (i.e. the amount of milk produced per supplies. By 2015, China’s dairy and livestock farms unit of feed concentrate), did not improve significantly, consumed 3 million tonnes of quality alfalfa, of which nor was there much difference between the feed 1.2 million tonnes was imported. With growth in the conversion ratios on backyard, small-, medium- and number of scale livestock farms, China’s demand for large-scale farms.34 quality alfalfa is expected to reach 6.9 million tonnes by 2020, of which 90% will be for dairy farms.35 China also depends on imports for soy, a key ingredient in feed concentrate.

Alfalfa and other forage products imports Soy imports (tonnes)37 (tonnes)36

1.8 90 1.6

millions 80 millions 1.4 70 1.2 60 1.0 50 0.8 40 0.6 30 0.4 20 0.2 10 0.0 0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Commercial dairy farms in China often depend on imported alfalfa and soy to feed their animals. This contributes to the high cost of raw milk.

34. Gale, F., and M. Jewison. 2016. “China as Dairy Importer: Rising Milk Prices and Production Costs,” International Food and Agribusiness Management Association Review, Special Issue, 19 (B) 35. National Alfalfa Production Development Plan (2016-2020), Dec 2016 36. UN Comtrade Database 37. UN Comtrade Database

14 | The ongoing modernisation of China's dairy sector Dairy farming sector

China’s raw milk production costs are higher than those of other countries with large modern dairy farming sectors. These higher costs are due mainly to higher prices of feed concentrate (e.g. corn, soybeans) and fodder. Increasing labour expenses are also an important factor. In 2018, raw milk produced in China cost 46% more than raw milk in New Zealand, the largest source of China’s dairy imports, and 53% more than the global average.38 .

2018 raw milk prices (USD/100 kg) 39

0 Global US New Brazil EU China average Zealand

China’s raw milk price is higher than other countries with modern dairy industries.

Contributing factors include imported forage and increasing labour costs.

38. China Dairy Data Report 2019 39. China Dairy Data Report 2019

15 | The ongoing modernisation of China's dairy sector Dairy farming sector Geographic and seasonal mismatch

In addition to the imbalance between total annual Raw milk production has seasonal variations that are domestic supply and demand, China’s dairy sector also not aligned with seasonal changes in consumption. suffers from geographic and seasonal imbalances. These periodic imbalances between supply and demand can create temporary gluts of raw milk. When Four provinces in the North (i.e. Heilongjiang, Inner supply exceeds demand, raw milk prices fall and Mongolia, Xinjiang and Hebei) account for more than processers convert excess raw milk to powder. This half of China’s milk production, but less than 12% of domestically produced powder, however, is generally the population. At the same time, twelve provinces produced at a higher cost than imported powder.40 clustered in the south and along the coast account These seasonal imbalances can negatively impact for 52% of the population but less than 20% of dairy small farmers who aren’t protected by price production. The distance between raw milk stabilisation measures or long-term purchasing production and dairy consumers is a limiting factor contracts. for consumption of fresh milk and chilled yogurt, which have limited shelf life and require continuous refrigeration.

China’s weekly raw milk price 2014-2019 (CNY)41

4.30 4.20 4.10 4.00 3.90 3.80 3.70 3.60 3.50 3.40 3.30 Jan 2014 Jan 2015 Jan 2016 Jan 2017 Jan 2018 Jan 2019

Seasonal changes in production and consumption contribute to annual price fluctuations. In 2019, raw prices have increased by 8% over 2018, reaching the highest levels since 2014. These high prices could support further investment in dairy farms.

It is also worth noting that China’s growing dairy consumption, combined with the withdrawal of hundreds of thousands of small farmers has resulted in an 8% year-on-year increase in raw milk prices during the second half of 2019. In August, prices reached their highest level since 2014.42

40. USDA, China Dairy and Products Annual, 15 Oct 2018 41. Wind, MARA 42. Wind

16 | The ongoing modernisation of China's dairy sector Dairy farming sector Ambitious growth target

While China’s dairy production has been flat since 2008, The government has announced its goal of increasing consumption has continued to grow. The gap between annual domestic production to 45 million tonnes by supply and demand has been met by growing imports, 2025, an increase of more than 40% over 2018.43 mainly in the form of milk powder. Powder is the most Achieving this target will require both improved output common dairy product for international trade due to its per dairy cow and an increase in the number of cows. relatively low shipping costs and long shelf life. Imports As the number high-productivity cows on modern, large- accounted for more than 30% of China’s dairy scale dairy farms grows and the number of cows on low- consumption, (as calculated in raw milk equivalents), productivity small farms falls, the average productivity of up from about 5% in 2007. China’s National Dairy China’s herd will continue to increase and could Industry Development Plan (2016-2020) aims to potentially reach levels seen in the US and Europe. maintain a self-sufficiency ratio of at least 70%.

China raw milk production and number of dairy cows44 tonnes of number of raw milk dairy cows

45 12 40 10 35

30 8 25 6 20 millions millions 15 4 10 2 5

0 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

Raw milk production (left axis) Government target production for 2025 (left axis)

Dairy herd (right axis)

Even as dairy consumption has continued to increase, China’s dairy herd has shrunk by 15% since 2008. Achieving the government’s raw milk production target of 45 million tonnes by 2025 will require substantial increases in both the size and productivity of China’s dairy herd.

43. 九部委印发《关于进一步促进奶业振兴的若干意见》, 6 Dec 2018, http://www.dac.com.cn/read/newgndt-18122614494484910108.jhtm 44. 2018, 2019 China Dairy Data Report; 2019 China Dairy Statistical Summary; 九部委印发《关于进一步促进奶业振兴的若干意见》, 26 Dec 2018

17 | The ongoing modernisation of China's dairy sector Dairy farming sector

The dairy herd, however, has decreased by 15% since 2008, as small farms left the industry. Expanding the percentage of China’s herd on scale farms will require Future dairy farm investment in new facilities and cows. Although there are plans to increase alfalfa planting45, dependence on imported fodder will likely increase. modernisation

If the 2019 increase in raw milk prices continues, it will China's current wave of dairy farm modernisation is help make profitable growth more sustainable and focused on standardisation, mechanisation, genetic investment in dairy farms more attractive.Nevertheless, improvement and farm scale. The next wave will be the increasing the number of scale farms will require shift to automated milking and feeding, and precision continued subsidies and other government incentives in dairy farming. These technologies will further improve order to meet increasingly strict environmental, food efficiency, productivity and animal health. safety and biosecurity requirements. Subsidies and incentives will also be needed to overcome high feed In the Netherlands, about 30% of raw milk is obtained costs and to compete with relatively cheap milk powder by automated milking systems (AMS)46, but AMS is imports. only used on an estimated 1-2% of cows in China. AMS Labour costs will continue to increase, driven by eliminates the need for human involvement in daily multiple trends, including the decrease in China’s milking, raises efficiency and improves sanitary working age population, the decrease in China’s rural conditions. population, and increasing wages and productivity in the manufacturing and services sectors. Labour costs Precision dairy farming is “the use of technologies to will also accelerate the shift to larger farms, where measure physiological, behavioral, and production costs can be spread over larger herds and there are indicators on individual animals.”47 It includes the use greater opportunities for automation. of online or inline sensors to monitor milk quality and udder health, automatic feeding systems to better manage and monitor calf health, wearable technology (e.g. accelerometers, rumination sensors) to measure cow behaviour and activity, video analysis or facial recognition, etc. Wireless, cloud and big data technologies can facilitate transmission, processing and analysis of the stream of information produced by these monitors.

45. 农业部关于印发《全国苜蓿产业发展规划 2016-2020 》的通知,18 Jan 2017 46. China Daily, “China that flows with milk and honey”, 5 Aug 2019, https://www.chinadailyhk.com/articles/116/202/152/1564988448870.html 47. University of Minnesota Extension, “Precision dairy farming: advanced analysis solutions for future profitability”, 11 Jun 2019, https://extension.umn.edu/dairy-news/future-precision-dairy-farming

18 | The ongoing modernisation of China's dairy sector The ongoing modernisation of China’s dairy sector

Dairy processing sector Dairy processing sector Consolidated industry structure

While China’s raw milk production is highly fragmented, its processing sector is much more concentrated. The largest three dairy processing companies in China account for about 50% market share, and the top two processors purchase 45% if the country’s raw milk production. In contrast, the top ten dairy farming companies together deliver less than 25% of China’s raw milk production. This gives large processors significant pricing power over farms. The industry structure in China contrasts with that of the US. The US dairy industry is dominated by dairy farm cooperatives. The largest three account for about 50% of raw milk production. The largest three US dairy processing companies account for only 22% market share. In spite of these large cooperatives and the large scale of US farms, low milk prices continue to force family-owned farms out of the industry in favour of industrial scale farms. In Europe, dairy cooperatives account for about 55% of the market.48

Market share of largest three dairy processers49 Market share of largest raw milk producers50

50% 50%

40%

30% 25% 20%

10%

0% 0% China US China US

China’s dairy processing sector is highly concentrated with the top three processors accounting for nearly 50% market share. The dairy farming sector is highly fragmented with the top ten companies producing less than 25% of China’s raw milk.

48. European Parliament, “The EU dairy sector: Main features, challenges and prospects”, 2018 49. China Dairy Data Report 2019, IBIS 50. China Dairy Data Report 2019, IBIS

20 | The ongoing modernisation of China's dairy sector Dairy processing sector

The consolidation of China’s dairy processing sector has been a long-term trend. The top two companies, Yili and Mengniu, together processed about 25% of raw milk production in 2010. By 2017, that number had risen to 45%. In 2008, China had 815 scale51 dairy processing companies with combined revenue of 143 billion RMB.52 By 2018, the number of dairy processors had fallen to 587, while the sector’s revenue had grown to 340 billion RMB.53

% of domestic raw milk purchased by Mengniu and Yili

45%

China’s top two dairy companies processed about 45% of China’s raw milk production in 30% 2018, up from 25% in 2010. This gives dairy processors significant pricing power over dairy farmers.

15%

0% 2010 2011 2012 2013 2014 2015 2016 2017

Yili Mengniu

51. “Scale” enterprises are those with annual revenue exceeding 20 million CNY 52. National Dairy Industry Development Plan (2016-2020), Jan 2017 53. Dairy Association of China, White paper of China Dairy Industry

21 | The ongoing modernisation of China's dairy sector Dairy processing sector

Vertical integration and cross-border expansion

China’s largest dairy companies are driving the yogurt, fermented milk beverages, ice cream and other modernisation of the industry through vertical products. In November, Mengniu agreed to acquire integration and product development. In China and Australia’s Lion Dairy & Drinks, a manufacturer of dairy overseas, they are acquiring and investing in raw milk and other beverages, and owner of several popular production bases, processing capacity and brands. brands.59 Mengniu opened a production facility in Jakarta in November 2018, the first factory opened by a Within China, Mengniu has acquired a majority Chinese dairy company in Southeast Asia.60 Indonesia’s shareholding in China Modern Dairy, China’s largest yogurt penetration is only 17%, compared to 80% in producer of raw milk, and Shengmu High-tech Dairy54, China and 95% in Europe.61 China’s leading organic milk producer.55 The value of China’s ice cream exports rose more than Overseas, Chinese companies have been investing in 300% between 2015 and 2017. 75% of 2017 ice cream dairy farms and processing capacity, both to increase exports went to Indonesia. This growth coincides with overall capacity and to deliver premium-priced imported China’s largest dairy companies’ Southeast Asia growth dairy products. In 2019 Yili acquired Westland, New strategies. Yili has launched a series of ice cream Zealand’s second largest dairy cooperative, in order to products in Indonesia62 and recently acquired Thailand’s secure a new and stable supply of quality raw milk.56 In largest ice cream producer.63 2010, Bright purchased a majority stake in New Zealand’s Synlait Milk, and remains a major During the past decade, Chinese companies have shareholder.57 acquired foreign IMF brands, as well as overseas IMF processing capacity. For example, Yili and Mengniu have Shanghai Pengxin purchased several large New invested in IMF manufacturing plants in New Zealand.64 Zealand dairy farms in 2012. They have also joined Feihe, China’s largest IMF producer, is building a plant investors linked to China’s largest e-commerce in Canada that will focus on premium goat milk IMF for company to co-invest in an associated New Zealand export to China.65 In 2019, Mengniu agreed to acquire company that owns dairy farms and exports premium- Australia’s largest producer of organic IMF.66 In 2015, priced UHT and fresh milk to China, the latter via air Yashili acquired Danone’s Asia IMF operations and transportation.58 brand, while Danone has purchased stakes in Yashili China’s dairy companies are also looking to Australia, and Mengniu’s New Zealand subsidiary.67 New Zealand and Southeast Asia to grow their sales of

54. China Mengniu Dairy Company Limited 2019 Interim Report 55. YiCai Global, Shengmu Dairy Sells 51% of Its Unit to Mengniu Dairy for USD 43.5 Million”, 24 Dec 2018, https://yicaiglobal.com/news/shengmu-dairy-sells-51-of-its-unit-to-mengniu-dairy-for-usd435-million 56. China Daily, “Chinese Dairy Giant Yili Acquisitions New Zealand’s Westland”, 1 Aug 2019, https://www.chinadaily.com.cn/a/201908/01/WS5d42e4e5a310cf3e3556367a.html 57. Bright Dairy 2018 Annual Report 58. New Zealand China Council, Understanding Chinese Investment in New Zealand, Aug 2019, https://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=12021328 59. China Daily, “Mengniu to buy dairy company in Australia for $407m”, 26 Nov 2019, http://global.chinadaily.com.cn/a/201911/26/WS5ddc822ba310cf3e35579f8d.html 60. Yicai Global, “China’s Mengniu Dairy Opens Indonesian Yogurt Factory to Extend Global Push”, 30 Nov 2018, https://yicaiglobal.com/news/china-mengniu-dairy-opens-indonesian-yogurt-factory-to-extend-global-push 61. Food Navigator, “Mengniu opens first SEA production base in Indonesia, aims to be no. 1 yogurt brand in three to five years”, 10 Dec 2018, https://www.foodnavigator-asia.com/Article/2018/12/10/Mengniu-opens-first-SEA-production-base-in-Indonesia-aims-to-be-No.-1-yogurt- brand-in-three-to-five-years 62. Foodbev Media, “Yili announces new ice cream products for Southeast Asia”, 25 July 2019, https://www.foodbev.com/news/yili-announces- new-ice-cream-products-for-southeast-asia/ 63. Caixin, “Chinese dairy-makers move to milk Southeast Asia trade ties”, 5 Dec 2018, https://www.caixinglobal.com/2018-12-05/chinese-dairy- makers-move-to-milk-southeast-asia-trade-ties-101355901.html

22 | The ongoing modernisation of China's dairy sector Dairy processing sector Product mix

China’s dairy product market is roughly 400 billion CNY. and yogurt (including both chilled and UHT). They are The leading products are yogurt, liquid milk and infant also the leading companies for ice cream production, milk formula (IMF). During the first half of 2019, milk combining for just over 20% market share. Yili is the powder showed the fastest growth of these major largest ice cream producer, Bright is the leading fresh categories.68 Sub-categories with high growth rates milk producer, and Feihe is the leading domestic include organic dairy products, goat milk IMF, fresh producer of IMF.69 (refrigerated pasteurised) milk, UHT yogurt and The main retail channels are modern supermarkets, premium UHT milk. hypermarkets, convenience stores and maternity China’s largest two dairy companies, Yili and Mengniu, stores. E-commerce sales for China’s leading both headquartered in Hohhot, Inner Mongolia, together companies grew by more than 50% in 2018.70 account for more than 50%market share in UHT milk

Estimated 2017 market share by product category71

Yogurt & UHT milk fermented milk products Butter & Fresh milk others Cheese Milk beverages Ice cream & Milk powder frozen (mainly IMF) deserts

Yogurt, IMF, and UHT milk are the leading dairy products in China.

64. New Zealand Herald, “Yashili Opens $220m Pokeno Formula Plant”, 6 Nov 2015, https://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=11541036; China Daily, “Yili Opens First Major Overseas Factory in New Zealand”, 25 Nov 2014, http://www.chinadaily.com.cn/business/2014-11/25/content_18974143.htm 65. Xinhua, China’s Feihe Invests $234 million US Dollars in Canada’s Agri-food”, 9 Aug 2017, http://www.xinhuanet.com//english/2017- 08/09/c_136509966.htm 66. China Daily, “Mengniu in $1 Billion Bellamy Bid”, 17 Sep 2019, http://www.chinadaily.com.cn/a/201909/17/WS5d802f92a310cf3e3556bcc6.html 67. Reuters, “Yashili Seals $159 mln Deal for Danone’s Dumex China Unit”, 2 Dec 2015, https://www.reuters.com/article/yashili-danone-deals- idUSL3N13R07M20151202; 68. Yili 2019 interim report presentation slides 69. Euromonitor, annual reports 70. Annual reports 71. Australian Trade and Investment Commission, Exporting Food and Beverage to China, Nov 2018; China Daily, “Yogurt is Top Seller in Dairy Products”, 24 Oct 2017; Euromonitor, Company annual reports; PwC estimates

23 | The ongoing modernisation of China's dairy sector Dairy processing sector

UHT milk Fresh milk

Because China has historically lacked cold chain Fresh milk is viewed as a premium product and more capacity, UHT milk has been its most widely consumed nutritious than UHT milk. Profit margins on fresh milk dairy product. It accounts for more than half of the liquid can be twice as high as on UHT milk76 and it faces milk market.72 With a shelf life of over six months at practically zero competition from imports. With room temperature, UHT milk is ideal for long-distance distribution range limited by shelf life, the fresh milk distribution, as well as for warehouses and retail outlets market is more fragmented than those of UHT milk and that lack refrigeration. This has contributed to a highly yogurt. Fresh milk accounts for less than half of China’s concentrated market, with the two largest dairy liquid milk market, compared to over 90% in the US, companies accounting for about two-thirds of all UHT Canada and Japan.77 Fresh milk is now common in first- milk sales.73 China’s largest dairy company reports that and second-tier cities, and China’s growing cold chain its UHT products have a penetration rate of 84% overall capacity is increasing fresh milk’s penetration in smaller and 86% in third- and fourth-tier cities.74 Longer shelf life cities and rural areas. The government is promoting also enables imported UHT milk to compete in China’s consumption of fresh milk as part of its efforts to market. increase dairy consumption and foster premium products. At least one company uses a 24-hour shelf life as a key branding attribute to emphasise the freshness Refrigerated warehouse capacity per capita (m3) 75 of its pasteurised milk.78 Bright Dairy, headquartered in Shanghai, is the market 0.3 leader in fresh milk.79 In 2018, Mengniu reported that it had built up its fresh milk supply chain and sales channels to reach 30 major cities throughout China.80

0.2 Refrigerated warehouse capacity in China (m3) 81

0.1 120

millions 100 0.0 China Western Europe US 80

China’s per capita refrigerated warehouse 40 capacity is one-third that of the US and one-half that of Western Europe. 20 But total refrigerated warehouse capacity has increased by about 150% since 2012. 0 2012 2013 2014 2015 2016 2017 2018

72. Australian Trade and Investment Commission, Exporting Food and Beverage to China, Nov 2018 73. Inner Mongolia Yili Industrial Group Co., Ltd 2018 Annual Report; China Mengniu Dairy Company Limited 2018 Annual Report; Australian Trade and Investment Commission, Exporting Food and Beverage to China, Nov 2018 74. Yili Interim Report 2019 75. Cold Chain Logistics Association, China Cold-Chain Logistics Development Report (2019); 2018 GCCA Global Cold Storage Capacity Report; USDA, Capacity of Refrigerated Warehouses 2017 Summary 76. 商界,《新希望乳业：区域霸主，一招“鲜”吃遍全行业》, 21 May 2018, http://www.kanshangjie.com/article/149869-1.html 77. USDA, China Dairy and Products Semi-annual, 17 July 2019 78. 商界,《新希望乳业：区域霸主，一招“鲜”吃遍全行业》, 21 May 2018, http://www.kanshangjie.com/article/149869-1.html 79. Nielsen; Shine, “Bright Dairy ready to milk the market”, 24 Apr 2019, https://www.shine.cn/biz/company/1904243586/ 80. China Mengniu Dairy Company Limited 2018 Annual Report 81. China Cold Chain Logistics Association, China Cold-Chain Logistics Development Report (2017, 2018, 2019)

24 | The ongoing modernisation of China's dairy sector Dairy processing sector

Yogurt Yogurt offers higher margins than UHT milk, as well as greater potential for product differentiation and In recent years, yogurt sales have grown rapidly, targeting of specific consumer segments. Chinese overtaking sales of liquid milk. China’s yogurt market is companies already offer a multitude of options for relatively concentrated, with the top three dairy consumers, but they also need to actively develop companies accounting for more than half of the market, new products and target specific consumer segments. similar to the US.82 Gross margins for yogurt are Unique products and premium branding can support estimated to be 30-40% for China’s leading dairy higher prices – directly improving dairy companies’ companies.83 bottom line. The US yogurt industry offers an example of how new 84 Market share of top three yogurt producers products and branding can rapidly take market share from established brands. Between 2007 and 2014, US sales of Greek-style yogurt increased from 1% to over 60% 50% market share, and drove a 50% increase in the overall yogurt market.86 During that time, a small Greek- style yogurt start-up quickly grew to become the second 40% largest yogurt company in the country, while the erstwhile industry leader fell to number three.Every 20% major yogurt producer quickly developed its own series of Greek yogurt products.

0% The lesson of the US market is that companies must China US continuously develop new products and branding that are targeted for very specific consumer segments. A typical supermarket in the US carries about 300 varieties of yogurt.87 Dairy companies, large and small, are constantly thinking of new ways to draw China’s yogurt market is relatively concentrated, consumers away from other their current favourite with the top three dairy companies accounting for yogurt product. over half of the market. Several yogurt products that delivered growth in the US have also been launched in China, including Greek, Icelandic and Australian styles, as well as organic, sugar-free, high protein and plant-based products. UHT yogurt consumption has been growing quickly There are also many innovations specifically tailored to 85 and now accounts for about half of the yogurt market. China’s consumers, including salted egg, avocado and Like fresh milk, refrigerated yogurt sales growth will green tea varieties of yogurt. depend on expanding cold chain capacity. Chilled yogurt contains live bacteria and its probiotic attributes are promoted as a health advantage over ambient yogurt. UHT yogurt has the advantage of long shelf life. It is more suitable for on-the-go consumption and for distribution to third- and fourth-tier cities with inferior cold chain capabilities.

82. IBISWorld, Yogurt Production in the US, Dec 2018 83. Dairy Reporter, “Now More Popular than Milk, China’s Yogurt Market Lures International Newcomers”, 7 Nov 2018, https://www. dairyreporter.com/Article/2018/11/07/Now-more-popular-than-milk-China-s-yogurt-market-lures-international-newcomers; China Daily, “Yogurt is a Top Seller”, 24 Oct 2014, http://www.chinadaily.com.cn/a/201710/24/WS5a0cee96a31061a7384071ee.html 84. EMIS, Yogurt and Sour Milk Products in China, Sep 2019; IBISWorld, Yogurt Production in the US 85. China Cold Chain Logistics Association, China Cold-Chain Logistics Development Report (2019) 86. IBISWorld, Yogurt Production in the US, Dec 2018; Neilson, Food Navigator, “Chobani Simple 100 Greek yogurt snags 1.3% share of US market just six weeks after launch”, 14 Mar 2014 87. Wall Street Journal, “Yogurt Sales Sour as Options Proliferate”, 9 Apr 2019, https://www.wsj.com/articles/yogurt-sales-sour-as-options- proliferate-11554811200

25 | The ongoing modernisation of China's dairy sector Dairy processing sector

Dairy companies must continuously develop new, differentiated products and branding that are targeted for specific consumer segments.

Product characteristics for differentiation

Characteristic for differentiation Liquid milk Yogurt & fermented milk

Fresh (chilled) or UHT √ √

Full fat, reduced fat or fat-free √ √

Flavourings √ √

Packaging (e.g. single serving, multiple serving, on-the-go) √ √

Nutrient fortification √ √

Lactose-free √ √

Plant-based √ √

Organic √ √

No artificial additives or preservatives √ √

High protein √ √

Drinkable or spoonable √

Solid ingredients (e.g. fruit, nuts, grains, chocolate chunks, etc.) √

Production style (e.g. Greek, Icelandic, Australian, Balkan) √

Probiotic √

Potential target consumer segments and related product differentiators for yogurt

Consumer segment Product attributes

Parents of young children Healthy food that kids like to eat

Dieters / calorie counters Low calories, low fat, low added sugar or low lactose

Athletes / fitness enthusiasts High protein

Older consumers Probiotic for better digestion Rich/creamy texture, foreign/traditional recipes, new or unique Foodies ingredients/flavours Vegans Plant-based milk and yogurt

Lactose intolerant Plant-based or lactose-free

Organic and clean label consumers Organic, no additives, no preservatives

26 | The ongoing modernisation of China's dairy sector Dairy processing sector

Ice cream The largest four producers account for about one-third According to industry estimates, China surpassed the of the market in China92, compared to over 50% in the US as the world’s largest producer88 and consumer of ice US.93 China’s leading ice cream manufacturer (by cream in 2016. China’s production has been growing retail sales value) produced nearly 400 thousand quickly, estimated at 5 million tonnes in 201889, tonnes of ice cream products in 2018 and reported compared to about 3 million tonnes90 in the US. Annual gross margins of 47% for its ice cream products per capita ice cream consumption is approaching seven during the first half of 2019.94 litres in China, compared to about 18 litres in the US. US per capita consumption has fallen by about 25% since its peak in 1994.91

88. China Daily, “China becomes the world’s largest ice cream producer”, 13 Oct 2017, https://www.chinadaily.com.cn/business/2017-10/13/ content_33194904.htm 89. China Market Regulation News, 《中国冰淇淋市场总规模达1239亿元》, 7 Mar 2019, http://www.cicn.com.cn/zggsb/2019- 03/07/cms115747article.shtml 90. USDA, “US production of ice cream and frozen yogurt totals 6.2 billion pounds per year”, 27 Sep 2019, https://www.ers.usda.gov/data- products/chart-gallery/gallery/chart-detail/?chartId=95003 91. USDA, Includes ice cream, frozen yogurt, sherbet and other frozen deserts 92. Euromonitor, Sector Capsules: Ice Cream and Frozen Desserts in China, 6 Aug 2019 93. IBISWorld, Ice Cream Production in the US, Dec 2018 94. Yili, 2019 Interim Results

27 | The ongoing modernisation of China's dairy sector Dairy processing sector

Like yogurt, ice cream is a product that offers great The cold chain distribution networks of hypermarket, potential for new product development and premium supermarket and convenience store chains will facilitate pricing. Its growth is even more dependent on cold chain growth in this category as these retail channels gain capacity than refrigerated yogurt and fresh milk. As a market share and displace independent shops and desert item that is not associated with health functions, it traditional markets. is also dependent on consumers’ disposable income China is a net exporter of ice cream. In 2018, China and willingness to spend on luxury items. Frozen yogurt exported over 31 thousand tonnes of ice cream and is often perceived as a healthier option than ice cream, imported nearly 22 thousand tonnes.95 and will likely benefit from increased consumer interest in health and nutrition.

China’s ice cream imports and exports (tonnes)96

25 thousands

0 2010 2011 2012 2013 2014 2015 2016 2017 2018

Import Export

China is a net exporter of ice cream. In 2018, China exported over 31 thousand tonnes of ice cream and imported nearly 22 thousand tonnes.

95. UN Comtrade 96. UN Comtrade

28 | The ongoing modernisation of China's dairy sector Dairy processing sector

Cheese China’s annual per capita consumption of cheese was Cheese has the advantage of a longer production time and only 0.1 kg in 2018, compared with about 18 kg in the shelf life. During periods where raw milk supply exceeds US and Europe. Currently China’s cheese consumption demand, the excess supplies can be directed towards is mainly as an ingredient in Western-style restaurant cheese production. The density and longer shelf life of foods or baked goods. China imported over 108 cheese offer advantages for storage and distribution. thousand tonnes of cheese in 201897, compared to Increased production of cheese would also increase the domestic production of only about 30 thousand tonnes.98 domestic supply of whey, a by-product of cheese The government, along with dairy companies, is taking production. China currently imports large quantities of measures to increase domestic cheese consumption whey powder, often used in IMF and in animal feed. and production. Increased cheese consumption would help achieve the government’s recommended daily milk consumption of 300g. (Producing 1 kg of cheese requires about 8 kg of raw milk.)

Cheese consumption in China (tonnes)99

140

120 thousands

100

0 2000 2005 2010 2011 2012 2013 2014 2015 2016 2017 2018 Net imports Production

China imported over 108 thousand tonnes of cheese in 2018, compared to domestic production of only about 30 thousand tonnes.

97. Dairy Association of China, White paper of China Dairy Industry 98. 2019 China Dairy Data Report, Production amount from 2017 99. Dairy Association of China, White paper of China Dairy Industry; 2019 China Dairy Statistical Summary; 2019 China Dairy Data Report; PwC estimates

29 | The ongoing modernisation of China's dairy sector Dairy processing sector

Infant milk formula imported raw materials, foreign brands, etc. The leading domestic IMF brand has reported gross margins China’s infant milk formula (IMF) market is the world’s of 70% on its IMF products.102 largest100 and is expected to grow by about 20% by 2023.101 The market is currently driven by two opposing After a brief spike following the relaxation of China’s one trends: China’s slowing birth rate and its growing child policy, annual childbirth numbers have continued income. The number of infants, the number of women their long-term decline. In 2018, there were only 15.2 of childbearing age and the birth rate all continue to fall. million births, compared to 17.9 million in 2016. The birth 103 At the same time, parents are increasingly willing and rate in 2018 was 10.94%, down from 12.95% in 2016. able to purchase more expensive products. To adapt to At the same time, per capita disposable income grew by these trends, companies have been increasing premium 54% between 2013 and 2018. IMF products that feature goat milk, organic milk,

Number of births and birth rate104 Per capita disposable income (CNY)105

40 17% 20 16% millions thousands 15% 30 18 14%

13% 20 16 12%

11%

14 10% 10 2013 2014 2015 2016 2017 2018

Number of births (left axis) Birth rate (right axis) Urban National Rural

The IMF market is currently driven by two opposing trends: China’s slowing birth rate and its growing income.

100.Caixin, “Is China’s former baby formula leader back from the brink”, 20 May 2019, https://www.caixinglobal.com/2019-05-20/in-depth-is- chinas-former-baby-formula-leader-back-from-the-brink-101417795.html 101.Bloomberg, Euromonitor, “China’s Lethal Milk Scandal Reverberates a Decade Later”, 22 Jan 2019, https://www.bloomberg.com/news/ articles/2019-01-21/china-s-lethal-milk-scandal-reverberates-a-decade-later 102.China Feihe Limited, Global Offering Prospectus, 30 Oct 2019 103.National Bureau of Statistics 104.National Bureau of Statistics; PwC estimates 105.National Bureau of Statistics

30 | The ongoing modernisation of China's dairy sector Dairy processing sector

Companies have also been shifting their focus to third- Specialised maternity and infant stores are the leading and fourth-tier cities where e-commerce and modern retail channel for IMF, followed by supermarkets/ retail chains are increasing their penetration. With rising hypermarkets.107 According to estimates, there are now rural incomes, these consumers can increasingly afford more than 100,000 maternity and infant stores in premium-priced IMF products. China.108 Online platforms, including cross-border e- commerce sites, are increasing their market share, and China’s IMF market is relatively fragmented compared to already account for an estimated 25-30% of IMF the US. The top four brands in China account for around sales.109 half of the market, compared to more than 80% in the US. Government policies, however are driving consolidation and localisation.

Market share of top four infant formula producers106

80% The top four brands in China account for around half of the IMF market, compared to 60% more than 80% in the US. Four of the top five are foreign brands. 40%

20%

0% China US

106. IBISWorld, Infant Formula Manufacturing in the US, Jul 2019; Bloomberg, “China’s Lethal Milk Scandal Reverberates a Decade Later”, 22 Jan 2019, https://www.bloomberg.com/news/articles/2019-01-21/china-s-lethal-milk-scandal-reverberates-a-decade-later 107. Nielson, Insights, “Challenges and new opportunities in mother and infant market”, 3 Jul 2019, https://www.nielsen.com/cn/en/insights/ article/2019/challenges-and-new-opportunities-in-mother-and-infant-market/ 108. Yashili, 2018 Annual Report, Nielsen 109. The A2 Milk Company, Stepping it up, Investor strategy day, 17-18 Sep 2019 110. Bloomberg, “China’s Lethal Milk Scandal Reverberates a Decade Later”, 22 Jan 2019, https://www.bloomberg.com/news/articles/2019-01-21/china-s-lethal-milk-scandal-reverberates-a-decade-later 111. China Daily, “Higher standards set for local baby formula”, 4 Jun 2019; Financial Times, “China’s baby formula plan hits foreign producers”, 4 Jun 2019; Reuters, “China wants domestically made baby formula to supply 60% of market”, 4 June 2019 112. Yashili, 2017 Annual Report

31 | The ongoing modernisation of China's dairy sector Dairy processing sector

Domestic IMF producers face multiple challenges. The Many Chinese IMF brands use imported milk powder first is that raw material costs in China are higher than as raw material. This reflects China’s inadequate raw those of dairy exporting countries such as New milk production as well as the cost advantages held by Zealand and Australia. The second challenge is dairy farms in New Zealand and other exporting favourable consumer perception of foreign brands. countries. Some Chinese brands produce and Four of the top five brands in China are foreign package premium IMF products overseas to meet brands110, and the current market share of domestic consumer demand for imported products.112 Chinese brands is estimated at only 40-45%.111 companies have also purchased foreign-owned IMF operations in China, and continue to use those brands.

ChinaChina major major dairy dairy raw raw material material imports imports (tonnes) (tonnes)107 113

1.2

millions 1.0

0.8

0.6

0.4

0.2

0.0

Whey powder Skim milk powder Whole milk powder

Many Chinese IMF brands depend on imported milk powder as a raw material. This reflects inadequate domestic raw milk production as well as the cost advantages held by dairy farms in New Zealand and other exporting countries.

China’s new e-commerce law became effective in authorities, establish a registered business in China January 2019. It includes new, more stringent and pay taxes in China. Failure to comply could result requirements for cross-border sales. Several foreign in their products being blocked by customs.114 IMF producers previously relied on “daigou” channels At the same time, foreign brands also produce IMF or direct cross-border sales to China via foreign inside of China, using domestically produced raw websites. Under the new law, they will likely need to materials. This helps to align with government plans to complete the China infant milk formula recipe increase the amount of domestically produced IMF. registration process, register with China customs

113. UN Comtrade 114. E-Commerce Law of the People's Republic of China, 31 Aug 2018, http://www.mofcom.gov.cn/article/zt_dzswf/deptReport/201811/20181102808398.shtml

32 | The ongoing modernisation of China's dairy sector Dairy processing sector

Infant milk formula regulations and policies IMF is one of the most strictly regulated products in China. The government has been enforcing increasingly stringent safety, quality and traceability requirements, and has been issuing policies to foster consumer confidence in domestic brands. The government aims to increase the market share of domestic brands and domestically produced IMF. Notable policies and regulations include:

• The Rules for Control and Oversight of Infant Formula • The National Dairy Industry Development Plan Milk Powder Production Enterprises, issued in 2013, (2016-2020), issued in January 2017, set specific stated that IMF manufacturers who use fresh milk as goals for consolidation, branding and vertical a raw material must have self-built or self-controlled integration. According to the plan, there will be three raw milk production bases and make progress towards to five companies in China earning more than CNY obtaining all of their raw milk from dairy farms in 5 billion in revenue from infant formula milk powder which they own a controlling share.115 by 2020; and the top 10 domestic brands will account for 80% market share.121 • The Standards for Infant Milk Formula Powder Production Company Food Safety Traceability • The Action Plan for Promoting Domestic Infant Records, issued in 2015, contains very detailed Formula Milk Powder was published by the NDRC record-keeping requirements, including product R&D and six other departments in June 2019. The plan and formulation, raw and supplementary materials aims to bring about greater industry concentration, management, production and processing, finished and includes a goal for 60% of IMF consumed in product management, sales management, risk China to be produced domestically. The plain also information collection and product recalls.116 aims achieve a clear rise in rankings for domestic brands.122 • The Administrative Measures for Registration of Recipes for Formula Powder Products for Infants and Young Children (CFDA Decree 26), (the The National Dairy Industry Development Plan (2016- Measures) was issued in 2016 and took full effect in 2020) domestic IMF brand market share target for 2020123 2018. All IMF products, including both domestic and imported products, must be registered with the State Administration for Market Regulation (SAMR). Each All others Top 10 business entity is limited to three recipes for each of Chinese brands the following age groups: 0-6 months, 6-12 months and 12-36 months.117 This regulation reduced the 20% number of IMF products in the Chinese market from 80% over 2700 in 2016118 to about 1200 approved recipes from 155 enterprises at the end of 2018.119 • Draft revisions of the Measures were published for comment in July 2019. These revisions include more stringent requirements for IMF recipe registration, and a requirement that applicants must possess the complete manufacturing process. The revisions also China’s National Dairy Industry Development clarify seven specific reasons for denial of registration Plan (2016-2020) aims to have 10 domestic applications, and provide more detailed requirements brands account for 80% of China’s IMF and prohibitions for labels and usage instructions.120 market.

115. 《婴幼儿配方乳粉生产企业监督检查规定》,3 Dec 2013, http://www.gov.cn/gzdt/2013-12/03/content_2540737.htm 116. CFDA, 关于印发婴幼儿配方乳粉生产企业食品安全追溯信息记录规范的通知食药监食监一〔2015〕281号, 1 Jul 2016 117. CFDA,《婴幼儿配方乳粉产品配方注册管理办法》, 6 Jun 2016, http://www.gov.cn/gongbao/content/2016/content_5145569.htm 118. 新浪财经,《奶粉注册实施一年配方数量锐减》, 9 M a r 2018, http://finance.sina.com.cn/chanjing/cyxw/2018-03-19/doc-if- yskszw2921237.shtml 119. Yashili, 2018 Annual Report 120. SAMR,《婴幼儿配方乳粉产品配方注册管理办法（征求意见稿）》修订说明, 26 Jun 2019, http://www.moj.gov.cn/news/content/2019- 06/26/zlk_3226527.html 121. National Dairy Industry Development Plan (2016-2020), Jan 2017 122. 关于《国产婴幼儿配方乳粉提升行动方案》的通知, 4 Jun 2019, http://www.gov.cn/fuwu/2019-06/04/content_5397264.htm 123. National Dairy Industry Development Plan (2016-2020), Jan 2017

33 | The ongoing modernisation of China's dairy sector Government policies for the dairy industry Government policies for the dairy industry

In December 2018, MARA and eight other departments published the Opinions on Further Advancing the Rejuvenation of the Dairy Industry (the Opinions).124 Its policy objectives included the establishment of scale dairy farming, closer links between the dairy farming and processing sectors, increasing raw milk production to 45 million tonnes by 2025, as well as improving quality, efficiency and competitiveness. The Opinions include eight measures to achieve these goals:

1. Accelerate the establishment of the basic 5. Promote the integration of dairy farming and position of scale dairy farming with measures processing development by encouraging cross- including: support for developing scale and family shareholdings and win-win relationships between dairy farms, support for farmers in developing processors and farmers; supervise and improve the processing and products, strengthening farming standardisation and signing of raw milk purchase insurance and loans, etc. contracts. 2. Lower the costs of dairy farming by developing 6. Improve the quality and safety of dairy China’s forage industry, including large-scale products by establishing municipal raw milk planting of alfalfa in Inner Mongolia, Gansu and purchase testing centres, supporting major dairy Ningxia, as well as by continuing the policy of counties, enterprises and qualified farms to changing grain production from food to feed in major establish their own testing systems, and improving dairy production counties. safety and quality oversight capabilities. 3. Improve dairy cow productivity with improved 7. Encourage main dairy provinces to lead the genetics, support for dairy farming and manure dairy rejuvenation with funds and policies to recycling infrastructure, and development of the support plans that are drawn up by major dairy dairy farm services system. provinces. 4. Strengthen and improve the dairy processing 8. Strongly promote dairy consumption with publicity industry by improving competitiveness, developing about the nutritional benefits of dairy consumption, refrigerated products, supporting the production of and by actively cultivating dairy product consumption dry dairy products (e.g. cheese, butter), and habits, especially for dry dairy products (e.g. cheese, improving the competitiveness, reputation and butter). market share of domestically produced IMF.

124. http://www.moa.gov.cn/xw/zwdt/201812/t20181226_6165640.htm

35 | The ongoing modernisation of China's dairy sector Keysto success Keys to success

In spite of cost pressures and import dependence, China’s dairy industry offers many opportunities based on China’s modernising dairy farms, growing cold chain capabilities, expanding middle class and favourable government policies. Dairy farming and manufacturing companies that take a rigorous approach to strategy will deliver long-term profitable growth. Here are some keys to success:

• Premium products for growing middle class • Cold chain expansion: Companies not only demand: China’s growing middle class, cold chain need to build their cold chain distribution capabilities and e-commerce market will sustain channels as quickly as possible, but they also long-term growth in premium product sales. must have tailored low-temperature products that Companies and investors should invest now in are ready to compete. Cold chain penetration is premium raw materials and specialty product advancing in third- and fourth-tier cities via both production, e.g. organic milk, goat’s milk, cheese, retail chains and e-commerce. etc. • Upstream integration: Processing companies need • Thorough consumer segmentation: Consumers to control their raw milk sources. Not only does this can choose from hundreds of dairy products; and help achieve national industry goals, but it facilitates products that aim to please everyone are often improvements to traceability, food safety, biosecurity, chosen by no one. Companies need to target very efficiency, supply chain resilience and raw milk price specific consumer segments. Each product and stability. marketing campaign should be tailored to specific • Human capital: As every stage of the supply chain age groups, health and fitness preferences, upgrades technology and scale, companies need nutritional goals, consumption occasions, etc. managers and staff who are comfortable with • New product development: Consumption habits technology, complexity and change. Key skills will in China have not yet stabilised, so there are include management of large-scale industrial farms, opportunities for new products to quickly capture sophisticated cold-chain logistics and inventory market share. The example of Greek-style yogurt in management, social media data analysis, etc. the US shows that even mature markets can quickly Recruiting, training and retention must be tailored to turn to new products and variations. Some these people. categories, e.g. cheese, are still true blue ocean • Government incentives: Growing domestic markets in China. Constant social media interaction production, modernising dairy farms, developing with consumers and data analysis are necessary for strong Chinese brands, increasing dairy timely and targeted product development. consumption and enhancing food safety are • Targeted, unique branding: Dairy product important national policy goals. Companies need innovations such as flavours, textures and to identify and utilise all the relevant government packaging are easily replicated by competitors. incentives in order to grow and compete profitably Companies must develop highly targeted brands while supporting the revitalisation of China’s dairy that will differentiate their products and build loyalty. sector. As with product development, social media • Regulatory compliance: Dairy products are interaction and data analysis are vital. among the most strictly regulated and monitored • Omni-channel agility: Distribution channels products in China, and regulations become more are changing and companies need to act demanding every year. Companies must anticipate quickly to be in the channels that consumers future regulations and policy developments, and currently prefer. E-commerce and modern retail incorporate them into their planning and strategy. chains (i.e. hypermarkets, supermarkets, maternity stores and convenience stores) are displacing traditional grocery stores. This report was written by Brian Marterer of PwC China

37 | The ongoing modernisation of China's dairy sector Contact us

Samie Wan China and Hong Kong Food Supply and Integrity Services Leader +852 2289 2019 [email protected]

Wenjing Cao PwC China Food Supply & Integrity Services Partner +86 (10) 6533 7026 [email protected]

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Brian Marterer PwC China Food Supply & Integrity Services Senior Manager +86 (10) 6533 8756 [email protected]

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