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Difficult Times for US Dairy Long-Term Trends, and Insights for China’S Dairy Companies October 2020 Table of Contents

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Difficult Times for US Dairy Long-Term Trends, and Insights for China’S Dairy Companies October 2020 Table of Contents Difficult times for US dairy Long-term trends, and insights for China’s dairy companies October 2020 Table of contents Executive summary 3 Introduction 4 COVID-19 market disruptions 5 Difficult trends for milk processors Bankruptcies and declining fluid milk consumption 7 Shrinking retail-to-farm margins on fluid milk products 8 Increasing capacity in the face of shrinking demand 9 Private labels and commodification 10 Increasing retail competition and consolidation 12 Vertical integration by retailers 14 Consolidation and vertical integration by dairy cooperatives 15 Premium milk product differentiation 16 Raw milk production and dairy farm exits Cheese and butter manufacturing drive raw milk demand 18 Traditional dairy farms cannot compete 19 Insights for China’s dairy industry 21 Contact us 24 Difficult times for US dairy: Long-term trends, and insights for China’s dairy companies | 2 Executive summary The US dairy industry has been facing a variety of difficulties, including the COVID- their market share. Organic, grass-fed, lactose-free and ultra-filtered high protein 19 pandemic, bankruptcies of two large milk processors and thousands of dairy milk are often priced nearly twice as high as conventional pasteurised milk. farms leaving the industry. This report looks at the long-term trends and underlying Dairy cooperatives market 85% of US raw milk on behalf of farmers, and have been industry structure that led to the current challenges, as well as insights from the US consolidating for decades. These cooperatives traditionally process about 35% of market that can be used to inform the long-term strategy of China’s dairy their raw milk in their own factories, mainly into dry products, cheese and butter. manufacturers. Dairy Farmers of America (DFA) is the largest US dairy cooperative, and markets The COVID-19 stay-at-home orders hit the US market in March of this year. Retail about 30% of raw milk sold by US farms. It owned more than 40 processing plants dairy product sales surged but food service demand for dairy products fell even prior to 2020. In May, DFA agreed to acquire 44 plants from Dean Foods and will more, resulting in the dumping of more than 160,000 tonnes of raw milk. Demand likely be both the largest marketer and processer of raw milk (by volume) in the US has begun to recover due to some food service re-openings and government once the acquisition is complete. programmes to purchase agricultural products and distribute them to people in need. US per capita cheese consumption has shown a strong long-term growth trend. Driven mainly by cheese manufacturing, raw milk production has been increasing The largest US fluid milk processor, Dean Foods, declared bankruptcy in late 2019, for decades, and has nearly doubled since 1970. followed by a second major fluid milk processor, Borden Dairy Company, less than two months later. These two events represented the culmination of several long- In spite of this growth, the number of US dairy farms has fallen by about 90% since term trends. 1970, as the average dairy farm size increased from 25 dairy cows to over 172. The total number of dairy cows in the US has remained practically unchanged, as Since 1975, US per capita consumption of fluid milk has declined by 40% as improved technology and farming practices have increased milk production per cow consumers’ beverage preferences and breakfast habits changed. The difference by about 50% since 1970. With automation and technology, large farms can between the retail price of whole milk and the farm price of raw milk declined by achieve higher dairy cow productivity and economies of scale. about 30% during the years 2015-2019. But as consumption continued its decline, the number of fluid milk processing plants increased by nearly 20% between 2011 Many small, family-owned farms cannot compete. The number of licensed dairy and 2018. herds has fallen by more than 6,000 since 2017. To maintain positive cash flow, small farms must sell premium-priced products, rely on family labour and grow US grocery retailers use low milk prices to compete for customers. Customers some of their own feed or fodder when possible. usually purchase additional products, with higher margins, each time they visit a grocery retailer’s store or website. Retail chain operators often undercut Analysing the dynamics of the US dairy industry can provide useful insights for manufacturers’ brands with cheaper milk sold under their private label brands. China’s dairy companies. Strategic decisions made today could help them in the Some leading retailers have built their own factories to process private label milk future to avoid difficulties currently faced by parts of the US dairy industry. and other dairy products. In spite of anticipated long-term growth in China’s dairy consumption, China’s dairy During the past 20 years, retail competition has intensified with the rise of companies need to actively develop new products for evolving consumer supercentres, warehouse club stores and discounters that compete mainly on preferences and growing cold chain capacity. Investing in start-up companies can price. Meanwhile, consolidation among supermarket chains has reduced the pricing be more effective than in-house innovation. Companies need to periodically adjust power of milk suppliers. their product portfolios to optimise growth and profitability. With economies of scale, large-scale dairy farms will continue to displace small dairy farms. While overall fluid milk consumption is falling, premium varieties are increasing Difficult times for US dairy: Long-term trends, and insights for China’s dairy companies | 3 Introduction The US dairy industry has been facing several challenges, raising questions about what kind of future it faces. In recent industry news, there have been three main areas of difficulty: the impact of the COVID-19 pandemic, the bankruptcy of two well-known US milk processors, and the ongoing exits of dairy farmers from the industry. How is the COVID-19 pandemic affecting the US dairy industry? What are the long- term trends and underlying industry structures that led to the demise of these leading dairy companies and small farms? Do these difficulties reflect the overall state of the US dairy industry? What can China’s dairy companies learn from their fate? This report analyses recent difficulties and ongoing trends in the US dairy industry across the retail, processing and farming sectors. It presents some key insights from the US that could be useful to China’s dairy companies. Difficult times for US dairy: Long-term trends, and insights for China’s dairy companies | 4 COVID-19 market disruptions Starting in mid-March of this year, many local governments in the US issued stay-at- home guidelines and restrictions on on-site restaurant dining, resulting in a surge in Monthly retail revenue from US eating and drinking establishments and grocery sales. According to Nielsen, there was a 53% increase in retail milk sales, a grocery stores 127% increase in retail butter sales and an 84% increase in retail cheese sales for the 1 week ending on 21 March. 80 s These restrictions also led to a steep drop in demand for restaurants and institutional 70 food service. In normal times, about half of the dairy industry’s revenue is estimated 60 Grocery stores to come from restaurants, school cafeterias and other food service channels.2 Ever USD Billion USD 50 since 2007, American consumers have spent more on food consumed outside of the 3 40 Food service & home than on food consumed at home. School cafeterias are estimated to account drinking places for about 7% of US dairy demand. On a regular school day, the government provides 30 school children with about 30 million lunches and 15 million breakfasts, with practically every meal including one serving of milk.4 Beginning in March, schools closed, and most restaurants were forced to close or Source: US Census Bureau limit their business to take-out and delivery. Monthly revenue in eating and drinking establishments was 30% below average in March and 50% below average in April.5 The rapid change in consumption patterns disrupted dairy processing and wholesale 11% of restaurant operators surveyed by the National Restaurant Association in distribution. Milk, butter, cheese and cream that are processed and packaged for March expected to close permanently due to the pandemic.6 restaurants, schools and other food service users cannot be easily shifted to retail because the product mix, portion size, packaging, and labelling are all quite different. Raw milk must be processed soon after production and cannot be frozen like meat or kept in long-term storage like grain. Many farmers were forced to dump their milk because dairy product demand from food service channels dried up. In April 2020, 1 Reuters, “US Dairy Farmers Dump Milk as Pandemic Upends Food Markets”, 3 Apr 2020 about 160,000 tonnes of milk (about 2% of total production) was dumped, roughly 10 2 CNBC, “Pandemic Fallout is Severely Threatening US Dairy Farms”, 6 May 2020 7 3 US Census Bureau times the amount dumped in April 2019. 4 School Nutrition Association, based on USDA FY18 preliminary data 5 US Census Bureau, seasonally adjusted figures 6 National Restaurant Association, “New Research Details Early Impact of Coronavirus Pandemic on Restaurant Industry”, 25 Mar 2020 7 USDA Agricultural Marketing Service, Dairy Market News, 15-19 Jun 2020 Difficult times for US dairy: Long-term trends, and insights for China’s dairy companies | 5 It appears that dairy farmers are adjusting to the demand shock. In April 2020, raw milk production was 1.2% higher than one year earlier, but May production was 1.1% Weekly average block cheddar cheese price on the Chicago Mercantile lower than last year.8 The amount of milk that was dumped returned to normal levels Exchange in May.
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