The global dairy market is likely to “remain tight” in 2011, due to an improvement in demand but limited supply, according to Rabobank. The bank said in its Global Dairy Outlook report last December that although consumption rates are set to be strong in the new year, growth in some regions will be constrained by physical limitations of supply.
“Drought in Russia and floods in Pakistan will heavily impact local milk production in the first half of 2011”, said Rabobank.
While these conditions are likely to create increased demand for imports, the bank said that domestic consumption is likely to be restricted. Consumption is expected to be supported by improving labour markets in the West, strong economic growth in import regions and strong buying in China.
Factors effecting supply levels include higher feed costs, ongoing requirements for farmers to reduce debt levels and the likelihood of limited supply growth beyond New Zealand. An increase in grain prices could also “dampen” milk production volumes and consequently lead to an increase in dairy prices, said the bank.
Rabobank has also changed its view on the likely role of China and India in global dairy markets. The bank has abandoned the view that the countries will reach self-sufficiency soon and now predicts that they will call on the world market more frequently in the next three to four years. Rabobank said that China in particular has a structural deficit that will be difficult to erode in coming years.
In 2010, China's milk and dairy industry mainly showed the following characteristics and changes:
- There was a raw milk supply shortage in 2010, but dairy imports and production substantially increased. Liquid milk and solid dairy production and consumption continuously grew, the supply and demand basically kept balance.
- Out of deficit, cattle farming went though narrow margin of profit in general.
- China's dairy producing companies strengthened the construction of milk resource bases, especially large-scale enterprises. The proportion of cow farms with more than 100 inventories accounts for 28.48% of the national total.
- In 2010, the total 13,500 milk purchasing stations were all certified, which effectively protecting the milk quality.
- Dairy processing projects that were newly built and expanded increased significantly. In addition, the implementation of new rules on the access to dairy production promoted the centralized and scaled development of dairy industry.
- The market of infant/young children's milk powder in China was more of a concern and domestic companies entered the top-end powder market though purchasing foreign raw milk bases, producing foreign agents, etc. However, imported milk powder makes up over 80% in the top-end powder market in China.
This year, the main development trends of the milk and dairy market will be expected as follows: the supply of domestic milk supply rallies; the total dairy imports continue to increase; the milk and dairy market are a balance between supply and demand; the dairy producing capacity continues to expand, with optimization of product structure.
The development I am watching is the Infant Formula Industry in China.
China is the world’s most populous country and one of the fastest growing pediatric milk formula markets in the world. The increasing trend towards double income families in China, coupled with the convenience and complete nutritional benefits offered by pediatric milk formula products, has resulted in increased acceptance by Chinese women of pediatric milk formula as a substitute for mother’s breast milk for their infants.
According to Euromonitor International, pediatric milk formula powder products accounted for 69.9% of the entire milk powder market in China in 2009. Furthermore, the total retail sales volume of pediatric milk formula in China was estimated to be approximately 340,300 tonnes in 2009; hence, China accounted for the largest share in the global powder pediatric milk formula market, by total retail sales volume, in 2009, according to Euromonitor International.
Euromonitor also expects China’s pediatric milk formula market to continue to grow due to the increasing demand for pediatric milk formula, higher average retail prices for pediatric milk formula products as well as macro‐economic factors such as increasing urbanization, rising disposable income levels and the growing number of working mothers.
The retail sales volume of pediatric milk formula is expected to grow by a CAGR of 14.9% from 2010 to 2014, with the retail sales volume size reaching 686,000 tonnes in 2014. The following chart sets forth the projected retail sales volume of pediatric milk formula products in China for the periods indicated:
A large number of pediatric milk formula production enterprises, both foreign and domestic, have entered into China’s market in recent years to compete for a share in the nation’s pediatric milk formula market.
Companies like Mead Johnson (MJN), Danone Dumex, Nestlé, (NSRGY.PK), Abbott (ABT), Wyeth, Synutra, Feihe (former American Dairy), Mengniu, Sanyuan, etc. battle with each other in Tier I (Beijng, Guangzhou, Shanghai) and Tier II cities (40 cities, primarily provincial capitals).
But the real deal is done in Tier III (the next 60 cities) and Tier IV (the next 500 cities). China's cities are classified into tiers based on population number and GDP/capita.
China's smaller cities are unfamiliar territory for many international dairy companies, which often face competition from Chinese counterparts that already know these markets well. Small cities have been serving as incubators for Chinese companies before they expand into larger markets. Such companies are skilled at identifying spaces in the market, experimenting, and learning and adapting as they go. Strong Chinese brands are emerging in packaged foods, quick-service restaurants, infant products, personal care products, footwear, and fashion retail.
Two US-listed China dairy companies are expanding and getting more and more recognized as quality producer. Which two I am going to tell you know.
The first one is Rodobo International (RDBO.OB). Rodobo is a producer and distributor of powdered milk formula products in China. Their target consumers include infants, children, the middle-aged and the elderly. The products for infants and children are currently sold under the brand names of "Rodobo" and "Peer", and its products for middle-aged and elderly consumers are currently sold under the brand name of "Healif".
Last week's First Quarter 2011 Highlights:
- Revenue was $25.6 million, up 153.9% from $10.1 million in 1Q10, close to the upper range of the Company's 1Q11 guidance $24 - $26 million
- Gross profit was $9.8 million, up 84.8% from $5.3 million in 1Q10
- Net income was $4.1 million, up 80.2% from $2.3 million in 1Q10, outperforming 1Q11 guidance range of $3.2 - $3.5 million
- Earnings per diluted share was $0.15, up from $0.14 in 1Q10
I had an email conversation with Stephen Tong, Vice President of Finance at Rodobo to learn more about the company and their strategy. In the short term they don't have expansion plans to enter Tier 1 or Tier 2 cities. Their market niche focus is on 3-tier and 4-tier cities, where the consumer is price sensitive and there is less exposure to international brands. In other words: less competition for local premium brands like Rodobo.
Marketing in Tier 1 and 2 cities requires the support of national wide advertisement campaigns on China’s central TV stations which is extremely expensive and it will kill the company's bottom line. Tong thinks their current market orientation is fit for the company. However, Rodobo will consider to enter into Tier 1 or 2 cities when the company becomes strong enough to compete with famous multi-national brands.
The company has plans to introduce new product formulas from time to time. They introduced their “Peer” brand series products (infant formula) in 2009, and purchased the exclusive formula use right for 10 years from the Chinese Nutrition Society and create the brand of “Healif” for the middle-aged product in 2008. Rodobo will continue to introduce new formulas to diversify their product lines by their own R&D team or co-development with institutions
Below you find some questions with answers of my conversation.
How much importance you give to 'high margin' products?
We’ve been pursuing and will continue to pursue “high margin” products. Our overall gross margin was indeed temporarily diluted after the acquisition of Beixue Group which mainly produces low margin whole milk powder products. As the result, the percentage of low margin products increased significantly. However, we believe our current product mix is favorable. First, our whole milk powder products will enable us to effectively use our existing surplus capacity in short-term, and we have great flexibility in absorbing marketing risks of formulated milk powder products in the long run. However, some of our competitors have a high percentage of infant formula powder which may be influenced by any negative allegation which was mainly about the infant. Second, though the gross margin of whole milk powder is low, there are very few distribution expenses and less administration expense for whole milk powder as we directly wholesale it to end user’s processing plant. Infant and elderly formula need more marketing and distribution spending. Finally, the acquisition of Beixue is very important to our growth strategy, the deal is not only less expensive and time saving compared to building up such a facility ourselves, but also bring us ample and steady raw milk supply in Hulunbeier grassland which is the best milk origin in China. It usually requires over 5 years to build up the long term relationship with farmers if we built new facilities by ourselves. We are remodeling the acquired facilities and upgrading some equipment. We will switch to producing high margin products step by step which will take a longer time as we need time to expand our marketing channels. It also depends on the market demand.
How do you see the Chinese dairy market in the future? Are there some trends you are following?
China’s dairy market is highly fragmented with no absolute dominant leader. The Chinese government is scrutinizing the infant formula industry after a series of scandals. New regulation requires that the manufacturer needs to purchase their own testing equipment, which can be very expensive, as well as personnel in the lab. Though these increasing costs may eventually transfer to the final consumer (parents), some small players may still not be able to afford these costs. It provides a lot of opportunity to companies like ours as we can access the US capital market. We still see increasing market demand for milk powder product in China. Although many multi-national brands have entered China’s, they mainly focus on 1st and 2nd tier cities in China. Because of the limitations of distribution channels, the imported infant milk formula has a hard time penetrating into the 3rd and 4th tier cities and rural areas which are our market niche. The imported infant milk formula is usually much more expensive than the local brand. We believe the gap between Tier1 and 2 cities and less developed areas will not be shrunk in next decade. Therefore, there always are plenty of markets for Chinese local brands.
When plans Rodobo to uplist their shares to AMEX or NASDAQ?
We are preparing to move to a major exchange, and we are closely communicating with some of the major exchanges. Our management, as well as our legal counsel are working on it. We expect to achieve this target as soon as we can.
If we go to the financials I think the stock has really potential to go to $ 5.00.
My estimates for 2011 and 2012 are:
EPS FY 2011 $ 0.60
EPS FY 2012 $ 0.72
At a price of $ 2.35, the stock is trading at a P/E below 4 and trading around book value.
Another US-listed Chinese dairy company that could benefit is Emerald Dairy (EMDY)
Through its wholly-owned operating subsidiaries, Emerald Dairy, Inc. is a producer and distributor of infant and children's formula products in China. The company's products are sold under two brand names -- "Xinganling," designed for middle and high-end customers, and "Yi Bai," designed for low-end customers. Emerald Dairy's products are distributed throughout 20 provinces in mainland China and sold in over 6,500 retail points.
The company has increased capacity from 9,000 tons to 19,000 in June of 2010.
Emerald is focused on China’s rapidly growing Tier 2 to Tier 4 cities, where demand for infant formula is growing faster than the industry average. The company's products are sold in 120 out of 600 Tier 2 through Tier 4 cities.
The company's FY 2010 EPS could be around $0.20 with acceleration to $0.30 this year. At a price of around one dollar, the stock is trading around a P/E of 5 and trading around book value.
Note
For defensive stock investors that are not aware of the risks involved in investing in Chinese companies I would recommend buying Danone (DANOY.PK), Nestlé (NSRGY.PK) or Abbott (ABT).
The best way for these international companies to expand into Tier 3 and Tier 4 is to make acquisitions so they don't have to set up a distribution network etc.
Rodobo International and Emerald Dairy are companies that could ultimately become victims of a bigger foreign or domestic player. Especially at these prices they are vulnerable.
Management of both companies welcomes cooperation with foreign big dairy producers if it is a win-win business. But they cherish the brands they created and are proud of them.
Disclosure: I am long RDBO.OB.
