Foreign food firms are somewhat perplexed by Chinese consumers' attitudes towards their products.

Although they are willing to pay a premium of up to 100 percent for imported processed foods, they seem to prefer local brands when shopping for more basic foodstuffs.

This phenomenon is best illustrated in China's burgeoning milk market, with fresh milk remaining the stronghold of domestic firms, while imported processed dairy products such as milk powder are selling as well as expected.

Consumption of milk, not a part of the nation's traditional diet, has grown in China among urban residents as they become increasingly prosperous a trend which previously occurred in Japan and South Korea.

Dairy Association of China figures show that fresh milk consumption has increased rapidly since 1996.

The total output value of China's milk industry was 45.66 billion yuan (US$5.5 billion) in the first 11 months of 2003, according to the association's latest figures. The industry's profits totaled 2.79 billion yuan (US$336.9 million) in 2003, a whopping year-on-year increase of 51.89 percent.

In comparison, milk production in 1996 was negligible.

The good performance of the "big six" milk firms Mengniu, Yili, Bright Dairy, Sanyuan, Sanlu and Wandashan is clear evidence of the industry's rapid expansion since then.

Between them, the "big six" control over half of China's fresh milk market.

Despite repeated attempts, foreign producers have had little success in gaining a firm foothold in China's growing milk market.

Although the world's top 20 milk brands have entered China since the end of 2002, none of them has made any meaningful headway, says the association.

This situation is similar to that confronting many leading international beer producers, with many top global brewers finding the Chinese market a hard nut to crack. This has forced to them to resort to "Plan B" buying their way into the market by taking an equity interest in domestic market leaders.

And this is what many foreign milk producers are now doing as they try to "re-enter" the China market.

For example, Fonterra Group Ltd, a New Zealand-based dairy company, is in final talks with Shijiazhuang Sanlu Group Co Ltd.

The foreign dairy giant is likely to buy a 39 percent stake in the Chinese firm.

Fonterra's goal is to develop a local partnership with a strong company that will allow it to take full advantage of its local knowledge and experience in the China market, the company said in a statement.

Though the two firms did not reveal any details of the deal, industry insiders predict co-operation between them will mainly involve fresh milk rather than milk powder.

"Multinational companies are trying to re-enter the rapidly growing Chinese milk market through mergers and acquisitions after having backed away from the market due to poor business," said Chen Yu, an industry expert from the China Dairy Market Consultancy in Beijing.

Take Danone as an example. The large French food processing company has had considerable success in marketing its biscuits and mineral water in China.

But it has failed to impress Chinese consumers with its dairy products. Blaming high prices for its poor sales, the company withdrew its line of dairy products from the Chinese market after a decade of efforts and sold its facilities to domestic enterprises.

It was not the only one to have retreated from the Chinese market.

The Italian food processing firm Parmalat transferred control of its joint venture in Nanjing to its local partner before filing for bankruptcy last December.

It also leased its outlet in Northeast China's Heilongjiang Province for five years to Yili Group, China's leading dairy producer.

Fellow dairy firm Kraft withdrew from Beijing's yogurt market and shifted its investment to some non-dairy products in 2002. Beijing Sanyuan Foods Co paid Kraft Beijing over US$9 million to buy back the 85 percent stake held by the foreign company.

"There is a combination of factors behind the retreat of these foreign dairy companies," said Chen Yu.

Most foreign companies do not operate their own dairy farms in China. And Chinese consumers do not consider imported milk to be as fresh as milk produced by domestic companies, which raise dairy cattle on large farms.

Foreign companies, despite their massive financial resources, have also failed to gain access to the lucrative distribution network extending into every city street and community.

Pricing is another major issue that has sidelined foreign producers. Retail analysts say that foreign producers have largely misread the buying habits of urban consumers, leading to the incorrect positioning of their products.

Parmalat, for example, focused only on marketing its relatively expensive high-end products in China. Its fruit-flavoured yogurt (100 grams) was sold at 2 yuan (US$0.24) per cup, double the price of similar local brands, while its main product, milk, was only sold in large supermarkets.

Furthermore, they seldom used television or newspaper advertising to promote their products, something which is not a good marketing strategy in an immature market like China, where customers have no brand loyalty and are easily influenced by advertisements and promotions.

In addition, high operating costs have also contributed to the problems of many foreign dairy producers in China, said Jin Biao, a senior official with the Yili Group.

"The industry's profit margin is quite thin," he says.

"The big salaries of just a few expatriate executives can easily eat up all the sales profits," he said.

Despite the setbacks, foreign producers have not given up the hope of getting a share of China's booming milk market. They can hardly afford to write off a market with such huge potential.

The figures speak for themselves. Consumption of dairy products in China averages at 9.7 kilograms per person, compared with 200 kilograms in Europe and the global average of 100 kilograms. There is evidently plenty of room for growth in the consumption of dairy products in China.

Although the old tradition of drinking tea and eating rice congee or soybean products is hard to change, consumers in Japan, South Korea and Taiwan Province who used to share the same traditions have extended their preferences to include dairy products. There are obviously good reasons for industry experts to predict that dairy products will become just as acceptable to Chinese consumers as society becomes increasingly prosperous.

"In the next five years, the dairy market will maintain an average two-digit growth every year," Chen predicts.

He foresees that foreign milk producers will make a big comeback in the Chinese market.

The market value of just one major international food processing company can be higher than the total production value of China's milk industry. With this kind of financial strength, they can easily muscle their way back into the China market, Chen says.

Fonterra, for example, posted sales of NZ$5.6 billion (US$3.86 billion) for the six months ending on November 30. That was already more than half of the total production value of China's milk industry for the whole of last year.

In comparison, Sanlu's annual sales amounted to less than 3 billion yuan (US$370 million).

"Foreign firms will become more competitive when the market is fully open," Chen says. But he says that international dairy producers may not try to compete with domestic producers by building large infrastructures in China, such as dairy farms.

As indicated by some recent transactions, they are expected to re-enter the Chinese market by buying into their domestic rivals. Other than Fonterra, Danone has bought a 3.58 percent share in Bright Dairy from Shanghai's municipal government for 121.03 million yuan (US$14.59 million).

The transaction increased Danone's holding in Bright Dairy to 7.7 percent, making it the third-largest shareholder in the domestic company.

Dairy Association of China Chairman Wang Huaibao says that this move signalled the return of foreign investment to the Chinese dairy market.

And investment bank Morgan Stanley, CGU-CDC China Capital Partners Ltd and Dinghui Investment invested a combined US$26 million in Inner Mongolia-based Mengniu Dairy in late 2002.

The foreign partners now hold a combined 33 percent stake in one of China's leading milk producers.

Direct investment in domestic producers is seen to be a more cost effective ways for multinational companies to secure a share of the Chinese dairy market. Such activities are expected to intensify when they are allowed to gain control of the local enterprises through mergers and acquisitions.

"The Chinese dairy industry will possibly follow the development course of the beer industry and start to absorb capital from abroad," said Yi Ming, an analyst for the Ping'an Insurance Group. "In time, a new market order dominated by a few large players is expected to emerge," he says.

Statistics from the dairy association reveal that 90 to 95 percent of China's over 1,500 dairy producers are small- to medium-sized enterprises, with little capital and low technology.

But this is changing. As the wave of mergers and acquisitions sweeps through the industry, many of these small operators will be absorbed by big players with their powerful foreign partners.

(China Daily May 13, 2004)