Fonterra's Chinese milk shake

BY PATRICK CREWDSON

As Fonterra extricates its Chinese business from the wreckage of the tainted milk powder scandal, the dairy giant is celebrating a milestone at its local farm – and deciding whether to expand.

WHEN calf number 1249 – the product of New Zealand Friesian stock and American sex-sorted bull semen – was born on a Chinese farm not far from Beijing, it was a positive milestone in a topsy-turvy year for Fonterra's China operation.

A milestone, because she was the first offspring of a Chinese-born cow on the 35-hectare farm 85 per cent owned by the New Zealand dairy giant.

Topsy-turvy, because even though Fonterra's 43 per cent-owned joint venture partner SanLu was the worst culprit in last year's fatal tainted milk powder scandal – over which Fonterra was excoriated at home – the New Zealand co-operative has reaped a windfall from Chinese consumers ditching domestic dairy for the safety of imported product.

With its China headquarters in Shanghai under the new leadership of former diplomat Philip Turner, Fonterra is now part-way through a stocktake to figure out how to advance its booming, yet arguably underperforming, China business without SanLu.

The demise of SanLu cost Fonterra just more than $200 million. It has also necessitated rejigging the business to fill some gaps – Fonterra licensed some of its consumer products through SanLu and sent them the milk from the farm in Tangshan.

But ironically, thanks to a combination of plunging world milk powder prices and Chinese consumers shunning local product, Fonterra's milk powder exports to China leapt to 152,000 tonnes in the July 2009 year, close to triple the previous financial year's figure.

As the largest importer of dairy ingredients into China, Fonterra profited directly from consumer distrust of local products.

But this golden season may be ending, as milk powder prices rise again and local brands recover. Mr Turner, Fonterra China managing director, expects the surge in imports to flatten in the next six to 12 months.

Part of the post-SanLu stocktake has been intensive number-crunching to map and forecast the state of the Chinese market. On the whiteboard in Mr Turner's office is the wry maxim, "The more you torture the numbers the more they confess."

In the job since June, Mr Turner, who is fluent in Japanese and French and is learning Chinese, replaced Bob Major, managing director of Fonterra China during the melamine crisis.

After the scandal broke in August 2008, Fonterra copped heavy criticism back home, accused of keeping quiet for too long after learning the industrial chemical melamine had been detected in SanLu milk powder.

Some commentators predicted the scandal would cause irreparable harm to Fonterra's reputation – and by extension to New Zealand's.

But New Zealand Trade and Enterprise trade commissioner in Shanghai Jeff Shepherd says Chinese consumers saw it as a domestic problem. "Having been here when it happened and now I think that there hasn't really been any damage to our reputation at all. We're still seen as a country that provides good quality, safe food."

Shanghai-based American Shaun Rein, managing director of China Market Research Group and a Forbes magazine columnist, says Fonterra's brand was damaged more among affluent consumers than with average Chinese. "Most Chinese viewed it as SanLu rather than Fonterra. So Fonterra will be able to sidestep it." Fonterra's "absurd" response to the melamine scandal: "We don't know what's going on, it's all them. We tried but what can we do?" had turned off affluent consumers concerned with quality control and oversight, but they were not the bulk of the market.

"Fonterra has good opportunities here. I don't think they're going to be hit very hard," Mr Rein says.

MR TURNER says when Fonterra chairman Sir Henry van der Heyden met Chinese President Hu Jintao and Premier Wen Jiabao on a visit with Prime Minister John Key in April, it amounted to an "official endorsement that Fonterra continues to be welcome in China".

"There's a misunderstanding in New Zealand about the impact of melamine on the business in China. The view here is that Fonterra did what had to be done and behaved very responsibly in ensuring that these problems were brought to the attention of the Government and fixed.

"That's one reason why Henry got the reception he did from Chinese leaders."

Twenty-two Chinese firms were implicated in the scandal, which saw six babies die and hundreds of thousands get sick. SanLu went bankrupt, chairwoman Tian Wenhua was jailed for life, two milk supply men were sentenced to death, and more than 60 people were arrested.

The two biggest Chinese dairy firms, Mengniu and Yili, posted NZ$140 million and $337m losses in 2008.

Fonterra believes the future of the Chinese dairy industry lies more in domestically sourced product than imports. As a pilot project, the farm was to show Fonterra could set up a local supply chain and produce New Zealand-quality milk in China. Mr Turner has declared that goal achieved, and says the farm is now turning a profit and is ahead of target on production and revenue.

"So we're now in a position where we can start to think about, `Do we want to expand into further farms in China?"'

In Tangshan, farm manager Todd Meyer is working to get herd numbers up as high as the site can accommodate. But early ambitions for eight or nine such Chinese farms have been dialled down.

"Those sorts of ideas were being discussed at a time when we had SanLu as a major JV partner, so the situation's quite different," Mr Turner says.

Also key in extricating Fonterra from its failed joint venture was the relaunch in August of bone and maternity health products Anlene and Anmum, which were previously licensed through SanLu.

New television commercials broadcast in southern and eastern China emphasised the clean, green New Zealand origins of the products.

Mr Turner believes China will become the world's largest dairy market within two decades. But he concedes the rapid growth of Chinese dairy production and consumption in the past 10 years took Fonterra by surprise.

Fonterra's food service business, which supplies butter and cheese to restaurants, fast food joints, hotels and bakeries, is seeing 20 per cent year-on-year growth.

Eight out of every 10 pizzas sold in China have Fonterra cheese on them. Yum! China, which operates Pizza Hut and KFC, opens new outlets at the rate of more than one a day. The demographic, economic and dietary changes are "coming together in what looks like a perfect storm of positive factors" for Fonterra products.

DOWN ON THE FARM

- Fonterra's 35ha Chinese farm is at Tangshan, in Hebei province, east of Beijing.

- 3000 cows arrived on the farm in May 2008 and the herd now has more than 4858 animals.

- All except two of the staff are Chinese.

- Cows are milked three times a day, producing enough milk to fill a pair of 30-tonne tankers each day.

- It is a containment system, not pastoral, so the cows live inside and do not graze grass.

* Patrick Crewdson's travel to China was supported by the Asia New Zealand Foundation. He travelled to Tangshan Farm courtesy of Fonterra.

- © Fairfax NZ News