The successful IPO of China Huishan Dairy Holdings Co. is fresh evidence of growing investor appetite for the Chinese dairy sector. As the largest dairy to operate a fully integrated supply chain in the country, Huishan is well-placed to benefit from recent developments in the industry, Katy Askew suggests.

China Huishan Dairy Holdings Co. reportedly raised HK$10.12bn (US$1.3bn) through its initial public offering in Hong Kong earlier this week. The company offered 3.79bn shares – about 26% of the group’s outstanding stock – at HK$2.67 each, the upper end of its indicative range. Although sizeable, the IPO was reportedly fully-subscribed and values the total company at around HK$38.96bn.

Investors pouring money into Huishan are no doubt tempted by the strong growth potential offered by the Chinese dairy sector. A Frost & Sullivan report prepared for Huishan in preparation for the IPO suggests sales of dairy products in China stand at around US$45bn a year. Frost & Sullivan predicts that will almost double by 2017 to $89bn.

Confidence in such forecasts goes beyond the sales patter rolled out in the company’s prospectus. Dairy is a dependable growth consumption item on the mainland. According to figures from Datamonitor, the Chinese dairy market has grown at a compound annual growth rate just north of 7% a year between 2008-13.

Rising demand is being driven by factors including a growing middle class, rising urbanisation and even the fact refrigerators are relatively commonplace in many Chinese homes. And there is still plenty of space for growth – according to a survey conducted by the Ministry of Agriculture earlier this year, China’s per capita milk consumption is only 21.7 kilograms, a fifth of the world average and about half that of many other Asian countries.

As Huishan argues in its prospectus, the dairy processor is somewhat uniquely positioned to cash in on this potential. Key to Huishan’s valuation has been its ability to convince investors that it has built a safe and reliable milk supply.

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Safety is the single biggest issue shaping the discourse around the Chinese dairy industry today.

Huishan operates in a sector that has been plagued by safety scares. It is impossible to talk about Chinese dairy without referring to the 2008 melamine contamination scandal, when contaminated infant formula killed six babies and sickened around 300,000 more.

The scare uncovered a practice that, it transpired, was relatively widespread. Suppliers used the industrial chemical melamine to artificially boost the nitrogen content of watered-down milk – meaning that it would pass protein tests that looked at nitrogen levels.

The melamine crisis prompted high-profile recalls, drawing in around 20 domestic dairy companies. It also undermined consumer confidence in the safety of domestic infant formula and dairy products in general, uncovering a major issue Chinese dairy companies – and regulators – are still attempting to grapple with.

The scandal rocked the Chinese food industry and demand for Chinese-made milk powder has never recovered. Further scares have done little to encourage consumers, and in 2009 and 2010 fresh incidents of milk formula contaminated with melamine were also uncovered. Other scares have spanned the spectrum of dairy products – from feeds, raw milk, liquid milk and milk powder – and included aflatoxins in cows’ feeds and unusual levels of mercury content in infant milk formula powder.

Agricultural dairy production has traditionally consisted of small scale farms, who sell raw milk to middle men, who in turn supply Chinese dairies. The complexity of the chain provides room for poor standards or – as it transpired – unscrupulous behaviour, fraud and adulteration.

Raw milk production is also facing the challenge of modernisation.

While the hukou system of household registration still works to restrict migration in China, the movement of workers from rural to urban settings remains evident. This – and other economic developments – has supported the growth of medium- and large-scale production.

However, the techniques used on an industrial-sized farm differ significantly from those employed on small-scale ones. Progress towards large-scale farming therefore remains a long and rocky path for Chinese agriculture. The five largest dairy farming companies in the country account for just 2.4% of the 18.3m cows in China, the Frost & Sullivan report says.

Farmers must adapt to these changes – a process that has limited production and can cause uncertainty and increased risk factors. The production of raw milk in China increased by just 2% last year, trailing the growth in demand.

Huishan suggests it is somewhat buffered from these concerns. The group claims to be the only dairy processor in the country that can meet 100% of its milk requirements, operating what it terms its “grass to glass” model.

“Our unique fully integrated business model allows us to exert complete control over the entire dairy industry value chain, which differentiates us from our competitors in China and ensures product safety and quality,” the company claims in its prospectus.

“The competing economic interests among participants of critical segments of the dairy industry value chain is the principal cause of food safety issues in China’s dairy industry. We believe our ‘grass to glass’ business model represents the best solution to address the lack of accountability in China’s dairy industry.”

Like many Chinese dairy firms, Huishan has also forged strategic links with international dairy companies in a bid to improve production standards. Swiss firm Hero Group, which sells infant formula under its namesake brand in China, holds a 4.34% share in Huishan, the company revealed.

While confidence in domestic brands remains weak, Huishan’s impeccable safety record – having side-stepped all of the scandals of recent years – and its position at the premium end of the market mean it is able to communicate a strong safety message to consumers.

Since the melamine scandal, the Chinese government has made some strides to tighten regulations and step up inspections. Nevertheless, a plethora of regulatory bodies overseeing a complex mix of businesses meant plenty of holes remained in the net.

In June, Beijing again moved to strengthen safety standards in infant formula production when nine government bodies – including the country’s Food and Drug Administration – united in an attempt to standardise and reorganise the domestic infant formula sector.

The state is pushing for consolidation in the sector, arguing that fewer, bigger companies will have higher standards and be easier to regulate. Officials reportedly aim to reduce the number of domestic infant formula firms to between three and five companies with revenues of over CNY50bn (US$8.17bn) by 2018.

While pushing for consolidation, on the one hand, Chinese regulators have also taken steps to encourage good practice in the dairy supply chain, including tax benefits and grants to promote safety standards. “Companies with complete control over their raw milk sources and stringent safety and quality assurance measures, such as Huishan Group, are expected to benefit from the implementation of such policy,” the company predicted.

At the same time as the Chinese authorities are pushing to improve standards of domestic production, international brands have taken a number of reputational hits.

Safety scares have prompted demand for foreign-made infant formula to surge in China. Multinational companies have benefited from a belief their products are safer. They have also been able to charge a premium for these products, an issue that was thrown into the spotlight earlier this year when the National Development and Reform Commission unveiled the results of an anti-trust investigation into the sector.

The NDRC probe drew in almost all the leading international formula makers operating in China, including Nestle, Mead Johnson, Danone, FreislandCampina, Abbott Laboratories and Japan’s Meiji. Hong Kong-listed Biostime and Chinese firm Beingmate were also examined by the regulator. The eight companies were found guilty of various forms of price resale maintenance and the combined ticket handed out was the largest in China’s anti-trust history.

The reputation of international brands was dealt a further blow this week, when Danone’s Dumex brand was charged with bribing hospital employees to promote its products to the parents of newborn babies.

Perhaps more significant for the prospects of international infant formula manufacturers is Fonterra’s recent botulism scare. The group recalled a batch of whey powder concentrate after tests revealed that it was contaminated with a bacteria that can cause botulism. The recall led to further consumer-facing recalls from Danone and Abbott Laboratories.

While the recall turned out to be a false alarm – and Fonterra acted quickly to contain the situation – it comes at a time when competition is intensifying in the Chinese dairy sector and may have gone some way to knocking international manufacturers off their pedestal. Indeed, the damage could have come at a key time in the development of dairy consumption patterns in China.

The race is on to offer Chinese consumers with safe, trustworthy dairy products and Huishan clearly intends to play a significant part in this.

Detailing its plans for the proceeds, the company provided a clear statement of intent.

Huishan plans to use about 34% of the proceeds to build 45 new dairy farms over the next three years; 17% will be used to grow the firm’s dairy herd and import 75,000 heifers from Australia or New Zealand; and 11% will be used to build a milk powder plant with output capacity of 33,000 tonnes a year.

Huishan has therefore set out an ambitious growth trajectory – and one that has received the backing of investors who have bought into the company’s strategic vision.