Chinese dairy giant China Mengniu Dairy Co. just got bigger. It has entered into an agreement that will see it take control of local infant formula maker Yashili. Mengniu is looking to reverse its fortunes in a category in which it has struggled. However, with concerns over food safety remaining high, there is a long road ahead as the company – and the country as a whole – look to build a safe and reliable dairy supply. Katy Askew reports.

China Mengniu Dairy Co. today (18 June) put the speculation to bed when it unveiled an offer to acquire Hong Kong-based infant formula group Yashili International Holdings.

A possible tie-up between the two companies was flagged last week, when each group halted trading in their shares pending an announcement. This morning that announcement came: Mengniu has issued an offer to acquire 100% of Yashili in a deal that values the company at around HK$11.35bn (US$1.46bn).

During 2012, Yashili generated net profit of CNY470.5m (US$75.7m), up 52.5%, on sales of CNY3.65bn, up 23.6%. The company operates a number of manufacturing facilities and is developing a plant in New Zealand.

Mengniu is offering HK$3.50 per share in cash, or a cash-and-share option of HK$2.82 in cash and 0.681 of a share in the “offeror”, which is “a private company set up by the offeror parent for the sole purpose of holding shares in the target”. The cash option represents a premium of approximately 9.4% over the closing price on Wednesday, the last full day that Yashili shares were traded.

While the acquisition is pending shareholder and regulatory approval, it seems only a matter of time before the deal is settled. Yashili’s two largest stakeholders have already agreed to sell their shares – worth a collective 75.3% of the outstanding share capital. Meanwhile, the Chinese government is pushing for consolidation in the dairy sector (and Mengniu’s largest shareholder is state-backed COFCO) so regulatory hurdles seem unlikely.

Through the acquisition, Mengniu said it aims to strengthen its hand in the high-growth infant formula sector. As with many other domestic players, the company has struggled to rebuild the reputation of its infant formula business following the 2008 melamine scandal. Mengniu was one of around 20 companies implicated in the affair, when formula made from milk laced with the industrial chemical melamine killed six babies and sickened 300,000 more.

The scandal rocked the Chinese food industry and demand for Chinese-made infant formula has never recovered as consumers seek out higher-priced foreign alternatives. Indeed, since 2008 domestic infant manufacturers have been plagued by further scares. In 2011 Mengniu recalled baby formula containing high amounts of aflatoxin, a carcinogen produced by fungus in cows’ feed.

Even as sales from domestic companies remain under pressure, the overall market for infant formula is witnessing strong growth.

The market for infant products – led by baby formula – boasted a growth rate of around 20% in 2010, rising to a value of CNY154bn. Projections from analysts Research in China suggest the expansion is expected to continue with a growth rate of “over 15%” anticipated into 2015, when the sector is expected to reach a value of around CNY370bn.

Through the acquisition, Mengniu hopes to help improve the reputation of infant formula that is made in China. Mengniu CEO Sun Yiping said the company intends to “offer consumers with more choices in dairy products that are safe, healthy and of highest quality”.

“With the huge room for growth in China’s paediatric milk formula market, the partnership with Yashili, one of the most successful milk powder brands in China, will greatly strengthen both companies’ business platform… It will generate important synergies for the development of the two companies, thereby capture the rapid growth of pediatric milk formula market in China,” she emphasised.

SWS Research equities analyst Sean Zhang suggests the move will allow Mengniu to catch up with rivals in the infant formula category. “Mengniu could gain significantly in the infant formula sector, within which Mengniu actually is a laggard compare to its peers, such as Yili,” Zhang telld just-food. “Yashili could also benefit from the potential Mengniu’s investment in terms of sharing Mengniu’s vast sales network.”

After Mengniu’s reputation took a hit in the 2008 melamine scandal, the group has been investing heavily in the development of a safe milk supply. It has poured money into farms in order to establish what it describes as “a safer and more stable value chain”. These investments have also included a move to take a 28% stake in China Modern Dairy.

The company has also looked to benefit from the expertise of international dairy firms. It has established partnership agreements with Europe-based dairies Arla Foods and Danone. Commenting today, Yiping said Yashili will continue to operate on a stand-alone basis but added the group will benefit from these arrangements.

“We will maintain Yashili as an independent operating platform upon the completion of the offer. In the future, we will introduce expertise both from Mengniu and international partners to enable Yashili to develop into a more internationalised paediatric milk formula brand.”

According to Zhang, Mengniu’s work to improve safety and reliability is having a profound impact on the Chinese dairy sector. Through a series of “international cooperation and domestic equity investment deals” the company has the potential to “change the competitive landscape in the whole dairy sector”, he suggests.

Strategic partner – and Mengniu stakeholder – Arla declined to comment on whether it would be directly advising Mengniu on managing Yashili’s product quality. However, Arla has thrown its weight behind the deal, suggesting it will broaden Mengniu’s portfolio of brands and sales channels.

“We see it as a positive step for Mengniu and for Arla that Mengniu is now strengthening themselves in the rapidly growing category of infant formula as this will expand their product range and sales channels within the infant formula category. The demand for infant formula in China is growing faster than most companies can keep up and will continue to do so for many years to come, so we welcome Mengniu’s efforts to play a key role in that category with a range of Chinese brands to compliment the imported premium Arla products from Europe,” a spokesperson for the group told just-food.

While the response to the deal seems to have been broadly positive, there are those who take a more sceptical line. Growth in the infant formula category has slowed to a single-digit rate in recent months and the majority of expansion is at the premium end of the sector. While Yashili saw strong sales growth in 2012, the company’s mass market positioning could potentially weaken Mengniu’s efforts to improve its consumer perceptions in what is a highly sensitive area.

This risk factor prompted one Hong Kong-based analyst to suggest the acquisition could be motivated more by politics than company strategy.

“Mengniu just partnered with international companies such as Arla and Danone and is working on upgrading their product portfolio. Acquiring a local, mass-market brand like Yashili could be negative to all Mengniu’s efforts, and Mengniu need to sort out potential food safety risks associated with Yashili’s raw milk source, production process, logistic systems, etc,” the analyst told just-food on condition of anonymity.

“In my opinion, this acquisition may well be Mengniu filling its ‘national service duties’ as the Chinese government is promoting the idea of building large scale, national dairy companies and improve dairy product quality. Being a state-owned enterprise, it is not surprising the government is pushing COFCO to consolidate the market regardless of the target companies’ quality. So this deal could just be a political obligation that COFCO/Mengniu needs to fulfil.”

Nevertheless, as an enterprise that is majority-owned by the Chinese state, perhaps Mengniu believes the imperative of developing a safe and trusted Chinese-produced supply of infant formula outweighs short-term concerns over Yashili’s profitability or whether the company will fail in an increasingly competitive space. Such investments are necessary in the long term if Mengniu – and the Chinese food sector – is to emerge from the long shadow of the melamine crisis.

In a recent interview with just-food, Nestle China chief Roland Decorvet spoke about the world’s largest food group’s approach to managing its Chinese dairy supply chain in order to ensure the safety of supplies.