Chinese regulators have launched an anti-trust investigation into the infant formula sector in the country and under pressure from the authorities, multinational formula manufacturers have implemented a series of price cuts. But will the move address the structural issues facing the category? Katy Askew investigates.

Chinese consumers pay more for infant formula products than consumers elsewhere. According to figures from Euromonitor International, the average unit price of infant formula in the country totalled US$24.60 in 2012, compared to an average price of $20.40 in western Europe and $16.30 in the UK. If you look at the premium end of the market – which is dominated by international brands – this price differential is exaggerated further still.

The stand-out factor driving demand for international infant formula brands – and more specifically brands that have been manufactured overseas – is that Chinese consumers have lost faith in the safety of the domestic industry.

Chinese manufacturers are yet to emerge from the long-shadow of the melamine contamination scare of 2008, when tainted infant formula killed six babies and sickened around 300,000 more. The scandal uncovered a relatively widespread practice, where Chinese milk was mixed with melamine to boost its protein content and hide the fact it had been watered down.

Thousands of tonnes of infant formula was recalled. The majority of companies that became embroiled in the scare were Chinese firms. Starting with Sanlu – which was part-owned by Fonterra – the scandal drew in more than 20 firms, including Beijing Olympics sponsor Yili and leading dairy Mengniu.

Since 2008, domestic infant manufacturers have been plagued by further safety scares. In 2011 and 2012 Mengniu and Ava Dairy recalled formula containing high amounts of aflatoxin, a carcinogen produced by fungus in cows’ feed. In 2012 Yili Group recalled its formula after “unusually high” levels of mercury were detected.

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Low confidence in locally manufactured brands has prompted Chinese consumers to turn to pricey foreign alternatives. Given this supply and demand dynamic, perhaps it should come as little surprise that premium – largely foreign – infant formula brands are more expensive in China than elsewhere.

However, according to China’s National Development and Reform Commission, manufacturers could nevertheless have broken competition laws by implementing minimum pricing requirements.

“The baby formula manufacturers are facing charges that include requesting distributors to sell their products at a price no less than the minimum price set by the manufacturers. The distributors that sold their products at a price lower than the fixed minimum price were punished. This practice could constitute a vertical monopoly and violate Article 14 [of the Anti-monopoly Law], while such resale price maintenance could restrict competition in the relevant market and harm the interests of consumers,” Michael Gu, partner at Beijing law firm AnJie says.

In addition, based on the “limited public information”, the NDRC “noticed a suspicious trend in recent years”, Gu suggests.

“One of the baby formula manufacturers would increase the price of its formula and the other manufacturers would in turn raise the price of their formulas. Different companies would take the lead at different times. If verified, this potentially collusive practice may constitute a concerted effort to eliminate or restrict competition.”

Such behaviour would breach Article 13 of the Anti-monopoly Law, which prohibits horizontal monopolistic agreements, Gu adds.

The law stipulates “a fine of 1%-10% of the violator’s annual turnover plus confiscation of all illegal gains” will be imposed on companies engaging in a price-fixing monopoly. Gu suggests the NDRC is “expected to issue new record-high penalties”, given the turnover generated by the companies involved.

The NDRC investigation has drawn in almost all the leading international formula makers operating in China, including Nestle, Mead Johnson, Danone, FrieslandCampina, Abbott Laboratories and Meiji. Local firms Biostime and Beingmate are also involved in the probe.

The industry has responded by offering “full-cooperation” with the NDRC and reducing prices, with some prices being cut by as much as 20%.

Speaking during a conference call with analysts yesterday (25 July), Mead Johnson management conceded price cuts were likely to hit the group’s sales.

“The 7% to 15% price reduction… in China will reduce annual sales by about US$55-$65m. In 2013, we will see a half year impact, with a sales risk in the low $30m range before any offsets,” CFO Peter Leemputte revealed.

Meanwhile, Nestle has denied its move to cut prices – by an average of 11% – will have a significant impact on the profitability of its global infant formula business.

“You have always to see things over time and I don’t see any real material impact in a sense that the business is also part of a bigger business in a bigger world, so we can handle it, no problem there,” CEO Paul Bulcke told journalists at a recent press conference in China.

According to Bulcke, the probe is part of the government’s drive to develop a clear regulatory framework for the sector. “It is by working together with the authorities that a real, transparent framework can be set up. And that is what is happening. It is a shaping and confirming of a regulation framework in China, which we welcome. It is only [through] clear rules that… you really have honest and sustainable competition,” he said.

Food safety specialist Rick Gilmore, chairman of the Global Food Safety Forum (GFSF), agrees the probe aims to strengthen the “troubled” infant formula sector.

“The anti-trust case by the Chinese government aims to bring down the soaring price of infant milk powder and close loopholes like the black market… This is one step to restore consumer confidence by making top-brand milk formula more affordable to Chinese people and restore consumer confidence in a troubled sector,” he suggests.

However, one senior industry figure tells just-food the investigation should not be taken at face value. The source denies multinational corporations are engaging in price-fixing activity in China because “there is too much to lose”.

The probe comes as the Chinese government has increased its focus on building confidence in the domestic supply of infant formula.

Beijing has signalled it is prepared to take action on infant formula. Manufacturers will be subject to the same product certification system that applies to drug companies in China. They will be required to provide food safety authorities with a detailed ingredients list and inform them of changes to the product make-up. Producers will be banned from importing and then re-packing large quantities of formula from overseas – a model that most recently saw Hero Group formula adulterated by a local distributor last April. 

The Chinese authorities also want to see the consolidation of the highly-fragmented domestic sector. A reduction in the number of domestic formula producers would simplify the task of overseeing production, the authorities believe.

In forcing down the price of premium products, through the use of the anti-monopoly probe, mass market domestic brands are likely to come under increasing competitive pressures, with the possibility smaller players with thinner margins will be squeezed out because they no longer enjoy the pricing umbrella set by industry leaders.

Torsten Stocker, formerly an analyst with Monitor-Deloitte, warns Beijing could face a number of “trade-offs” as it pursues this policy.

“Reduced industry profitability levels may discourage players to invest in further building their own supplies of milk and enhancing quality throughout their supply chain. It may also discourage international and mid-sized domestic players to expand their distribution footprint, ‘raising the game’ in the sector across more of China,” he warns.

Significantly, in the near term, Stocker even suggests the immediate margin pressure could prompt smaller players to cut corners and skimp on “costly” quality controls.

The near-term risk the probe could in fact reduce safety standards in the sector is clear. Even if the pressure to force down the price of premium infant formula products does further the government’s agenda and speed consolidation in the sector, this course of action would nonetheless seem to be a considerable gambit.