Undeterred by recall, Fonterra seen pushing on with own-brand China plan

By Naomi Tajitsu

WELLINGTON (Reuters) - Fonterra (FSF.NZ), the world's largest dairy processor, is moving ahead with plans to launch its own branded milk formula in China, undeterred by a recent botulism scare and Beijing's crackdown on foreign firms over alleged corrupt sales practices.

China is a magnet for foreign milk formula makers, with its $12.4 billion market expected to double by 2017. Foreign firms are under scrutiny, however, after reports alleged companies had bribed medical staff to recommend their products to new mothers.

Authorities have also fined a group of mostly foreign milk formula producers $110 million for price fixing.

New Zealand's Fonterra Co-operative Group (FCGHA.NZ), owned by some 10,500 farmers, supplies 90 percent of China's milk powder imports by selling its raw material to other companies to make products ranging from infant formula to cheese on frozen pizzas.

While China is its biggest export market, Fonterra has stayed away from selling its own branded baby formula there since a poisoning incident in 2008, when six infants died and thousands fell ill after Chinese dairy firm Sanlu was found to have added melamine to bulk up its infant products.

Sanlu collapsed as a result of the scandal, while Fonterra, which held a stake in the Chinese firm, was criticized for failing to blow the whistle sooner and more loudly.

On Wednesday, Fonterra reported an 18 percent lift in its full year profit, despite a drought trimming earnings. Net profit after tax for the year to July 31 was NZ$736 million ($608 million), compared with NZ$624 million last year.

Normalized earnings before interest and taxes (EBIT) fell to NZ$1 billion from $1.03 billion a year ago, in line with guidance given in July.

Fonterra is investigating the recent contamination scare, when it said it found a potentially fatal bacteria in one of its products, triggering recalls of infant milk formula and sports drinks in nine countries including China.

New Zealand's Ministry for Primary Industries later said tests showed the botulism scare had been a false alarm because whey protein concentrate made by Fonterra contained a less harmful bacteria.

Fonterra's China expansion strategy, which also includes building a UHT milk processing plant by 2016, is part of the company's global plan to generate more earnings from value-added products, as opposed to lower-margin bulk milk powder.

DISTRACTION

While Fonterra's reputation has been knocked by the August product recalls, analysts say this should have only a limited impact on its growth plans.

"At the margin, it will have been a bit of a distraction and there's potential for some delay in terms of some initiatives," said Arie Dekker, strategist at Deutsche Bank in Auckland. "But initiatives like the UHT plant and expanding food services in China, they're not going to be pushed back significantly because of the botulism issue."

Fonterra, which controls nearly a third of the world dairy trade and generates around 7 percent of New Zealand's GDP, cut its forecast in July after a drought this year sapped milk production.

As global dairy prices hover near record highs, Fonterra has warned that high input costs may dent margins in the current first half.

Its push further into China comes as Beijing seeks to consolidate its domestic dairy industry to improve food safety.

Fonterra was among the foreign dairy manufacturers fined last month for fixing the price of infant milk formula - which is highly prized among Chinese who don't trust locally made formula after a series of food safety scandals.

The 2008 scandal, in particular, shredded public confidence in Chinese dairy companies, opening the door to foreign formula firms, which have now grabbed about half of the total market and can sell for more than double the price of local formula.

In pushing its own brand in China, Fonterra will be up against rivals such as Danone (BN.PA) - a major customer whose brands command 9.2 percent of the Chinese market - and Mead Johnson (MJN).

"A lot more is going to depend on whether Fonterra can craft an effective brand and compete head to head with Danone, Mead Johnson and local players like Beingmate," said James Roy, senior analyst at China Market Research Group in Shanghai.

"That's really the bigger challenge, building the brand up, because that's not something they have established here yet."

($1 = 1.1946 New Zealand dollars)

(Graphic by Catherine Trevethan; Editing by Ian Geoghegan and Paul Tait)