Milk a Substitute for Cola in China?

China's dairy sector is reportedly generating 60 billion yuan (US$7.5 billion) in annual sales and is expected to grow by 20%-25% this year. Dairy firms and their investors are clearly optimistic despite a historically lactose-intolerant nation.

The largest player, China Mengniu Dairy, controls almost 1/3 of the market and twice as much as its largest two rivals, Inner Mongolia Yili Industrial Group and Bright Dairy & Food.

Mengniu's H1 profits surged 39% to US$43.2 million while its shares listed in Hong Kong have more than doubled. Mengniu is a master of marketing and must be, since it contracts from about 3,000 milk suppliers, not owning any farms directly.

Milk beverages are seen as a substitute for cola drinks, seen as something trendy. Mengniu is expanding both its scale and scope economies, now offering more premium milk beverages and introducing related products such as ice cream and milk tablets. Its biggest risk is its supply chain, followed by renewed interest in China among foreign companies such as Groupe Danone of France which has increased its stake in Bright Dairy to 11.55%.

Mengniu has an extremely thinly traded listing on the OTC in the U.S. Among other companies mentioned in the article, Danone trades in the U.S and both Mongolia Yili and Bright Dairy are listed on the Shanghai exchange with Class A shares. BNP Paribas, Citigroup, and Merrill Lynch have a "buy" rating on Mengniu. Mengniu is not a top-25 holding of any of the China funds traded in the U.S. Comment calling milk essentially a substitute for cola may be a cause of concern for Coca-Cola and Pepsi. Per Coke's Q1 conference call in 2005, the company's China strategy is focused on three areas: carbonated soft drinks, non-carbonated beverages such as tea (think Nestea), and value-added hydration (think POWERade).