Chinese Cheeseheads Accurately Reflect China's Consumer Spending

Just received the latest issue of the McKinsey Quarterly and, like always, it does not disappoint.  The folks at McKinsey usually include a highly informative and unique article on China and in this issue Richard C. Cheung and Andrew J. Grant write about "China's Booming Dairy Market" [free registration to view may be required].  Now I know that even for the most ardent China watcher this one does not sound good, but stay with me here because it is. There is definitely information in this article that applies to China's food products market as a whole and even to its entire consumer market. 

The article predicts "China's dairy industry will double in size, to nearly $20 billion, by the decade's end," and it foresees "changing consumer tastes, retail modernization, and the country's increasing affluence will transform competition in this nascent industry and likely usher in a wave of consolidation�a transformation that could be mirrored in other product categories across China."  It goes on to state that now is the time for foreign dairy companies to come to China, because China still very much needs their "capabilities in areas such as product development, branding, and channel management."

The article notes three important findings:

1. China's consumers are "adopting the purchasing habits of their Asian neighbors and seeking higher-value-added products such as milk beverages, cheese, and yogurt:"

Today these products account for one-quarter of China's dairy consumption, compared with nearly 60 percent of Japan's. This proportion will change as Chinese incomes rise; indeed, we expect that over the next five years revenues from sales of milk beverages, cheese and desserts, and yogurt in China will grow by 22, 38, and 31 percent a year, respectively. For dairy companies, this is welcome news�such products command margins two to three times higher than that of liquid milk.

2.   The second important finding is the growing importance of China's second tier cities in the consumer economy:

A second factor�one also seen, to varying degrees, throughout China's packaged-goods sector�is the growing importance of midsize cities as consumer incomes rise. In 2004, for example, China's 3 biggest cities accounted for 14 percent of all dairy revenues; in 2010, their share will fall to 11 percent. From now until the decade's end, 70 percent of the growth in net revenues will come from the next 100 cities, the second and third tiers.

3.  The third finding is the growth in the proportion of sales by China's modern grocery stores:

Our third finding is a shift in the channels through which dairy products will be sold, as well as in how they are sold. In 2000, modern grocery-retailing formats (such as supermarkets and hypermarkets) accounted for one-fifth of packaged-goods sales in urban China�a proportion that by 2004 had grown to about one-third. The December 2004 removal of regulatory barriers on foreign retailers all but guarantees that global giants such as Carrefour will continue to expand into China. For dairy producers, the shift in formats will mean big changes. By 2010, nearly two-thirds of China's dairy sales will come through modern formats, compared with 40 percent in 1998.

The article notes that the big grocery stores springing up rapidly in China are a "double-edged sword for China's dairy industry" because though they increase distribution efficiency, they also "negotiate more tenaciously than mom-and-pop stores do when it comes to entry fees or shelf space." Some of the modern-format retailers also are launching their own private-label dairy products.

The article posits that to succeed in the Chinese dairy business, Chinese dairy companies will need to increase their Research and Development (R&D) budgets to bring them more in line with their Western counterparts:

To succeed, domestic companies must build new capabilities in areas such as product development, branding, account management, and marketing. Milk beverages and yogurt, for example, are innovation-driven products requiring strong R&D formulation and consumer segmentation skills, and many domestic dairy companies have little of either. The top five Chinese dairy companies, for instance, spend less than 1 percent of their revenues on R&D, compared with 3 to 4 percent for their Western counterparts.

According to McKinsey, the Chinese dairy industry is still "wide open" to foreigners and "foreign dairy companies are capitalizing on the sector's openness."  For example, the world's largest dairy exporter, New Zealand's Fonterra recently purchased a 43 percent stake in San Lu, a large Chinese domestic dairy company.  Fonterra's 43 percent stake in Hebei based San Lu will cost about $107 million.

The Chinese consumer is stepping up the quality of its purchases.  Consumer spending in China's second tier cities is likely to continue to increase in proportion to China's largest cities and the sales growth of the big modern grocery stores in China will outstrip those of the smaller "mom and pop" stores.  All of these things bode well for foreign food product and consumer companies.