China's latest fake milk powder scandal blamed on chaotic sales channels

Chaotic sales channels have been blamed for China's latest fake infant formula scandal where 22,600 cans of counterfeit milk powder were sold under the brands of Chinese infant formula maker Beingmate and US-based Abbott Laboratories.

Fonterra Cooperative Group [NZX: FSF] has a close association with both – it invested in an 18.8% stake in Beingmate last year and is jointly developing a new dairy farm hub in China with Abbott.

Nine people were arrested over the weekend and charged with making and selling fake products in seven provinces and Chinese media report they were all long-time formula distributors who were familiar with production processes.

Wang Dingmian, former director of the Dairy Association of China, was quoted as saying chaotic sales channels in China's dairy industry were responsible for the problem whereas in countries like Australia supermarkets usually buy products directly from manufacturers with no traders involved.

The bust has worsened Chinese consumers' already fragile trust in domestic infant milk formula following the 2008 melamine scandal involving Fonterra's partner Sanlu, in which six babies died.

Christina Zhu, Fonterra's managing director Greater China, said the government had been clear that the latest case was a criminal issue and the companies involved had taken a responsible approach to it.

Although industry experts have absolved the two companies of blame, they have suggested it could cause long-term brand damage to the pair, which are among China's biggest infant formula brands.

"We have been monitoring the media and social media commentary carefully and at this stage there is no reason for us to believe there will be any long-term impacts from it," Ms Zhu said.

Shenzen-listed Beingmate has already suffered two consecutive years of revenue decline, reporting a 10% sales drop last year. However, earnings rose 50% percent, recovering from a 90% fall the year before. Its share price is currently 11.91 yuan, significantly below the 18 yuan apiece Fonterra paid for its 18.8% stake last year.

Ms Zhu, who is on the Beingmate board, said the investment's rationale remains, which includes infant formula forecast to rise by 10 to 15 percent following last year's relaxation of China's one-child policy.

Beingmate's share price reflects a drop in China's capital markets and Ms Zhu said she was more interested in its operational performance.

The company had been working hard on a turnaround, with the latest results showing a stronger second half performance. "That's no accident," she said. "In the final quarter there was a big pickup on the previous quarter."

Finalising details of the distribution agreement for Fonterra's Anmum brand, which has been in the Chinese market since 2013, and the Darnum joint venture in Australia, took longer than expected, she said. Fonterra announced in February, subject to regulatory approvals, the first product destined for Beingmate's Chinese customers will roll off the Darnum line in the second half of this year.

"Beingmate is not just important for Fonterra, this distribution agreement is also an important part of the portfolio for Beingmate," she said, because of the Chinese consumer preference for foreign brands.

There has been rapid growth of cross-border e-commerce sites, with Chinese consumers preferring to buy overseas-branded formula on the internet rather than from local franchised stores which are viewed as less safe.

Chinese authorities had already signalled tighter regulations on infant formula, which in the medium to long term is expected to boost larger domestic operators such as Beingmate and foreign brands that mainly rely on offline channels and business-to-consumer flagship stores.

Ms Zhu said Beingmate was well-placed to pick up market share once the new regulations are enforced. Morgan Stanley analysts have also named Beingmate and Yashili as potential beneficiaries.

The new regulations are two-pronged, relating to cross-border e-commerce and registration.

Cross-border e-commerce involves direct parcel delivery, someone bringing the goods in their suitcase, and free-trade or bonded zone importation where an importer brings in a container and then ships out individual parcels to consumers.

Previously these models incurred a personal postal articles tax which for food products was 10%. Two regulations introduced on April 8 aimed to level the playing field between cross-border e-commerce and the general trade where importers pay import tariffs and value-added tax of 17%.

For food products, the personal postal articles tax has lifted to 15%. The authorities also introduced a new "positive" list for goods entering free trade zones with value limits on purchases of 2000 RMB per shipment and 20,000 RMB per person annually. Food items that fall within the value limit attract an 11.9% tax but those that go above the value limits will incur the general trades tax of 17%.

All of Fonterra's consumer brands are on the positive list and MsZhu said the impact will be minimal given less than 1% of its products are sold through e-commerce channels.

Chinese authorities also filed an updated WTO notification in January signalling domestic and imported infant formula will have to be registered by January 2018 with the CFDA (China Food and Drug Administration). It's thought likely it will include those sold through cross-border e-commerce channels.

The new regulations mean one company can produce only three brands with nine formulae and proper Chinese labelling is required. It's expected to reduce the number of domestic formula brands on sale from over 2000 to around 400. Two years ago Chinese authorities slashed the number of foreign infant formula brands that could be sold in the country from more than 800 to about 94.

Analysts expect the whole market to suffer in the near term as sellers leaving the market lower prices to shed inventory.

Zhu said the timing keeps changing for the release of the detailed regulations which are still being drafted.

(BusinessDesk)