An In-depth Look at 7 Key Trends Shaping China's Dairy Sector: Part 1 Premiumization

In my last article, I gave a brief overview of the 7 key trends that shaped China's infant formula sector. In this article, I will take a deeper dive into those topics and offer some context on newer trends shaping China's dairy sector during these uncertain times.

1) A Race to the Top: Premiumization Trends

To get a grip on premiumization trends in China's dairy sector you need to understand Chinese consumer's hierarchy of needs.

Chinese consumer hierarchy of needs (dairy)

1. brand recognition
2. provenance/origin of products
3. ingredients, functionalization, and segmentation (evidence-based efficacy)
4. Packaging

These 3 key components are key checklists for all enterprises looking to tap into the potential of China's premium markets. Established multinationals like Danone and Nestle and Chinese dairy giants like Yili, Mengniu, and Bright dominate the market by being able to make products that tick all 3 boxes.

Brand recognition = Safety x Quality x Time

Surveys of Chinese consumers reveal that food safety is still the key driver of purchasing preference. Food safety profile as a driver of purchasing behavior is particularly pronounced in dairy and even more so for brands that are positioned as mid to high-end products.

Chinese consumers place huge amounts of trust in established brands and are willing to pay a premium in exchange for peace of mind and a strong food safety track record. Issues relating to food safety can cause massive damage to brand reputation both in terms of their impact on consumer behavior and in how Chinese customs officials and market supervisors treat products circulating in the market (SAMR) or during customs clearance (GAC).

Provenance

Provenance and product origin are two areas highly related to brand recognition and in the eyes of Chinese consumers are a corollary of the food safety theme. China's environmental issues have directly led to many of its biggest food safety issues. Pesticide residues and abuse of veterinary medicines are just two areas that have negatively shaped the perception of Chinese consumers towards domestic products. Things are improving but the impact of scandals is lasting.

Consumers' perception of the country of origin where products are sourced is a factor in purchasing decisions. Clean and green is the order of the day and it's little wonder that China's main dairy trading partners for premium dairy products are countries like Ireland, New Zealand, Holland, Australia, and France. These trends are reflected in the marketing pitches of the big players that heavily utilize origin marketing themes depicting pristine and green environments and free-range grass-fed cows grazing in open pastures.

Origin of Products (Milk Source)

Another key component of a premium product that overlaps with food safety and provenance themes is the origin of the milk source. In China milk source has a major influence on consumption behavior with 3 main drivers namely:

1. Organic milk
2. A2 milk
3. Non-bovine milk (goat milk in the ascendency but signs of growth in buffalo, sheep, donkey, camel)

*** Grass-fed (an emerging trend in China)

Organic milk

Using the organic infant formula sector as a surrogate marker for overall growth in the wider organic dairy space we can see that year-on-year growth has maintained at 22% which is roughly 3 times higher than the growth rate experienced by standard infant formula. The sector is now conservatively estimated to be valued at well over 10 billion RMB annually. Interestingly China has also added an organic standard for key functional ingredients like OPO allowing companies to produce both organic and functional products commanding even higher premiums.

Sales of organic milk jumped 77% in 2019 despite the products being on average close to 50% more expensive than standard milk. In the organic IF space former Australian owned company Bellamy's still occupied the top spot, despite being previously unable to register any of its products and being confined to cross-border and daigou trade channels. More recently the company was acquired by Chinese giant Mengniu as part of a broader strategy of overseas acquisitions of high-value assets and IP by China. Mengniu's acquisition of Bellamy's also effectively guaranteed product registration and access to all important general trade channels. Unsurprisingly just several months after Mengniu acquired the company Bellamy's successfully registered a product albeit via a proxy (a previously registered subsidiary of Mengniu's).

A2 Milk

The poster boy for China's A2 milk sector is the AUZ/NZ Synlait/a2 milk company JV that has exploded in China since its launch just 7 years previous. Its achievements have been monumental. According to the a2 Milk Company's 2019 annual report, its China business unit reached roughly 230 million euros up 73.6% year on the year (almost all of which was sold in China).

The most remarkable thing about A2's success story is that its early growth was achieved without largescale investment in sales and marketing in China. Growth was instead achieved primarily through unregulated Daigou channels (Chinese diaspora/expats buying and sending products from abroad for resale in mainland China, primarily using e-commerce and social e-commerce). Today a2 Platinum (flagship product from the a2 milk company) is now available in over 18,400 bricks and mortar stores, up from 16400 in 2019.

Product segmentation and product portfolio diversification have yet to take a major hold in the A2 space. A2 infant formula products are still the most important category although in the last year the new product development strategies of the big players have trended towards greater segmentation.

Since its launch, we have seen a slew of copycats trying to cash in on the huge growth in the a2 sector with product launches from the following companies (all through cross-border e-commerce as the a2 milk company holds a trademark on the use of a2 terminology in infant formula):

New a2 IF Product launches in China:

• Bellamy's (Organic a2 IF - Beta Genica 8)
• Wyeth - Illumina a2
• Danone - Aptamil Essensis 3 / Cow&Gate a2
• Yili - Jinlingguan (Reformulation of Jinghu with a2)
• Nestle - Nan a2
• Mengniu - Future Star a2
• Junlebao - Zhizhen a2 (Vertically integrated supply and production)

Non-bovine milk (Goat, sheep, donkey, camel, buffalo)

Market dynamics often precipitate regulatory changes and based on this axiom you can use regulatory changes to predict future market movements. With this in mind, we can look at China's recent ratification of new dairy standards allowing more diverse milk sources from a wider variety of animals as an early signal of how the market will expand and diversify in the future.

While cow milk is in the ascendancy and unlikely to be mooved from the top spot, the remarkable success of the goat's milk sector in China should serve as solid proof of principle that alternative milk sources offer viable market potential. Indeed if we look at China's various cross-border e-commerce channels where alternative dairy has been traded for the last several years (prior to legalization via new standards) we can see there has been strong growth in niche segments like buffalo and camel milk (assessed by YOY growth rather than overall market scale).

Goats milk powder has become a staple of Chinese mothers looking for an alternative to cows milk, primarily due to issues relating to cows milk allergy which are prevalent in Chinese infants. The market value of goat milk is expected to exceed 1 billion RMB this year, with top player Ausnutria's flagship brand Kabrita accounting for approximately 25% of the entire market and experiencing year on year growth of + 45%.

An analysis of registered infant formula products also reveals a large number of registered goat milk powders with the number closing on 100 registered brands and expected to increase when SAMR product registration backlogs are cleared. Big players are also focusing on the goat milk market with Wyeth, Yili, Beingmate, Feihe, H&H Biostime, and Meiling all increasing investment in the sector

Functionalization and Segmentation

Direct product advertising, nutrient and content labeling, and use of functional labeling claims are strictly regulated in China under a complex tapestry of over-arching laws and regulations such as the advertising law, food safety law, vertical product standards, and horizontal labeling standards.

However scientific content marketing through various channels such as recommendations from friends, family, and trusted sources like internet forums and interests groups, offline conferences, Wechat official channels, social e-commerce channels like Red, and group buying platforms like Pinduoduo have become effective means to "educate" consumers on the benefits and clinical efficacy of health-related products, particularly value-added dairy fortified with a range of functional ingredients.

The rise of evidence-based efficacy content marketing is a major factor driving premiumization trends and is important method companies use to avoid China's restrictive advertising laws but still "sell" the clinical efficacy of their products.

• For products traded through general trade channels ingredient selection must comply with both vertical product standards specific to the product category and also broader horizontal standards which apply to all products e.g (GB 2760, GB14880, GB 28050, etc.)
• Products traded through cross-border e-commerce are not subject to the same regulatory constraints and therefore a wide range of ingredients and corresponding functional claims can be used.

Dairy companies invest heavily in R&D to discover and be first to market with products containing the latest functional ingredients. One key method heavily employed by dairy companies in China involves the reverse engineering of human breast milk to reveal key functional ingredients.

• Insights from molecular genetics on the differences in the sequences of the casein fractions between cows milk and human milk paved the way for discoveries on the potential clinical benefits of a2 beta-casein.
• Advances in immunology and neonatology revealed the importance of immunomodulatory ingredients like Lactoferrin, which is increasingly appearing in the new product development strategies of companies looking to leverage consumer anxiety over COVID-19.
• Commercialization of R&D on the role of the microbiome and its impact on various aspects of human wellbeing has driven massive growth in pro and prebiotics with several of China's large dairy companies now owning patents on probiotics. The addition of prebiotics (various forms of long-chain sugars/fibers) is also a common strategy.
• Use of proprietary nucleotide ratios
• Fatty acid ratios and fatty acid composition e.g OPO, DHA, ARA, EPA ratios - associated with cognitive and developmental benefits
• Various forms of dairy fermentation, hydrolysis, etc. to yield new bioactive compounds.
• For example on March 5th, 2020, Junlebao released two powdered milk products - Xinyi lactoferrin milk powder and other high protein, high fiber products designed to promote digestive health. 
• Junlebao launched ULTREE, an organic milk powder which likes its a2 product Zhizhen a2 is produced using a vertically integrated supply chain from grass to glass. The product utilizes hydrolyzed whey protein and two active probiotic formulations—Bb-12 and HN019. The product achieved over 16 million euros worth of sales in its first month since launch and since then has been trending upwards
• HMOs: Although China expressly forbids the use of GMO derived ingredients in infant formula traded through general channels, the sale of HMO products through cross-border e-commerce has been exceptional.

Segmentation:

As high yielding dairy segments like infant formula become saturated and competition increasingly fierce, companies have begun to develop new product segments designed to address:

1) Different demographics (senescent population, teenagers, pregnant/lactating women, sports nutrition, millennials, Gen Zs, hospitalized, or people with specific medical conditions - FSMP, etc.

2) Different consumption scenarios (snack foods, lunch foods, meal replacements, etc.)

In line with this value-added dairy particularly cheese, yogurt, protein shakes, dairy-based meal replacements, etc. have been experiencing rapid growth.