Food for Thoughts - China’s food industry heads for massive correction

It all started in mid September when the New Zealand government responded to a request from the Fonterra Co-operative Group (‘Fonterra’), a dairy company owned by more than 11,000 New Zealand dairy farmers. Fonterra alerted its government that it had reason to believe the baby milk formula made by Shijiazhuang San Lu Group Co. (‘San Lu’) was contaminated with melamine, an industrial chemical. San Lu Group is a joint venture between Fonterra and the local Shijiazhuang government. In December 2005, San Lu entered into a joint venture agreement with Fonterra which took a 43% interest for NZ$152.3 million (US$107.0 million). San Lu is one of the largest milk product manufacturers in China and, for the past 15 years, it had consistently captured close to 20% of China’s milk powder market.

National Treasures

As this milk scandal continues to reveal those producers that could have used melamine in their products, one of the largest and most recent private equity investments was engulfed in the vortex of this food scandal. The famed White Rabbit candy, the signature sweet of the Shanghaibased Guan Sheng Yuan (Group) Co. Ltd, has been a household name for decades. On 21st September, the Singapore government found the industrial chemical melamine in the candy. It led to an immediate halt of sales and export of White Rabbit. The move underscored the severity of the depth and breadth of worry caused by melamine.

White Rabbit candy holds a special position in the history of China’s food culture. In 1972, when President Richard Nixon made his landmark visit to China to restore relationship with the world’s most populous nation, Premier Zhou Enlai presented his guest with White Rabbit candies.

Earlier in the year, CITIC Capital Holdings Ltd. (‘CITIC Capital’) had injected US$70.96 million to take a significant stake in Guan Sheng Yuan (Group) Co. Ltd. It was one of the largest investments in milkrelated products by private equity investors in China. As domestic sales of White Rabbit have been halted while the ban of its export is in force, uncertainty clouds this maiden investment undertaken by a joint venture fund between CITIC Capital and Bright Food Group.

In 2007, CITIC Capital teamed up with Shanghai-based Bright Food Group to launch a 2 billion yuan (US$264.4 million) fund. It was among one of the earliest yuan-denominated funds established in China.

Food Glorious Food

China’s food and beverage industry has been one of the most popular target industries for private equity investors in recent years, as the country’s middle class has grown. Since 2006, investors have allocated no less than US$1.9 billion to 47 food and beverage producing companies (fig. 9). Among them, Hunan Taizinai Group, to which Morgan Stanley Private Equity Asia, Actis and Goldman Sachs have jointly committed US$73.0 million and Warburg Pincus’ aggregate US$96.0 million commitment to Synutra International Inc. (‘Synutra’) are by far the largest. While Hunan Taizinai Group was not among the list of companies found to have used melamine to raise the protein level of its products, Synutra, which is currently listed on NASDAQ, is facing testing times.

Contaminated

On 16th September, Synutra, which is a producer of infant formula as well as other milk powder products, revealed that it “has been informed by China’s Administration of Quality Supervision, Inspection and Quarantine that certain lots of its U-Smart series of products have been contaminated by melamine…..”. As a result, Synutra was recalling all of the affected products. The incident has eroded investors’ confidence in the company. Between 15th and 30th September, Synutra’s share price has lost 40.1%. At the end of the ninth month of the year, its share price closed at US$20.13. To add salt to the wound, a Pennsylvaniabased law firm announced that it was investigating potential claims against Synutra “concerning possible securities violations related to the Company’s (Synutra) business and operations” (fig. 10).

Even the legendary China Mengniu Dairy Co. Ltd. (‘Mengniu’), which had helped to define the private equity investment landscape in China when its investors began to pare down their holdings back in June 2004 with envious returns results, was wrapped in this melamine contamination scandal. On 17th September, Mengniu’s trading was suspended, when around 10% of the 28 baby milk powder samples that were tested were found to be tainted with melamine. A day later, some additional 12 liquid milk products made by Mengniu were tested positive for the toxic chemical. It led to the Inner Mongolia-based milk producer announcing that it would halt productions of these contaminated milk products and will shoulder all costs associated with the recalls. It was a costly experience for Mengniu. On 23rd September, when its trading resumed, it share price slumped by 60%, a far cry from its past glorious days (fig. 11).

Mengniu was one of the earliest dairy products enterprises to be backed by private equity investors. Between December 2002 and September 2003, Morgan Stanley, CDH Investments and Actis had committed an aggregate US$61.23 million to the company. At Mengniu’s initial public offering as well as at later dates, private equity investors had disposed of virtually all of their holdings in Mengniu, reaping an impressive return of 4.6 times their combined invested capital. It was the first illustrious investment performance of a China play that opened the floodgates for private equity investors (fig. 12).

Comments

In 2007, San Lu was lauded as a model company of good quality by the domestic television programme “Weekly Consumer Report”. As Fonterra’s Chinese partner faces the grim reality of being taken over by its rival, Sanyuan Food Co., Fonterra had marked down the book value of this investment to about NZ$62 million.

For both Mengniu and Synutra, the scandal stripped off the elite status that both companies had previously attained. The “Famous Brand Certification” previously awarded to them by the government was revoked (fig. 13).

In an interview with Xinhua News Agency, Mr Ge Junjie, general manager of Guan Sheng Yuan (Group) Co. Ltd, maker of White Rabbit sweets, described the disgrace that the favoured candy has fallen into as “a good lesson”. Hopefully, all China’s food manufacturers will share the commitment expressed by Mr Ge to supply consumers with “healthy, safe and high-quality food”. Such gain can only come after much pain.

Asia Private Equity Review (APER) is the foremost voice on matters related to private equity/venture capital in the region. Well-recognised as being the singular source for accurate and timely news, in-depth analysis and global perspectives, APER is published by the Hong Kong-based Centre for Asia Private Equity Research. For further information please visit their website at www.asiape.com or email them at \n This e-mail address is being protected from spambots. You need JavaScript enabled to view it ' TARGET='_blank'> This e-mail address is being protected from spambots. You need JavaScript enabled to view it