Economic and demographic forces are stacking against the China dairy industry. S&P Global Ratings believes moderating growth in the sector will compel rated firms to enter new categories and to expand offshore, pushing up leverage and adding volatility to earnings.

What's happening:  A steep drop in revenue in the China dairy sector suggested to some that a multidecade boom is finally ending. The sales of China's top three dairy firms (Inner Mongolia Yili Industrial Group Co. Ltd., China Mengniu Dairy Co. Ltd. and Bright Food (Group) Co. Ltd.) dropped 9%-13% in the first half of 2024.

Why it matters:  Slower growth will prompt entities to make riskier bets, in our view. We think the downturn is temporary, and that China's dairy market will continue to grow. However, a shrinking population and moderating economic gains will translate to a likely 2%-3% compound annual growth rate (CAGR) in volume sales over the next two decades--half the rate of the prior two decades. To replace lost growth, large dairy firms will venture into unfamiliar markets.

What Are The Credit Implications?

As volume growth moderates, firms will push for higher-value goods.  Revenue gains will be depend on volume growth in lower-tier cities and rural areas, and more generally on an emerging preference for more expensive food that generates more value--a so-called premiumization in tastes.

Deflationary pressure may tip the industry into declining or flat growth for the next 12-24 months. When raw milk oversupply is remedied, revenue growth in the preceding years may return to low- to mid- single-digit percentages annually, on the back of a volume CAGR of 2%-3%.

Even such modest gains will require product innovation and revamped channel strategies. For example, Mengniu and Yili and are rolling out products to capture a shift in preferences toward cheese, fresh milk, and organic products, and away from shelf-stable milk. We believe Mengniu is well positioned to capitalize on Chinese consumers' move toward premium categories, given its sales lead and brand strength in these segments.

The profit margins of Yili and Mengniu, China's biggest dairy firms by sales, will expand modestly in the decades ahead. Both companies will roll out innovative, high-margin products and pass increased costs to consumers, in our view. Swings in raw milk prices could still introduce some margin instability.

We see a higher likelihood for firms to experiment with health supplements, soft drinks and overseas expansion.  Mengniu and Yili are pushing into growth markets such as Southeast Asia. Even as they face lower requirements for big capital expenditure domestically, they will need to spend more on production offshore.

The move into any new market is risky, and will involve trial and error and inevitable setbacks. This will add volatility to the leverage, cash flow and credit quality for Mengniu and Yili.

Demand for raw milk at China Modern Dairy Holdings Ltd. could increase faster than the wider market if consumption of dairy solids (such as cheese and butter) takes off. The company's creditworthiness still largely hinges on parental support from Mengniu.

Finally, China's falling birth rate will likely weigh on Health and Happiness (H&H) International Holdings Ltd., given its heavy reliance on IMF sales. Growth and margin pressure in the IMF segment will remain an overhang to the company's credit profile, since it is a smaller player in a shrinking segment.

Where China's Dairy Market Will Go From Here

The basics of the China dairy growth story remain intact. Dairy penetration in China is still low compared with other countries. According to Euromonitor, China's dairy consumption per capita was about 18 kilograms (kg) per year in 2023, which is two-thirds of the world average (25 kg) and about a third of the consumption in the U.S.

We believe that annual per capita dairy consumption in mainland China will eventually plateau at 28 kg-30 kg. With similar cultural preferences and diets, dairy consumption in mainland China on a per capita basis should get closer to that of Hong Kong and Taiwan, at roughly 30 kg per person each year.

Chart 1

However, dairy consumption in China won't likely reach a comparable level with that of the West. Chinese agricultural conditions and dietary habits differ.

For example, dairy is commonly used in Western cooking but not typically in Chinese food. The prevalence of lactose intolerance among Chinese people and higher dairy prices in China than in the West also lower the likely consumption ceiling.

Rural Areas, Restaurants To Drive Volume Growth

Upper- and middle-class urbanites in China view dairy products as staples. The category has a high penetration rate in wealthy tier-one cities.

Use of dairy is far lower in China's rural areas and lower-tier cities. These regions as such will generate much of the volume growth in the next decade. We see plenty of room for rural intake to rise, to come close to urban levels of consumption.

Chart 2

Rural consumption could reach 65%-80% of urban consumption over the next decade, up from 55%. In the next one to two years, cheaper milk prices stemming from an oversupply of raw milk will aid consumption gains. Over the next 10-20 years, growth will depend on wealth accumulation and the emergence of new dietary habits.

For example, the expansion of Western bakeries, coffee chains and bubble tea shops into lower-tier cities will increase dairy consumption frequency. Government-led school milk programs and an emerging perception that dairy is healthy will also facilitate the dietary change.

An Aging Population Will Be A Likely Positive For The Industry

Demographics will shape China's dairy sector, but not in straightforward ways.  A shrinking population is a clear negative for the industry. Lower birth rates and an aging population will also depress Chinese dairy consumption over the next five years.

This is the wrinkle in that assumption: An aging population may be positive to volume growth 10-15 years from now.

In Asia, per capita intake of dairy products typically drops as people grow older. Taiwan data indicates dairy intake per day drops to 120 milliliters (ml) to 140ml after age six, from 380ml daily consumption for a newborn up to age three. From there intake is stable but sees a minor uptick at age 75-plus, to about 150ml each day.

Chart 3

We think the current per capita intake of most age groups for mainland China is lower than in Taiwan. However, that line could move up for teenagers, adults and elders with rising rural consumption and dietary changes. Furthermore, the uptick in consumption by the elderly in mainland China could be greater than the increase seen in Taiwan. A Beijing study found that people over 60 consumed 60%-plus more milk than their middle-aged counterparts.

Furthermore, the sheer number of people entering the ranks of the aged each year in China is huge. The country is aging rapidly. Take milk formula as an example. Even though total daily consumption of adult formula will always be lower on a per capita basis than for infants, the growing number of elderly will likely offset declining baby consumption, in our view.

Based on Yuwa Population Research, the cohort above 60 years of age could grow by 47 million by 2030, whereas the cohort of children below two will decline by 6 million.

There is another wrinkle: adult powdered milk won't save the day in value terms. People are simply much more willing to pay higher prices for infant formula than that formulated for adult use. IMF volume sales in 2023 were 60% larger than adult powdered milk consumption. However, the IMF market is 6x larger than the latter in dollar terms.

Chart 4

Chart 5

Dairy Firms Will Have To Live With Lower Growth

China's dairy sector has long served as a barometer of China's growing prosperity. As per capita spending power has steadily climbed, so have consumers' taste for dairy goods, which make food rich and flavorful.

That trend is not changing but it is moderating. Chinese annual GDP gains are tapering off as the economy matures. Powerful demographic forces are depressing demand for high-margin IMF. A persistent deflationary dynamic is hitting prices and profits. These forces are playing out against what is still a much under-penetrated dairy market, creating volume growth alongside tightening margins. The upshot is a much moderated dairy industry in China.

Firms will have to work harder for their gains. This will likely involve experimentation and innovation, and likely risk.

Editor: Jasper Moiseiwitsch

Digital Designer: Halie Mustow

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