RETAKING LOST GROUND: In the first quarter of this year, Mengniu recovered 90 percent of its sales volume from before the melamine scandal (ZHAO YINGQUAN)

A combined financial venture between China's largest agricultural trading and processing company and a private equity firm formed to milk profits from the dairy business has led to the biggest share acquisition in the Chinese food industry. China National Cereals, Oils & Foodstuffs Import and Export Corp. (COFCO), based in Beijing, and Hopu Investment Management Co. agreed to buy a 20-percent stake in China Mengniu Dairy Co. Ltd. on July 6 in a deal valued at HK$6.12 billion ($784 million).

The two companies co-established a special investment vehicle that is 70 percent owned by COFCO and 30 percent by Hopu. It will become the largest shareholder of the Chinese milk producer.

As early as 2006, COFCO initiated a development strategy of forging itself into a whole-industry-chain grain and oil producer.

Acquiring Mengniu provides an excellent opportunity for COFCO to gain ground in the dairy industry, said Ning Gaoning, President of COFCO, at a press conference held on July 7.

In choosing Mengniu, one of China's biggest dairy producers and suppliers, as COFCO's strategic partner, COFCO is able to expand its "whole foodstuff industry" territory on a mature platform, Ning added.

Mengniu in crisis

Founded in Inner Mongolia in 1999 by Niu Gensheng, a former employee of Yili, another Inner Mongolian dairy giant that is now Mengniu's largest competitor, Mengniu has grown into one of the country's leading manufacturers of milk, yoghurt and other dairy products.

Starting business with a team of only nine people and 9 million yuan ($1.32 million), Mengniu managed to sustain itself and expand after a short time. In 2004 Mengniu got listed on the Hong Kong stock market, and its total value amounted to HK$4 billion ($516 million), an average annual growth rate of 365 percent.

But the soaring profits and rapid strides were suddenly halted by the melamine scandal in the second half of 2008. After its products were found to be contaminated, Mengniu's share, sales volume, as well as reputation fell dramatically.

Mengniu's mid-year report gave a net profit of 583 million yuan ($85.7 million) in June 2008. But the total loss caused by the melamine scandal amounted to 1.5 billion yuan ($220.6 million).

In 2008, Mengniu posted a net loss of 949 million yuan ($139.6 million), according to its annual report released in April 2009, a dramatic decline compared to its 936-million-yuan ($137.6-million) net profit in 2007.

JOINT HANDS: Ning Gaoning, President of COFCO, and Niu Gensheng, President of Mengniu, shake hands at the press conference held July 7

The matter was further complicated by the controversy surrounding the safety of using osteoblast milk protein (OMP) in Mengniu's Milk Deluxe in February 2009. China's General Administration of Quality Supervision, Inspection and Quarantine banned Mengniu from adding OMP to its high-end milk product, Milk Deluxe, in February.

Larger losses may be inevitable, some insiders said. Since Milk Deluxe was the pillar product for Mengniu to fight against the negative effect of the melamine scandal, sales may continue to plummet, negating profits.

Meanwhile, owing to its atomized ownership structure, Mengniu has been plagued by hostile takeovers in recent years. According to international common practice, when major shareholder's stock is less than 25 percent, the company may face potential risk of hostile takeover, said Niu at the press conference.

"Mengniu is exposed to this danger," he added.

With COFCO becoming the biggest shareholder and promising not to sell its share in three years, Mengniu's crisis is averted.

From field to table

While it used to be a monopolistic, state-owned foodstuff import and export company, COFCO has successfully transformed itself into a diversified enterprise through a series of mergers and acquisitions.

In 2007, it merged Sifang Sugar and Suozhou Sugar into COFCO Xinjiang Tunhe Co. Ltd., making that company China's biggest beet sugar producer. In March 2006, COFCO acquired China Grains and Oils Group Corp. and turned it into the country's largest food and oil distributor with total assets of more than 60 billion yuan ($8.8 billion).

COFCO's current business covers five areas, including foodstuffs and oil trading, agriculture and food processing, biomass energy production, real estate development and financial services.

Building a complete industry chain has always been COFCO's first and foremost task and will continue to be so in the near future, Ning said. The purpose of COFCO's industry chain is to turn the corn harvested in Jilin Province in northeast China into ham on the table for Shanghai residents, Ning added. The food industry chain comprises foodstuff manufacturing, cultivation, processing, marketing, packing and logistics.

COFCO's investment in Mengniu is a natural extension of its industry, as it strives to build the whole foodstuff industry chain, said Ning.

By taking advantage of Mengniu's low stock prices, COFCO was able to march into the dairy industry, said Zheng Qi, a food industry analyst at China Securities Co. Ltd.

A sweet marriage?

The new buy is being referred to as a "public-private partnership," Ning said. But will the marriage of the two companies turn out to be a sweet one?

The key factor to the successful cooperation of the two companies lies in the two parties' ability to function together and eliminate the major differences in their spirit and team culture, said Wei Sanshui, a financial writer who has published two books on COFCO.

The merger of the two companies may be a success, since state-owned companies are rich in resources, but have difficulties in their own reform, while private companies have well-functioned incentive mechanisms, but lack resources for potential development, according to Wang Yu, a stock analyst at aastocks.com.cn, a financial website based in Shanghai.

As Mengniu's new long-term strategic investor, COFCO will place three non-executive directors on Mengniu's board of 11 directors. COFCO says it will not interfere in Mengniu's day-to-day management, nor will it try to alter the dairy producer's current management team or business strategy.