* Fonterra says to "vigorously" contest suit
* Lawsuit comes as Fonterra cuts earnings, dividend forecast
* Danone to stop buying Fonterra products
* Fonterra units down 1.7 pct; Danone shares down nearly 1 pct
WELLINGTON/PARIS, Jan 9 (Reuters) - French food group Danone said it would sue wholesale dairy exporter Fonterra and stop buying products from the New Zealand firm following a contamination scare that sparked the recall of infant milk formula across Asia.
The world's largest yoghurt maker did not say how much money it was seeking, but it has previously said it wanted full compensation for what it says were 350 million euros ($476 million) in lost sales following the recall of the company's Dumex and Karicare infant formula products.
Danone buys a range of dairy ingredients from Fonterra, but is one of its biggest customers for milk powder, according to analysts who cover the sector. Fonterra, which said it would contest the suit "vigorously", declined to give details on its sales to the French firm.
Danone has said that Fonterra supplied about 16 percent of the milk ingredients for its baby food business, which accounts for 20 percent of its total revenue.
In August, Fonterra said it had found a potentially fatal ingredient in a range of products sold by multinational companies. After recalls were issued across nine countries including China, the scare turned out to be a false alarm because the ingredient was found to contain a less harmful bacteria.
In a statement, Danone said it was starting proceedings in the New Zealand High Court against the world's largest dairy processor, as well as arbitration proceedings in Singapore to bring all facts to light and obtain compensation.
The company said it was also terminating its supply contract with Fonterra and would make any further collaboration contingent on a commitment by Fonterra to full transparency and compliance with Danone's food safety procedures.
"This affair illustrates serious failings on Fonterra's part in applying the quality standards required in the food industry," Danone said.
Danone told Reuters it would source products from other firms, without elaborating.
Other potential suppliers could include Glanbia, which is building a new milk powder plant in Ireland, and Arla Foods, which recently told Reuters it has "massively benefited" from a desire by milk powder buyers to diversify supply after the food safety scare and a drought last year highlighted the risk of over-reliance on one supplier.
Some dairy brands in China, for example, have started to look to diversify.
Glanbia and Fonterra's much smaller competitors in New Zealand would not comment on whether they had seen more business from Danone as a result of the dispute. Arla was not immediately available.
Danone's decision to halt purchases may be an effort to distance itself from the source of the perceived problem.
"It's all about trying to rebuild their brand," said an analyst, who added that Danone was unlikely to face any supply interruption. "This isn't a panic decision today. They've been looking at (diversifying) since the minute it happened."
Danone has a cushion, the analyst said, since the sudden, sharp drop in consumer demand means there is a large amount of product that still needs to be sold.
Fonterra, a farmer-owned co-operative, has denied any legal liability to Danone regarding the recall.
"Fonterra has been in ongoing commercial discussions with Danone and is disappointed that they have resulted in legal action," the company said in a statement.
Shares in Fonterra's trading fund closed down 1.7 percent, while Danone shares were down 0.7 percent at 1245 GMT.
SETTLED WITH SEVERAL CUSTOMERS
The two sides started negotiations in October, after Danone recalled its Dumex formula products in China, where demand for foreign branded infant formula is high due to a series of domestic food quality issues. It is a key growth market at a time of sluggish demand in Europe.
Eight companies issued product recalls in August. Danone is the first to take legal action against Fonterra. In December, Fonterra said it had reached agreements to compensate six firms and that it was "very, very close" to an agreement with an affected nutritional company.
New Zealand's largest company controls roughly one-third of global dairy exports and is a major wholesale supplier of milk powder used in milk formula and other food products marketed by Danone, Nestle and other multinationals.
A big court settlement in Danone's favour would hurt Fonterra's bottom line given that it has already slashed its earnings and dividend forecast on the back of rising production costs at a time when it is struggling to keep up with soaring demand for milk powder.
"A large fine of the magnitude that Danone ... has stated would have a material impact. You'd have to either remove your dividend or address your capital structure," said Rickey Ward, head of equities at Tyndall Investment Management in Auckland.
Ward said that given strong global demand for dairy products, particularly from China, Fonterra was unlikely to have problems finding new buyers to replace cancelled orders.
"It's not nice to lose a big customer ... (But) there's large global demand and short supply so Fonterra may be able to fill that void if there is a big void," he said.