* China dairy market is dominated by local producers
* Sales of dairy products in China forecast to grow to $89 bln by 2017
* Mengniu shares jump as much as 9.5 pct to record (Ads analysis, quotes)
By Denny Thomas and Donny Kwok
HONG KONG, Feb 12 (Reuters) - France's Danone SA is spending 486 million euros ($665 million) to lift its effective stake in China's top dairy firm, China Mengniu Dairy Co Ltd, as it aims to boost its presence in one of its most important markets.
The investment by the world's biggest yoghurt maker will boost its effective holding in Mengniu to 9.9 percent from 4 percent, making it the Chinese company's second-biggest shareholder.
Danone's commitment to China comes after the French company suffered a series of setbacks last year, including being fined for anti-competitive practices after a probe into price-fixing. It also recalled infant formula products in Asia due to an unfounded health scare stemming from New Zealand-based supplier Fonterra Co-operative Group.
"Danone's willingness to pay a premium for the stake suggests that they are bullish over the long-term prospect of the China's dairy industry," said Alex Wong, a director at brokerage Ample Finance Group.
Mengniu shares rallied as much as 9.5 percent to an all-time high of HK$40.35, although the stock gave up much of those gains as traders locked in profit from the past year's rise of more than 65 percent.
The stock trades at 24.8 times 12-month forward earnings, compared with 19.6 times for Hong Kong-listed food products companies, according to data from StarMine. The average for Asia-Pacific region sits at 18 times.
Booming Chinese demand for dairy products has sparked a raft of M&A and IPOs in the country's dairy sector. Food-safety scares have also boosted demand for foreign baby milk formula, pushing Chinese dairy firms to seek ties with foreign makers.
Sales of dairy products are expected to nearly double from 2012 to 2017 to about $89 billion, according to projections by business consulting firm Frost & Sullivan.
Danone, the maker of Bledina baby food and Volvic water, formed an alliance with Mengniu in May 2013, under which the companies agreed to produce and sell chilled yoghurt products in China.
Under the new deal announced on Wednesday, Danone and COFCO Dairy Investment, a venture with China's state-owned COFCO, will subscribe to a reserved rights issue by Mengniu at HK$42.5 per share, a 15.3 percent premium to Mengniu's previous close. By 0701 GMT, the shares were trading up 3.1 percent at HK$38.00, while the benchmark Hang Seng index was up 1 percent.
COFCO, Danone and dairy cooperative Arla Foods, Mengniu's three core shareholders, will combine their stakes within COFCO Dairy Investments, Danone said in a statement. COFCO owns 16.3 percent of Mengniu and Arla owns 5.3 percent.
Danone has long aimed to establish a major presence in China. Its first joint venture with China's largest beverage company, Hangzhou Wahaha Group Co, fell apart in 2009 after 13 years.
China's dairy industry is dominated by local companies including Modern Dairy, China Huishan Dairy Ltd and YST Dairy. Foreign players have taken a significant role in niche markets such as milk powder after a 2008 food safety scandal.
Mengniu plans to use the proceeds to cut debt. Deutsche Bank advised China Mengniu, the Chinese company said.
To see the statement please click (link.reuters.com/wuq76v) ($1 = 7.7564 Hong Kong dollars) ($1 = 0.7312 euros) (Additional reporting by Elzio Barreto and Nishant Kumar; Editing by Edwina Gibbs and Stephen Coates)