TANGSHAN, China The Hangu dairy farm was all that remained from the ruins of Fonterra's NZ$200 million investment in China after its state-owned partner Sanlu collapsed in 2008 following revelations that its baby formula was contaminated by the chemical compound melamine.
The farm, on brown fields northeast of Beijing, is now the breeding ground for a new international investment strategy by the New Zealand company, the world's biggest dairy exporter.
Post-melamine, Fonterra (FCGHA.NZ) is building and operating its own large-scale dairy farms overseas, so it can be certain of the quality of the dairy products it sells.
"There were 21 companies in China that had melamine in their milk. One company chose to do something about it," Fonterra's China president Phillip Turner told Reuters.
"We blew the whistle. We kind of blew our own foot off because it destroyed our investment. But I think that's the way, I think consumers appreciate it."
While Fonterra bets that Chinese customers will trust in its quality, China is betting the future of its dairy industry on farms like the 3,000-head operation at Hangu and an even newer prototype at Yutian in Hebei Province.
Graphic: China's milk industry link.reuters.com/cud76s
Reuters Insider on Fonterra link.reuters.com/wac37s
The government wants to boost annual milk output to 90 million tonnes by 2030 from 30 million now. Given limited pastureland, the only way to do that is by building large-scale farms and sharply raising herd productivity.
A Chinese cow generally produces about half the milk of her American or European cousin. Lower output is largely due to genetics and feed.
Fonterra's cows in Hebei are black and white Friesians which have travelled by ship from New Zealand. They are crossed with American stock bred for life in long, concrete-floored barns.
Fonterra chose the Tangshan area of Hebei in part because of the easy availability of water and corn for feed. It supplements with imported alfalfa.
It ultimately plans to build four or five hubs, each made up of about 16,000 cows across several farms, in the plains that stretch northeast of Beijing.
Fonterra sells about $2 billion of imported milk products in China, its biggest market. The hubs would allow the cooperative to produce in China, using its own milk, in a departure from its practice in New Zealand of buying from independent member farms.
"Melamine changed our view a little bit in that getting the milk supply right is our priority in any country," said Peter Moore, who heads Fonterra's international farming division.
"We are looking to go into India. Now, the first thing we would do is secure the milk supply."
For the time being, milk from its farms is sold to nearby Chinese and foreign dairy processors to raise the average quality of their milk.
"We have a clear plan to develop our own supply, either through our own farms or farms we control. We are very clear we need to control our own milk supply," Moore said.
Four years after the melamine scandal, China's dairy industry has barely recovered. Milk production was basically flat at around 35.5 million tonnes from 2007 to 2010, before ticking up by about 3 percent in 2011.
Milk product exports crashed from 134,500 tonnes in 2007 to 36,800 tonnes in 2009, and have only just begun to revive. Imports have soared to almost a million tonnes a year, after briefly losing ground to Chinese-made products in 2007.
Chinese travelling overseas come back laden with boxes of milk powder to give to friends and relatives.
"Food safety is one of the most sensitive topics in China," said Chen Lianfang, dairy analyst at Beijing Orient Agribusiness Consultant Ltd.
"So any foreign investors in China's big dairies, including Fonterra, need to make safety and quality the top priority."
China's planners had fixated on dairy as a way to modernize the farming industry and raise nutrition levels in a population that does not traditionally drink products made from cows' milk.
A new taste for sweet yoghurt and ice cream has expanded along with growing cities and stores with refrigerators. Chinese dairy consumption more than tripled from 2001 to 2010.
But in the past decade, the expansion of the herd outpaced the availability of good feed and refrigerated collection and distribution networks. Subsidies meant farmers with little experience invested in dairy cows, producing poor quality milk which they sold to middlemen with even poorer safety standards.
That all came to a head in 2008, when reports surfaced of babies developing kidney stones after drinking tainted milk formula. In a subsequent trial, Sanlu executives said they reported the problem to the government, but the public was not told until after the Olympic Games wrapped up in Beijing.
At least six Chinese infants died and 300,000 were made ill. Trade partners briefly closed their markets to Chinese milk. The United States and European Union still impose stricter checks on Chinese-made dairy products than on other Chinese exports.
It has been more than a year since the EU detected any melamine traces in Chinese milk exports, EU Commissioner for Health and Consumers John Dalli said on Wednesday.
But just last April, Chinese authorities seized 26 tonnes of melamine-tainted milk powder that was sold to an ice cream producer in the southwestern city of Chongqing [ID:nL3E7FR0F3].
Dairy firms Mengniu (2319.HK) and Yili (600887.SS) together account for 44 percent of dairy products markets in China. They source their milk from a combination of large-scale suppliers and communities of small farmers that keep up to 10 cows in small backyards.
(Editing by Ron Popeski)