As demand slows, consolidation is looming for a British dairy sector struggling to remain competitive against European rivals. Michael Barker reports

The UK dairy industry is under siege. An ever-decreasing UK milk pool, fierce competition from Europe, weak ingredients prices and a global slowing of consumer demand for dairy are conspiring to make life extremely difficult for suppliers.

And things are expected to get worse next year. The global dairy industry is unlikely to recover until the end of 2009 or early 2010, according to analysts at Rabobank. So why has the UK industry been hit so hard and how torrid will things become?

Most of the big dairy suppliers have warned that the outlook is going to deteriorate over the next few months. Robert Wiseman has admitted that tumbling bulk cream prices will hit it hard. Though its longer-term prospects are good following the opening of an £80m dairy, the company may have to re-evaluate its prices in the short term.

Dairy Crest, meanwhile, announced that its full-year results would be as much as 10% down. It spooked the stock market enough to knock 25% off the company's share price, prompting analysts to downgrade their forecasts. Britain's biggest dairy also confirmed a number of redundancies - and it is not the only one bracing itself for job cuts.

First Milk said in October that jobs were at risk as the company sought to streamline operations.

And then there's Dairy Farmers of Britain. The £562m farmer-owned co-op has endured a tough few weeks. It cancelled a scheduled half-yearly interest payment to members, has seen the departures of several high-profile figures, and this week announced it was closing two dairies, rationalising four distribution depots and consulting over laying off as much as a quarter of its staff. It also said it would have to drop its standard milk price by 2ppl to 23.5ppl.

One reason the UK dairy industry is suffering so badly is that milk supply is extremely tight. The shelf price of milk has risen more than a third over the past 18 months as a result. As farmers quit and dairy herds diminish, supply is being forced below sufficient levels. This means retailers may increasingly be forced to look abroad to fulfil their dairy requirements.

What is happening in Europe is as much the cause of the UK's problems as events on these shores.

The average prices for butter and skimmed milk power, for instance, have plummeted across Europe recently, both almost halving in value in the past year. Abundant production in these sectors is keeping prices down. On the Continent, the consequence has been an uneasy standoff between farmers and processors over returns. If milk begins to follow suit, supermarket buyers will expect to pay less for their milk next year than they did this year.

Downward price pressure
Higher volumes of European Cheddar are reaching the UK, and with competition in that market set to intensify following new EU quota regulations (see box), there will also be downward price pressure in the cheese market.

So where does that leave the UK industry? Processors undoubtedly want to reduce milk prices, as Dairy Farmers of Britain has done, to relieve the pressure on their strained margins. Now that input costs have come down somewhat, there will be an opportunity to do that, which in turn will offer supermarkets the chance to lower their prices on shelf.

The dilemma they face, according to DairyCo head of market information Huw Thomas, is whether to risk sacrificing their farmer suppliers' margins for their own benefit. "Processors will be squeezed because they don't want to drop prices and send the wrong message to farmers, and therefore lose more production," he says. "So they are looking to hold prices for as long as they can."

Reduced milk price
They will have to relent eventually as the pressure of lower competing prices from Europe starts to take hold, says Chris Edwards, head of dairy training at Reaseheath College. "Processors would like to see the milk price reduced as they are working on margins of less than 1% profit," he says. "The situation will lead to a reduced milk price next year."

Retailers under pressure to be seen to be offering the lowest prices still want to buy British, but there may be a limit to their patience when cheaper dairy products are available elsewhere. There are already rumours that one major supermarket has switched its own-label Cheddar contract from a British to an Irish supplier and is supplementing that with German cheese.

While liquid milk will continue to be largely sourced from the UK, it will be increasingly attractive for producers to source ingredients such as skimmed milk powder, butter and even cheese from cheaper East European and Far East markets, says Edwards.

Call for consolidation
Rationalisation is widely seen as the only way UK processors can compete with their giant European rivals. The consensus is that in an intensely competitive dairy industry, those with the most modern facilities will squeeze out those who are unable to invest in their businesses.

"There will be no place for the inefficient in this new world, that's become abundantly clear," says Gwyn Jones, chairman of the NFU's Dairy Board.

"Consolidation is obviously what's needed and the time is getting nearer when this will be discussed publicly."

This view is echoed by Thomas. "More rationalisation is inevitable over the medium and longer term," he says. "There are some very large processors in Europe now. It's a game of scale and efficiency."

And it's a game that only few dairy producers can win. If processors drop prices, their farmers suffer, potentially leading to a further reduction in the UK dairy herd and more imports, though consumers get lower prices for key foods at a crucial time.

If prices remain high, retailers retain a higher margin and farmers are happier, but processors will come under severe pressure and be forced to further streamline their businesses.

On the plus side, British consumers have a love affair with dairy that should sustain volumes throughout the recession. And the tough conditions are forcing businesses to become more efficient, building some world-leading new facilities along the way.

But this will come as little consolation in an industry under pressure to rationalise. There are going to be casualties, and some of them may well be big. Those able to negotiate their way through the choppy waters will undoubtedly be all the better for it. As the adage goes, what doesn't kill them may well make them stronger.
imports set to rise
The EU has changed its rules on production limits in the run-up to the abolition of milk quotas in 2015 -infuriating UK dairy producers. Under the new rules:

l More dairy products will be produced in the EU

l Countries such as Ireland and Italy will be able to scale up production from 2009. Ireland's increase is the equivalent of £100m of dairy products over five years

l Increased imports could lower on-shelf prices in the UK

l The UK's low production means it is not expected to fill its own quota

l Retailers could be more tempted to switch contracts to cheaper Continental manufacturers