Customers choose milk products at a supermarket in Xuchang, Henan province. GENG GUOQING/FOR CHINA DAILY

Inner Mongolia Yili Industrial Group Co's competition with China Mengniu Dairy Co in the $52 billion Chinese dairy market is going upscale, centering on a premium, organic segment that makes up just one percent of the country's milk consumption.

Yili is paying 4.6 billion yuan ($680 million) for 37 percent of China Shengmu Organic Milk Ltd. The Hohhot, China-based company could lift its stake further, giving Yili majority control of the largest Chinese organic milk producer and the only one in the country currently certified to meet European standards.

China's milk companies have been struggling to win back the trust of customers after a series of food safety scandals, including a 2008 case involving melamine-tainted milk that was blamed for the death of infants. That's led Yili and Mengniu, the country's top two dairy producers with about 40 percent of the market, to introduce new products and enter collaborations with overseas suppliers and brands.

The acquisition of Hong Kong-listed Shengmu gives Yili another platform to make deals and conduct other activities globally, marking "a turning point for their international expansion," said Chang Jiang Securities Co Ltd analyst Liu Yuan.

"The acquisition allows Yili to secure an organic milk supply and to widen distribution for the segment," Liu added.

Yili shares rose as much as 3.1 percent to 17.83 yuan in Shanghai, extending a gain of 7.3 percent on Oct 17. The Shanghai Stock Exchange Composite Index was little changed. In Hong Kong, Mengniu fell as much as 2 percent, while Shengmu has requested a temporary trading halt since Monday.

Yili's Shengmu deal is the second-biggest dairy industry transaction worldwide in the past two years, after Danone's $10 billion acquisition in July of WhiteWave Foods Co, maker of the best-selling US soy milk brand Silk.

The tiny proportion of organic milk sold in China compares with about 10 percent globally, giving the segment a lot of room to grow, according to Liu. A one-liter packet of Yili-branded pure milk costs 9.7 yuan while Shengmu's organic pure milk costs 15 yuan for a package of the same size, according to prices listed on Alibaba Group Holding Ltd's Tmall e-commerce website.

Yili is planning to raise as much as 9 billion yuan via a private placement for four investments, including buying 2.35 billion shares in Shengmu. That deal could trigger a mandatory offer and holders of further 2.31 billion Shengmu shares are likely to accept, according to Yili, giving it about 73 percent control of the organic milk-maker.

"This helps Yili improve its brand equity in the high-end segment, where its rival Mengniu currently has the advantage," said Haitong International Securities analyst Nicolas Wang. "And Yili has a very good distribution network in China, which benefits Shengmu."

Mengniu was China's top dairy company by retail sales of products such as milk, cheese and yogurt until 2013, when Yili drew even and then overtook it, according to Euromonitor International.

Mengniu, also based in Hohhot, owns a 25 percent stake in China Modern Dairy Holdings Ltd, the country's biggest raw milk producer that supplies 70 percent of the milk for Mengniu's premium brand Milk Deluxe, according to Modern Dairy's website.

Mengniu's high-end milk products "are fairly competitive," Haitong's Wang said, adding that China's dairy industry has been dominated by the rivalry between it and Yili nationally as the remaining companies tend to be regionally focused.

Yili and Mengniu may use a multipronged strategy to widen their lead over smaller rivals in China, said retail analyst Thomas Jastrzab.

"Both will likely combine acquisitions of premium brands, expand joint ventures with multinationals and develop more differentiated products to attract affluent shoppers," he said.

Bloomberg