Fitch Ratings expects further consolidation - both horizontally and vertically - in China's dairy industry, although acquirers might face higher pricing and execution risks as the number of quality targets shrink, it said in a report on Friday.

Dairy companies will be driven to consolidate by higher demand, tighter raw material supply and stiffer competition, it said.

Restructuring in the industry was initially spurred by a series of food safety scandals, including a highly publicized incident in 2008 in which several babies died after consuming milk formula contaminated by melamine.

However, consolidation, which will help boost food safety standards, took time to materialize after the 2008 melamine incident.

The slow pace of consolidation was partly due to company reluctance to make acquisitions amid the uncertain demand outlook for domestic dairy products following the scandals, a lack of mature acquisition targets and the long process of negotiation. It was not until last year that industry consolidation took off.

According to statistics from Capital IQ, there were 44 IPO/M&A deals in the dairy industry in 2012, compared with 39 deals in the year to the end of August.

In June, the government said it aimed to reduce the number of domestic milk powder manufacturers to 50 from 127 and nurture 10 large-scale dairy entities with an annual income of over 2 billion yuan ($330 million) to take over 70 percent of the market in five years.

This move demonstrated the government's resolve to clean up the industry's reputation, avoid more food safety lapses at smaller players and fend off competition from foreign companies, who now account for more than 60 percent of the market compared with less than 30 percent before the 2008 scandal.

Although the dynamics of the milk powder segment are different from the broader dairy sector, the recent consolidation in the infant formula milk powder sector highlights the government's broader plans to enhance food safety standards and boost consumption of local products.

Apart from policy-driven consolidation, a severe shortage of raw milk in China will also likely force companies to step up consolidation along the industry value chain.

Dairy companies will also seek M&A activity to tap the growing demand from consumers who are more aware of the benefits of milk and have more spending power. Demand will also grow following the government relaxation of its one-child policy.

Consumer confidence in domestic producers is also gradually returning thanks to enhanced quality control by manufacturers and the government's closer supervision.

Big national dairy names with strong brands and robust cash positions, such as China Mengniu Dairy, Inner Mongolia Yili Group and Shanghai Bright Dairy will be the ultimate winners in the consolidation process, based on the solid execution of their ongoing acquisitions, although their spending on M&A and business expansion will likely raise their funding needs.

There could however, be a short-term impasse in the dairy industry because the smaller number of quality acquisition targets in the industry and the expected demand growth will widen the gap between sellers' and buyers' expectations on pricing.