Which way to churn?

As promotional stunts go, slashing the price of staple foods is a depressingly familiar one in supermarket store wars as rival retailers seek to woo punters with loss leaders as the economy takes a downturn.So, in one sense, the latest milk price war conducted by the UK's largest supermarkets should come as no surprise. What dairy processors and farmers want to know, of course, is who will actually fund these cuts in the long run, says Paul Deakin, md of Meadow Foods, the UK's largest independent dairy ingredients business: "I think a lot of people in the dairy industry were really disappointed when they saw what Asda and Tesco & Co were doing.

"Things like this can undermine the whole market, because they spread like a virus. The retailers might not immediately come knocking on their suppliers' doors for money, but it always happens in the end."

Meadow Foods, a £250M turnover business that produces 15,000t of butter, 25,000t of anhydrous milk fat (AMF) and dairy proteins from its site in Chester; and vast tonnages of sweetened condensed milk and chocolate crumb from a site near York, is exposed to the whims of the commodity markets to a degree, accepts Deakin. "Cream prices at the start of last year were 82p per kilo. By September, they were £1.45. Given that you need two and a half tonnes of cream to make a tonne of AMF, managing your margin in a situation like this can be tough. We can only afford to be in those areas on monthly pricing."

Indeed, dairy ingredients suppliers, like stockbrokers, make their money by trying to predict which way the market is moving, says Deakin, who trained as a chartered accountant and carved out a successful career in corporate finance before joining the dairy industry. "Cows don't produce a steady stream of milk all year round. As the demand for liquid milk is fairly static all year round, however, all the variation gets absorbed by the ingredients industry, which can make life very challenging!"

One option worth exploring now given that the price of some food ingredients now fluctuates as much in a single day as it did in a year in the early 1990s, is getting into hedging, he says. "We think it's quite likely that a commodities hedging market will develop for dairy products."

But Meadow Foods does have some key strengths in a volatile market, he claims. "Our USP is security of supply. We have contracts with farmers covering more than 400M litres of milk, so that when we say we can supply you with a product, we genuinely have access to the raw materials to produce it." Key to this has been the recent acquisition of West Lakes Dairy Park, which has given Meadow Foods access to 200M litres of milk from Cumbrian farmers, says Deakin.

While supermarkets make great marketing capital of the fact that they work directly with some dairy farmers, this is less a reflection of altruism than a fear that they cannot rely on processors to provide consistent supplies, observes Deakin. "Last year a number of dairy companies let customers down because they could not secure the supplies they needed. But if you ask Tesco whether they really wanted to get involved with direct supply contracts with farmers, they would probably say no, it was just a matter of expediency. But it's a political hot potato."

The same could be said for chocolate crumb, in which Meadow Foods is the only UK manufacturer with the exception of the chocolate companies themselves, notably Cadbury, which got itself into some very high profile bother in 2006 after its chocolate crumb factory in Marlbrook was found to be at the centre of a salmonella contamination. "We picked up some business from Cadbury in the wake of the outbreak," says Deakin.

"I think that there will be more outsourcing in future. Making chocolate crumb means dealing with farmers, and milk procurement is something big manufacturers just don't want to get involved in anymore. It's what makes my job so interesting. One day I'll be on the phone to the UK md of Nestlé and 10 minutes later I'll be talking to a farmer about problems with his milk cheque."

So what does the future hold?

Further merger and acquisition activity, predicts Deakin. "When the big farmer co-ops in the UK decided to get into processing, they acquired poor manufacturing assets, and that's still an issue. My own view is that there is only room for two co-ops, not three."

The basic problem in the UK is overcapacity, he says. "With the reduction in milk supply, there is a surplus of manufacturing assets in the UK. There are three major butter manufacturing plants in the UK, any one of which could produce the volumes coming out of the other two as well. That's not sustainable."