“The milk processors would do a deal with Woolworths and then come back to us and drop our price,” he said. “So I wrote to Woolworths and said, ‘We can sell you milk here that’s better than what you’re getting.”

Farmers in Australia’s $4 billion dairy industry are striking direct deals with supermarkets that control 80 per cent of the country’s grocery sector, as a drive to sell milk for $1 a litre squeezes profits. That’s threatening milk processors Kirin Holdings, Parmala, and Fonterra Cooperative.

“Coles and Woolworths have such a degree of market power that it makes it difficult for suppliers to make a return,” said Nick Green, a spokesman for Australian Dairy Farmers, a group representing both processors and farmers. “Any industry is unsustainable if it’s only barely breaking even or making a loss.”

Australia’s dairy industry -- dating to 1788 when four cows, a bull and a calf were shipped to Sydney to feed the British penal colony that was the country’s first European settlement -- has seen milk export volumes more than double since 1993. That’s largely due to surging demand from Asia, which has lifted global dairy consumption 27 per cent since 2000.

$1 litre

The shift has driven investments by dairy companies. At Kirin, Japan’s largest drinks maker, Australian dairy and soft drinks are the largest overseas business with 9.4 per cent of group sales. The country is also the second-biggest region for Parmalat, accounting for about 20 per cent of revenue and outstripping sales from its home market of Italy. Fonterra, based in Auckland, New Zealand, has its largest overseas investment in Australia, with 14 per cent of group assets in the country, according to data compiled by Bloomberg.

International might hasn’t helped the processors take on Australia’s supermarkets, which have been pushing down prices since Coles first cut milk to $1 a litre in January 2011, said Ben Craw, a director at consultants PPB Advisory in Sydney.

“They’re trying to take out the middleman,” he said. “Processor margins are going to have to decline.”

Lost contracts

Kirin’s Lion, which in 2010 had supplied all of Coles’s and Woolworth’s store-brand milk outside Western Australia state, last week lost contracts with Coles amounting to about half its remaining store-brand business.

Coles said April 10 it would instead buy 200 million litres a year -- about 10 per cent of the country’s fresh milk consumption -- from farmers’ cooperatives Murray Goulburn Cooperative and Norco Cooperative Murray Goulburn says it will spend A$120 million on two processing plants to handle the new business.

Bale and other dairy farmers in the Manning Valley, about 300 kilometres north of Sydney, today received regulatory backing for a similar deal, to collectively bargain with Woolworths, the country’s largest retailer, and Milk2Market for three years. Bale says he currently sells to Parmalat.

The industry has “been structured in a certain way for a period of time: farmer sells to processor, processor sells to retailer,” said John Durkan, Coles’s merchandise manager. “There’s no rule that says it has to be structured like that forever.”

Safeway, Sainsbury

Woolworths and Wesfarmers, owner of Coles, together account for about 80 cents of every dollar spent on groceries in the country, and are each larger than Safeway or J Sainsbury.

Even as suppliers have suffered, the tight control on costs and supply chain has boosted earnings at the two retailers. Woolworths’ shares have risen about 21 per cent this year and Wesfarmers has gained 14 per cent.

Australian antitrust authorities are investigating allegations from suppliers that the supermarkets have misused their market power, Rod Sims, chairman of the Australian Competition & Consumer Commission, told a parliamentary committee February 13. Sims didn’t say whether the investigation was looking at the dairy sector, and the complainants haven’t been named. Both supermarkets say they will cooperate with the investigation.

Discounts bite

Dairy discounting is starting to bite at milk processors. Kirin’s Lion has written off more than half the value of the dairy businesses it bought for $3.68 billion in 2007 and 2008. Lower prices were to blame for a 10 per cent drop in sales at the Australia and New Zealand dairy and drinks unit last year, Lion said February. 14.

Fonterra, the world’s largest dairy exporter, blamed Australia’s “very competitive retail environment” for a 32 per cent drop in first-half earnings at its local unit March 27. Fonterra is studying Coles’s deal with Murray Goulburn and “reshaping its business” in response to the “challenges in the Australian marketplace,” spokeswoman Louise Nicholson said.

Earnings at Parmalat’s Australian unit fell 83 per cent in the first quarter of 2011 after a retailer “drastically” cut prices for store-brand milk, chief operating officer Antonio Vanoli told a May 2011 investor call. Parmalat is focusing on higher-margin products such as branded milk and yogurt, according to a presentation July 31, and earnings before interest, tax, depreciation and amortization rose 21 per cent in the country during 2012.

Milk’s return

Too much pressure on suppliers risks backfiring, said Stephen Scott, head of research at Ord Minnett Group.

The bulk of Australian dairy production is already used to make cheese, butter, yogurt, milk powder, and other extracts used in ice cream and commercial baking. Just 25 per cent goes to fresh milk for the local market, and that could slip further if the business isn’t profitable, Scott said.

“In the short term the supermarkets have the power,” Scott said by phone. “In the medium term, if they don’t pay enough for milk, it will be processed and exported. Milk will find the highest return.”