Arla UK warns more costs will hit margins

Arla said that rising costs in raw materials and energy, together with aggressive retailer price cuts, would damage performance in 2005.

The milk processor's shares fell sharply following the news, which should not have been a complete surprise after Arla's underlying profits for the six months up to 31 March slipped from £23 to £22m, thanks to similar cost pressures.

However, Arla's troubles - despite its deal as the sole milk supplier to Asda-Walmart - do emphasise the importance of value-added products to a dairy industry struggling to make money.

Branding has become one route to success. A recent report by Euromonitor on global dairy products said distinctive brands were crucial in the struggle to revive large categories made up of traditionally staple items that have often become viewed as commodities by consumers.

And some firms are already making moves to re-organise behind marketing and development of value-added versions of everyday brands.

Dutch dairy giant Campina announced it would merge is European dairy businesses to do just that. Spokesperson Ria Feldman said Campina had spent a lot on research and development, and this was helping it to develop value-added products that were harder, or even impossible, for supermarkets to copy and sell as private label.

Recent products to emerge from this investment include Campina fresh milk that stays fresh for a week as well as Campina Optiwell low-fat and low-calorie dairy and yoghurt drinks.

Arla itself is no stranger to this sort of tactic. The firm reported strong half-year growth for its for its Cravendale fresh milk brand and even said sales had been held back because demand had exceeded production capacity.

Cravendale contains only one per cent fat and Arla said it was planning to launch flavoured and 'one-shot' varieties later this year.

This kind of innovation could become a sink-or-swim issue for dairy processors over the next few years if cost pressures continue to increase.

Worryingly for UK dairy processors, the country's milk production is likely to slip to more than 1bn litres under quota by 2007/08 because more producers are quitting than expected, according to a recent report commissioned by agriculture ministry DEFRA.

The report says this would constitute the 'worst case scenario' envisaged by an original study of producers in 2003.

Such a scenario could inevitably tighten supplies and increase costs even further for processors, although Arla is reportedly considering reducing the price it pays for milk in the near future.