THE perfect storm that has coalesced around the beleaguered Chinese baijiu sector in the past year is threatening to drown industry players, leading market watchers to wonder if baijiu makers could stay afloat.

Since this column touched on the challenges facing industry players last June, the baijiu sector has, like a drunkard staggering around in his vomit, lurched from one crisis to another. The cumulative effect of all the negative developments was that the stock prices of baijiu makers plunged. The stock of industry leader, Kweichow Moutai, closed at 200.25 yuan (US$32.3) per share on May 30, down from its 52-week high of 266.08 yuan per share, according to CapitalVue data.

To briefly recap, the bursting of the baijiu bubble was precipitated when the Chinese central government pledged in March 2012 to ban the use of public funds to buy high-end baijiu. To cope with the changing industry landscape, baijiu makers had then embarked on a series of measures, such as limiting production volume in a bid to prevent large drops in prices.

However, the outbreak of the plasticizer scandal in November 2012, where excess levels of the harmful plasticizer chemical were first discovered in Jiugui Liquor's product, deepened the industry gloom.

The turn of 2013 failed to improve the fortunes of the industry as Moutai and Wuliangye Yibin were fined a total of 449 million yuan for price fixing. The two industry giants had set floor prices for their products and demanded distributors strictly adhere to their pricing strategies. The former had to pay 247 million yuan, while the latter was fined 202 million yuan, accounting for one percent of the total sales revenue of the two companies in 2012, according to the National Development and Reform Commission.

Collateral damage

Any hopes industry players had of a relaxation of the curbs were dashed when Premier Li Keqiang reiterated the curbs in March this year. It became clear that the baijiu sector would be the collateral damage of the government's crackdown on corruption and wasteful spending.

According to industry portal Jiuwenhua.cn, the baijiu sector recorded a 15.2 percent year-on-year rise in total profit in the first quarter of 2013, sharply down from the growth rates of more than 40 percent in previous years.

The decline in sector profitability was reflected in the first quarter earnings of individual baijiu makers. For instance, Moutai, which had recorded net profit growth rates of about 50 percent in the past two years, posted net profit of 3.59 billion yuan, a growth rate of only 21 percent, according to its quarterly report.

There is a palpable sense of pessimism engulfing the entire baijiu sector. Nowhere is this best exemplified than in the drastic drop in the prices of Moutai, which had retailed for more than 2,200 yuan per bottle during the Spring Festival last year. This same bottle of Moutai was selling for between 1,100-1,200 yuan per bottle during this year's Spring Festival, according to Yunnan Information Daily.

However, this sense of doom and gloom may be overdone as there are pockets of opportunities for contrarian investors with a huge appetite for risk. No doubt net profit growth dropped, but this was a reflection of the forces currently buffeting the sector. Looking forward, not all baijiu makers will be affected by the curbs by the same extent.

Top baijiu makers would face greater challenges from the severe cutbacks in spending. The curbs will effectively change the driver of mid and high-end baijiu consumption; from one driven by government consumption to one that is powered by mass consumption.

Thus, high-end baijiu makers, long used to plucking the low hanging fruits of government and corporate clients, will now have to develop the mass consumer market through increasing investments in brand promotions, sales channels, online and export sales expansion, to generate demand.

Greater pressure

However, every dark cloud has a silver lining. High-end baijiu makers may benefit from the worsening industry climate as small unprofitable distilleries are expected to come under greater pressure and could exit the industry.

Besides, any success in gaining market share in the individual consumer goods market may mitigate the effects of lower government and corporate demand, providing the catalyst for a long-awaited recovery in share prices.

Unlike makers of high-end baijiu, mid-range baijiu makers are the beneficiaries of a favorable confluence of factors, and could actually thrive during this period of austerity for the baiju industry.

By virtue of the fact that these companies produce baijiu for the common folk priced at between 100 and 300 yuan per bottle, they will be less impacted by regulatory policy changes.

In addition, mid-range baijiu makers will benefit from mass consumption upgrade following the steady rise of incomes, and also from the urbanization of China. According to the National Bureau of Statistics, China's urban population accounted for 52.57 percent of the total by the end of 2012, still a long way from the 2030 target of 67 percent. The above factors would certainly herald the rise of mid-end baijiu as a major industry growth point.

However, the road ahead will not be smooth, and crooked places will need to be straightened. Though the low and mid-end products of mid-range baijiu makers may benefit from the mass consumption upgrade and urbanization, their high-end products will be pressured by price cutting from high-end baijiu distillers.

In addition, continued cost pressures will become the new normal during the industry transition. Expense ratios are expected to continue to trend up as investments on advertisements, sales network construction, long-term channel expansion, especially in areas where the baijiu makers concerned do not have a presence, are expected to increase.

The lack of a national standard for plasticizers means that fears over the quality and safety of baijiu still exist. The industry can ill-afford another scandal, which would result in a further erosion of consumer confidence and hasten the introduction of further curbs by the General Administration of Quality Supervision, the new "super regulator" for food and drug safety, further adding operating costs.

It is always darkest before dawn and it is certainly easy to overlook the possibility that light has come. Though the many challenges may seem insurmountable, the time for industry players to arise and shine could well be close at hand. Baijiu makers which focus on what is truly essential, make the right choices, and implement the appropriate strategies, will be able to successfully navigate the storm and position themselves for the upturn.

CapitalVue provides China capital market, fundamental and time-series databases. Read more on www.capitalvue.com.