Sanlu Group, the first Chinese dairy to be embroiled in a nationwide scandal over contaminated milk, may be taken over by Beiijng’s Sanyuan Food Co., Ltd. (SSE: 600429), one of the few major milk producers in China that managed to skirt the crisis.

Shares of Sanyuan have been suspended from trading in Shanghai since September 26, as the company has received “a relevant department's notice to do research on a merger scheme,” according to statement from Sanyuan.

Caijing learned that the target of the merger is likely Hebei-based Sanlu, which has been reduced to near-bankruptcy after mass recalls and evaporated consumer confidence.

On late September 26, a source close to Hebei Province’s State-Owned Assets Supervision and Administration Commission (SASAC) told Caijing that “the two companies have contacted but no agreement has been reached so far.”　

A source from Sanlu added corroboration, saying a rumor about a merger with Sanyuan has spread inside the company.

Sanyuan has not been available for comment.

Earlier in September, milk products from Sanlu and 21 other Chinese dairies were found to be contaminated with melamine, an industrial chemical that can cause kidney disease. Four infants have died and about 13,000 others are still in the hospital as a result of drinking tainted baby formula. Sanlu's operation has been halted, and the company is now facing a huge compensation settlement for the victims.

A source from Sanlu told Caijing that the company will recall around 10,000 tons of milk powder and will provide a 700-million-yuan refund for consumers. According to official data, as of September 31 2007, Sanlu's held assets of 533 million yuan, including 173 million yuan in cash.

However, Sanlu has become strapped for funds in the wake of the scandal. "Sanlu's cash flow has been disrupted," said a source closed to Sanlu's management, adding that the company has recently been lobbying bank for loans. But hope is minimal. Caijing learned that Hebei SASAC sent a team to Sanlu with the aim of overhauling the company.

Wang Shuang, an analyst from TX Investment, said the takeover of Sanlu is quite possible, as Sanyuan is one of the few companies that has benefited from the crisis.