* Co-op accepting milk supply from non-members for first time

* Fonterra is battling foreign processors for NZ milk supply

* Increased competition could stoke output, drag on prices

Fonterra, New Zealand's huge dairy cooperative, has begun buying milk from non-members for the first time in its history, a major strategic shift as it battles foreign-backed processors that have sprung up in the world's No.1 dairy exporting nation.

International dairy markets have been closely watching how the company, at the heart of an industry that accounts for nearly a third of all New Zealand's exports, copes with the onslaught of foreign rivals as the race to tap booming demand from emerging economies intensifies.

The increased competition for market share could also stoke production, dragging on global milk prices that have already been hit by growing global supply, particularly as Europe deregulates its dairy sector.

Fonterra has signed up "a number" of farmers that are not members to supply the Mymilk subsidiary it started late last year, the unit's head told Reuters.

"The majority of sign-ups have been for new conversions," said Mymilk CEO Richard Allen, referring to sheep and beef farmers who have moved to dairying. He declined to give specific figures.

"There's an element of farmers diversifying their supply portfolio while having the option of a stepping-stone to joining the co-op."

Mymilk allows non-Fonterra members to supply processing plants operated by the co-op for up to five years, avoiding a hefty initial capital outlay known as "sharing up" - sometimes equivalent to a year's production.

Mymilk suppliers will get slightly less for their milk than shareholders, and are not entitled to benefits including farming and financial advice. Milk collected by Mymilk will be capped at 5 percent of Fonterra's total supply, which was around 16 billion litres in 2014.

FIGHT BACK

Fonterra wants to win back supply share that has dropped to around 87 percent from 96 percent in 2001, when it was formed from the consolidation of two major dairy co-ops.

While New Zealand production has risen to record levels since then, so has competition, with around 10 processors including France's Danone and firms owned by China Mengniu Dairy Corp now fighting for milk supplies.

The dash for supply is particularly fierce in the country's South Island, where conversions from sheep to dairy farming have increased output faster than in the North Island, the traditional dairy heartland.

The prospect of avoiding Fonterra's initial joining fee was reason enough for Willy Leferink to supply Synlait, partially owned by China's Bright Dairy and Food, when he started his fourth dairy farm in the South Island's Canterbury region in 2013.

"We were hoping to supply Fonterra, but the capital requirements at the time were such that we decided to go with Synlait because we didn't need to put any capital up front," said Leferink, whose other farms supply Fonterra.

"It was a purely financial decision."

Pricing flexibility also gives smaller firms an advantage over Fonterra, which is required by anti-monopoly rules to set its farmgate price according to globally traded dairy prices.

Oceania Dairies, owned by China's Inner Mongolia Yili Industrial Group, has been building processing plants in New Zealand, snapping up suppliers with the promise of higher payouts without sharing up. It has been offering 10 NZ cents above Fonterra's payout, expected to be NZ$4.70 per kilogram of milk solids this year.

Some analysts said Fonterra's shift to accepting milk from non-members could help for a while, but it would need to make membership more attractive by offering a sustained increase in dividends to maintain its success down the road. The company is expected to pay a dividend of 25-35 NZ cents per share this year, up from 10 NZ cents last year.

"In the short term Mymilk might help fill up some of the plants which might not be fully utilised at the moment," said Susan Kilsby, dairy analyst at AgriHQ.

"But the only real way they're going to get farmers to share up is to generate good returns on those shares, to incentivise owning shares rather than just the right to supply milk." ($1 = 1.3667 New Zealand dollars) (Editing by Lincoln Feast, Gavin Maguire and Joseph Radford)