With more and more of China’s 1.3 billion population drinking milk every day, it’s tempting to think that China’s dairy industry is the next boom sector.

On the surface, profits look like a sure bet for the country’s dairy industry: milk consumption is estimated to be growing at a rate of 15% to 20% a year, with per capita consumption of urban residents around 22.54 kilograms (kg), according to the Dairy Association of China, compared to an annual world dairy consumption per capita of 100 kg. Of that total, liquid milk and yogurt accounted for 97.77% of the demand, with the rest in milk powder. To meet this surging demand, China has been ramping up its milk production capacity, increasing it at an annual average of 14.6% over the last 10 years. For 2006, Chinese milk output reached 32 million tons, making China the world’s third largest producer, following India and the United States.

The shear thought that so many Chinese are consuming dairy products could easily drive investors to pour their money into the segment with the expectation that there really exists a proverbial cash cow. However, the business as of late has been going through some tough times as a result of rising commodity prices and over supply.

The sector’s initial boom made some companies rich with the industry’s total revenues last year reaching over $7.5 billion. The leader has been China Mengniu Dairy Co. Ltd. (PINK: CIADF), which controls one-third of the Chinese liquid milk market—more than the combined market share of its two closest competitors: Yili Inner Mongolia Industrial Group Co. and Bright Dairy & Food Co. China Mengniu Dairy manufactures a plethora of dairy products, ranging from milk to yoghurt to ice cream and powdered milk.

According to its 2006 financial statements, Mengniu’s net income grew by a phenomenal 59% from 2005 to reach $727.4 million. The U.S. shares of the company (Mengniu is also listed in Hong Kong) are currently selling at $4.40 a share, above their 52-week low of $1.79 on Oct. 6, 2006. Other profitable U.S.-listed players include China Dairy Group Ltd. (PINK: CHDFF) whose stock is currently selling at $0.32 a share. Last year, the firm posted a net income of $13.3 million, a 7.8% growth from 2005.

Fast forward to this year, though, and one will find that the Chinese milk industry is struggling.   One reason is because the milk bonanza has attracted a surfeit of new players. 

According to the Dairy Association of China, there are now at least 717 dairy producers with sales of at least $600,000 year. The result is over capacity; while annual production is over 32 million tons, actual Chinese consumption is only around 20 million tons. Even when losses during the production cycle are taken into account, there is an annual excess supply of at least five million tons of milk, not including the additional two million tons of production capacity that is expected to sprout up each year. 

Another big problem is higher production costs. Grain prices have skyrocketed in China and the costs for cow feed have jumped by 30% in the past year, according to the People’s Daily, a Chinese newspaper. The rising costs, coupled with the over supply of milk, have resulted in the industry’s inability to raise prices (whole milk prices are hovering below $0.33 a liter compared to the United States, where milk is about $1 a liter). To make matters worse, Chinese producers are also facing competition from importers who can produce the milk at lower costs than the Chinese. In fact, imported milk products in 2006 reached 2.3 million tons, an increase of 9.1% from the 2005 levels.

This perfect storm has been devastating for the Chinese milk industry. According to the Dairy Association of China, this year’s industry profits will significantly decrease, with 30% of dairy companies currently operating at a loss and another 30% barely above the red line.

While some milk producers, like China Mengniu should be able to survive, it is best for small-cap investors to wait for the industry to self correct. By doing so, they will avoid being stuck with the other product that cows are known to produce.