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Lex is a premium daily commentary service from the Financial Times. It helps readers make better investment decisions by highlighting key emerging risks and opportunities.

Fancy a splash of milk with that? In China's case the country does not have nearly enough to offer. Small dairy farms with low production yields are failing to meet demand while distrust of scandal-hit local brands has driven parents as far as the U.K. and Australia in search of foreign-made baby milk. And to top it all off, one of these foreign producers was caught up in its own scare this month. Still, the share prices of China Mengniu, the domestic industry's biggest dairy processor, and China Modern Dairy, the top supplier, just jumped after Mengniu's tie-up with Groupe Danone SA, among others, boosted first-half sales. If China's milk industry can shed the scandals, it is worth investors taking a look.

Over the past seven years, China's milk consumption has doubled, but raw production has been growing at less than 2 per cent a year. The country's dairy farms are mostly small operators and the top five producers hold a mere 5 per cent of the total market, according to Macquarie research. For example, Modern Dairy, at number one, has only a 1.3 per cent share. And its average milk yield per cow, at 5 tonnes a year, is a sixth below more developed producers such as Australia and half that of the U.S. Domestic production already falls 30 per cent short of demand that itself is expected to keep growing by more than 10 per cent a year for the foreseeable future. That will almost double milk consumption from about a pint, or half a litre, per person each week by 2018.

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Beijing officials are trying hard to get the milk industry in order. The government took an 18-per-cent stake in Mengniu in 2009 after the company was laid low by the melamine scandal. This year, Mengniu bought a 28-per-cent stake in Modern Dairy, among other deals. Having a number of much larger-scale milk suppliers would make it easier to control quality; a big factor in the recent contamination scandals was the myriad of small producers that failed to meet onerous rules. Meanwhile, China's number two supplier, Liaoning Huishan Dairy, is readying a Hong Kong listing to raise about $-1billion (U.S.) to fund more cows and improve yields. Investors should consider more than a splash.

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