It has been my endeavor for a while to find a strong business in dairy industry. Following are some thoughts -
BACKGROUND
The starting (exciting?) assumptions to look at dairy industry are as follows =>
- The liquid milk business is a high ROCE business (50%+ in some cases) with negative working capital cycle. Some parts of value added product businesses like curd, flavored milk, ice cream also have equally strong return ratios with decent working capital cycle.
- A large part of the market is controlled by co-operatives. Since opening the market to private sector, private companies has slowly gained market share by creeping in. Is this trend going to continue for several years? In addition to this, a large part of liquid milk market is controlled by unorganized players. So trend of co-operatives to private players & unorganized to organized is here for long term?
- India has large vegetarian population & milk/milk products form large part of the diet. As incomes grow, expenditure on milk/milk products will only go up?
PARAMETERS FOR STRONG BUSINESS
- The milk production is seasonal in nature where there is milk surplus in the flush season (monsoon, winter) & milk deficit in dry season (summer). The consumption of milk & milk product is counter cyclical to above trend i.e. consumption is more in dry months & less in flush months. The access to direct milk from farmers in dry season is one of the first ingredient of competitive strength of the business.
- The spoiler for above point is Skimmed Milk Powder (SMP) market. We have an industry where milk prices are determined by local factors but some parts of commodity (SMP) are also traded in international market (similar to Sugar). There are several minute aspects to SMP angle. In flush season, excess milk gets converted into SMP & in dry season SMP is converted back into milk products.
If export prices fall or are lower than domestic SMP prices in flush season, a lot of players who create SMP tend to make losses. This price depression in SMP tends to flow to milk procurement prices because some players would rather import SMP & add butterfat to create milk. Also Hotels, Restaurants & Catering (Ho-Re-Ca) sector is most sensitive to prices than quality & first to go for lower priced milk. The margins tend to go up in some times but there is also social distress with farmer groups suffering. This is what is largely happening now. The scenario can play out on the positive side as well if export prices of SMP shoot up in flush season.
So second important ingredient of business strength is de-linking business completely from SMP volatility. As SMP can be stored for a year, so strong business has to have products that can consume own SMP & on net basis in the year have no dependence on SMP prices. - A large part of milk procurement market is controlled by co-operatives like Amul & Nandhini. Some of these players have state support in terms of subsidy & these players do not have a profit motive. So ability to defend your market share against co-operatives is third important ingredient of the strong business.
How does one defend the market share from co-operatives? There are a few things one can do.
First, always procure complete milk from the farmers no matter the season & pay them on time with transparency w.r.t. quality, fat content.
Second, build strong operational efficiency in the business by the virtue of density i.e. procure more milk per unit area & sell more milk products per unit area.
Third, try to build strong brands with high quality products & make switching costs high in the mind of consumers. The combination of this might allow you to charge more to customers without losing them & still pay farmers more than rest throughout the season. - There is high probability that growth rate of value added products (VADP) might grow faster than consumption of liquid milk. These VADP can be categorized into capital efficient ones (like curd, ice creams) & capital-inefficient ones (like cheese, Paneer, Ghee, Butter etc.). The capital inefficiency stems from high working capital days, sometimes 120+ days.
Since milk prices fluctuate widely throughout the year, so ability to pass on these prices to consumers is fourth ingredient of the strong business.
Passing on high milk procurement prices in liquid milk products is rather difficult, so having higher/growing % of capital efficient VADP products can help to achieve this to an extent. Another way to pass on milk price fluctuations is to have institutional clients where price variations clause is built into contract. But doing institutional business in capital efficient matter is difficult due to high working capital requirement.
Also due to fluctuating milk procurement prices, the bottomline would tend to be fluctuating over the years & hence a different metric is required for valuing the business.
MAJOR PLAYERS
The major players on co-operative side are - Amul, Nandhini, Mother Dairy, Avin.
The major players on private side are - Hatsun, Heritage, Prabhat, Parag, Nestle, Godrej (Jersey Creamline).
MILK PROCUREMENT
The milk procurement by all of the above players in India amount to ~ 600 Lakh Liters Per Day (LLPD). Amul alone procures ~260 LLPD of the above pie. Nandhini (from Karnataka Milk Federation - KMF) procures ~ 60LLPD milk. Karnataka government provides ~5 rs./Liter subsidy to farmers supplying milk to Nandhini & hence no private players have been able to make inroads in Karnataka market for procurement. Mother Dairy is subsidiary of National Dairy Development Board & Avin is the Tamil Nadu Co-operative player. Avin procures ~30 LLPD milk whereas Mother Dairy procures a little more than that.
On the private side, Hatsun stands out with highest milk procurement of ~30LLPD milk. Heritage, Parag & Prabhat all procure anywhere between 10-15 LLPD milk. In case of Hatsun, the milk per farmer is much higher than say Heritage as both have ~3-3.5L farmers.
PRIVATE PLAYERS
Hatsun
Hatsun has largely focused on liquid milk, curd & ice cream products & has stayed away from capital inefficient VADP products like cheese, Paneer. Hatsun has strongest brands in categories they operate in like - Arokya (Liquid Milk), Arun (Ice-creams). They also have Ibaco brand for other products. There are some reports where Hatsun is able to charge 1Rs. more to end consumers & they pay 1Rs. more than rest of the industry to farmers. Hatsun has very little impact from the prices of SMP. Hatsun remains the strongest business in private sector side.
The sore points for me have been - high levels of debt & valuation. Also I don’t know if brand Arun, Arokya, Ibaco can travel pan-India.
I will end Hatsun section by quote from Mr. Chandramogan in recent Outlook Business Issue ->
"We are creepers, not aggressive go-getters. We are always considered a nuisance by established players who try to put up defenses & then give up".
Heritage
Heritage has largely followed the path of Hatsun with lesser intensity. In AP & Telangana, they have relationship with ~3L farmers but milk procurement is still at only 10-12LLPD compared to 30LLPD of Hatsun. This might be because of lower productivity in AP/TS or other players also have good share of the pie. I need to work out this detail. Heritage has also largely focused on liquid milk & capital efficient VADP products (22% share). Heritage make losses in capital inefficient VADP products like Ghee, Butter compared to some other players. Heritage is a net SMP consuming company & not an exporting one.
I don’t know the strength of Brand Heritage & I am going to assume that it is not a lot. The company has been trying to re-invent brand Heritage but I find efforts to be rather average. The company has guided 6000Cr of sales & 40% share of VADP by 2022. Heritage manufactures the curd for Nestle.
As it is clear in this business, density is priceless. So, I don’t know how the strategy of the Heritage to go to select markets of Mumbai, Punjab/Haryana/Delhi with acquisition of Reliance Dairy are going to work out.
Heritage has 3.75% share in Future Retail & how they use this capital remains a key moniterable. They have created JV with French major Novandie for VADP products. They have also created a new ice-cream brand Alpenvie.
The management of Heritage has strong political connections & how they drive business also remains another key moniterable. The record of wealth creation of past 25 years is very good & I hope it remains that way.
Prabhat
Prabhat is Srirampur & Pune based dairy player who started out with major focus on institutional sales (Modelez etc.). The capital ratios of Prabhat have been poor & now they are starting to look at B2C business with introduction of products in liquid milk, curd etc. They aim to be a regional brand in near future with 50% sales contribution from B2C by FY20. Prabhat has third largest cheese processing capacity after Amul & Parag.
Parag
Parag is Pune (Manchar) based dairy player who has focused aggressively on VADP products. I think VADP forms ~70% of the Parag’s product mix with Cheese/Paneer being major constituent. Parag is also only player who has tried corporate dairy through its subsidiary Bhagyalaxmi. Parag has also introduced new product categories like whey protein in India.
Both Parag & Prabhat do not have strong procurement networks like Hatsun. They have both have relationships with ~2L farmers & procure ~10LLPD milk. I think 10-30% of the milk procured by these guys is from agents, middlemen. Also, I am not sure about the connect these guys have with farmer community & may be vulnerable to co-operatives/Hatsun kind of player taking over their procurement network.
With this framework, I will just put few more interesting points I found post Q1 results ->
- The impact of price crash in SMP is probably highest on co-operatives like Amul, Nandhini.
- The milk procurement price for Maharashtra based players have been in the range of 20-25 Vs. 32 for Heritage. There is a lot of excess supply of milk in MH & hence the link crisis. To control this, some state support has been announced in following ways -
One, 20% export incentive to export SMP by central government, Amul is being offered 50Rs./Kg subsidy by Gujarat government.
Two, MH government has fixed minimum procurement price of milk at 25Rs./Liter & has announced 5Rs./Liter incentive for producing VADP products for 3 months. - Ghee, butter, cream prices have crashed by 20% in Q1 FY19.
- Parag refused to divulge the inventory value of SMP stock in Q1 FY19 & said that they did not incur much loss from SMP.
- Heritage is starting 1LLPD UHT plant & Parag also claims to have this capability. UHT milk can last for 90-120 days if packaging is not opened. I am yet to figure out the capital efficiency of this move. My guess is - this might be better than converting milk into SMP or going to capital inefficient VADP products.
- The regulatory risk of price control can not be ruled out completely.
Disc - I hold tracking quantity in Heritage, Hatsun, no investments in the rest. This is not a buy/sell recommendation. Investors are advised to do their own due diligence. I am not a SEBI registered analyst.