We are a dahi company, not a dairy company,” insisted Jochen Ebert, the then managing director of Danone Foods & Beverages India in 2014, pointing out how his company differed from other dairy players in India. Four years later, the ‘dahi’ company is exiting India. The world’s largest player in yogurt, Danone thought it could tap the needs of working women for hassle-free, ready-made curd. The French company was, however, missing one key ingredient in its product portfolio — one that Ebert himself flagged as a differentiator — liquid milk.
Liquid milk or pouch milk is an important ingredient for dairy companies in India as it not only provides scale but also helps build brand equity. The latter can then be leveraged to drive other value-added products such as curd, buttermilk, cheese, butter etc that have higher margins.
To be fair to Danone, setting up a dairy business in India is tricky. Compared to the West, which has large dairy farms, India has several small dairy farmers. One needs to aggregate these farmers to ensure regular milk supply and procurement. In the first five years of its operations, Danone India procured milk from a third party vendor, Schrieber Dynamix Dairy’s facility in Baramati. However, it failed to make deeper inroads into the Indian dairy market.
While the dairy business accounts for nearly half of Danone’s €25 billion global turnover, it contributed just 10% to Danone India’s FY17 revenue of 707 crore. It was hardly surprising that the French major decided to switch completely to nutrition products that made up 90% of its turnover here.
If Danone got it wrong and exited, home-grown dairy players have spent years building a strong procurement network, and, in turn, brand equity through liquid milk. Consider Parag Milk Foods. It started operations in 1992 in Manchar near Pune, selling liquid milk in areas around Mumbai and Pune besides exporting skimmed milk powder. Parag’s procurement network today spans 200,000 farmers across 29 districts of Maharashtra, Andhra Pradesh, Karnataka and Tamil Nadu, meeting 80% of its overall needs.
Hyderabad-based Heritage is a step ahead, sourcing 95% of its milk requirement from 300,000 farmers across eight states. Chennai-based Hatsun Agro procures milk directly from 380,000 farmers across India. Prabhat Dairy, which has its roots in Shrirampur near Shirdi, buys milk from 85,000 farmers to meet 70% of its requirement (see: Direct benefit).
Direct procurement from farmers helps in controlling costs as well as working capital. “Procuring from middlemen or third party vendors adds to costs as agents on average charge 0.7 per litre. As more milk is directly procured from farmers, the dairy companies’ cost structure improves,” says Tejashwini Kumari, analyst, IIFL.
While the ability to procure directly from farmers gives dairy companies a competitive edge, getting the product mix right helps balance growth and profitability. Fundamentals of dairy companies are, in fact, heavily influenced by what they are offering and to whom. For instance, Parag, which gets 66% of its revenue from value-added products, has one of the highest gross margins in the industry at 27%. While Hatsun’s revenue share from value-added products is lower than 35%, its gross margins are at par with Parag at 27%. For Heritage, revenue from value-added products stands at 24% with gross margin at 21%.
However, on account of a largely B2B business, Prabhat makes among the lowest gross margins (20%) in the industry. This, despite 85% of its revenue coming from value-added products. The focus on B2B also translates to lower return ratios for the company. In FY17, the company’s ROE stood at 7%.
Cognisant of this issue, the management is now eyeing the B2C segment, which contributes 30% to the topline currently, to account for at least 50% of revenue by FY20. According to Vivek Nirmal, joint managing director, Prabhat Dairy, as the share of B2C revenue increases, the return ratios will also improve. Prabhat wants to transition into the B2C space with traditional value-added products like curd and buttermilk. “These products not only offer healthy margins (30-33%) but also have relatively shorter working capital cycle compared to other value-added products,” Nirmal adds.
For instance, even though cheese has a slightly higher margin (30-34%), it has a longer working capital cycle as cheese needs to be aged (see: Delicious mix). Prabhat though is optimistic about the cheese consumption story in India. It plans to introduce cheese products in the B2C format over the next two years. With manufacturing capacity of 30 MT/day, the company’s cheese plant is third largest behind Amul and Parag and contributes 24 crore to the overall business.
As of now, its cheese business is completely dependent on institutional sales. The Horeca segment (Hotels, Restaurant and Catering) accounts for 60% of cheese and paneer sales, while the QSR segment accounts for the balance 40%. The current capacity utilisation at the recently set-up cheese plant stands at 20%. The management is also looking at raising the capacity utilisation from 20% to 80% by FY20. At full utilisation, it claims the cheese unit could become a 350-crore-business.
With changes afoot, Prabhat’s revenue is expected to grow at 14.2% CAGR and net profit at 54.4% CAGR over FY17-20. Analysts reckon that Prabhat presents an attractive opportunity as it is still at a very early stage of its evolution towards a B2C model. Currently, Prabhat trades at 10x its FY20 estimated earnings. “Even though Prabhat has lower gross margin, it still has among the highest operating margins compared to the other listed dairy names. That is because it has a pricing understanding with its B2B clients that allows it to pass on the rise in milk prices to its clients,” says Kumari. Prabhat’s Ebitda margin stood at 9% in FY17.
Unlike Prabhat Dairy, RG Chandramogan-led Hatsun Agro has steered clear of the B2B segment from the beginning, building a strong B2C business instead. Depending solely on the B2B segment, he says, is not feasible due to lower margins and higher credit component in transactions.
As a leading player in segments where the cash conversion cycle is fast, Hatsun’s return ratio is the highest in the industry (ROE of 46% in FY17). The company has 14% market share in curd and milk – both with short working capital – in South India. Moreover with market share of 60%, Hatsun’s Arun brand is the market leader in the ice-cream space in the South. Gross margins in the ice-cream business (45%-50%) are even higher than that of curd.
Yet the Hatsun CMD reiterates the importance of building a strong milk brand. “People consider pouch milk as a commodity. But, branded milk is a value-added product by itself. Try convincing a housewife to change her milk brand, it is quite unlikely that she will switch to another brand. We have used our milk distribution channels to sell curd and other fresh dairy products. This has kept our distribution costs low. For ice-creams, we have built a separate cold storage distribution network.” Over the past five years, Hatsun’s topline has grown at 21.23% CAGR, while profit has grown at 38.6% CAGR. Starting from the southern state of Tamil Nadu, Hatsun has scaled up its business, expanding into different states – Kerala, Telangana, Andhra Pradesh and Karnataka. Maharashtra, which shares its border with Karnataka, is the next port of call for Hatsun.
If investor sentiment is anything to go by, Hatsun has got it all figured out. At 47.53x its FY20 earning estimates, the scrip’s premium is the highest in the dairy industry. Analysts reckon that a fresh dairy products company like Hatsun is comparable to a FMCG player with strong brands, growth and superior ROCE. Over FY17-20, Hatsun’s topline is expected to grow at 18% CAGR and profit at 23% CAGR. To fuel the growth, the company is incurring 850 crore on capex over FY18 and FY19.
Heritage’s story is somewhat similar to Hatsun. Heritage derives 65% of its sales from the high-ROCE milk segment. It further plans to increase its sales in high margin fresh dairy value-added products such as curd, which will sustain its high return ratios (FY17 ROE: 25%). Heritage also has a strong B2C franchise, with more than 90% of its sales coming from the segment.
The company aims to increase the share of value-added products in its topline to 40% from the present 24%. “As the pie of value-added products in the overall revenue grows, the overall margins will rise along with the capacity to absorb fluctuations in milk prices,” says Nara Brahmani, executive director, Heritage Foods.
Milk price fluctuations have been a cause of worry for dairy players. “Over the past two years, private dairy companies did well as prices of milk saw a sharp fall. However, these prices are not sustainable as the cost of production is higher for the farmers. Going ahead, farmers won’t be willing to produce at these prices. As they cut their supply, milk prices will eventually move to sustainable levels,” says RS Sodhi, managing director, GCMMF.
This is where value-added products can act as a buffer against any margin erosion in pouch milk. Besides curd, Heritage has entered into a JV with French dairy company Novandie to launch flavoured yogurt and English desserts in India. The firm already sells value-added products such as flavoured milk, curd, butter milk, frozen dessert and ice-cream. Shradha Sheth, analyst, Edelweiss Capital says that the strategy of combining high ROCE pouch milk segment with high-growth and high-margin curd, yogurt and ice-cream segments (2x Ebitda margins vs liquid milk) will yield dividends in the longer run (see: Where’s the crème?).
Heritage has also set an ambitious target of reaching 6,000 crore topline by FY22 (2,642 crore in FY17). Accordingly, the company is looking to expand its presence beyond its home state of Andhra Pradesh. In April 2017, Heritage completed the acquisition of Reliance Retail’s dairy business. “The acquisition has given us a good foothold in Delhi, Punjab, Haryana, Rajasthan and Himachal Pradesh. It also gives us access to additional 200,000 litres of milk per day, increasing our handling to 1.4 million litres across 15 states,” says Brahmani. While Reliance Dairy’s ‘Dairy Life’ and ‘Dairy Pure’ would continue to operate as standalone brands, the company is seeing traction for milk and value-added products too. “We have also entered the Western markets by acquiring a small dairy near Pune and will be growing organically in the region.”
While there is little room for re-rating for the richly-valued Hatsun, analysts reckon Heritage, too, should trade at 30x FY20 estimated earnings from the current 50x. Over the past five years, it has seen its topline grow at 13.65% CAGR, while profit has grown at 48.33% CAGR. Over FY17-20, analysts estimate Heritage’s topline to grow at 8% CAGR and profit at 17.4% CAGR.
Within the mid-sized players —Parag and Prabhat — the former has a well-established set of brands in both liquid milk and value-added products. Besides focusing on the traditional value-added products like curd through its GO brand, Parag is also focusing on emerging value-added products like cheese under the same brand name.
In fact, it has been the most aggressive player. Anticipating a huge demand for cheese from QSR and hotels and restaurants, Parag set up India’s second largest cheese plant in 2008. The plant doubled Parag’s cheese manufacturing capacity to 40 MT/day. After entering the cheese market much before other private dairies, managing director Devendra Shah is now betting on protein foods. “The health and nutrition industry is growing at 25% CAGR and that is why we have launched ‘Avvataar’ a whey protein powder,” says Shah.
Moreover, along with large-sized dairy players, even Parag and Prabhat are working on a national footprint. Parag has been supplying to West and Southern markets through its operating facilities. To strengthen its presence in North, the company recently acquired Danone’s factory in Haryana. This will help Parag in distribution of milk, flavoured milk, buttermilk, curd, fresh paneer and yogurt in Delhi, National Capital Region and Haryana. It will reduce the factory-to-market distance in the North. Until now, Parag was supplying to the northern markets through its Pune plant. Prabhat is also talking about tapping tier-II and tier-III cities in North, East and Southern markets.
However, Amul’s Sodhi says that private dairy players run the risk of shrinking profitability by competing across markets. “There is no need to go pan-India. These players have strong presence in certain regions. By focusing on their core markets, these players can sustain sizeable market share,” he says. Shah though says that any pressure on profitability is only going to be short-term. “There is huge demand for dairy products across India and by staying in one’s own comfort zone; dairy companies would be putting limits on their own potential,” he adds. Parag is trading at 20x FY20 estimated earnings and over FY17-20 its topline is expected to grow at 14% CAGR, while net profit is expected to grow at 53% CAGR.
Indians’ love for dairy products show no signs of waning. Listed dairy companies are each at different stages of evolution and investors need to find the one suitable to their tastes to reap the rewards of the new-age white revolution.