Dairy: Everyone wants the cream! Insights on M&A

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The dairy sector is of strategic importance for a country like India as it not only serves as a source of livelihood to a number of farmers, but is also an important source of nutrition provider to the large population.

Of late, the dairy market has generated a lot of interest from Private Equity as well as the strategic investors. In this report, we have attempted to present an investment hypothesis to explore the growing potential of this industry. Our perspective is based on discussions with key industry players and secondary research.

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Dairy: Everyone wants the cream! Insights on M&A

  1. 1. Dairy: Everyone wants the cream! The local state cooperatives have been traditionally leading the liquid milk segment, though private players have given the cooperatives a run for their money by diversifying into value added products (VAP) i.e., curd/ yogurt, cheese, flavoured milk, ice cream, buttermilk and UHT milk (ultra high temperature treated milk which has a longer shelf life).The growth in value added products has also attracted major International Dairy players to explore the Indian market and has seen the entry of large international dairy companies . Of late, the dairy market has generated a lot of interest from Private Equity as well as the strategic investors. Some notable investments being IDFC-Parag, Rabo- Prabhat, Black River-Dodla and Carlyle- Tirumala which exited to Lactalis.3 Some of the factors which may have played a key role in generating investor interest in the sector include: • Large and scalable opportunity • Significant conversion happening from loose milk to packaged milk • High growth in value added products • High returns on capital employed (ROCE’s) • Margin levers through shift in product mix In the following section, we have attempted to present an investment hypothesis to explore the growing potential of this industry. Our perspective is based on discussions with key industry players and secondary research. Competition from State Cooperatives There is significant institutional support to the cooperative milk movement in India which allows them to subsidise farmers and control procurement. Even though the cooperative sector in structure is a farmer aggregated concept, election of politically affiliated representatives makes it political and populist in nature. Cooperatives in states such as Gujarat and Karnataka dominate milk procurement, set the MRP and control the market share. On the contrary, Uttar Pradesh, ranked foremost in production, has the least influence on the cooperative sector, while Maharashtra andTamil Nadu are milk rich states with equal presence of the private and cooperative sectors.4 One may need to estimate the strength of the cooperative in each state of operation independently and build sensitivities in projecting milk procurement costs. Product mix and diversification plans Pouch milk which dominates the product portfolio of the Indian dairy companies yields lower margins in the range of 5-7 per cent.5 However, the overall product mix is changing rapidly in favour ofVAP which is also pushing up the margin profile to double digits.Therefore, a business that can propel growth throughVAP is likely to give higher returns. Challenge of local procurement Prohibitive freight costs often require one to source locally in order to achieve scale in each market.There are examples of companies backward integrating into dairy farms, however, usually due to the highly fragmented farmer base, procurement agents are a reality in this business. The dairy company may need to set up a reliable procurement agent network and should be able to manage seasonal fluctuations of supply. It should have the ability to expand and contract procurement during lean and flush seasons respectively. In addition, to maintain a consistent base of suppliers of unadulterated milk, some companies have started setting up own collection centres and providing additional services such as free veterinary services, subsidised cattle feed, cattle financing, insurance, etc. which is essentially a cost of doing business. Additionally, transparency in payment terms based on milk quality and timely payment have been key factors in maintaining a strong supplier base. A reliable procurement base, with effective quality checks and transparency in operations are important considerations to evaluate. 1. Times of India, July 25, 2013 2. Outlook Business magazine, Dec 21, 2013 3. Deal intelligence sourced fromVenture Intelligence 4. Industry discussions, KPMG analysis 5. Outlook Business magazine, Dec 21, 2013 India is the largest milk producer in the world1 with dairy products providing an important source of protein in the diet.The Indian dairy market is currently estimated to be USD 10 billion2 and is expected to more than double by 2020. Dairy is predominantly a regional business with the exception of a few large national and multinational private players who have managed to create a nation wide brand and outreach. INSIGHTS ON M&A KPMG IN INDIA © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.
  2. 2. Investment in Cold Chain Milk being a highly perishable product is dependent on temperature-regulated storage and transportation to maintain quality. Organised players are setting up village level bulk milk coolers and chilling plants to reduce wastage and improve the quality of milk. International players are investing substantially in this space, and therefore the inability to make the desired investments in the cold chain infrastructure may limit the local private players. Evaluating the quality of capex incurred and the time taken for the milk to reach the first chilling centre could be effective. Distribution and branding For the pouch milk, the dairy companies primarily operate through the distributor model along with small presence through franchisee stores which help in branding. One may need to improve the distributor network for increased market penetration given the challenge of fragmented consumption centres and perishable nature of the product.The economics for the distributor also depend on managing optimum volumes, given thin margins and zero credit period. ForVAP and UHT, one may also need to align with modern trade formats which can pose their own challenges. Consumer connect often plays a significant role, therefore, a private player may need to innovate in branding and distribution model to obtain a competing edge of the cooperatives, who are often traditionally weak on this front. It may be difficult to change brand loyalties in case of liquid milk, however, it is relatively easier in the case of VAP.The brand should be able to dominate certain markets where it has a stronghold and has the capability to scale up to leverage its regional procurement channels. Corporate governance and robust systems Procurement of milk and farmer liaison may involve exerting political influence which poses corporate governance challenges. Historically, diary companies did not have sophisticated ERP systems to track inventory and product wise margins. Product margin allocation is not straight forward due to the homogenised nature of processing and creation of by- products for which costing is not tracked. Companies, therefore, tend to rely on indicative estimates on historical product wise margins which need to be analysed carefully. Also, it is important to critique the company level strategy given the tendency to run the business basis aggregation of the regional profit and loss accounts. Role of the government in the dairy sector The dairy sector is of crucial importance to the government as it employs 90 million people6 and provides additional income to the farmers.The dairy sector is also important from the point of view of overall control on inflation. Both the central and the state governments have played a crucial role in the growth of this sector in India and in making India the largest producer of milk.The central government plays a crucial role in helping ensure growth of milk production in the country through a number of policy initiatives on animal husbandry, veterinary sciences and animal nutrition. In addition, as a tool for controlling inflation and protecting farmer’s interest, the central government. from time to time also take certain policy decision on imports and price regulations.The National Dairy Plan initiated in 2010 by the government has been another important step to help ensure growth of milk production. State governments also play a crucial role in the implementation of central government programmes, as well as managing the local animal husbandry. While on an overall basis, the state and central government are playing the role of enablers, it has been observed in the last few years that state governments have started to play an active role in milk price regulations which is likely not only putting pressures on the state co-operatives financials, but may also be impacting the profitability of the private sector which does not augur too well for the long term growth of the sector. Way forward The dairy sector is of strategic importance for a country like India as it not only serves as a source of livelihood to a number of farmers, but is also an important source of nutrition provider to the large population. Milk production in India over the last five years have grown in the range of 4 to 4.5 per cent,7 however the demand for milk and milk products is growing at a much faster rate thus putting increasing pressure on milk availability and pricing. Increase in the cost of fodder, medicines and services have also put significant pressure on the milk prices in the country. Government is undertaking a lot of initiatives under the National Dairy Plan to increase the production of milk in the country and the success of these initiatives would be important for growth of the sector. It would therefore be important for all the key stakeholders to attempt to ensure adequate availability of milk in the country, so that it does not impact our self sufficiency in the area. In summary, the sector has witnessed considerable interest, and with the expansion intoVAP and changing consumer lifestyles, it seems poised to continue on its growth trajectory. Further, the interest of international players and diversification plans of the domestic corporates seems to have created viable exit opportunities. Investors though, may need to place their bets carefully and evaluate the challenges around procurement, competition from state cooperatives, market penetration and brand strength. 6. Grain NGOWebsite Article: Defending People’s Milk in India 7. KPMG analysis, National Development Dairy Board
  3. 3. For more information on this article, please contact: Vikram Hosangady Partner and Head Transactions & Restructuring Co-Head -- Private Equity T: + 91 44 3914 5101 E: vhosangady@kpmg.com kpmg.com/in Nishesh Dalal Partner Transaction Services T: + 91 22 3090 2659 E: nishesh@kpmg.com The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG International. Printed in India. KPMG in India KPMG in India operates from 11 cities with a work force of over 8,000 employees led by over 200 partners.TheTransactions & Restructuring team comprising over 200 professionals is an advisor to a large client base which includes leading Indian companies, global corporations and private equity funds. OurTransaction Services team works with clients to assess and analyse proposed transactions, highlighting the value drivers, risks and opportunities in the deal.We have a track record of being involved in more than 300 transactions annually and have a leading market share in transaction advisory services.We provide due diligence support in, both pre-deal (financial, tax, commercial and operational, vendor assist, deal structuring) as well as post deal (integration planning, synergy assessment and post deal support) stages of a transaction. Our Corporate Finance professionals advise clients on fund raising, joint ventures, acquisition and divestment transactions. We advise clients in many forms, from analysing strategic options to assessing value, to structuring deals, conducting negotiations and helping secure the optimal terms for a successful closing. OurValuation Services team provides analyses of business interests, tangible and intangible assets. Our focus sectors include consumer and retail, logistics, industrial, insurance, banking and finance, food and agriculture, power, roads, transportation and ports. From raising or restructuring capital, to buying or selling a business, to making strategic and policy decisions based on value, we strive to provide objective advice to our clients, challenge conventional wisdom and employ creativity and skill in devising and executing a favorable outcome. ‘Insights on M&A’ is a Point ofView series that covers current trends and themes relevant to the prospect of M&A in India. Contributors to this article from KPMG in India: Amit Bhandari, Associate Director,Transaction Services; Reshma Pai, Associate Director,Transactions & Restructuring

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