Understanding the milk business
Demand & Supply - Demand likely to outstrip supply: Dairy is a fundamental part of the Indian diet, with the average Indian household spending 22% of its food and beverage budget on milk and milk products! Supply on the other hand has been growing at a slow rate, with milch animals growing at a 2.2% CAGR, and yield growing at a 1.7% CAGR.
Government intervention - Favour cooperatives, against imports: The high dependence of small milch farmers on milk as a source of livelihood has led to the government having strict controls over milk powder imports, with imports at just 0.07% of our production. Some states incentivize cooperatives with subsidies of Rs4-5 per litre, driving a stronger foothold of firms like Amul (Gujarat), Nandini (Karnataka), Vijaya (Andhra Pradesh) and Aavin (Tamil Nadu).
Market Structure - Fragmented & Localized: India has amongst the most fragmented dairy markets in the world. Around 35% of the milk produced is used for self consumption. The rest is divided between traditional milkmen 10%, unorganized dairy 33%, and organized dairy 22%. Customer preference is likely to drive a slightly higher rate vs unorganized. With a weak cold chain and high contribution of the low margin liquid milk keeps the market fairly localized - companies therefore compete largely with players in their geography.
Business Mix: Dominated by liquid milk, moving towards premiumization: Liquid milk (currently 67% of sales) has a razor thin EBITDA margin of 4-6%, and is expected to grow mid single digits going forward. Value added products are likely to grow at a much higher rate driven by consumer capability and need - driving their part of the mix up from 33% in FY15 to 42% by FY25.
Sourcing - Relationship with dairy farmers critical: Given the highly competitive environment, having a strong procurement network becomes critical. Firms attempt to do this by having a multi-pronged relationship with the milk farmers - partnering with them on everything from feed, to veterinarian services, to financing for cattle and having a quick and transparent payment methodology. The breadth and depth of the relationship with procurement partners serves as a competitive edge. Firms can also procure milk form third party suppliers - although the objective is generally to maximize farmer procurement. Firms also provide farmers incremental support in low demand seasons by continuing to absorb milk supply and convert it to milk powder for use in peak season.
Processing: Processing facilities are classified into two broad categories - liquid milk processing and value added product manufacturing. The market has been consolidating with smaller players being priced out of the market that allows larger players to acquire capital assets at a lower rate. The high volume low price nature of milk makes sure that the processing facilities are generally in the same regions as the procurement units.
Distribution: Firms can reach customers via own Retail Parlours, generally operated on a franchise model, but generally reach customers door to door via milk and milk product distributors & agents. As a daily recurring use item, the second model helps with reach, while the branded franchise stores help with brand and value added product sales.
How do you analyze a dairy business: Doing business in a competitive commoditized space is always tough. We believe the following factors will help the winning businesses in the industry- 1. Strength of relationship with farmers - Reduces the threat of a new entrant and gives you more control over product quality. 2. Asset efficiency- Being able to set up and acquire capital assets at lower rates, and use them optimally will be a key driver of returns in a low margin dairy business.
3. Strength of brand & fridge space- Strong brands will be able to sell more of their value added products and get share of the limited fridge space at the retail touch points.
With the context set, let's dig deeper into the business of Dodla, and see how they have been doing on the parameters we wanted.
Analyzing Dodla's business
Strong procurement moat: The firm has a strong procurement network of 10.3 lakh litres that they acquire from 109,670 farmers from 6,771 village level collection centers. The relationships with the farmers are multi-pronged where they work with small regional MFIs to help farmers with cattle financing, work with local vets for the cattle, and provide their own cattle feed brand. This is quite a sticky relationship, and the firm is increasingly working towards 100% direct procurement (currently at 94%).
Modest processing and distribution network: They've been growing processing capacity at a 14% and currently have 13 processing plants with 1.70 MLPD capacity. These plants have a vary level of capacity (0.02 MLPD to 0.26 MLPD) and utilization (9% to 105%). There tends to be a natural mismatch in the demand (higher in summer months when heat drives milk and milk product demand) and supply (higher in rains when cows have better foliage) which necessitates a buffer in terms of capacity. The firm also manages the winter surplus by converting it into milk powder (25,000kg capacity) in their TN and AP plants. The firm also has a decent distribution network with 861 milk distributors, 3,285 distribution agents and 393 Dodla Retail Parlours. The firm has been ramping up advertisement spend from 64cr to 111cr FY 18-20, as it attempts to strength its currently weaker brand, and drive footfall to its retail parlours. These parlours will be in low cost residential areas, and will also double down as a distribution center for the online delivery players.
Extremely efficiently run business: In terms of asset efficiency they run one of the most efficient businesses in the sector with an asset turnover of 4.4x (more than twice of large competitors vs Hatsun at 2.1x and Heritage at 2.0x) and tight working capital cycle (11 days, vs heritage at 13 days and Hatsun at 27 days). The business therefore generates a decent ROCE of 17%, substantially above its dairy competitors.
Focussed value added business growth: The firm has been focussed on the curd business in its value added products, adding gradually to the others - paneer, icecream et al. The short working capital cycle driven by the faster turnaround in curd, as well as the higher margins in the curd business makes it an attractive long term proposition.
Concentrated in highly competitive markets: The business is concentrated largely in the southern states of Telangana (3% market share), Andhra Pradesh (11% market share), Karnataka (9% market share), Tamil Nadu (4% market share) and Maharashtra. Like the rest of India all of these markets are extremely competitive, with large incumbents (sometimes politically backed), state backed cooperates, and eager new entrants. This does add a fair amount of concentration risk for the business, but is more a function of the industry vs Dodla.
Temporary margin benefit: The firm took a decent price hike from Rs 44.98 to Rs 48.79 post Covid expecting procurement prices to increase. However the procurement prices actually feel driven by depressed HORECA demand from Rs 32.98 to 31.26, driving a super-normal growth in profitability in 9M20. While the procurement costs will increase as demand normalizes, the price hike is likely to be sticky that will continue to help the firm earn double digit margins. Given the superior operating efficiency that the firm has demonstrated, even working at the normalized margin levels should help them earn attractive returns on capital.
To buy or not to buy
This is a purely educational piece, and not intended as investment advice. Please consider the subsequent paragraph purely educational, and conduct your own diligence or consult an investment adviser for any investment decision.
It is always interesting to analyze businesses with some inherent volatility and cyclicity. To analyze these well, it is essential to separate the secular themes from the transient ones. Here are the factors that we think would persist - high asset efficiency and tight working capital management, growth of value added business in a calibrated manner, reasonably strong moat around procurement built via faster payment and multi-pronged relationships. On the transient side - we believe there has been a positive impact of COVID on margins (driven by cheaper procurement and a sharp price hike) offset by lower revenue due to loss of peak summer month sales. Adjusting for transient changes, we reach a 20x-22x PE multiple, which appears attractive given the fundamentals of the business.
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