Description

Parag is an Indian dairy company that focuses mostly on value added products unlike its competitors. The company has been investing in building its brand and distribution channel which has placed itself in a good spot to take advantage of the structural growth in the product segment. The stock is trading at a discount to its peers despite having better growth prospects. I believe there is a 65% upside potential as stock should rerate over the next few quarters.

Industry dynamics:

India is the #1 dairy producer globally, but the industry is highly fragmented and mostly unorganized. India produces about 170mn tons of milk per year and is around $105bn industry. Of this the organized sector is just about 15% since the rest is either self-consumed or sold in the unorganized market. Within the organized space, dairy cooperatives control about 50% of the market implying the remaining available market for the private players is about $8bn. Within the dairy industry sales, about two-thirds of the volume is fresh liquid milk (not UHT) and the remaining is value-added portfolio (VAP). VAP products can be further split into Traditional and Emerging. Traditional VAP products include ghee (clarified butter), paneer (similar to cottage cheese) and curds which form about 32% of the volume share, and emerging products like cheese, whey, UHT and flavored milk forms the remaining ~2%.

India has a big vegetarian population that is dependent on dairy products for their primary source of protein. Despite this, the per capital consumption of dairy is much lower compared to other developed countries (Indians consume about 97 liters per year compared to about 280 liters per year in the US and EU, and about 155 liters in Brazil). There are several structural changes that are happening within the dairy industry in India: i) shift from unorganized to the organized sector, ii) increase in VAP product consumption. This is because the per capital income is increasing and consumers are focused on convenience and quality. Industry experts (IMARC and Euromonitor) believe that the organized dairy market can grow at 20% CAGR for the next few years. Within the dairy, traditional VAP segment can grow at ~20% and Emerging VAP can grow at ~25% CAGR.

From a competitive dynamic perspective, the private players operate on a regional basis and there are no real pan-India players, except for Amul (cooperative organization; not listed). Private players mostly operate close to their milk procurement region because the dairy products offered have low shelf life and transportation can be expensive. Companies like Parag are increasing their VAP basket which can make them a pan-India operator. In India, the fresh milk business has very high ROIC – margins are very thin but the capex required is low and asset turnover is very high, which gives about 40% returns. On the other hand, VAP segment have higher margins but lower returns since they are capital intensive and have lower asset turnover. This is one of reason why the private players have not made a push into the VAP segment. Parag is looking to play the long game by making the initial investments and trying to solidify its presence in the VAP segment, so that it can benefit from the long-term structural growth of the segment.  

Quick Company overview:

Parag has been operating in the industry for over 25years; mostly in the west (Maharashtra state is about 85% of sales). Company currently processes about 1.3mn liters of milk on a daily basis. About 68% of revenues come from VAP, 20% from fresh milk and 13% from skimmed milk powder. Company has 3 processing plants (including 1 plant in Sonipat in north India which it acquired from Danone and has just started operations). Retail (b2c) and institutional (b2b) sales split is about 67/33%. Cheese is sold to institutional clients like Yum brands and Domino’s Pizza. Whey powder is mostly sold to institutional clients like Nestle India and UHT Beverage factory. Company claims to be procuring 95% of the milk directly from the farmers through its integrated supply chain over the years.

Investment thesis:

Company has the one of best value-added product portfolio in the Indian dairy industry. Revenue contribution from VAP basket as increased from 56 % in 2014 to 66% in FY18 and is expected to be ~70% in next 1-2years. Company has taken bold steps and invested substantial capital to develop the VAP basket in India over the last decade.

• Started cheese in 2008, UHT and premium milk in 2010/11, B2B whey protein in 2014, juice drink and consumer whey protein in 2017.
• Company has successfully built strong brands like Gowardhan (fresh milk, ghee, paneer), Go (cheese products, UHT milk), Pride Of Cows (premium milk), and Avvatar (Whey powder; recent initiation) which are well recognized and some sell at a premium to competition (Cheese and Ghee sell at about 5% premium to major peers).
• Company is now #2 in Cheese with ~35% market share; contributes to 20-22% to its total revenues. Ghee (clarified butter) contributes another 20-22%; here the company has been able to build pan-India premium brand
• Company has a dairy farm of 2000+ Holstein cows that offer premium milk which is sold at 2x the normal milk price. While the product contributes to less than 3% of revenues, the company has been able to build a brand around this

Potential opportunity for growth is huge. The company should comfortably be able to grow its topline at 15%+ CAGR for the next several years.

• The structural shift from unorganized to organized dairy and shift from fresh milk to VAP products will continue, increasing the demand for dairy products for organized players like Parag. Additionally, increasing per capital income, urbanization, and consumer preference for better quality and convenience will drive segment growth.  
• Emerging VAP products like Cheese and Whey powder are expected to see fastest growth rate. Currently less than 1% of the milk procured is used to cheese given the low penetration. Similarly, retail whey powder segment is expected to grow at 25-30% cagr due to the low base effect. Company had been supplying whey mostly to institutional clients until last year; In 2017 Company launched whey powder for the retail segment. Consumer whey commands about 10x more realization and margins are around 45% (highest in the dairy products). Currently whey contributes about 3% of total revenue (almost 100% from B2B) but is expected to increase 3-4x in next 3-4 years mainly due to the consumer whey growth. This will boost topline as well as margins.  

Valuation is attractive and trading below peers – I see upside potential from rerating of the stock. Parag is currently trading at 19x LTM earnings. Peers like Heritage and Hatsun are trading at 31x and 100x LTM earnings.

• Some of market concerns include i) Parag’s business model of high VAP product and low fresh dairy is different from traditional players like Heritage and Hatsun, which have much longer trading history, ii) most of Parag’s new product and product segments have been in the market for less than 5 years, iii) currently, most of the sales come from 1 state, and iv) high working capital compared to other dairy peers
• Working capital issue: Working capital for Parag was about 75days or ~20% of revenues in FY18. This is compared to the average working capital cycle of 15-20 days for Heritage and Hatsun. The key difference in the working capital is due to the revenue contribution VAP products. Most of Parag’s peers are highly dependent on fresh milk and other low inventory day products where the working capital cycle is very low. In the case of Parag, since it is dependent on products like Cheese that has (3-6months of gestation period) low inventory turnover. On the other hand, payables were around 80 days as compared to ~15days for peers. According to the company, this is because i) its payables to farmers can range from 15-30days (unlike 10-15days for peers), ii) it sources fat directly from institutional players (instead of purchasing milk and converting into ghee/butter), which affords them higher payable days, and iii) higher percentage of packaging and materials requirement due to VAP products. In addition to the management’s justification, I believe that the company procures a much higher percentage of milk from third-parties (not 95% directly from farmers as per the management) which allows it to have higher payable days. In spite of all the explanations, I find that the working capital cycle is high and a genuine concern. Despite this, I like that the management acknowledges the problem and the company has been working to get this under control. The company has hired Vector Consulting (a well know domestic consulting firm) to improve its backend and frontend supply-chain and distribution reach to reduce its working capital and improve the freshness of its products.
• I believe that the company should rerate to 25x FY20 earnings ($19mn consensus) in the next 1 year, implying stock price of about Rs 400 per share or approx. 65% appreciation. For the rerating to happen, company will need to demonstrate a few more quarters of steady growth, margin improvement and reduction in working capital.  

Risks:

The stock isn’t without any risks. I cannot give the corporate governance a clean chit given the limited trading history. When investing in Indian stocks, one needs to be overly cautious about the promoters. Given the limited trading history one cannot with certainty say how the promoters will treat the minority shareholders. The promoters previously had some income tax violation cases against them. Currently the promoters own 43.5% of the shares outstanding and about 5.6mn or 14.5% of the shares outstanding have been pledged by the promoters according to the last filings.

Catalyst

company will need to demonstrate a few more quarters of steady growth, margin improvement and reduction in working capital.