heritage food

Heritage Foods (India) Ltd (HFL) is one of South India's leading privatesector milk processing and distribution companies. Hyderabad based HFL ispromoted by Mr. Chandrababu Naidu and family. It has got presence in southIndia's three leading states i.e. Andhra Pradesh, Tamil Nadu and Karnataka.It derives its turnover from large cities in Andhra (42%), Tamil Nadu (28%)and Karnataka (30%).*Industry Outlook: -*Incidentally, in India, only 15% milk is processed in factories for liquidmilk and milk production otherwise most of the milk comes from unorganizedsector (which sells loose and often adulterated milk). But, this scenario isexpected to be changed sooner then later amidst changing demographiccondition. Global consumption pattern shows that as income increases, theconsumption of protein foods increases. India is no exception. As per theICRA report, increasing income always accompanied by a change in the foodbasket.The growth of disposable income, change in family structure, focus onhealthy, nutritious and quality products are likely to result in demand fora shift towards branded safe and quality dairy products. Growing demand ofDiet milk, Fortified milk and other such niche categories are example of it.The projected demand for milk and milk products in 2020 is expected toincrease more than five times to 289 mn tones from 52 mn tones in 1993. Sourban India is going to be effective market for branded and healthy milk andrelated products. Currently nearly 50% of total milk produced is beingconsumed by urban India. The expected rise in urban population (it isestimated to grow by 85 million over the next 10 years, the second highestin the world) and the amplification of the affluent & upper middle levelgroups would be a windfall to Indian dairying.*Diversifying into Food Retailing and Infrastructure Development: -*It has recently announced its intention of foraying into retail business forfood processing products. Here the company will not only market only its ownproducts but also that of other food processing companies. It decided toappoint KSA Technopak (India) Pvt Ltd, a Curt Salmon Associates jointventure, as consultants for the proposed processed food products retailbusiness. KSA has to its credit successful experience of working withleading FMCG majors such as ITC and HLL. At present, three teams of KSA areworking out details on procurement, technology and logistics for foodproducts retailing. I expect the final report of KSA on the business modelto be ready by March-end. I expect once the retail foray takes shape,company growth from this segment will spur the revenue and valuations.Further the company also proposed to gain from the booming infrastructureindustry using its current networth towards taking up of projects in the BOTmodel. It has recently Floated an infrastructure company – Heritage InfraDevelopers Ltd, wherein the company would hold 51% equity. The company hasplots of land in Hyderabad, Chennai and other cities. It will developcommercial and residential flats on these plots. Also, this new subsidiaryis expected to participate in government infrastructure projects. The paidup capital of this company will be Rs. 90 mn. It will pay 6 to 7 mn toacquire 51% stake in this company. This will be a one time funding activityand further free cash flows of Heritage food will not be deployed to fundthe expansion activities of this infrastructure company.*Future Outlook: -*HFIL's future growth would be driven by increasing consumption of milk, gainin market share from unorganized sector (which sells loose and oftenadulterated milk), entry into new cities and higher sales of value addedproducts such as ghee, Curd, Paneer, Cream etc.On the back of better monsoon this year the raw milk prices (accountsfor 79-81% of total operating expenditure) have fallen by approximately 10%in all three states in which the company operates. This is quite visible inthe Nine Month operating margins, which are at 8.15% compared to 7.8% of theFY05. For the nine month ended December'05, the turnover has increased by 9%YOY while PAT has increased by 42.75%, jumped to Rs.9.85 Cr.*Valuations: -**At CMP of Rs.175, it is selling at just 8.33x its expected FY07 earnings ofRs.21, which is very low for the company which has maintained CAGR of 41% insales and 39% in net profits since inception and average RoE of over 25%during the same period*. In its core business, company expects its volume togrow 15-20% going forward on the back of venturing into new states likeKerala and also by increasing its market share into existing states byopening more plants and distribution centers. *Diversifying intoinfrastructure development & processed food products retailing would lead tode-risking of revenues and company's earning will be on high growthtrajectory than what has observed so far from its core business, hencegoing forward HFL is ideal case for PE re-rating. I think Re-rating wouldhappen someday or other.****Also, in terms of Market cap/Sales ratio, its valuation is ridiculouslycheap. The company is available at a market cap of around Rs.165Cr. It isselling at Mcap/ Sales ratio of 0.57 for its FY06 sales of Rs.287.1Cr.Taking into consideration past return ratios up to 2004; it has potential toachieve Mcap/ Sales of 1.3 to 1.5 which is benchmark for commodity playersin normal times. Even if we give 1 time Mcap/ Sales over FY06 sales, HFL isavailable at very cheap and attractive valuations.* *I feelthat the Heritage Foods's Share price would Outperformer broad market rally.****Concerns: -***The dairy business is susceptible to seasonal fluctuation. Drought in theprocurement area leads to shortage of milk outputs, this in turn impacts thequantity of milk a company can procure process & sell. Also, the liquid milkbusiness is not capital intensive and there very few entry barriers forkeeping out new entrants. So, going forward, higher competition level mayimpact company's growth and profitability. However, we are confident onHFL's business model amidst its latest initiatives of entering intoretailing of high margin, value added packaged milk products andinfrastructure development activity. We also feel that the company isuniquely positioned to capture growth in existing states as well as newstate such as Kerala.