Hatsun Agro Products (NSE: HATSUN, BSE: 531531) is based in South India and was incorporated in 1970. Hatsun is the largest private sector dairy company in India. The company’s brands include AROKYA, which offers fresh milk; Hatsun, which offers paneer, ghee, extra cooked ghee, Skim milk powder (SMP) and dairy whitener; Arun Ice creams (an ice-cream brand); IBACO ice creams (premium ice-creams), OYALO (pizza) and Santosa, which offers cattle feeds.

Indian Milk Industry

India is the world’s largest milk producing nation. Unlike in developed nations, milk production in India is dominated by marginal farmers and landless labourers owning 1-2 animals each and using manual means for dairy farming. Milk productivity of cattle and buffaloes in India is still only 1/8th of the global average. Land prices in India are very high, which makes running large dairy farms unviable. So, dairy farming will continue to be dominated by small and marginal farmers for the foreseeable future.

Estimates from National Dairy Development Board (NDDB) suggest that only 52% of milk production is marketable as ~48% is self-consumed by dairy farmers. National Sample Survey Office (NSSO) data suggests that ~92% of a rural household’s milk spends are on liquid milk. The proportion of liquid milk in total milk spends has remained flat over the last 20 years, indicating the resilience of this product in the dairy consumption basket. Similarly, for an urban household the proportion of spends on liquid milk out of total spends on milk products have remained constant at ~86% over the last 20 years with spends on other products also being almost constant. It is only over 2010-12 that the proportion of milk spends on value-added dairy products has increased both in the urban and rural areas.

While there aren’t exact estimates of refrigerator penetration in India, various sources suggest the penetration is 10-20%. The penetration levels are particularly low (1-2%) in rural India. The refrigerator penetration is low in households as well at retail level. The need for refrigeration is particularly critical in a tropical country like India. The long-life Ultra Heat Temperature (UHT) dairy products which do not need refrigeration are more expensive than the normal dairy products. This has also been one of the reasons for milk consumption being limited to liquid milk, which then is converted to ghee to prolong its shelf life without the need for refrigeration.

What makes Hatsun Agro Product stand out?

Access to quality milk is needed to produce fresh and value-added dairy products. Due to the highly perishable nature of milk, timely marketing and distribution are equally important to sell maximum products without losses. Hence, milk procurement and marketing are the two key drivers of competitive advantage for a vertically integrated dairy business. However, quality has been an issue when it comes to direct procurement from agents / vendors. Hence, dairy companies prefer to procure milk directly from farmers. Direct milk procurement network needs to be built gradually by gaining the farmer’s trust.

Every private dairy company has established a dominant market share in its home region of operations but finds it difficult to enter new regions. As private dairy companies look to focus on the B2C segment, they will have to set up their own milk procurement networks to procure quality milk.

Hatsun has over 10,000 milk banks covering over 13,000 villages. Milk is procured from around 3.2 lakh farmers. The company operates about 1,100 rural milk procurement routes. A new and advanced process of procuring and chilling the milk at the village level using ABC (Active Bulk Cooler) has been introduced in 400 plus locations.

Company	Daily milk procurement (million LPD)	% milk procured directly	Diversification of procurement base
Hatsun Agro	2.82	~100	70-75% from Tamil Nadu; 25-30% from 4 other states in South India
Heritage	1.38	~100	60-65% from Andhra Pradesh; 35-40% from 5 other states in South India
Parag Milk Foods	1.40	~100	85% Maharashtra

Given the ability it has exhibited in the past in expanding its network beyond its home state, we believe Hatsun can grow its direct milk procurement ahead of peers.

The highly perishable nature of liquid milk and the fact that 85% of milk is water makes transporting liquid milk over large distances not viable economically. As a result, the pouch milk market is dominated by regional private or co-operative dairy companies procuring milk from adjacent areas. Sizable presence in one region can be leveraged to enter adjoining markets. Hence, attaining scale is extremely important in the liquid milk business. Demand is normally stable and voluminous in a liquid milk business, which helps in steady scaling up of the direct milk procurement network. Given that pouch milk cannot be transported over long distances, threat from national players trying to leverage their pan-India distribution is limited in this category. Capital investments in processing and procurement facilities are the only major capital investments needed for a liquid milk business.

A portfolio of fresh dairy product allows the company to utilize unsold pouch milk to produce fresh dairy like curd and paneer instead of converting the unsold pouch milk into butter/cream. Different varieties of cheese, UHT milk, flavoured UHT milk, UHT buttermilk, probiotic yoghurt and baby food are some VADPs. Britannia and Nestle have a major presence in these categories. Nestle has its own milk procurement only for a few product categories like baby food and the rest are contract manufactured. As the target market for these products is still small, investment in own milk procurement is not economically viable yet. By contract manufacturing these products, they avoid incurring capex. These companies leverage their brand equity and distribution reach to get the maximum realization for these products.

Given the high capital investment needed in manufacturing and sales of value-added dairy products, significant advertisement and branding expenses are needed to create national brand equity to compete with domestic and MNC dairy brands, and limited target market. We believe over the medium term (3-5 years) this portfolio will not yield significantly high margins to generate returns higher than companies operating in only a fresh dairy product business. Hence, companies with focus on the fresh dairy products portfolio are preferred bets.

Hatsun derives ~80% of its revenue from milk and milk products, while the remaining comes from ice creams and other businesses. Heritage has only presence in fresh dairy products, whereas Parag Foods is more focused on value added products.

Given that co-operatives in Maharashtra and Gujarat are more entrenched players in pouch milk, hence the business models of Western and North India private dairy companies have evolved around manufacturing SMP (commodity) to divert the excess milk production in these regions or towards VAD products (High capex, high working capital requirements) which have far less competition from unorganized players.

Impact of COVID-19 & Outlook

Demand for daily essentials such as fresh milk remains unaffected, not to mention its immunity-boosting properties amid the Coronavirus scare. Production of milk in India has risen more than 6% since 2014 and the government aims to raise the output to 254.5 million tons by fiscal year 2022 from 187.8 million in 2019.

While earnings of companies across the industry will be affected in the upcoming quarters due to the ongoing lockdown and disruption in supply chain, long-term investors should focus on companies that have direct milk procurement networks and widespread distribution.

Hatsun which is focused on fresh dairy products and has shown the ability to grow their direct milk procurement networks, is better placed to protect their milk procurement network and product market share from the threat of cooperatives.

The company’s revenue mix has been consistently stable over the years with milk and milk products contributing the maximum share. Total revenue of the company has been growing at a CAGR of 17.2% over the past 10 years. EBITDA and Net profits have been growing at a CAGR of 23.66% and 51.76% respectively over the same period. With strong brands under its belt, established infrastructure and demand for pouch milk expected to be perpetual, Hatsun is expected to maintain its dominant position in its key markets and also aid them to tap new territories.

The company is currently available at a CMP of INR 530.05 (as on May 11, 2020) at a PE of 64.92, which is just below its 10-year median PE of 67.10. Promoters held 73.58% stake in the company as of Dec 2019. For a long-term investor the current valuation seems expensive to enter since there is less margin of safety. We believe the market has already priced in Hatsun’s superior distribution and milk procurement capabilities.

Team 3C Capitals

Sources

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