Friday, May 2, 2014

Heritage Foods - decent moat that shows promise but not yet in the greats

I love the dairy business and am always trying to find dairy companies to buy. It is one that takes an enormous doing to gain the customers' trust, inventories have to be held low as the goods are perishable and once you are established you can charge the earth for that trust. Nestle in India charges its customer huge premiums for consistent quality of milk and its products across the length and breadth of the country. Unfortunately Nestle trades at wild premiums at all times and it is unlikely that I will ever get to own Nestle. I analysed Kwality dairy for you and that didn't turn out to have a great moat so lets now look at Hertitage foods!

Heritage foods was established by N Chandrababu Naidu (who is know to have convinced Microsoft to setup a huge center in Hyderabad) in 1992. The dairy business is hugely profitable and all the other businesses seem to be losing money. As a dairy I think it might be one of the better run businesses and is a supplier to Nestle as well.

1. How good is the moat?

Grade B moat
  • Seems to have a good relationship with the milk producers - a key for the dairy industry
  • Brand - the brand is fairly strong in various areas like Andhra, Karnataka and Tamil Nadu
  • Sales and distribution - the network is strong - especially the 1176 franchises that sell their products. They also have their own retail network which is like an advertising platform in itself. Very strong here. Although the owned retail business consumes lots of capital and is losing money.
  • Employees - no great moat here
  • Pricing power - the brand does seem to have good pricing power in the dairy segment where the profits seem to be going up
  • I call this a grade B moat as the performance has not been consistently good for a while before this can be called a moat company.

2. Risks

  • The Dairy business returns on capital are good but the rest of the business segments which account for over 22% of revenues and over 40% of the capital employed are all not only loss making but EBITDA negative which is a very on the edge thing.
    • The company has been investing heavily in these negative EBITDA businesses using up good capital generated from the dairy business
  • Much like other dairy companies the margin % is very thin at around 3% (which is up from less than a %) and the RM% of sales is very high at 77% (down from over 80%)

3. Financials

  • Cash flow from operations has been consistently higher than net income which is a good sign for the honesty of the financials
    • Reasons are simple - the interest and depreciation are large numbers and the capital consumption items like inventory, debtors and creditors have been kept under control & improved
  • Debtors as a % of sales are around 1% - which is spectacular!
  • Inventory as a % of sales is around 5% which is high for a dairy company but I suspect this is coming from the retail business
  • FX outflow due to term loan repayments on a foreign current term loan from bank of baroda
  • Margins - Margins are thin but rising at 3% or so. This is a point of big concern.
  • No apparent goodwill on the books
  • ROIC in FY 2013 is 22.5% but before than was sub 10%. ROE in FY2013 is 35% but before that was lower.

4. Soft factors

  • I found this stock on the Dolly Khanna holdings list and she seems to have sold stock between Dec 2013 and Mar 2014 which is not a good sign
  • Promoter holding has been steady at 40% or so
  • Last insider transactions were in 2012

5. Pricing

  • Overall for now I think pricing is irrelevant as the moat is not good enough to call this a moat list member yet but I am confident that in some time this is a likely candidate to have a moat.
  • Even though sales have grown at 18% CAGR from FY2009 till FY2013 current growth is down to about 8%
  • The CFO is so much higher than the net income that I am tempted to value this on a CFO basis
    • This would be valid if the depreciation claimed is far higher than what is actually the case and I cannot find evidence of that. The depreciation claimed on the negative ROCE businesses is as real as it gets. Even on the milk business the capital investments have been massive
  • On P/E basis I would say this would be in the buying range at around 5.9 times earnings and its currently trading at 13.43 times trailing 12 months. Again if the retail, bakery and agri businesses started become decent ROIC then this needs to be recalculated.