Dt Chain 060614

Rabobank Industry Note #432- April 2014

Rabobank International Food & Agribusiness Research and Advisory

Shiva Mudgil [email protected] +91 22 2219 7130

www.rabotransact.com www.rabobank.com/f&a

Contents

Strong demand for dairy

creates need to secure milk

supplies 1 Challenges to growth in

supply of quality milk 2 Private milk processors

need to focus on upstream

linkages 3 How should private

processors address milk

supply constraints? 4 Conclusion: Private

processors to develop

upstream linkages 5

The organised dairy sector in India has shown strong growth in the face of price increases for dairy products. Further growth in value-added dairy products will compel private milk processors to reinforce upstream linkages in the supply chain to secure additional supplies of quality milk. Private processors need to seize this opportunity to focus on milk procurement models for the future. The key will be to support farmer-driven dairy farming, with downstream companies playing the anchor role to involve service providers such as those supplying feed, genetics, healthcare and equipment.

Strong demand for dairy creates need to secure milk supplies The organised dairy sector in India has experienced strong value growth of 15 percent per annum over the last five years. Increased retail prices for dairy products have had little impact on demand. The market in traditional categories is being formalised at a rapid rate with value growth rates of 10 to 15 percent per annum for packed milk and indigenous products. The smaller base of value-added categories, such as cheese and infant milk foods, is expanding strongly at 20 to 25 percent per annum. Milk processors are aggressively looking to smaller cities to build market share. Meanwhile, global companies and investors are renewing their interest in India following the acquisition of Tirumala by Lactalis. Securing raw milk supplies will be a key challenge for all milk processors to support their growth plans.

One of the factors driving profitability of the private processors is upstream integration with strengths in milk sourcing. Processors with strengths in milk procurement have shown good financials with EBITDA of 6.5 to 9 percent and ROCE of 20 to 30 percent (see Figure 1).1

Figure 1: RES Chart - Comparison of private milk processors in India: milk sourcing strength is a key factor in improving profitability (2012-13)

RES: R ROCE%, E EBITDA%, S Milk sourcing strengths

Milk sourcing strengths from Low to High

Bubble represents private milk processors operating in India

Source: Company annual reports, MCA, Government of India, Rabobank research, 2014

Milk sourcing strengths relate to share of milk procured through own infrastructure. This is through setting up village collection points, bulk milk coolers and milk chilling centres to

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0% 5% 10% 15% 20% 25% 30% 35% 40%

EBIT

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ROCE%

Tier2 dairy companies with

scope of improvement

Tier1 dairy companies

with good procurement

strengths and financials

Potential

position

1 EBITDA: Earnings Before Interest, Tax, Depreciation and Amortisation; ROCE: Return on Capital Employed; Milk sourcing strengths: percentage of milk procured from farmers through owned infrastructure.

Milking the Chain Enhancing the Upstream Linkages in Indian Dairy

Page 1/5 | Rabobank Industry Note #432 - April 2014

Milking The Chain reach out to dairy farmers directly. Processors with strengths in milk sourcing have less

dependence on agents/intermediaries where quantity and quality of raw milk is questionable and vary across lean and flush seasons. These processors are able to manage the milk supply well. They interact with farmers on a daily basis and provide them with support for feed and healthcare services, in turn earning the farmers loyalty. This is one of the strengths that help them earn a better realisation per litre of raw milk handled when manufacturing value-added dairy products.

Processors with a higher dependence on agents for raw milk end up paying high prices for raw milk without any certainty of daily supply of quality milk. Agents are not loyal and tend to shift to buyers quoting higher prices. These processors have invested in processing, and not in procurement infrastructure. The potential to earn higher returns is much lower in this model. This means that efficient employment of capital, such as into procurement, can drive profits. There is scope for tier1 processors to further improve their performance by focusing on milk sourcing. In addition, it is also critical for tier2 processors who target tier1 levels of returns to invest in procurement to secure raw milk supplies.

Challenges to growth in supply of quality milk The key challenge for milk processors is securing milk supply. Competition amongst processors has become intense in recent years, to capture a higher share of raw milk supply. The record surge in exports of skimmed milk powder (SMP) in 2013 has led to direct competition for raw milk between SMP processors and liquid milk marketers. Raw milk prices increased by 20 to 25 percent in key milk producing Indian States in 2013,which was above the normal increase of 10 to 15 percent in previous years. Milk prices have remained high during the winter season, which is unusual. Processors are showing strong demand for good quality raw milk, which is proving increasingly difficult to source.

Limited potential for small and marginal dairy farmers2to improve milk production It is becoming challenging to procure additional quality milk from small and marginal farmers. This farmer segment currently contributes 70 to 80 percent of total milk production. With the common practice of distributing land in a rural household to the next generation, the number of small landholdings is increasing. While small landholdings will continue to play a significant role in the future (see figure 2), smallholders working on a low input-low output concept are constrained in increasing the quality of their milk production. These farmers with limited landholding are unable to increase their herd size beyond single digits. They are finding it difficult to access services such as good quality feed, genetics, and animal healthcare, and they do not have the management skills required to manage a larger herd size.

Figure 2: Relevance of small and marginal landholdings and area under fodder and grazing

Growth of area under different landholdings Area under fodder and grazing (thousand ha)

(2005/06-2010/11)

Marginal:< 1ha, small: 1 to 1.99 ha, semi-medium: 2 to 3.99 ha, medium: 4 to 9.99 ha, large: 10 ha

Source: Department of Animal Husbandry, Agriculture Census, Planning Commission, Industry sources, Rabobank research

A major issue is service delivery, particularly for genetics, nutrition and animal healthcare. It becomes less viable for single stakeholders to deliver services profitably to a large number of smallholder farmers. For example, high yielding fodder-seed companies are facing challenges in delivering services to small farmers, while they have experienced success when partnering processors.

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Fodder Crops Pastures andgrazing land

2005-06 2007-08 2009-10

CAGR (- 1.9%)

CAGR (- 0.7%)

2 Small and marginal dairy farmers: Farmers owning 1 to 2 acres of land and 2 to 3 heads of cattle.


Milking The Chain Increasing land scarcity for fodder resources

Increasing shortage of land coupled with dependence on favourable monsoon seasons is compounding problems for availability of quality fodder. The shortage of available landcaused by increasing urbanisation and growing food demandis increasing pressure on available land for fodder (see figure 2). A major deterrent to small and marginal farmers is the cost of good quality fodder. Most of these farmers feed household food waste to their livestock, which does not provide balanced nutrition. This brings the quality and quantity of available fodder into question.

Manufactured cattle feed yet to realise its potential Manufactured cattle feed accounts for only 10 to 15 percent of total animal feed requirements. The remainder is provided by home mixers and household food waste. Cattle feed demand potential was more than 60 million tonnes in 2012-13, based on 0.5 kg of cattle feed required for 1 litre of milk. However, total cattle feed production was 7.5 million tonnes and has increased at a CAGR between 5.5 percent and 6 percent over the last 5 years. Dairy farmers have neither the financial support nor the access to knowledge necessary to grow the cattle feed market.

No significant increase in livestock productivity and crossbred cattle population The milk yield of cattle and buffaloes has grown marginally over the last 5 years (see figure 3). The proportion of high milk-yielding crossbred cows in the total livestock population has grown from 13.5 percent in 2007/08 to 15.1 percent in 2012/13. The growth in the adult milch herd was lower than the total female population of cows and buffaloes. Furthermore, with artificial insemination (AI) coverage at the low level of 35 percent, capacity is limited to replace low quality breeds with higher quality animals.

Figure 3:Milk yield and livestock population in India

Milk yield (litres/day) Livestock population (in millions) and proportion of cows and buffaloes

Source: Department of Animal Husbandry, Government of India, Rabobank research

Private milk processors need to focus on upstream linkages

Private processors need to improve milk supplies to meet growth aspirations Private processors are experiencing strong demand for quality products. Given the impediments to increasing milk production, private processors have to become actively involved upstream to promote and enhance their milk supply. There is a strong case for private processors to play a greater role in this part of the supply chain, and is directly relevant to fulfilling their growth aspirations for product portfolios geographically.

Service providers need support to develop a viable model Service companies in nutrition, genetics and farm equipment have been trying, with little success, to reach dairy farmers, because of difficulties in achieving delivery efficiencies in the large and fragmented base of small and marginal farmers. These companies would benefit from milk processors that are able to create a shared platform. Farmers transact daily with these processors and place a high level of trust in them compared to other stakeholders.

6.47 6.71 6.8 6.63

6.97 7.02

4.41 3.94

4.53 4.58 4.71 4.8

2.11 2.17 2.2 2.22 2.27 2.36

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Crossbred cows Indigenous CowsBuffaloes

CAGR 1.6%

CAGR 1.7%

CAGR 2.3%

46.9% 46.6% 46.6% 46.5% 46.3% 46.2%

39.5% 39.3% 38.9% 38.7% 38.8% 38.7%

13.5% 14.1% 14.5% 14.8% 14.9%

15.1%

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Buffaloes Indigenous CowsCrossbred cows


Milking The Chain National Dairy Plan focuses on cooperatives

The National Dairy Development Board focuses on improving farm linkages through the National Dairy Plan (NDP). The first phase was launched in 2012-13 and will be in effect until 2016-17. However, only cooperatives are involved in this plan. Private processors share is more than 50 percent of raw milk procured through organised channels and without their participation; this plan will have low penetration and will need a longer implementation period. Private processors do not have any option other than creating their own model to improve their milk supplies.

How should private processors address milk supply constraints? Private processors need to reduce their dependence on agents and engage directly with dairy farmers to source good quality milk. This includes investment in upstream linkages in the dairy value chain. It also requires private processors to become more involved with service providers of feed, nutrition, genetics, equipment and animal healthcare. However, these processors will have difficulties in improving milk supplies without the support of these enablers.

Ongoing: Formalisation of milk procurement The conversion from an unorganised to an organised milk procurement chain3 will be a continuous and steady process. The organised procurement channel will account for 34 percent of total milk supplies by 2018/19 compared to the current level of 24 percent (see figure 4).Private processors have gained a larger share than cooperatives in the formal milk procurement channel. Capital access to support the growth ambitions of private processors will increase the gap further in coming years. However, the process is slow because it involves significant investments in infrastructure for milk centres, high costs in logistics and collection, and low capacity utilisation in the initial years. This may also lead to crowding of the infrastructure investment by processors in some regions, which will limit investment returns and lengthen the payback period.

Figure 4: Forecast of formalisation of the milk procurement channel

percent of total milk handling percent of organised milk handling

Source: Historic - Government of India, Rabobank research; Rabobank estimates and forecasts

Long term: Large-scale dairy farming Large-scale dairy farming is still evolving in India, with promising opportunities in the long term, but constrained in the near to medium term. Most large dairy farms are not run profitably and face the following challenges:

High fixed and variable costs At least three years are needed to achieve targeted production levels Herd size and yields are constrained by a shortage of high yielding cattle breeds in

India A ban on imported dairy cattle Commercial disposal of dry cows prohibited for religious reasons (except in a few

states) Limited availability of quality fodder Shortage of management skills to operate large dairy farms.

57%

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2012-13 2013-14e 2014-15f 2015-16f 2016-17f 2017-18f 2018-19f

Organized milk handling (LHS) Private processors' share (RHS)

3 The organised channel: milk is procured by private processors and cooperatives directly from farmers. The unorganised channel: milk is procured by agents/intermediaries.


Milking The Chain However, industry stakeholders are working around these challenges, which will be a slow

and gradual process. These large dairy farms will mainly be driven by farmers. This trend is noticeable in Punjab state, where farmers with cattle herd sizes of 200 to 300 are increasing their herd size further. But this upgrade will be slow and phased. The quality of cattle breed will improve over generations. Companies offering high fodder-yielding seeds are exploring viable models to work with farmers and processors. In time, farmers will gain expertise in managing large dairy farms, and a gradual herd upgrading will lead to reduced overheads.

Evolving: Dairy farming driven by medium scale farmers Medium scale dairy farming is the emerging concept for the short to medium term. The dairy industry is experiencing strong traction, with many aspiring farmers capable of managing large farms with 50 or more head of cattle increasing their herd size. These farmers need the support of private milk processors to create easier access to services such as feed, breeding services, and milking practices. Milk processors can provide financial support to farmers to move to mechanised dairy farming with a guaranteed off-take arrangement for the milk. Contractual agreements between processors and farmers can benefit both parties.

Service providers will be willing to partner processors and farmers because they gain delivery efficiencies for services in, for instance breeding, artificial insemination, feed and nutrition, mechanised milking processes, and animal healthcare. Milk processors will gain directly with this engagement, which will lead to improved supplies of quality milk with cost efficiencies and reduced transactions. It will be easier to procure a similar quantity of milk from 500 farmers with 100 cows each than from 50,000 farmers with two cows each.

Conclusion: Private processors to develop upstream linkages Considering the limitations to improving milk supplies, private processors will have to actively develop an enhanced value chain that involves all stakeholders, including dairy farmers and feed, fodder, nutrition, genetics and equipment providers. Direct sourcing from farmers is critical for milk processors and will require a dedicated focus to lift the quality and quantity of the milk supplied. Large-scale corporate dairy farming is only likely to develop in the long term. In the meantime, medium-scale farming will be essential to secure sufficient milk supplies. Processors will have to play an anchor role for other stakeholders. This will help create integrated dairy companies involved in milk production and in the processing and distribution of dairy products, yielding higher returns in the value chain.

This document is issued by Coperatieve Centrale Raiffeisen-Boerenleenbank B.A. incorporated in the Netherlands, trading as Rabobank International (RI). The information and opinions contained in this document have been compiled or arrived at from sources believed to be reliable, but no representation or warranty, express or implied, is made as to their accuracy, completeness or correctness. This document is for information purposes only and is not, and should not be construed as, an offer or a commitment by RI or any of its affiliates to enter into a transaction, nor is it professional advice. This information is general in nature only and does not take into account an individuals personal circumstances. All opinions expressed in this document are subject to change without notice. Neither RI, nor other legal entities in the group to which it belongs, accept any liability whatsoever for any loss howsoever arising from any use of this document or its contents or otherwise arising in

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Strong demand for dairy creates need to secure milk suppliesChallenges to growth in supply of quality milkLimited potential for small and marginal dairy farmers2to improve milk productionIncreasing land scarcity for fodder resourcesManufactured cattle feed yet to realise its potentialNo significant increase in livestock productivity and crossbred cattle population

Private milk processors need to focus on upstream linkagesPrivate processors need to improve milk supplies to meet growth aspirationsService providers need support to develop a viable modelNational Dairy Plan focuses on cooperatives

How should private processors address milk supply constraints?Ongoing: Formalisation of milk procurementLong term: Large-scale dairy farmingEvolving: Dairy farming driven by medium scale farmers

Conclusion: Private processors to develop upstream linkages

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