"If it's not a poor harvest, it's some kind of infection or a global disaster"

"As soon as you start to break down costs into components, you run into dollars"

Judging from your financial statements, 2014 turned out to be a great year for Cherkizovo Group — EBITDA doubled to $176 million in the first half. Will this trend continue to the end of the year, and what is the reason for it?

Yes, this will be a record year for Cherkizovo Group — we're expecting revenue of nearly 70 billion roubles (52.8 billion roubles in 2013 — SF), and profit will grow significantly. Profit has not been affected by sanctions but by the outbreak of African swine fever in Europe at the beginning of the year. The EU was the largest importer of pork to Russia, and when our veterinary service restricted meat imports, domestic prices went up sharply. At the same time, prices rose around the world, because the problems with infected animals started in many countries, including the United States. First pork and then poultry started getting more expensive. Due to rising prices and increasing volumes we recovered after a very difficult 2013, and were able to compensate for the losses from last year's slump in meat prices.

What about the sanctions and the weakening of the rouble?

The food embargo hasn't really affected our business, because imports were banned earlier. But the devaluation of the rouble that we're seeing now, will have serious and various consequences, of course.

The cheap rouble gives us competitive advantage in terms of exports and import substitution. But things aren't that simple. You'd think that if we feed Russian pigs on Russian grain, the jump in currencies shouldn't worry us. But as soon as you start to break down costs into components, you run into dollars. Seventy per cent of the costs of meat production are tied to foreign currency.

For example, grain is the main fodder. At this point, the company covers only a quarter of its consumption with its own grain. Grain is a commodity, and its prices are quoted in US dollars. It's exported, and so it responds instantly to fluctuations in the exchange rate. A couple of months ago we bought grain at 6 roubles per kilogram, but now it costs 8.5 roubles. Of course, it affects our costs and prices on the shelf. There are both major threats and great opportunities here. The government could restrict exports of grain and fertilizers through duties and export quotas. Otherwise, food inflation won't be restrained. The main concerns now are associated with inflation and rising prices not only for meat, but also for food in general.

Why the concerns? It's good for your business when food prices rise.

Not really. People don't get more money. Today, every Russian consumes an average of 75 kg of meat a year. This is the average consumption level for Europe. People in the US eat 110–115 kg of meat per year, but this is an inflated level. Remember that in 2000 this figure was less than 60 in Russia. Our market could drop that low. We're predicting that people will buy only 70 kg of meat next year. This means that Russia won't actually need imports. Import substitution will reach its full potential, and we'll have overproduction of pork. Production costs will start to increase, but demand will decrease, so margins will be under pressure from two sides.

So is it a myth that the rouble will weaken and Russian manufacturers will drive out foreigners?

We've already nearly ousted them on the meat market. Poultry meat is mainly domestic, pork imports are closed, and only beef imports have a significant share. We're facing a drop in demand, not a fight with foreigners. The government's position is very important. Will it help maintain demand? There's the example of the US, where the government spends $50–60 billion a year on food benefits. Low-income residents receive $200–300 on cards that can only be spent on food. People are fed and production increases.

But people save on food last.

That's right. Sales of TVs and cars will probably fall even more, but this doesn't mean that people will eat less meat. For some people, it will be a luxury. For the last two or three years, the government has consistently indexed pensions and wages, and incomes have increased. Now they're no longer growing, which is a risk for our business.

Recently, we've been chasing growth in consumption rather than driving out imports. So despite price volatility, we haven't stopped our investment program. We've invested about 50 billion roubles in the business in 10 years. This year we started a new pork project worth 4 billion roubles in Voronezh and Lipetsk Regions.

Cherkizovo realized a gain of $250 million from an IPO for 27.8% of its shares. After the placement, Igor Babaev withdrew from daily management, entrusting the role of CEO to his son.

"The global meat market isn't sexy"

On the one hand, you're talking about market saturation and the crisis of overproduction, and on the other hand about large-scale projects. Why build new farms if people will be eating less meat?

Let me explain. Construction of a new farm takes two years. It takes a year to reach full capacity. Payback takes another five to seven years. We're not actually concerned about what will happen in a year or two. Forecasting demand for the next ten years is a difficult and thankless exercise.

In any case, everything is cyclical. The recession has obviously already started. Things will be bad for a year or two. Then there will be a rebound. We're expanding our operations, because both the domestic and global markets are competitive.

We probably won't invest as aggressively next year as the last four years. But we'll definitely finish the projects we've started. For example, we're currently expanding turkey meat production together with the Spanish company Fuertes. Output will reach 40,000 tonnes in 2016.

Have the sanctions affected this partnership?

No. We have long-standing friendly relations. We've known each other for more than ten years. The geopolitical situation is obviously very difficult, but they believe in us and in the potential of the Russian market.

There's also another example: we were considering the possibility of setting up a pizza plant in Russia with another Spanish partner. But they said they weren't ready to invest, citing the current situation. I think this was an excuse, not the reason.

What is the company's current debt load? Do you have any foreign currency loans?

We estimate the load at 25–27 billion roubles. This is quite a comfortable level for our business. Fortunately, all debts are denominated in roubles. Our revenue is in the national currency, so we did all our borrowing in roubles. We have no desire to increase the load: the cost of borrowing is currently increasing, and the increase is significant.

Has politics influenced your relations with investors and shareholders in any way?

Stock markets have not been in the best condition for several years. We can’t say that everything was fine and then suddenly collapsed. This year will be the best in the group's history. We paid dividends for the first time and we intend to pay them in future. But this hasn't been evident in our shares. There is slight capitalization growth, but many investors are being forced to sell our shares just because we're operating in Russia.

How much would Cherkizovo shares be worth if your company was located in Brazil, for example?

Let's take the P/E multiplier (price/earnings — SF). Companies like ours in Brazil traded with a multiplier of 12–15, but we were evaluated at 3–5. We're growing better and our margin is higher, but the difference is three times. Why? Investors don't always act rationally.

You have to understand that the global meat market isn't sexy, and it's not the most attractive one for investors. Consumption in developed countries is stagnating. The US and Brazil export meat, and until recently, Russia was a unique market — it imported meat, and domestic consumption grew. But this is poorly reflected in our capitalization.

A family-owned joint stock company

Cherkizovo is both a public and family-owned company. The company held an IPO in 2006 to make it easier to carry out M&A transactions, but more than 60% of the shares are still held by members of one family. The company's founder Igor Babaev is chairman, his eldest son Sergey Mikhailov is CEO, his younger son Evgeny Mikhailov is head of business development, and their cousin Ludmila Mikhailova is CFO. According to Sergey Mikhailov, this model is very convenient, since key decisions are made by one family where everyone trusts one another. But there are also independent directors involved in management, who can look at the situation from the outside, and shareholders trust them. The main disadvantage of this situation is that when the family gets together for a celebration, they start to discuss business.

"There are no quiet times at all"

Do you already have export programs?

They're minimal. We had no motivation to enter other markets, but the situation may change. Exports are a challenge. No one is waiting for us. A lot of countries subsidize exports. Under WTO rules, Russia is deprived of such opportunities.

But when domestic demand drops, agricultural enterprises will have to develop exports. Our country currently exports a lot of primary commodities (grain, oil) and has the ability to export products with higher added value, such as meat. The lower the rouble drops, the more potential this strategy has. There was a similar situation in Ukraine, and now they export a lot of chicken. People there began to eat less meat, and there was a serious devaluation of the hryvnia, but exports flourished. This is good for business, but probably not for the country's population. But they have no other choice.

Sooner or later, Russia must move from grain to meat production. We have all the necessary resources.

Everyone knows Cherkizovo as a sausage manufacturer, but most of your revenue (more 70%) today comes from pork and poultry meat. Does diversification help in difficult times?

We have four business lines: poultry, pork, grain, and sausages. There are inverse segments: when meat prices rise, it means we earn less on meat processing, but more on sales of raw materials. For example, income from meat processing will be minimal this year. But if meat prices are falling, we earn more from sausage. It's roughly the same with grain. Our goal for the medium term is to start supplying about 50% of our own grain.

The second level of the safety net is different kinds of meat: pork gets more expensive, so people buy more chicken, and vice versa. Diversification is the foundation of our strategy. Today, when prices are jumping up and down, it's obvious that the strategy is right.

But if the recession drags on, demand for all kinds of meat will drop, and for sausage too. How would a major crisis affect your business?

We're very crisis-resistant, because there are crises every year in the agricultural business. If it's not a poor harvest, it's some kind of infection or a global disaster. There are no quiet times at all. This keeps us on our toes. Look, for five weeks in February and March 2013, Russian pork prices fell from 100 to 60 roubles per kilogram. A year earlier, we had a poor grain harvest, and fodder prices doubled in six months. But we survived.

How dependent is your business on government subsidies?

Agricultural manufacturers around the world are tied to state regulation. In Europe, 100 billion euros are allocated to support agriculture every year; and tens of billions of dollars in the US, China, and Brazil. In Russia it's 5 billion euros. Our environment reflects the market situation and is most transparent.

When people wonder why meat is cheaper in Europe than in Russia, you need to understand that it's expensive for local taxpayers. State support in Russia has historically been low, and even after joining the WTO, government subsidies were limited to 5–6 billion euros per year. However, you can't build this business without government involvement: you simply can't compete on equal terms.

The main form of support in Russia is subsidized loans. But market rates in the EU start at 1.5–2%! And our government subsidies are reducing the rate to 2–4%. So subsidies simply bring the market to European standards — we're initially at a disadvantage. Agriculture needs long-term, capital-intensive investments. If the money is at market value, payback will take 10–15 years. So no one will take the risk.

What is Cherkizovo's main goal now? The market seems to be saturated. Do you have room to grow?

The Russian meat market is worth $40 billion per year. We're the largest manufacturer, but our share is less than 5%. There is huge growth potential. On developed markets, the top 3 players in each segment usually control more than 50%. Our market is very fragmented. It has a lot of small players, so consolidation is inevitable. For example, this year we bought Lisko Broiler for 5 billion roubles, and we're looking at other assets. Things are difficult and incomprehensible today — people are in no hurry to sell assets, because they don't know what will happen. But I think that next year will be a good time to buy, because everyone will need money.