Ludmila Mikhailova: "We are interested in the top 10 poultry producers"

The Chief Financial Officer and co-owner of Cherkizovo Group talks about the Company's development strategy, plans for consolidating the poultry meat market, and why the future belongs to big agribusiness.

Cherkizovo Group has spent nearly 15.7 billion roubles on M&A in the poultry business since 2007. As a result of these investments, the Company's share of the poultry meat market increased from 2.5% in 2004 to 11% in 2013. EBITDA of the division increased from $36.2 million to $176.1 million between 2007 and 2012. The Group is not only taking over competitors, but is also growing organically. Sales of poultry meat have nearly doubled in the last five years to 343,000 tonnes.

Buying after the crisis

In the last seven years you have bought three poultry production companies: Kurinoe Tsarstvo, Mosselprom, and Lisko Broiler. If you compare these deals, which of them was easier and more successful from the business standpoint?

The deal with Lisko Broiler was the easiest one. Since the company's owner, Nikolai Belokonev, personally managed the enterprise and knew everything about it, he provided quick and accurate information. He is a very experienced, competent manager who knows all the finer points of his business. So we bought the assets literally within three months. Buying Kurinoe Tsarstvo in 2007 was more difficult in the legal sense, because the American fund Agribusiness Partners International L. P. owned shares in the company. Of course, it was a larger deal than that with Lisko Broiler, and negotiations lasted more than six months. This was my first major M&A since I started working at Cherkizovo.

There were also certain difficulties with Mosselprom in getting information about the asset (it was larger than Kurinoe Tsarstvo), and negotiations went on for nearly a year and a half. Plus, the process was legally complex, since the owners received Cherkizovo shares for the company, so we had to hold an additional share issue, review all the documents and agree with the sellers on the details of the transaction.

The market was very volatile in 2010 and 2011 when we were discussing the conditions. Prices increased due to a poor harvest, and everything was changing. The longer negotiations drag on, the harder it is to reach an agreement. On that score, everything with Lisko Broiler was transparent: there was one majority owner, an understanding of the value of the business, and money in the bank.

Judging from the dates of the deals, you bought broiler assets about once every three years.

If you compare the dates of the deals with periods of high volatility in grain prices, you will see a certain correlation: we bought the companies right after difficult years for the agricultural industry. We started negotiations with Mosselprom in 2010, when it was going through hard times, and the asset was not in the best situation. Lisko Broiler's margin was twice as high in 2012 as it was in 2013. In a crisis, players understand that the scale of business is important in order to manage expenses better, control the cost of production, and negotiate with chains. This encourages M&A.

Does that mean the owners of Mosselprom and Lisko Broiler were forced to sell?

I wouldn't say that. We had a sense that Mosselprom's owners had been getting prepared to sell it. If it had been forced, and the owners were trying to get out of the business, the negotiations wouldn't have gone on so long. It was the same with Lisko Broiler. We didn't see that the owners were keen on selling the asset, but we started negotiations and the deal turned out to be mutually beneficial. In difficult market conditions, selling a company or consolidating and becoming part of a large corporation is a good decision for second-tier players. A significant reason for us becoming a public company was the ability to use the company's shares for acquisitions.

The former owners of Mosselprom received about 2% of Cherkzovo's shares. Do they own any shares now?

I can't really comment on this, but anyone who is interested can find it out from our shareholder register, since it is public information. Given the fact that capital markets have dropped sharply since we bought the company, getting out wouldn't have made sense. At the time of the transaction, the share price was higher than it is now (on May 11, 2011, the day the deal was announced, Cherkizovo shares were trading at $19.25/GDR on the LSE and for 795.5 roubles per share on MICEX; on April 11 of this year, the closing price the LSE was $10.25/ GDR, and 574.9 roubles on RTS-MICEX — Agroinvestor).

The company is significantly undervalued today according to key multipliers, but investors buy stocks not only on spec, but also with expectations that the company will pay dividends. We've grown quite rapidly in recent years, but we still haven't paid dividends.

Are you planning to?

We regularly return to the question of paying dividends. It all depends on the aggressiveness of the Group's capital investment programs and its financial performance. Based on last year's results, we spent our free cash flow mainly on buying Lisko Broiler. So far, we're expecting a good year, according to all indicators and forecasts. Grain prices aren't as high as they were at the start of 2013, and the company's size is working to its advantage as well. Of course, a lot will depend on the harvest in the country, meat prices, and macroeconomic indicators.

But we're discussing a dividend policy, both to support shareholders and to increase Cherkizovo's investment attractiveness as far as possible, given the heavy outflow of capital from Russia. Our share history was initially about growth, not returns. However, today it's probably worth considering that stocks should pay dividends to shareholders.

Last year was not a very good one for the company.

Profitability in 2013 wasn't really typical in the long-term outlook: prices for pork and poultry dropped sharply at the same time as grain prices increased. By now, grain prices have fallen from 11-12 roubles/kg to 5-6 roubles/kg, while pork prices have recovered. After imports were banned this year, pork prices jumped from about 62 roubles/kg live weight with VAT in the first quarter of the last year to 100-105 roubles/kg today (in the first week of April — Agroinvestor). Broiler meat prices have also recovered, so profitability has improved. However, we don't have EBITDA margins of 22-26% for poultry production like we did in 2009 and 2010, and we probably won't in future, unless grain prices fall to 3 roubles/kg. On the other hand, European markets are closed, and there's a shortage of fresh meat on the market. Pork has already become very expensive, and the processing industry will have to switch to cheaper chicken and turkey. Increased demand for them should push prices higher, so we can still see higher margins in poultry production.

What margin are you anticipating at year end 2014?

We're not making direct forecasts, but we're expecting an average of 12-15% for poultry production. This is normal, considering that we have quite a strong brand. Margin for pork could reach 40%, depending on price stability and growth rates.

Synergy is important

Cherkizovo built its poultry production cluster by acquiring operating facilities, but then started to invest in creating new ones. How do you decide whether to buy an asset or build one from the ground up?

Our poultry production cluster is the result of both takeovers and organic growth, although our most aggressive form of growth has been M&A. In the pork division, we had a strategy for developing greenfield projects, because when we started investing heavily in this business in 2005, there was nothing to buy.

Old-style complexes weren't initially built properly and were inefficient, so it was impossible to do anything with them. We've completed the main investment phase in pork production now and are moving to full capacity. Small pork producers with new, high-quality assets sometimes approach us, but we have other priorities right now; and in the short-term we're not considering takeovers in the pork business.

It's a different situation in the poultry business. There were and still are good poultry factories in the country; and unlike pork production, you can quickly make some corrections with additional investments to increase output. That's why we've made M&A deals, and then added capacity and increased production, like we did with Kurinoe Tsarstvo. In this sense, our Eletsprom project isn't really greenfield. We're building an agroindustrial park based on the existing facilities of Kurinoe Tsarstvo. At the same time, we are and will be looking at other companies, and will continue our market consolidation strategy by building up assets in clusters wherever possible and feasible. I don't think it makes sense to develop greenfield projects in the poultry business today, except in the Far East or Altai.

And it's unlikely that anyone will consider investment projects, taking into account that starting next year, loans in the industry won't be subsidized. Incidentally, the company is owed about 1 billion roubles in interest reimbursement subsidies from the federal budget. In this situation, there is no obvious attractiveness of investing in new poultry production projects. Our shareholders expect returns, so we evaluate our investments very carefully in terms of payback, and are very cautious about investment projects.

Which poultry industry assets interest you?

Some facilities are so old and inefficient and have such a low level of biological security that it's impossible to improve their performance indicators. So we're attracted to high-quality assets. We might be interested in players from Russia's top 10 poultry production companies. M&A deals are a question of price, negotiations, and the shareholders' interest in selling the asset or becoming part of Cherkizovo. Of course, we look at how well the asset will fit into our structure in order to achieve synergy.

We also assess the geographic and logistics position: it would be difficult for us to buy a poultry farm in Siberia; but who knows. If the region is strategically important and the government starts supporting business development there, we may look at options for entry. Right now, we're attracted to the Central Federal District, since we have land and established logistics there. We're also looking at brand quality and which market niche a product occupies. For example, we don't have much of a presence in the south, but the acquisition of Lisko Broiler will probably expand sales.

Is the south a target region for you in terms of location or buying facilities there?

Although this is a new market for us, we're now looking and will continue to look at companies in the Southern Federal District for consolidation. But it's hard to say how interesting the macro-region is. We need to evaluate our sales strategies. Since grain production there is export-oriented, feed components will always be more expensive. We're not interested in small-scale assets, because we won't gain much synergy from them. Unlike many competitors, Cherkizovo's business is quite concentrated, although not as strongly as companies in Belgorod Region. On that score, our facilities are located at fair distance from one another to reduce biological risks, but in terms of logistics and infrastructure, they are efficiently clustered in the central part of the country.

A year ago you bought the Dankov Meat Processing Plant near Lipetsk. How attractive are M&A deals in the meat processing sector?

We appreciated the advantages of meat processing last year, when this division allowed us to at least partially maintain the margin we lost in the pork division. Profitability for this division reached a record 11% at year-end 2013. We're currently considering options for takeovers of meat processing facilities. The main selection criteria are the scale of business, region, market position, and brand.

What is the synergy between poultry production and meat processing?

Today there is no synergy as such, because we mainly sell branded products. It's somewhat different when it comes to using poultry meat to make sausages, i.e., MDM (mechanically deboned meat) or frozen raw meat. We're trying to use the potential of our brands as much as possible. Petelinka and Mosselprom are key brands on the Moscow market, with a share of about 38% in modern chains. This gives us advantages in negotiations with retailers, or when we're buying ingredients for production, e.g., packaging or veterinary preparations.

How much grain do your companies consume, and how much does the Group itself grow?

We started grain farming two years ago, which was a new segment for us. It's still not very large-scale — it supplies about 15% of the grain we consume. We need about 800,000 tonnes of grain per year, with consideration for the new poultry production asset and reaching full capacity of pork division projects. We manufacture our own feed. Lisko Broiler has a feed mill, so we'll be able to meet our needs there as well.

Ready to buy

Where is the limit to organic growth? If there is a concept of market share or production levels for poultry meat at which you will say now you'll only improve performance and cut costs, and direct investments to other projects?

We're constantly working on cutting costs. We don't have any goals for production levels or becoming first on the market, although obviously we're trying to become the industry leader. But when we increase capacity, we do a strategic evaluation of the feasibility of growth. If we have a slaughtering facility that is operating below capacity, it's worth adding assets like bird houses to improve efficiency. In another situation, we realize that there are production or logistics constraints, when there's no need to increase capacity in some part of the chain.

You're increasing production levels, improving efficiency, cutting costs, and raising financial indicators. Which one has priority?

We take a comprehensive approach. We can significantly increase production and buy assets, while always focusing on efficiency. Before we do something, we analyse the facility's payback period and investment attractiveness, and also evaluate possible synergy. Our challenge is to reduce transportation, manufacturing, and management costs, regardless of how fast we grow. The market is changing. It's already saturated, and competition is becoming stiffer. So we need to cut costs in order to maintain our margin. But product quality and brand relations are also important. That's why we're focusing our efforts on positioning our trademarks and marketing.

Investing in deeper processing is one of the company's strategies. We're introducing new products and offering various ready-to-cook brands. Our monitoring confirms that this segment of the market is growing.

What are Cherkizovo's competitive advantages?

We have good relations with retail chains, and our products are sold by key retailers. This is an important advantage: not all companies are able to build a distribution system; and today, sales are a key factor in the existence of a business, not just success. The company is continuing to grow, and due to economy of scale, we're maintaining our leading position, not only in output, but also as a manufacturer of products with the lowest production cost on this market. Our poultry meat brand is also one of the strongest in the country.

When will you be ready to buy something else?

This depends on financial resources and whether the companies want to join our Group or sell their facilities to us. We're ready to talk, and we're continuing to look at assets. Shareholders are coming to us, banks are offering various options, and industry associations are helping a lot, because consolidation of the industry is being actively discussed. We're always open to offers, although not all of them will be interesting for the company. It would be difficult for a player of our size to swallow two large deals at once. But in terms of structure, we're at a new management level now, because over the last two or three years, we've formed a strong new team of managers. Work is going smoothly, and all processes are running much faster.

Does the company have access to low-cost loans?

Of course. We have an effective rouble rate of about 2%, adjusted for subsidies. But the cost of money is increasing, and we expect that all banks will raise their interest rates by about a per cent and a half. However, I think that even under these conditions, Cherkizovo can count on the most attractive terms, given its reputation, openness, and official credit rating. Especially since long-term, reliable partners like Sberbank and Gazprombank understand our business well.

The banks are saying there's a shortage of high-quality borrowers in the industry.

The agricultural industry is heavily indebted. At the end of the last year, a lot of pork producers applied to refinance their debts when the selling price was 10% lower than the production cost, profit was out of the question, and they were technically in default. Obviously, no banker wants to become a farmer, so the banks' attitude is understandable: give money to efficient players. Given the sector's volatility, it makes sense that if a large holding receives a rate of 9.5%, a smaller, riskier player will get 12-13%. We emphasize that Cherkizovo is a large, high-quality company. And the banks listen to us.