Primary Offer. Parag Milk Foods: Not much to milk

India is among the largest producers and consumers of milk and dairy products across the world. But the per capita consumption is lower compared with other nations.

Besides, quality issues in loose milk or in milk from some of the co-operatives are driving demand for milk from the private sector. Higher income levels and changing dietary patterns are leading the demand for value-added products, such as cheese, paneer, yoghurt and flavoured milk.

Parag Milk Foods, operating the ‘Gowardhan’ ‘GO’, ‘Topp Up’ and ‘Pride of Cows’ brands, is a play on this opportunity. The company is raising up to ₹300 crore from a fresh issue to repay part of its working capital loan, enhance production capacity for cheese, whey and curd and expand its storing, handling and packing capacities. An offer-for-sale of about ₹450-465 crore is also planned.

With growing brand presence in the retail space, good foothold in segments such as sweet whey and cheese (32 per cent market share) and supplies to institutional customers, such as Pizza Hut, Taco Bell, KFC, Domino’s and Nestle, Parag’s prospects are promising.

But the company is banking on the overheated valuations in the FMCG segment. At ₹220-227, the stock will trade at about 44 times its expected 2015-16 earnings. Pricing has been inspired by similar valuations (trailing) of other mid-cap peers, such as Prabhat Dairy and Hatsun Agro, while Heritage Foods trades only at 23 times. Investors need not subscribe to this issue, considering that room for upside in the stock is limited at such a high valuation.

Parag derives two-third of its revenue from value-added segments. Yet, at 7-8 per cent, operating margin in the last few years has been at around the same level as Hatsun Agro, which derives majority of its revenue from fresh milk (ArokyA).

Parag’s foray into branded products in 2010 and related branding, advertising, distribution, infrastructure and employee expenses and lower operating efficiencies at one of its plants, have weighed on profitability.

With the bulk of the investment and capacity expansion phase done with, operating margin is expected to improve in the coming years. The company’s plans to increase production of higher-margin consumer whey/colostrum products (as health supplement foods and beverages) and introduce high-protein cheese and curd will also aid margins.

Secondly, the company is expected to breathe easy on the working capital front in the near to medium term.

It has been facing a crunch due to higher inventory holding requirements in the manufacturing stage for products such as cheese.

Working capital borrowings have pushed up the debt-to-equity ratio to 1.6 times presently; interest cover stood at a low one to two times in the last few years.

Parag is relying on the repayment of working capital loans amounting to ₹100 crore from the IPO and improved free cash flows after the investment phase to help ease the situation.

With the raw material to sales ratio at a high 70-80 per cent, fluctuation in milk availability is a risk. Reduction in supply of milk during 2013-14 and consequent increase in prices was a major reason for the 23 per cent fall in profits that year compared with 2012-13.

While price increase can be passed on to fresh milk buyers, pricing power does not come by easily in other products as well as in institutional sales.

Parag has since strengthened its supply chain network for procurement of over one million litres of milk a day.

Revenue in the last three years grew at an average annual rate of 17 per cent to ₹1,440 crore in fiscal 2015; net profit grew 11 per cent to about ₹26 crore.

Retail investors will get a ₹12 discount on the final issue price.