Kwality Ltd Initiating Coverage By Nirmal Bang

Kwality is one of the largest manufacturer of milk & milk products in the private dairy sector in India with processing capacity of over 3.2 mn litres/day. With its diverse product portfolio, comprising of milk powder and fresh milk products, the company caters to customers under its “Kwality” and “Dairy Best” brand. Recently, the company won legal battle of “Kwality” brand.

INVESTMENT RATIONALE

Building consumer-focused dairy products company: Kwality is transforming rapidly from a traditional B2B dairy player to a consumeroriented branded products company. At present, the company derives 68 per cent revenues from institutional segment and balance from retail segment. Over the next three years, the company intends to increase consumer business from the present 32 per cent to 70 per cent on the back of capacity expansion, widening product portfolio including valueadded products (VAP) like flavored milk, paneer, cheese, and butter, among others, brand building and increasing distribution reach.

Enhanced focus on VAP to expand EBITDA margin sharply:

Kwality reported gross profit margin and EBITDA margin at 9.4 per cent and 6.1 per cent respectively in FY16, mirroring product mix (liquid milk revenue at 53 per cent) and business mix. We believe product mix shift towards VAP with higher realizations coupled with B2C business model will expand EBITDA margin (8-9 per cent) over long term. However, increase in brand building cost will offset gross margin expansion in the short-run.

Free cash flows to aid deleveraging:

Kwality has been reporting negative operating cash flows / free-cash flows over the last two years. This has also resulted into increase in debt from Rs. 1096 crore in FY14 to Rs. 1500.6 crore in FY16. Interest expense as percentage of EBITDA has remained at elevated levels (40 per cent) during the same period. Now, the company is entering into higher free-cash flows period aided by EBITDA margin expansion and reduction in working capital cycle.

Valuation & Recommendation:

Business model transformation, expansion in EBIDTA margin, decline in working capital cycle and deleveraging are key value drivers for re-rating in the stock. We estimate Kwality to clock 23 per cent CAGR in net earnings over FY16-FY19, among the best in dairy sector. RoCE will improve significantly from 18.5 per cent in FY16 to 24.3 per cent in FY19, largely attributable to margin expansion. With strong free cash flows and debt repayment, the stock is set to re-rate over the medium term. We value the company at 10x FY18 EBITDA to derive a price target of Rs150. We recommend BUY on the stock with a price target of Rs150 over the next 9-12 months.