Doubling up

CLT main focus is milk: it started as a milk supplier/distributor in the Turin area. Over time, however, the company has expanded beyond its initial distribution area, adding the whole Piedmont region, where it is currently market leader, and then two more regions in Northern Italy (Veneto and Liguria). Moreover it has diversified its product offering, adding long-life and extended shelf life (ESL) milk, fresh and long-life cream, yoghurt and fresh cheeses. More recently it has also moved beyond dairy products and added categories such as fresh pasta, eggs and ready-prepared salads.

The company was founded in 1950 but largely remains a family-owned business. The major shareholder is Finanziaria Centrale del Latte di Torino, which is controlled by the founding families, and of which the municipality of Turin owns a 20% stake. Another shareholder is Lavia, which is also owned by one of the founding families. The acquisition of CLF adds an extra region (Tuscany) to the business and is highly complementary. It also adds the Mukki brand, which has strong recognition locally and could be leveraged across the CLT domestic portfolio and internationally.

We calculate a fair value based on our DCF model of €3.00, which represents 8% upside. The main sensitivities to our forecasts and valuation are outlined below. The key event this year is the merger with CLF, which is due to complete on 30 September. In the longer term, the company is trying to diversify away from liquid cow’s milk and into fresh produce, which is a more attractive market. The CLF acquisition will be margin enhancing and also significantly EPS enhancing.

As an alternative to our DCF valuation, we look at CLT’s key metrics versus the peer group. We calculate that CLT now trades on 18.1x 2017e P/E and 8.4x 2017e EV/EBITDA (again on a post-merger basis), a premium of c 6.5% on P/E, and a discount of 3.4% on EV/EBITDA, to the average of our peer group of dairy processors.

Management’s outlook for FY16 is cautious as the overall market remains subdued. Consumption of fresh milk in Italy has suffered due to the recession, which has put pressure on both pricing and volumes, but also due to a shift in consumption and the increased fashion for dairy-free and vegan diets. Q116 results were in line with the cautious tone set out at the start of the year.

Net debt remains high, at €20.7m at December 2015, and we assume €36.6m debt for the CLF business, thus resulting in a total net debt of €57.3m on a pro forma basis. The new entity will be renamed Centrale del Latte d’Italia (CLI). This equates to c 6x net debt/EBITDA coverage on a pro forma basis for FY16, although it declines to 4.8x for FY17.

CLT’s key sensitivities include:

CLT is a regional Italian dairy producer. The company has a strong base in fresh milk, UHT milk and yoghurt. It has also diversified into branded fresh food products, with ranges of eggs, cheese, pasta, vegetables and ready-to-eat salads. CLT started in Turin in 1950 to serve the market in Piedmont, and has since acquired operations in two other northern Italian regions, namely Liguria and Veneto. The planned merger with CLF is set to transform the business by adding a fourth region (Tuscany). We illustrate the breakdown of revenues by category and by geography in Exhibit 1 and 2 below.

The merger with CLF will almost double CLT’s sales. The two businesses are complementary as they both operate regionally in the Italian fresh and UHT dairy segments. We illustrate the pro forma revenue breakdown of the enlarged group in Exhibit 3 and 4.

Both CLT and CLF have leadership positions in their respective key markets, thus making them regional champions. CLT has four existing factories, which are all well invested with the latest technology for production, treatment and packaging of its products. CLF has one production site in Florence, which was built in 2005 and is also equipped with the latest technology.

Both CLT and CLF have a base milk business, but have also chosen to diversify into two main categories:

Another common strategy for both CLT and CLF is the creation of their own strong local brands to support their product portfolio. Over the past two years, CLT has set its sights on international expansion: it started exporting UHT milk to China, and recently signed an agreement with a distributor for the UAE, Kuwait, Saudi Arabia and Oman. We believe it should be able to leverage CLF’s Mukki brand for export once the merger completes.

CLT has clearly become more acquisitive in an effort to diversify away from the relatively low-growth fresh milk business. CLF is a large acquisition and we expect it will take a few years for the integration to be complete. That said, we believe more acquisitions are likely in future as the business continues to grow and the strategy to diversify and to enhance scale continues.

The Italian fresh milk and ESL (extended shelf life) market was worth €574m in 2015 (source: IRI Infoscan Hypermarkets + Supermarkets), but it is very localised, with different players in the different regions. Milk brands tend to be local and tied to each region or province, and indeed consumers are used to buying local milk brands. There has been some degree of consolidation, with Parmalat and Granarolo emerging as the two leading players on a national scale both with c 23% market share, but even they use several local brands in addition to their main brand (eg Centrale del Latte di Roma and Centrale del Latte di Milano respectively). Distribution is also affected by the local nature of the business, with a significant proportion of fresh milk bought on a regular basis, and hence in local shops rather than in supermarkets or hypermarkets. This again tends to favour regional and local brands. While fresh milk typically lasts a few days before souring, ESL milk is microfiltered and lasts up to one month, but still requires refrigeration.

The market has steadily declined over the last few years, mainly as a result of volume declines. The economic crisis in Italy caused consumption to fall across the board in the consumer space, and more recently a fashion for vegan and dairy-free diets has also caused a shift in consumer behaviour which has led to volume declines. CLT has been gaining share in the regions in which it operates, as illustrated in Exhibit 20.

The Italian UHT milk market was worth €878m in 2015 (Source: IRI Infoscan Hypermarkets + Supermarkets). UHT milk is ultra heat-treated and hence is an ambient product with a shelf life of c three months. The ambient nature of the product means it is more widely bought as part of a bigger shopping basket and hence distribution is more skewed towards the mass channel. Promotion is much more prevalent in the UHT segment, though volumes have suffered for the same reasons as fresh milk, namely the economic crisis and the consumer shift away from dairy consumption. CLT’s market share has fluctuated somewhat, and this has been caused predominantly by promotional activity in the market.

Again, at national level CLT’s (and CLI’s) market share is very small, but improves at regional level. Parmalat remains very strong even at regional level, and this is due to its brand strength and also the ambient nature of the product, thus consumers find it less compelling to buy a local brand as the product is associated with being more highly processed.

In 2014 CLT began exporting UHT milk to China. Volumes remain small, but this could present an interesting growth opportunity. In 2015 CLT signed an agreement with a Dubai-based distributor.

The Italian yoghurt market was worth €1.2bn in 2015 (source: FY15 results presentation). The market is dominated by the major players, with Danone, Muller and Yomo/Granarolo making up 50% of the market. CLT is a small player at both national and regional level, but it has had a stable market share over the past few years.

Although CLT’s share is small, the company has had some success with new product launches. With deep-pocketed multinational competitors on the scene, CLT cannot compete on the R&D front with new products, but it can react quickly to new launches given its smaller size, and it has been successful in tapping into the market for lactose-free products.

This segment accounted for 6% of sales in 2015 and it encompasses a range of ready-washed, dried and often pre-mixed salads. These products have been developed for the local, more traditional trade mentioned above, where a lot of fresh milk is still bought. These local shops do not have the logistics of the larger food retail chains, and hence rely on more regional fresh produce. Due to the relatively short shelf life of both fresh milk and prepared salads, CLT can leverage some of its fixed costs and has added the prepared salads line to enhance its offering.

CLT launched a soy milk in Q213, and followed this with the launch of a rice milk in Q415. Dairy-free milk is proving successful given the trend in Italy for vegan and dairy-free diets. Although the segment is small, growth has been impressive.

This segment acts as a byproduct of the fresh packaged milk business: CLT’s contracts with its milk suppliers stipulate that CLT will buy all the milk produced by the farmer. This obviously changes daily but the main variation is due to seasonality. In addition, the volume of milk required by the fresh packaged milk business can have its own (separate) seasonal variations. Any excess milk, therefore, is sold on as bulk milk and cream to local businesses, mainly cheese- and butter-making businesses and ice cream shops or factories.

This includes a diverse range of fresh products, spanning from fresh cheese to eggs, packaged fresh pasta and pesto sauces, eggs and pre-sliced and packaged cured meats. The strategy here is the same as for the prepared salads segment, so the products have been developed for the local shops. The segment accounted for 20% of sales in 2015.

In December 2015, CLT announced its intention to merge with CLF to create a new entity known as Centrale del Latte d’Italia (CLI), which will also be listed on the STAR segment of the MTA, and will become the third-largest dairy/cheese player in Italy. The key terms are as follows:

The merger between CLT and CLF is highly complementary. The two businesses are very local in their own territories, but operate in similar channels. While at the national level, milk market shares are significantly lower than the larger competitors such as Parmalat and Granarolo, at the regional level both CLT and CLF have leading shares.

The rationale and key benefits of the merger are set out below:

CLT’s key sensitivities include:

CLT’s recent share price performance has been stable and it has outperformed relative to the FTSE MIB on a three-month, six-month and 12-month basis. On 2017 estimates (ie on a pro forma post-merger basis), CLI trades at 18.1x P/E and 8.4x EV/EBITDA, with a 2.3% dividend yield. This is a premium of c 6.5% on P/E, and a discount of 3.4% on EV/EBITDA, to the average of our peer group of dairy processors.

We use DCF analysis to value the shares, and we calculate a fair value of €3.00, or 8% upside from the current level. Given the impending merger with CLF, our valuation is based on the combined entity. We have assumed no cost synergies, which is in line with company guidance. For the sake of prudence we have assumed no revenue synergies and we have based our CLF forecasts on the information that is currently available.

Our DCF is based on our assumptions of 1.5% terminal growth rate and 3% terminal EBIT margin. Our WACC of 5.8% is predicated on an equity risk premium of 4.5%, a borrowing spread of 5% and beta of 0.9. Below, we show a sensitivity analysis to these assumptions and note that the current share price is discounting a terminal EBIT margin of 2.7% (which compares to CLT’s reported EBIT margin of 2.7% in 2014 and 1.6% in 2015) with a terminal growth rate of c 1.5%.

For the standalone CLT business, we forecast 1.1% revenue CAGR translating into 5.6% EBITDA CAGR and 21.2% net profit CAGR 2015-2018. Our financial forecasts include the CLF acquisition but CLT’s management has so far given no financial guidance on the merger and the data available are not complete. The estimates are entirely our own: we have assumed very little growth between 2014 (the last available accounts) and 2016, which is consistent with the trend in the prior years. We have assumed sales of €84m for the CLF business in both 2016 and 2017, and EBITDA of €5.6m, in line with the reported 2014 figures (on an IFRS basis).

Our standalone CLT revenue forecasts are conservative. We model relatively high growth of 4% in 2016, partly driven by a bounceback following a weak 2015, and also spurred by export growth of UHT milk into new markets such as UAE and Kuwait, and new product launches such as 250ml formats of milk and cream targeting single households. We forecast a significant slowdown in subsequent years to give the 1.1% CAGR, as we see milk and basic dairy products as a stagnating category with stable or slightly declining volumes and pricing driven mainly by the movement of the underlying commodity.

We forecast some improvement in the underlying CLT gross margin and EBIT margin as we expect the latter to recover following a disappointing 2015. We forecast EBIT margin progression for the overall entity as CLF’s business had EBIT margins of 3.4% in 2014 (vs CLT’s 2.7%), with margin then settling at our 3% terminal EBIT margin assumption (see our DCF valuation section above: we run a 10-year DCF and hence our terminal EBIT margin is in 2026).

We expect the net finance costs to remain broadly flat on an ex-CLF basis over the forecast period to 2018, though of course the additional debt taken on from CLF will add to the finance costs. Management has indicated that capex levels are likely to remain elevated as the Turin plant is modernised and some investment is made into the Vicenza factory. We forecast the operating cash flow will go towards capex, and hence debt will increase slightly due to the dividend payments. In the longer term, however, we expect capital expenditure to normalise at much lower levels, given the business has relatively low top-line growth and is not overly capital intensive.

We expect the tax rate to be 35% in underlying terms. It is bound to vary year-on-year depending on any exceptionals and also subject to rebates, but we believe the long term rate will be c35%.

Fluctuating commodity costs are an issue for all food manufacturers, and this is particularly the case for food that is relatively unprocessed such as fresh milk. Earnings are therefore likely to be more volatile due to changes in the raw milk price. We currently forecast a flat dividend.

As alluded to above, the Turin plant is due to be modernised. The plant was earmarked for closure, with the view of building an entirely new factory on a different site, but following the announcement of the merger with CLF, that decision has been reversed and instead the existing factory will be modernised. In addition some investment is being made to automate the packaging lines in the Vicenza factory. This results in elevated levels of capital expenditure in the medium term, with management expecting these to normalise again by 2020. This will depress FCF generation in the medium term and we forecast net debt to increase marginally over the period.

Although CLT has a relatively high level of debt vs its market cap (c 40%), within the consumer staples universe it is an efficient capital structure. The debt maturity profile is adequate, with 26% of debt maturing within one year as of 31 December 2015 and 12% of debt with a term over five years.