Centrale del Latte d’Italia — Steady

CLI’s main focus is milk: it started as Centrale del Latte di Torino (CLT), a milk supplier/distributor in the Turin area. Over time, however, the company 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). In 2016 it merged with Centrale del Latte di Firenze, Pistoia e Livorno, adding a new region (Tuscany) and the new entity was renamed Centrale del Latte d’Italia (CLI). Over the years the company 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 added categories such as fresh pasta, eggs and prepared salads.

The company was founded in 1950 but largely remains a family-owned business. The largest shareholder is Finanziaria Centrale del Latte di Torino, which is controlled by the CLT 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.

We calculate a fair value based on our DCF model of €2.82, which represents 0.8% upside. The main sensitivities to our forecasts and valuation are outlined below. 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 and profitable market.

As an alternative to our DCF valuation, we look at CLI’s key metrics versus the peer group. We calculate that CLI now trades on 70.9x 2017e P/E and 11.3x 2017e EV/EBITDA. The P/E is inflated due to the relatively elevated debt level in the short term associated with the CLF acquisition, and hence the high interest costs. We expect these to normalise by 2019. On EV/EBITDA, CLI trades at a premium of 12.4% to the average of our peer group of dairy processors.

Management’s outlook for FY17 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. Q117 results were in line with the cautious tone set out at the start of the year, which continued from 2016.

Net debt remains high, at €60.2m at December 2016. We forecast net debt to rise to €66.7m at end FY17, which equates to c 8x net debt/EBITDA coverage, though it declines to 7.1x by FY19.

CLI’s key sensitivities include:

CLI is the third-largest dairy producer in Italy. 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 subsequently acquired operations in two other northern Italian regions, namely Liguria and Veneto. The merger with CLF transformed the business by adding a fourth region (Tuscany) and almost doubling sales. We illustrate the breakdown of revenues by category and by geography in Exhibit 1 and 2 below.

CLI has leadership positions in its key markets, thus making it a regional champion. CLI has five factories, which are all well invested with the latest technology for production, treatment and packaging of its products.

CLI has a base milk business, but has also diversified into other fresh dairy products, such as yoghurt, cream and fresh cheese, and also perishable fresh packaged food products, namely fresh prepared vegetables, salads, fresh pasta and eggs. It has created its own strong local brands to support its portfolio. Over the past three years, CLI has set its sights on international expansion: it started exporting UHT milk to China, and also signed an agreement with a distributor for the UAE, Kuwait, Saudi Arabia and Oman.

The merger with CLF was large (CLF sales were c €85m in 2015 vs CLT’s sales of €97m), and we expect it will take a few years for the integration to be fully complete. Nevertheless, 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) milk market was worth €551m in 2016 (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 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. CLI has been gaining share in the regions in which it operates thanks to the strength of its brands.

The Italian UHT milk market was worth €831m in 2016 (Source: IRI Infoscan Hypermarkets + Supermarkets). UHT milk is ultra heat-treated and hence is an ambient product with a shelf life of around 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. CLI’s market share has fluctuated somewhat, and this has been caused predominantly by promotional activity in the market.

Again, at national level CLI’s market share is very small, but improves at regional level. Nevertheless, CLI’s national share has more than doubled during 2016, from 1.5% to 3.7%.

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. CLI is a small player at both national and regional level. With deep-pocketed multinational competitors on the scene, CLI cannot compete on the R&D front with new products, but it can react quickly to new launches given its smaller size, and in the past it has been successful in tapping into the market for lactose-free products. In 2016, however, CLI’s yoghurt sales declined 10.7% due to lower revenues in full fat natural yoghurt and also overall market weakness in the multipack probiotic segment.

This segment accounted for 8% of sales in 2016 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, CLI can leverage some of its fixed costs and has added the prepared salads line to enhance its offering. Sales were up 5.6% during 2016 as prepared salads were successfully introduced across the CLF platform.

CLI launched a soy milk in Q213, and followed this with the launch of a rice milk in Q415. It launched an oat milk during 2016. Dairy-free milk is proving successful given the trend in Italy for vegan and dairy-free diets. Although the segment is small, growth continues to be impressive, and was a stellar 28.9% in 2016.

This segment acts as a by-product of the fresh packaged milk business: CLI’s contracts with its milk suppliers stipulate that CLI 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. The segment is very small (it accounted for 2% of sales in 2016), but is subject to wide swings as it is dependent on spot pricing.

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 22% of sales in 2016 and posted strong sales growth of 9.5%.

In 2016, Centrale del Latte di Torino (CLT) executed a merger by incorporation with Centrale del Latte di Firenze, Pistoia e Livorno (CLF), and the new entity was named Centrale del Latte d’Italia (CLI). The merger between the two companies was highly complementary as the two businesses were very local in their own territories and had leading market shares at the regional level in their respective areas. They also operated in similar channels. The highlights of the transaction were as follows:

CLI’s key sensitivities include:

CLI’s recent share price performance has been stable and it has underperformed relative to the FTSE MIB on a three-month, six-month and 12-month basis. On 2017 estimates, CLI now trades on 70.9x 2017e P/E and 11.3x 2017e EV/EBITDA. The P/E is inflated due to the relatively elevated debt level in the short term associated with the CLF acquisition, and hence the high interest costs. We expect these to normalise by 2019. On EV/EBITDA, CLI trades at a premium of 12.4% 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 €2.82, or 0.8% upside from the current level. We have assumed no cost synergies from the recent merger, 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 a 1.5% terminal growth rate and a 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 3% (which compares to CLT’s reported EBIT margin of 2.7% in 2014, 1.6% in 2015, and -1.1% in 2016) with a terminal growth rate of c 1.5%.

On an underlying basis, we forecast 0.7% revenue CAGR translating into 8% EBITDA CAGR 2016-19. 2017 reported figures will obviously contain an extra nine months of the CLF figures compared to 2016, as the merger only completed on 30 September 2016. We have assumed low sales growth in underlying terms, and margins should benefit in 2017 from the inherently higher margins in the CLF business (3.4% in 2014 vs CLT’s 2.7%), but again in underlying terms we forecast a more muted improvement.

In top-line terms, 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 gross margin and EBIT margin as we expect the latter to recover following a disappointing 2016. The merger is margin-enhancing given CLF’s higher base, and we then assume the margin settles 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 2027).

We expect the underlying net finance costs to remain broadly flat over the forecast period to 2019, though of course the additional debt taken on from CLF will add to the finance costs, and this is incorporated into our overall forecasts. 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 c 35%.

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 undergoing modernisation. This is a staged process, with the upgrade of the pasteurisation phase and new tanks (currently ongoing), the automation of the logistics side (planned for FY18-19), and an upgrade of the production lines (FY20). In addition, some investment is being made to automate the packaging lines in the Vicenza factory, and these should become operational by Q417. On the CLT side, the Florence site is undergoing investment to increase the capacity of the existing automated warehousing facility. This results in elevated levels of capital expenditure in the medium term, with management expecting these to normalise again by 2020. This will depress free cash flow generation in the medium term and we forecast net debt to increase marginally over the period.

Although CLI has an elevated level of debt vs its market cap (c 150%), within the consumer staples universe it is an efficient capital structure. The debt maturity profile is adequate, and well-balanced with 27% of debt maturing within one year as of 31 December 2016 and 27% of debt with a term over five years.

Consumers generally remained cautious during Q117 and the overall domestic Italian market continues to be weak. Raw materials – in particular liquid milk – were up significantly during the quarter, in line with previous guidance. Management has already taken action and increased list prices from 1 April 2017, with full effect from 1 June 2017. This means there will continue to be some pressure on underlying margins in Q2, but it should ease in H2.

The yoghurt business had a tough start to the year. The overall yoghurt market was under pressure in Q1, and CLI’s business in particular suffered from increased promotional activity by the competition, which caused a loss of volume and market share. Q2 is unlikely to show much improvement, particularly given the cool weather (yoghurt consumption rises in warmer weather) during April. There should be some recovery in H2, however, as prices on existing lines are realigned as of 1 June to address the price gap, and new products are launched across the CLI regional platforms (including a plant-based yoghurt).

Q1 gross margins were down sharply (16.0% vs 20.2% in Q116) and this was caused by the significant increase in raw material costs. Labour costs were down 150bp and hence somewhat mitigated the impact at the EBITDA level, but the margin was still down to 1.5% (vs 4.3% in Q116). As mentioned above, we expect that the price increases implemented by the company, coupled with a more benign outlook for raw materials in H2, should help the business recover during the remainder of the year. We leave our forecasts unchanged at this time.