CCL Products… What’s Brewing?

Instant coffee is commercially prepared from carefully selected green coffee, which is roasted, extracted, evaporated and converted into solid form by either freeze-drying or spray- drying, after which it can be rehydrated to make coffee. CCLP is the world’s largest private label instant coffee manufacturer.Before going deeper into CCLP, let us take a quick look at the entire value chain of the industry

From the above flow, it is very clear where the money lies. The taste of coffee is determined by the roasting/ processing method and know-how about the various types of coffee used and the blending thereof.

The most commonly used methods of processing instant coffee are: 

Spray drying: Producing dry powder from liquid by rapidly drying with a hot gas. Cheaper process and low quality compared to freeze drying. Freeze drying: Freezing the product by lowering temperature and then ice is removed by sublimation. Premium quality and higher margins

This also makes roasting/processing a very capital intensive and IP (Intellectual Property) specific business with long gestation periods (it is not easy to get the perfect blend overnight). We will look at the advantages of this later when we analyze the company in a certain level of detail. If you have further interest, you can read more about the industry value chain, and where the various Indian players (Tata, HUL, Nestle, CCD) operate…

Now back to CCLP: 

CCLP is in the business of manufacturing instant coffee at large scales. It has 200+ blends of coffee and exports them to over 90 countries, where it serves major retailers and coffee brands. 

CCL has manufacturing facilities at two places in India: Duggirala and Kuvvakolli (SEZ). It also has operations in Vietnam (non-military operation, in the form of a spray dried unit) and an agglomeration unit in Switzerland. 

Let’s take a brief look into their subsidiaries and what they do: 

Subsidiaries: 

1. Jayanti Pte Limited (Singapore)- does not have operations. Foreign subsidiaries WERE a step down via this company. In FY18: “ The Board has decided to wind up M/s. Jayanti Pte Ltd by transferring the shares held by it in /s.Grandsaugreen SA and M/s. Ngon Coffee Company Limited, to the parent Company, there by making both the Companies directly owned by CCL as 100% Subsidiaries.” -source: Annual Report
2. Continental coffee SA (Switzerland)- It is an agglomeration unit, operations started in FY11. (Advantage: Closer to European clients. So reduces transportation cost) 
3. Ngon Coffee Company limited, (Vietnam) – Instant coffee manufacturing unit, started operations in 2014 (Two advantage: Closer to producers- transport of processed coffee is cheaper than transporting of beans, due to higher space utilisation; also, Vietnam is a tax haven). Also keep in mind, Nestle and other global giants are present here. 
4. Continental Coffee Private Limited- Promotes instant coffee BRANDS in Indian market. (Folks in Bangalore must have seen this on the shelves of every supermarket. Also served by IRCTC. And has some other institutional tie-ups like Mahindra Holidays). – started operations towards the end of FY16. Currently the third largest coffee brand in South India. In 2018, Praveen Jaipuria (former Chief Marketing Officer @ Dabur) was appointed as CEO of this subsidiary. 
5. CCL Beverages Private Limited: Incorporated in FY20, to implement agglomeration and packaging project in India (Andhra Pradesh). 

We will look into the financials of the subsidiaries in details later on in our document. 

Some business updates:

Global instant coffee revenue is USD 96 Billion in FY20. This market is expected to grow at 11.5% CAGR over 2020-2025. Asia-Pacific leads in terms of market share and is expected to retain top spot. (Conclusion: opportunity size is huge)

As the company manufactures over 200 blends of coffee, onboarding clients with specific requirement is not very difficult for CCLP. For major brands, it is very difficult to shift their sourcing as it might be a major risk factor for them. Hence customer stickiness/ retention is high in the industry. Over last couple of years, CCLP has onboarded a few big brands including JDE coffee (world’s second largest coffee player, JDE was formed by the JV of coffee division of Mondelez with Douwe). Current share of sales to brands is 50%. 

Company claims that during Covid-19, in-house consumption of coffee has increased. This trend MIGHT be sustained (no guarantee of permanent shift in this trend yet).

Company claims to have cost advantage over competitors who import roasted coffee (thus paying high duties, and they also have high operating costs) (30-35% lower cost than Nestle Nescafe and HUL Bru), but advantage might not be sustainable in the long term when competitors start setting up plants in India. Will need to monitor this advantage going forward. Moving on…

Now the most important question: Where does the competitive advantage (business moat) come from? It is in their Intellectual Property (like the taste of coke is unique, the 200+ blends of CCLP are unique and extremely difficult to replicate). Just to understand and appreciate the complexity/ barrier-to-entry a little better let’s see this example: One of their largest customers, stopped taking orders from them in 2018, and started their own production facility. The same client came back to CCLP in 2020 and placed orders because they were unable to replicate the same blend (taste/ aroma) which they sourced from CCLP.(source: earnings call) (Before you ask who, Company has not disclosed the name of the client, and your guess is as good as mine.) This means that CCLP is not just a contract manufacturer (like a Foxconn or Lloyd or Dixon). It is something more. And backward integration for coffee brands is a difficult job. Acquisitions is a more feasible option for brands (JDE has acquired Super). 

So let us look at the Gross Margins of CCLP to support the above arguement…: 

If CCLP was just a contract manufacturer, it would not have commanded 40% + gross margins consistently for over a decade. (For further research, I would advise you to take a look at the gross margins of some contract manufacturers named above, both domestic and international. Their Gross Margins are not so impressive) 

Just for a comparison, let us take a high level look at their closest competitor (from Brasil): Cacique

You can find out about their other competitors from analyst reports. For the listed ones, financials are easily available. 

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Now that we have understood the business a bit, let us look at the financials. As we have already seen, the company has many subsidiaries with significant operations. Hence consolidated statements will give us a complete picture of the company’s financial position. Here it is: (Pardon some minor and inconsequential approximations in the below table)

Observations: 

Ngon Coffee Limited

1. 10-year sales have grown at a CAGR of 14%, 20-year CAGR is 17% (which is pretty decent for such a capital heavy industry).
2. Gross margins are consistently over 40% for over a decade…currently slightly higher than 50%. It has been maintained despite volatile coffee prices. This has happened because of two factors: CCLP works on a cost-plus model since 2010. (Till 2010, margins would fluctuate depending on highs and lows of coffee prices.)  Also, if you want to get a supply from CCLP, then you need to place the order one year in advance. Hence coffee prices are inconsequential for CCLP’s margins.
3. PBT has shown a consistent upward trend for a decade.
4. 10-year growth metrics: 
   
   
5. From 2015 onwards the tax rate declined… What could have caused this? Ngon coffee, which is situated in a tax haven started generating profits from 2015. This is what gives them the low tax advantage. 
6. Company has generated FCF of ~70 Crores, after undertaking heavy capex in recent years, and being in a capital-intensive business.
7. However, they have not generated enough cash to pay for their dividends. This is one thing I do not like about the company. They give a lot of dividend. I would have been a happier investor had I not received the dividend, because all I do with it is I buy more CCLP shares from what comes out as dividends. (And I lose on taxes and transaction fees). They have better use of the cash than I do as an investor. Moreover, in recent years when capex was so heavy, they could have done without giving any. 
8. The receivable days and WC cycle have increased from 2017. This makes us wonder if the financial position of the business is deteriorating…. To get a conclusive answer, I will go back to my old friend ROCE (returns on capital employed). The ROCE levels have improved significantly from 25% in FY15 to 28% in FY19. This means that despite additional working capital, capital utilization of the company has improved.
9. However, in lieu of the increased receivable days, it is important to mention that, in their entire history, the company had zero write offs in receivables account. Most of their business is from old customers who are repeat customers and have strong relations with CCLP. (However, one might investigate further and listen to conference calls and management guidance as to why receivable days are increasing- to maintain client relationships)
10. Fixed assets turnover was at its highest in 2018 at 3.1 (which is slightly on the higher side for manufacturing companies) and has ranged in between 2.2 and 3.1 in recent years. 
11. Self-sustainable growth rate has improved from 8% in 2014 to 20% plus in recent years (despite paying heavy dividends, which is a fantastic development). Higher this ratio, the faster a company can grow without taking on external debt. 
12. Another important point to note is that the interest the company is paying on its debt is at 4%. Average debt through FY21 is 445 Cr, and interest paid on the debt is 9 Cr. The entire debt has been taken for the expansion of the India unit (5000 ton Freeze dried unit set up) and for expanding the branded business. 
13. We have to appreciate the growth in PAT and Cash Flow from Operations for CCLP between 2011 to 2020. (Realization per Kg has been increasing consistently)
14. Overall debt of the company has remained flat between 2010 to 2020. Company has said they want to retire this debt going forward. Interest coverage ratios have always been very comfortable (not important enough to highlight as it does not pose any significant business threat). 

Financials of subsidiaries:

Ngon Coffee Limited

In FY19, some orders got deferred. Margins of FY20 down because some premium mixes were sold in FY19.. 

Continental Coffee SA

Concern: Sales has not really picked up here, in this forward integration effort. Need to monitor going forward. 

Continental Coffee Pvt Ltd. 

This is an interesting subsidiary and let us spend a little time here to understand what is going on.

This business was started in the middle of FY16. They have targeted the south Indian market, which enjoys a 60% share of instant coffee sold in India. CCLP is currently the third largest brand in south India (After NESTLE Nescafe at no 1, and HUL Bru must be no 2). They have an overall 5% market share. 

Distribution reach: Current direct reach is approx. 95,000 retail outlets and by end of FY22 targets to reach about 150,000 retail outlets directly. Distributor expansion has been impacted due to Covid, but indirect reach is approximately 10,000-15,000 outlets currently. Pull from wholesale markets develop as brand grows. Currently it is a very small brand. (For comparison purpose on scope of growth: Two largest brands in India: Nestle and Bru have a direct reach of around 500,000 – 700,000 outlets and total reach (incl indirect reach) will be over 1,000,000 outlets.  

They have also closed a few institutional clients (Club Mahindra and IRCTC have been mentioned by management in previous con calls) in this space. 

This business is currently generating PAT margins of -5%. Management expects this business to be EBITDA positive in FY22. (It takes 7-10 years for a FMCG brand in general to make profits, take a look at ITC).

Now the obvious question is why the growth is so slow…  In 1997, CCLP had tried to venture into the B2C segment, trying to enter the instant coffee market pan India. Not only did they fail miserably, but they also lost a lot of capital. But that was under the leadership of Challa Rajendra Prasad. This time around, with Challa Srishant (his son) at the helm, and a slow and cautious approach towards this branding initiative, chances of loss of large capital is slim. (More on why I like Challa Srishant more as a leader than his father in Management analysis). Also, they have an able and experienced person spearheading this B2C business (we have already talked about Mr. Jaipuria in the subsidiary section). (If you want a margin of safety, you better pay for it- CCLP is paying for it in terms of a cautious approach this time around.) 

Having said this, it is an extremely audacious effort, and to significantly eat into the market share of Nestle and Bru (which they have already done to a small extent in South India) would be a difficult task. Good thing is, there is ample room for all three brands to grow as the market is expanding and the current base for CCLP is very small. 

I am not commenting on when I expect this business to start contributing significantly to bottom-line and cash flows… Predicting when an event will happen in the future is not my competence. But if it happens, then the business will show outsized growth in sales, margins and cash flows. 

Recent Capacity augmentation: 

FY19 capacity is at 30,000 tons and FY20 capacity is 35,000 tons. They have added freeze dried capacity which gives higher margins. Now, priority one is to attain 90-95% capacity utilization of this unit before they splash out further cash to expand capacity, but management has plans to expand capacity to 55,000 tons by FY24 (again subject to progress in terms of capacity utilization). 

Some investment has also been made in a bottling unit which is a part of the forward integration drive. It is an added advantage for branded clients as they do not have to worry about bottling and can focus on marketing and retailing. 

Next phase of incremental profitability will be driven by: 

1. Higher share of premium coffee (freeze dried). 
2. Higher share of value-added products. 
3. Foray into small packaging, and not only bulk selling (5% higher margin there)

All these factors have been possible because of a shift towards branded players from supermarkets and retailers. Though company will never turn away from their retail clients anytime soon because most of them have been repeat clients for over 10-15-20 years. 

Management analysis

1. Mr. Challa Rajendra Prasad (father) is the promoter and founder of the company. Has tremendous technical knowledge about the industry and also sits on the Coffee Board of India. 
2. Mr. Challa Srishant is his son. He joined the company sometime in 2005. Company has made significant progress under his leadership. Under his leadership the company shifted to a cost+ model for sales and undertook international expansion and B2C expansion initiatives. He seems like a capable leader with a good vision. Studied law (gold medalist in Corporate law and was Andhra Pradesh state topper and gold medalist in Mathematics prior to that). He is at the helm right now. Leads all con calls. Has over 15 years of experience in the industry and has a good track record. 
3. Mr. Praveen Jaipuria is the CEO of Continental Coffee Private Limited. As already mentioned, he was the head of marketing at Dabur.
4. No shady third-party transactions noticed in the company over the years. Company does not invest cash in any related business. No hint of minority shareholders being cheated in the history of the company. 
5. Promoters have about 46% shareholding (consistently increasing over the past decade) 

Key business risks: 

1. New technology which disrupts existing technology for processing instant coffee (Lindy’s law comes into effect here. Since inception, instant coffee has been made like this). 
2. There is a customer concentration risk in their bulk business. Top client gives them 10% of their business. 

Valuation:

Downside protection valuation: 

I will not show a DCF model here, as I believe an investment rationale makes sense only if the valuation is so obvious that it can be done on the back of an envelope and still look attractive. 

We have already established that the company has a significantly strong moat in the industry. So, there is little risk of the company facing any permanent hit on their earnings power. Now, historically sales have grown at 14% CAGR. Profit has grown much faster than sales (we have already noticed that). Assuming going forward profits increase at the same rate as sales growth (conservative assumption given what we have already seen about their expansion plan, incremental realization per KG and focus on increasing margins), and the B2C business fails, we still make a CAGR of ~14% on this investment. (underlying assumption is exit P/E ratio remains same as entry P/E ratio.)

Even if P/E ratio contracts by 20% at the end of year 7, and PAT grows at only 14% (realization per KG remains flat, again another conservative estimate), we still double the money in 7 years. So even in a very conservative scenario, we do not lose capital.

But if the B2C efforts starts to pay off, the upside potential is tremendous as the business will get re-rated, due to sales growth along with increasing ROCE (driven by higher profitability-better realization from pricing and pack sizes and better receivable days) … 

I strongly believe that with FY21 PAT expected to be around ~180 Crore INR, the PE multiple of ~16.5 (Current market cap of 2,927 Crores INR) provides a healthy margin of safety. Heads, I win big; tails I win small. Chances of permanent loss of capital is minimal in my opinion.

Disclosure: Invested since 2016. Views might be biased.