PKM Duda Growing strong on pork z Development of distribution network to fuel expansion z Asian markets to bolster sales and margins z Own raw material supply to provide an edge z Buying spree to continue, mostly in distribution z Low raw material prices in 2006 to support margins z DCF model indicates target price of PLN 16; we therefore recommend to Buy. February 22, 2006 Company Report Initial Coverage Small/Mid -Cap Research CEE Equity Research
Transcript
PKM Duda
Growing strong onpork
z Development of distributionnetwork to fuel expansion
z Asian markets to bolster salesand margins
z Own raw material supply toprovide an edge
z Buying spree to continue,mostly in distribution
z Low raw material prices in2006 to support margins
z DCF model indicates targetprice of PLN 16; we thereforerecommend to Buy.
z Duda plans to increase the number of distribution centers (either viaacquisitions or greenfield investment) from the current six to 10-14 within thenext two years (at a cost of PLN 20mn). The comprehensive distributionnetwork enables the company to earn higher margins and boost revenue.
z Duda has an export license for South Korea and expects to receive approvalto enter the Japanese market. The Asian markets absorb mainly pork parts,offering vast growth opportunities in terms of profitability and revenue.
z Development of a raw material supply base provides price stability for thecompany. Even more importantly, it allows improved meat quality and stockmanagement. Within two years, 50% of raw material should be provided byown pig farms with planned outlays of PLN 60mn.
z For several years, Duda has swallowed companies in order to build avertically integrated meat company. The company will now focus onacquisitions in selected areas, which are key to its growth strategy. However,most projects also assume organic growth.
z After the unfavorable external environment in 2005 (in terms of currency andraw material prices), 2006 should be a relief. The FX market should stabilizeand raw material prices are expected to fall, due to the rising supply oflivestock.
z We valued the company with our DCF model, which indicates a 12-monthtarget price of PLN 16. Therefore, we initiate our coverage with a Buyrecommendation.
Duda acquired meat distribution company Makton in 2004, adding to its operations (itwas previously a pure slaughterhouse and meat cutter). Presently, Duda has a verystrong position in central (Warsaw), southern (Krakow) and western (Poznan) Poland.It plans to develop its network of distribution centers from six to 10 by the end of 2006,and to at least 14 by 2007. Duda intends to invest PLN 10mn annually. The firm wouldlike to purchase at least two centers in northern Poland. However, it is possible that allwill be built from scratch in the form of a greenfield investment. New geographic coveragewill include the entire northern part, plus the southwestern and southeastern corners ofPoland. The development of a comprehensive nationwide distribution network is apriority for the company, as it would provide Duda with the opportunity to boost salesand lift margins. The company will distribute pork parts from own cutting plants andprocessed meat (charcuterie, poultry) from external meat producers. Expansion intonew regions will additionally strengthen Duda’s position as a carcass supplier for meatproducers.
The Polish meat market is not expected to grow at an impressive rate. Therefore, Dudaseeks growth opportunities in Asia. In December, Duda got a green light for export to SouthKorea. In February, it expects to receive clearance for sales to Japan. Both of thesemarkets are very absorptive in terms of pork, which paves the way for the company toestablish good trade relations and propel its top line. The investments in quality and highstandards are now bearing fruit. Moreover, these markets mostly order pork parts (whichare more processed than just half-carcasses) and pay substantially higher prices thanPolish recipients. This translates into fatter margins, thanks to a shift in the productstructure towards more processed meat. The only risk is the strong currency. Althoughcontracted prices are adjusted to reflect FX changes, they may decrease Duda’s overallcompetitiveness in the long run. Nonetheless, the Japanese market has so much potentialthat, as soon as the company gets an export license, the stock price should soar.
Duda currently has two farrow-to-wean farms with output capacity of 100,000 pigs perannum. The company’s target is to cover 50% of the demand for pigs (which presentlytotals 800,000 a year) through its own raw material supply chain within two years. Inorder to achieve such a ratio, Duda has to set up or acquire at least four farms, whichwill cost approximately PLN 60mn (PLN 15mn per farm). The aim of this investment is
Sales breakdown exports
Source: Erste Bank
0
200,000
400,000
600,000
800,000
1,000,000
1,200,000
1,400,000
2002 2003 2004 2005e 2006e 2007e 2008e
Domestic Export
Company Report
Company Report Duda, February 2006 Page 4
Acquisitions tocontinue, mostly indistribution
Market conditions toimprove
Consolidation waskey to success
to immunize production from the volatile cost of livestock. Furthermore, it will increasethe quality and meat yield, thanks to full control over the rearing process. Finally, ownfarms allow the introduction of very tight management of stock and improved logistics.Duda will be able to plan the timing of supplies in advance to a one-hour level of accuracy.This brings cost savings and increases efficiency.
The company’s growth has been fueled by acquisitions in the last several years. At present,Duda’s appetite has still not been sated. Furthermore, the company is concentrating onimproving efficiency via organic expansion into distribution and pig husbandry. Duda plans(through vertical development) to keep margins in-house. However, this does not mean thatthe company will not actively take part in the consolidation process underway in the meatmarket. Duda is keeping all options open regarding the execution of its strategic plans. Itintends to take over one to two farms and a meat distributor in northern and southern Poland.However, if the prices are not satisfactory, the company will set up own ventures instead.Recently, Duda purchased Borys, a slaughterhouse and meat cutting plant in Ukraine forEUR 0.2mn. The output capacity is relatively small and amounts to several hundred pigs perday. Although Duda will be a less aggressive predator in the future, if a good occasion arises,it will not miss it.
In the last year, conditions on the pigmeat market were disadvantageous for thecompany. To start, demand from Ukraine for Polish pigs and low domestic supplyresulted in high prices of livestock, which adversely affected margins and forcedproducers to hike meat prices. This, coupled with the strong currency, damaged thecompetitiveness of Duda on foreign markets. Secondly, appreciation of the PLN resultedin increased imports of meat (especially form Denmark), usually of low quality.Obviously, this increased pressure on margins. The sum of these negative factorsimpacted Duda’s figures, which in our opinion were below the company’s potential.However, in 2006, the situation is anticipated to improve. The increased headage oflivestock pulls prices down (in January, pork decreased by 11% y/y) and this trend isexpected to continue.
History
Duda was established in 1990 as a family company under the name of “Trade andProcessing of Food and Agricultural Products”. Six years later, the company wastransformed into a limited liability company, which facilitated its further development. In2002, Duda was transformed into a joint stock company, which accelerated the growth.At the turn of 2002 and 2003, Duda was floated on the WSE and gathered capitalearmarked for future growth. In 2003, the company started to aggressively consolidatethe meat industry and develop its own raw material supply by acquiring five companies.In 2004, the group was enlarged by another several companies from the meat industry,including Makton and Eurosmak, which were paid in shares. Poland’s entering the EUon May 1, 2004 opened the way for the company to absorptive western markets. Lastyear, Duda restructured its group and swallowed another two enterprises. Despite theunfavorable external environment (strong currency and high prices of raw material), thecompany managed to improve its results. During the last couple of years, Duda hascompetently used EU funds to modernize its production lines and propel expansion. Atpresent, the company is the third largest meat producer in Poland, with greatopportunities for growth and promising prospects.
Company Report
Company Report Duda, February 2006 Page 5
Structure and ownership
PKM Duda (Polish Meat Concern Duda) is owned by the Duda family, who set up thecompany. They hold a 34.89% stake. Duda also attracted two institutional investors,PZU OFE and Julius Bear, which hold 14.0% and 5.0% stakes, respectively.
The group structure can be divided into three segments: (1) supply, breeding andhusbandry, (2) slaughtering and meat cutting and (3) distribution. The first segmentconsists of six subsidiaries, the second consists of three and the last has four. All areowned by PKM Duda, the capital group leader (which is focused on red meatproduction). The structure and Duda’s share in each of these companies are illustratedin the following table.
Each company will be described in detail in the next section.
Shareholders
Source: Duda
Group structure
12.6%
11.5%
10.7%
10.6%5.0%
49.5%
Duda-Jankowiak Bogna Duda Marcin Jerzy Duda DariaOFE PZU Julius Bear Others
PKM DUDA – capital leaderSupply, breeding and husbandry Slaughtering, meat cutting and
processingDistribution
Company Report
Company Report Duda, February 2006 Page 6
Strategy and Overview
PKM DUDA is a red meat producer and the group’s holding company. The firm is focusedon slaughtering and cutting of pork. The company’s plant is situated in Grabkowo, asmall town in the western part of Poland. This modern slaughterhouse was built in 2002and complies with all EU norms. It has slaughtering capacity of 3,000 pigs daily(production of 200 tons of pork). It is the only such specialized plant in Poland. Dudaalso operates one of the largest freezing facilities in Poland located in Grabkowo andKobylin Stary, with storage capacity of 25,000 tons.
The company purchases pigs from contracted suppliers and sells carcasses (85% ofproduction) and pork parts (15%) produced at its meat cutting unit.
All subsidiary companies are divided into three sectors. In the agricultural sector, thereare six companies, which are the first link in Duda’s group (creating a raw material supplychain). Eko-Duda produces crops (corn, sugar beet) for feed. Pleszew is concentratedon purchasing and storing of grains used in the feed production. Agroprof and Rolpolproduce crops (rape, wheat, rye, corn) on land leased from the governmental AgriculturalProperty Agency. Wizental is a breeder of beef and dairy cattle.
Agro-Duda is specialized in pig breeding and grain purchase and storage. In April 2004,the company acquired two breeding farms. The first one, Miodary, is leased for 20 years,and has annual capacity of over 40,000 piglets. The second one, Nowy Swiat, is ableto produce 55,000 piglets. These two farms cover 1/8 of total supply for PKM Duda.
The production sector consists of three subsidiary companies (plus parent companyPKM Duda). The first is Jasan, the biggest horse meat producer in Poland. Jasan hasoutput capacity of about 22,000 horses per year. 90% of horse meat is exported, chieflyto Japan and Italy. Jasan also slaughters cattle, which is then supplied to another Dudasubsidiary. The second company is Polska Wolowina, concentrated on slaughtering ofcattle. It has annual revenue of about PLN 30mn. Almost 40% of total sales are exported.Finally, Eurosmak is focused on pork meat cutting. Its sole recipients are Makton andFedrus, other members of the group. It has two meat cutting plants near Warsaw and,since January 2005, one near Poznan (western Poland), purchased from Kompar.Previously, Duda planned to acquire all of Kompar, but, due to legal risks, it decided tosimply pull out its assets.
All of Duda’s Polish plants are very modern, have advanced production lines and complywith EU norms. They have been granted ISO and HACCP certificates. Presently, Dudapurchased its first assets abroad. Borys is a small slaughterhouse and meat cuttingplant in Ukraine with daily output of several hundred pigs.
The distribution sector comprises four companies, which together have six distributioncenters. NetBrokers operates an Internet commodity exchange for trading of agriculturalproducts. It provides industry-specific information and allows trade offers online. Itsrevenue amounts to over PLN 33mn p.a. It mainly supports import-export transactions.Duda has a 56% stake, while the rest is held by ComArch. Secondly, Euro-Duda wasestablished to facilitate the delivery of existing export contracts and to provideslaughtering and meat cutting services in the biggest plants located in Germany. Fedrusis a meat distributor active in the western part of Poland. It was consolidated into thegroup as of 2H05. It owns one distribution center and its annual sales amounted to PLN73mn in 2005. Makton is the largest subsidiary in the whole group with annual revenueof approximately PLN 350mn. It distributes pork parts from Eurosmak plants as well ascured meat and poultry supplied by external meat plants. It operates three distributioncenters near Warsaw and two close to Krakow. It offers over 1,500 products from thelow, medium and high-quality segments. The distribution network comprises 250 dealer-
Company Report
Company Report Duda, February 2006 Page 7
operated outlets. As Makton has its own fleet of refrigerated vehicles, it can deliver meatwithin several hours. Its client base includes wholesalers, who purchase goods in bulk,and retail shops.
The process of production in the Duda group starts at the stage of husbandry and endsthe moment the meat is delivered to the end-client. However, Duda skips the deepprocessing phase (i.e. production of cured meat, canned meat and meals). Thestructure of processing and production is illustrated below.
The process of pigmeat production in the Duda group begins in the agricultural segment.There, feed is produced from harvested crops and pigs are bred on two own farms. Pigbreeding is conducted on a contract fattening basis. This basically means that, after theweaning stage, piglets are provided by the company to contracted farmers for nurseryuntil the pigs reach market weights. Piglets are fattened using feed supplied by aprovider associated with the company. The process is conducted in accordance withestablished rules and schemes designed to achieve uniform breeding conditions andhence the high quality of the material. Afterwards, the pigs are repurchased at a pre-determined price and delivered to Duda. Presently, 12.5% of the group’s demand issupplied through this system.
In the second stage, pigs are slaughtered and turned into half-carcasses. Approximately15% is then processed in a meat cutting plant situated next to the abattoir. The obtainedproduct is 22 pork parts, including loin, tenderloin, ribs, etc., which are sold towholesalers in Poland and abroad. The majority of half-carcasses are sold directly toexternal meat processing plants, who manufacture cured meat, sausages and packedmeat products. The rest (5%) is purchased by Eurosmak, which dissects carcassesin one of its three meat cutting plants and supplies the pork parts to Makton and Fedrus.However, Eurosmak buys more carcasses on the open market than from the parentcompany, as it is cheaper and more efficient. One of its negotiating strengths is theability to easily substitute carcasses, bought from other suppliers, with those comingfrom Duda.
Last but not least, the distribution stage, which is becoming increasingly important inthe group structure. Makton and Fedrus distribute not only pork parts from the group’smeat cutting plants, but also products from external meat processors. These producersare very often supplied by Duda with half-carcasses. Thus, in general, carcassesproduced by Duda are processed outside the group, but ultimately return and aredistributed via the company’s network.
Production process
Charcuterie, poultry
DUDA
80%
87.5%
12.5%OWN FARROW-
TO-WEAN FARMS
External FARMS
FEED
WEAN-TO-FINISHFARMS
SLAUGHTER HOUSE
MEAT CUTTING
EXTERNAL MEAT (PROCESSING)
MEAT CUTTING PLANTS
EXPORT, EXTERNAL DISTRIBUTORS
15%
5%
EXTERNAL SLAUGHTERHOUSES
EUROSMAK
DISTRIBUTION MAKTON +
FEDRUS
WHOLESALERS
RETAIL SHOPS
Source: Duda
Company Report
Company Report Duda, February 2006 Page 8
Duda’s strategy is to develop each of its three segments, but also to utilize synergiesstemming from the control of several links in the value chain. All segments complementeach other and cooperate tightly in order to save costs and keep more margins in-house.
In the agricultural segment, Duda intends to increase the share of pigs coming from itsown farm system to 50% of total livestock supply. As Duda needs 800,000 pigs p.a.,this would require raising the output capacity of own farms fourfold. To achieve this, thecompany will build or acquire at least four farms by 2008. The cost may total PLN 60mn.One of the main obstacles to building a pig farm is a restrictive law, which demands anextensive area for rearing, the effective utilization of liquid manure and compliance withsanitary regulations. All in all, local authorities are very reluctant to approve the openingof a new farm. Therefore, apart from being costly, such an investment is also time-consuming. However, covering half of own demand for pigs has three unquestionableadvantages:
z price stabilizationz improving quality of meatz more efficient stock management
On the livestock market, prices often change rapidly, with an impact on the company.The aim is to avoid unexpected fluctuations and stabilize the raw material costs.Secondly, taking control of the breeding process allows the production of fatter pigs withhigher meat yield and better quality. Production lines at Duda’s slaughterhouse havedaily output of 3,000 pigs. The cost per unit does not depend on the weight of the pig.The current average weight of a pig is 108kg. Increasing this to 120kg (with a better meatyield) results in a significant cost reduction, due to improved efficiency. On top of that,own farms enable the company to plan supplies to an accuracy level of one hour. Thanksto its transportation fleet, Duda will introduce stocks “on wheels”, which againconsiderably increases efficiency.
However, most importantly, the situation and competition on the livestock market is thebiggest risk for Duda. The shortages in pig supply and rising prices are disrupting theproduction process and inflating costs. In our opinion, having own farms gives thecompany an enormous edge over its competition.
CAPEX
Source: Duda, Erste Bank
0
10,000
20,000
30,000
40,000
50,000
60,000
70,000
80,000
90,000
100,000
2002 2003 2004 2005e 2006e 2007e 2008e
PLN '000
Company Report
Company Report Duda, February 2006 Page 9
In the production segment, the company has little to improve. The production facilitiesare modernized and, due to its specialization, Duda has an edge over its competition.The company is not active in the deep processing of meat and has no intentions tochange the present situation. Entering this competitive segment would change Duda’sposition from a supplier and distributor of Poland’s largest meat producers to their directrival. In our opinion, this is a reasonable strategy, and the potential risks and costsoutweigh the possible gains from revenue and margin increases. Furthermore, alongwith development of own distribution, Duda intends to purchase an additional cuttingplant. The company also purchased a company in Ukraine. This market involvessubstantial political risk, but its potential and growth prospects are compelling. Theacquisition concerns a small slaughterhouse with output capacity of several hundredpigs per day. The cost amounted to PLN 0.8mn. Nonetheless, it is a very importantfoothold, also paving the way for exports to Russia.
Expansion in the distribution segment should fuel growth in the next two years. Dudaplans to develop most aggressively in this segment. Presently, Duda has six distributioncenters, although it intends to have at least 10 by the end of 2006 and 14 by 2007. Theannual cost may amount to PLN 10mn. The company is very close to finalizing theacquisition of a meat distributor in northern Poland, which will add two centers at a costof PLN 6mn. Subsequent centers will either be built from scratch or acquired. One wayor another, we think that shifting the company’s center of gravity towards distributionis a compelling strategy. First off, Duda plans to take over a distribution company inSilesia, which will be supplied with pork parts from Eurosmak’s Krakow plant. Secondly,Duda will take over a distribution company in the country’s southwest corner, which willbe supplied from the parent company’s plant. Thirdly, a distribution company in northernPoland with a meat cutting plant situated nearby is to be acquired. In the case that oneof these acquisitions does not end in success, Duda will set up own subsidiaries.Thanks to its distribution development, the company will surely benefit from:
z nationwide coveragez firmer relations with clientsz a jump in revenuez scalez expanding the production of pork parts
The company’s distribution network will cover all of Poland, which will strengthen itsposition. Moreover, with a more comprehensive distribution network and nationwidecoverage, Duda will become a more important partner for leading meat producers inPoland. As Duda is also their supplier of half-carcasses, the relations will be firmer. Thecompany usually signs agreements with clients according to which Duda distributespart of their products.
With the growing size of the company, its negotiating position towards suppliers andother distributors also improves. This is another advantageous development.
Company Report
Company Report Duda, February 2006 Page 10
Furthermore, due to the group’s size and efficiency, Duda can quickly turn around acquiredcompanies. In the case of greenfield investments, the company has the experience and abilityto rapidly climb to top positions among local distributors. A good example is the Krakow area,where Duda established an own distribution center. After just a couple of months, it was aleader, beating local wholesalers that had been present for years. The outlays on distributionare relatively small, but development in this sector will be the main top line driver. On top ofthat, healthy margins earned on this business guarantee that Duda still has huge growthpotential. We expect these margins to have amounted to about 8% in 2005.
Duda’s management is engaged in creating additional value for the company and isdedicated to improving the results. To reward management, Duda introduced amotivational scheme in 2004. In 2006, 2007 and 2008, management will receive up to0.5mn new shares, depending on the company’s performance in the previous year.Management will get the following each year:
z 0.2mn shares if EBITDA per share grows by 20%, 40% and 60% in 2005, 2006and 2007, respectively (the base year is 2004).
z 0.2mn shares if EPS grows by 20%, 40% and 60% in 2005, 2006 and 2007,respectively (the base year is 2004).
z 0.1mn shares if the share price outperforms the WIG index by 10%.
If one of the above conditions is not fulfilled in a particular year, it can be made up forin the subsequent year. The quarterly cost of this program is estimated at PLN 1.4mn(PLN 5.6mn p.a.). Thus, in 2006, 0.4mn shares will be issued, as EBITDA grew by 53%and EPS jumped by 33%. However, the stock price underperformed its benchmark (theWIG index) by 53%.
Duda is benefiting immensely from Poland’s EU entry, as it receives funds from threesources. Firstly, Duda has over 3,000 ha of arable land, which is subsidized by over PLN1.5mn p.a. Secondly, the EU sometimes refunds exports of beef to countries outside theEU. Approximately PLN 0.6mn per year flows in to the company under this program. Finally,the EU supports the modernization and restructuring of companies active in agriculture,including meat processing (but not distribution). From funds already received under theSAPARD program, the company still has to account for PLN 12mn (as money received fromthe EU is not booked as one-off profit, but is spread over several years). This means thatPLN 1.5mn will go through the P&L for the next eight years. Furthermore, Duda and itssubsidiary Eurosmak have filed motions to receive subsidies for their investments totalingPLN 32mn (up to 50% will be refunded). The money should flow in during 2006-08.
Distribution - expected sales breakdown in 2005
Source: Erste Bank
57.0%31.7%
9.3%2.0%
Curbed meat Meat Poultry Canned meat
Company Report
Company Report Duda, February 2006 Page 11
Sales and revenue
We expect 2005 revenue to have surged by 55.4% y/y, on the back of acquisitions andexpansion in the distribution sector. The top line came in at PLN 829mn. EBIT reachedPLN 42.2mn, for 40% growth. The operating margin was down 0.5pp to 5.1%. Net profitamounted to PLN 29.2mn, which translates into a 25% y/y increase. The net margindropped to 3.5%, from 4.4% in the previous year. The operating profitability stems fromthe lifted gross margin on sales, due to the improved product portfolio. The bottom linewas damaged by high financial costs, due to the rising debt and one-off items.
2005 was very unfavorable for Duda. The high prices of livestock trimmed margins, whichotherwise could have been considerably higher. The delay in signing export contractsto South Korea curbed sales. On top of that, disposing of assets at subsidiaries incurreda loss of PLN 3mn.
We think that the company’s future prospects look much brighter than the situation in2005. The realization of its growth strategy will result in a robust sales growth tempo,cost savings and gradual immunization from volatile livestock prices. Moreover, theseprices are presently over 10% lower than a year ago. Additionally, the consolidation ofFedrus will boost the top line in 1H06 by approximately PLN 45mn. Export contractsalso contribute to revenue and earn nice margins, despite the strong PLN.
We envisage revenue in 2006 at PLN 1.02bn, for 23% y/y growth. The gross margin willimprove, mostly due to the lower prices of livestock. EBIT should reach PLN 51.6mn (up22% y/y). The bottom line should increase by 16%, amounting to PLN 33.7mn.
On the cost side, we expect the structure to change slightly, with the rising share ofexternal services and employment costs and declining share of materials. However,livestock makes up 75% of the total costs.
Sales volume ('000kg) Sales value (PLN '000)
Source: Erste Bank
0
10,000
20,000
30,000
40,000
50,000
60,000
70,000
80,000
2003 2004 2005e 2006e 2007e 2008e0
100,000
200,000
300,000
400,000
500,000
600,000
2003 2004 2005e 2006e 2007e 2008e
Company Report
Company Report Duda, February 2006 Page 12
The margins Duda earns on pork carcasses after slaughtering are stable in terms ofvalue, staying in the range of PLN 0.6-0.8 per kg of hot carcass weight. Obviously, whenthe price of livestock falls, these margins get closer to the higher end of the range (andvice versa). Furthermore, the margins expressed in percentage points are climbing evenmore steeply. The margins in the meat cutting unit, which produces pork parts, aresomewhat higher.
Consequently, we expect the gross margin on sales at 13.4% in 2006, 0.4pp higher thanin 2005. The EBIT margin is anticipated to be flat compared to the previous year at 5.1%.The net profit margin should edge down to 3.3% in 2006, compared to the 3.5% expectedin 2005.
Cost structure
Source: Duda, Erste Bank
Pork prices
Source: Duda, Erste Bank
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
2002 2003 2004 2005e 2006e 2007e 2008e
power and materials depreciation external services
employment cost other cost
2.00
2.50
3.00
3.50
4.00
4.50
5.00
5.50
6.00
6.50
2003 2004 2005e 2006e 2007e 2008e
PLN / kg
PORKPIG(HCW)PIG
Company Report
Company Report Duda, February 2006 Page 13
Seasonality is most clearly visible in the company’s agricultural segment. There, therevenue and costs peak in 3-4Q and the results are visible after the harvest. In the meatsegment, sales culminate in 4Q as Poles purchase more meat in winter, while traditionalholidays boost demand.
In our opinion, the increasing debt will not hinder the company’s robust growth. The D/E ratio is at a safe level of 0.6, and we do not expect the company to exceed this figure.The development will be financed with own funds and credit. Duda generates niceoperating cash flows, and is thus able to go ahead with its strategy.
Margins
Source: Duda, Erste Bank
Seasonality
Source: Duda, Erste Bank
0%
2%
4%
6%
8%
10%
12%
14%
16%
2002 2003 2004 2005e 2006e 2007e 2008e
Gross EBIT Net
0
50000
100000
150000
200000
250000
III 03 IV I 03 II III IV I 04 II III IV I 05 II III IVe
PLN '000
Company Report
Company Report Duda, February 2006 Page 14
Products
Duda mainly produces two types of meat: beef and pork. Pork accounts for almost 98%of sales. The pork offering comprises carcasses, half-carcasses, pork parts (ham, loin,tenderloin, collar, belly, jowl, loin ribs, heads, feet, etc.), pork trimmings, fats, porkintestines and pork offal. The assortment in beef meat is analogous, with the additionof beef skin. Duda also offers horse meat, which is sold on the Italian and Japanesemarkets. In terms of value, pork carcasses make up 74.4% of pork sales and pork partsaccount for 18.6%. In terms of volume, the share of carcasses is 68.4%, while partsconstitute 17.3%.
Duda’s distribution arm offers cured meat, poultry, canned meat and pork parts (loin,tenderloin, ribs, etc.). The pork parts are supplied exclusively by meat cutting plantsowned by Duda. The remaining part of the assortment is supplied by external meatproducers. In 2005, we expect the distribution business to have made up ca. 40-45%of total revenue.
Duda also offers some trade services, namely distribution of meat and charcuterie(cured meat) products, trade agency services (Internet platform) and specialized cuttingservices. Moreover, the company provides freezing services, as it operates one of thelargest freezing complexes in Poland with storage capacity of 25,000 tons. Thecompany also provides services in the agricultural segment (storage), but they are ofminor importance.
Production structure
Pork Beef
Source: Duda
2.40%
1.60%
2.30%
0.70%
74.40%
18.60%
Carcasses Parts Trimmings Fats Offal Intestines
62.30%8.00%
16.60%
8.90%
4.20%
Carcasses Parts Trimmings Skins Offal
Company Report
Company Report Duda, February 2006 Page 15
Major customers and suppliers
Domestic receivers of the company’s products can be divided into five categories:
z meat processing plantsz meat dissecting plantsz super and hypermarket chainsz small retail shopsz service receiversz others
The first group consists of leading meat processing plants located throughout thecountry. The second group is clients, who buy pig half-carcasses and beef quarters, asthey do not execute activities concerning purchase and slaughter of livestock on theirown. The sales to the third group have been climbing steeply (doubling in 2004) as aresult of Duda’s efforts and new EU rules, which concern compliance with strictrequirements in meat dissecting conducted by commercial chains. However, thesesales dropped in 2005, as Duda withdrew from several contacts, due to their lack ofprofitability. The fourth group of customers is supplied by the group’s distribution arm,Makton. The fifth group of recipients mainly orders storage and freezing services.
The share of exports in total sales is estimated at 17% for 2005, which translates intoPLN 140.5mn. However, as the company intends to expand in Asian markets (SouthKorea and Japan), it may reach 25% in 2006. Duda presently has an export license foran abattoir and cold storage room, which enables the company to sell meat to all EUcountries and South Korea. The company expects to get a green light for export to Japansoon. Export is a very important direction for Duda’s development, and in our opinion,this part of revenue should grow very quickly. Since 2002, exports have risen from a merePLN 27.7mn to PLN 140.5mn in 2005, translating into a robust tempo of +72% p.a. Asthere is no rose without a thorn, due to the very strong currency in 2005, the marginson export sales have been squeezed substantially. Apart from export to EU countries,Duda established trade relations and exported meat to countries such as Belarus,China, Romania, Russia, Ukraine and Bulgaria. The company received an exportlicense for South Korea in 4Q05.
Recipient structure of parent company
Source: Duda
15%
15%
5%65%
Supermarket chains Export Own distribution Meat processors
Company Report
Company Report Duda, February 2006 Page 16
Duda buys livestock for further processing. The purchase of raw materials is mostlybased on long-term cooperation with the suppliers. Presently, over 75% of the pigs aredelivered under such agreements. This guarantees high quality and continuity ofsupplies. The supplier base is highly diversified, to ensure that Duda is not dependenton one or two companies. Almost 95% of raw material is purchased directly fromspecialist pig, livestock and agricultural farms and individual farmers in order to eliminateintermediaries. One problem is the recurring decreases in the quantity of livestockavailable on the market, which temporarily inflates prices. In order to insulate itself frommarket fluctuations, Duda begun to build a raw material supply chain, as describedearlier.
Taking a glance at the price moves of pig livestock for the last three years, we can seethat after EU entry, prices jumped considerably. Shortly after the initial shock, adownward trend occurred. According to a recent forecast, pig prices will continue todecline, due to increasing headage, which exceeded 18mn (+6.6% y/y). The price isdetermined primarily by the supply and demand relation. Farmers tend to rear more pigswhen the relation of livestock price to feed price is favorable or when the demand for meatis high. This relation (to rye) came in at 10.9:1 at the end of 2005, which indicates thatfeed prices were very low. This predetermines further headage growth in the first half of2006.
Prices (PLN)
Source: Agricultural Market Agency
2.00
2.50
3.00
3.50
4.00
4.50
2003 2004 2005 2006e 2007e
PIGMEAT CATTLE2005 in detail
3.2
3.4
3.6
3.8
4
4.2
4.4
I 05 II III IV V VI VII VIII IX X XI XII
Competition
Duda conducts a very specific business, and for many of the other companies in itssector, it can be a client, supplier and competitor all at the same time. On the livestockmarket, it competes with meat processors, other slaughterhouses and meat cuttingplants. The competition on this market is very tough. An additional obstacle is therelatively short maximum distance of supplies. The company has an advantage over itscompetition, as its very modern, unique transportation fleet it is capable of transportingpigs as far as 300km. The harsh competition is the main reason why developing ownfarms is a key issue for Duda to be able to grow sustainably in the long run. On theabattoir and meat cutting market, Duda’s rivals consist mostly of small local plants. Inthe slaughterhouse business, Duda is the clear leader in Poland. In distribution, Dudais again a leader, with the most comprehensive distribution network. The largest players,like Sokolow, JBB and Animex, are either Duda’s clients or suppliers (or both).
Company Report
Company Report Duda, February 2006 Page 17
There is a risk that the top meat producers will decide to move a step backwards anddevelop own slaughterhouses, but in our opinion such a scenario is not very likely. WhenPoland joined the EU, most were forced to modernize and comply with EU norms inprocessing and slaughtering. Moreover, specialization and experience is very importantin this business.
Forex exposure
Duda’s exports are mostly charged in USD (Asian markets, CIS countries). Thecompany has no natural hedging. Therefore, it is exposed to an increasing currency risk.In our opinion, this is not very serious, as the prices contracted to Asia are adjusted tocurrency changes. Secondly, the margins on sales to eastern countries are still abovedomestic ones, so there is no risk of losing profitability there. PLN appreciation is moredangerous for the domestic market - it encourages competitors to import cheap meatfrom western countries (Denmark, for instance), which puts pressure on sales margins.
Polish meat market
The Polish meat market is very fragmented, with over 3,500 active companies. Theseenterprises operate in different segments and include both small local slaughterhousesand large multinational concerns. The meat industry lacks specialization and efficiency.Most of the companies are obsolete and their average return on sales fluctuates around1%. What is more, tough competition puts substantial pressure on margins.
Nonetheless, red meat production is one of the most important food industries, withestimated sales of PLN 12.2bn (plus PLN 3.6bn in revenue generated by wholesalers).Meat is one of the main ingredients in every Pole’s diet. In 2004 and 2005, the Polishmarket was shook by major external events: EU accession, the spread of mad cow andfoot and mouth disease and the Russian ban on imports. The latter two obviously hada negative impact on the overall industry. As for the future outlook, EU entry paved theway for expansion in its absorptive markets for modern producers, which invested intechnology and quality in advance of joining the union. In addition, CAP (CommonAgriculture Policy) impacted market prices of livestock and, consequently, meat. Inany case, companies with adequate size and quality proved that nice margins can beearned in this business.
0.00%
0.20%
0.40%
0.60%
0.80%
1.00%
1.20%
1.40%
1.60%
1.80%
2.00%
4Q02
1Q03
2Q03
3Q04
4Q03
1Q04
2Q04
3Q04
4Q04
1Q05
2Q05
3Q05
Return on Sales - Industry
Source: EuroMoney Polska
Company Report
Company Report Duda, February 2006 Page 18
The meat industry is now facing consolidation that started several years earlier.Companies are integrating vertically and horizontally to increase their market shareand survive in the highly competitive environment. In our opinion, the market leaders willreap profits on their investments, as smaller ones go bankrupt and the market continuesto grow at a sustainable rate.
The meat industry consists of four links in the value chain. The first is supply, breedingand husbandry, which provides the raw material for further processing (namely pigs andcattle). The second is slaughtering, dissecting and meat cutting, which produces mainlypork half-carcasses and beef quarters. The third comprises meat processing, used inthe manufacture of traditional red meat products, charcuterie (cured meat), sausages,canned meat, etc. The final link is distribution, including warehouses, retail shops andsupermarket chains.
The market consists of a large number of players, but the top three hold approximatelya 19% share of the market. Duda currently has a 3.5% share of the total meat market,which is valued at PLN 24bn.
EU regulations
The market is influenced by the prices of raw material and the Polish currency. After EUentry, Polish companies received access to western markets, where profitability ismuch higher. However, the strong Polish currency damages margins. Another problemfor an average Polish meat producer is lack of funds to promote their brand or assortmentabroad. The prices of materials depend on the supply and demand relation for livestock,supported by an intervention price set by the European Commission.
The meat industry, as part of the agriculture industry, is regulated by CAP. Generally,there are three tools used to improve the EU meat market:
z public interventionz grants to support private storagez export refunds/subsidies
The first (as far as the pigmeat market is concerned) takes place when the average EUprice, weighted to reflect the relative size of the pig herd in each member state, fallsbelow 103% of the basic price. The basic price is set at EUR 1,509.39 per ton for pigcarcasses (category R). On the beef and veal markets, public intervention is authorizedwhen the price of juvenile cattle or steers fall below EUR 1560 per ton. However, publicinterventions have not been used for at least twenty years.
Animex, 9.2%
Sokolow, 6.3%
Duda, 3.5%
JBB, 1.8%
Indykpol, 2.7%
Others, 69.0%
Market shares
Source: Duda
Company Report
Company Report Duda, February 2006 Page 19
The payments for private storage can be made on the beef or pork market when theaverage price on the Community market falls below 103% of the basic price (set at EUR2,224 per ton for beef).
The export refunds concern beef, while subsidies concern pork that complies with EUsafety and quality standards. Nonetheless, the EU intends to eliminate all exportsubsidies in agriculture before 2013. The rates are set by the EU ManagementCommittees and vary depending on their class and quality. For instance, in I-XI 2005,Polish pork exports of 6,600 tons were subsidized by PLN 3.6mn; beef exports of 15,200tons received PLN 43.3mn.
There are also emergency measures to help stabilize the markets in the case of differentcrises (like mad cow disease). Foreign trade is regulated by common customs tariffsand is subject to export/import permissions.
An additional regulation that damages the profitability of a large number of smallerproducers is the obligation to comply with EU norms in terms of quality and hygiene.This is another trigger for a wave of consolidation.
Threats and chances for export
Poland’s pork exports doubled after EU entry from 80,000 to 160,000 tons. However,depending on the direction, the outlook looks totally different. On one hand, Polishforeign trade was hampered by external problems spurred by its eastern neighbors. Lastyear, the Polish meat industry had trouble exporting its products to Russia. In 2005,Poland exported 25,000 tons of pork to Russia, but since November 10, 2005, this tradehas been barred. Russia accused Polish producers of counterfeiting export permissions.This ban hurt many producers and resulted in an increased supply of pigmeat on thePolish market. Although the Polish government intervened firmly, the ban is still in effect.Apart from this, the prices of livestock were pushed up in 2005 by demand for pigscoming from Ukraine. Due to currency and legal changes, Polish pigs became cheapfor the Ukrainian meat industry, which started to buy them on the Polish market.Consequently, the supply for the domestic industry dropped and prices increased.
On the other hand, there is a great opportunity for Polish exports in opening Asianmarkets for Polish products. It is very likely that the Japanese market will become openfor Polish pork in early 2006. This is one of the largest world markets, offering very highprices and ordering not only meat, but also processed products. Although it is hard toobtain export permission, 60 of Poland’s most modern producers proved their qualityand are very close to getting the necessary approvals. Japan is expected to absorb atleast 50,000 tons of Polish pork, which means that export sales will exceed 200,000tons. What is more, China is likely to follow soon thereafter.
Another issue tormenting the meat market is a broad ‘twilight’ market. According torough estimates, this accounts for up to 30-40% of total meat consumption. Thisproportion has even increased since EU entry, as has price inflation.
The future outlook for market prices is favorable for meat processors. The prices oflivestock are anticipated to drop, due to rising headage. In the case of pigs, as aconsequence of the favorable relationship between feed and pig prices, headage roseby 6.6% to over 18mn. This tendency is expected to continue in 2006, with theproduction of pork amounting to 1,070-1,100 tons, i.e. +10-13% y/y. This will result ingreater supply and, consequently, lower prices. As for beef and veal, the headage hasalso climbed to 5.5mn (+2.4%) and is expected to grow in 2006 by a further 3%.Therefore, its prices should stabilize at about PLN 4.00 per kg of live weight.
Company Report
Company Report Duda, February 2006 Page 20
For the entire EU market, the envisaged growth measured by CAGR for 2005-12 in beefconsumption is –0.3% (0.0% for the ten new members), with pork at +0.4% (+0.8%).On the overall Polish meat market, the increasing share of white meat in totalconsumption is easy to see. In 2000, poultry accounted for 24% of meat consumption,but in 2004 its share jumped to over 33%. The total consumption of meat and fish isgrowing at CAGR of 1.8% (excluding fish, at 2.6%). Growth at this stable andsustainable rate is expected to continue for the next several years. The per capitaconsumption of beef is at 4.0 kg and pork at 39.0 kg (compared to 17.9 kg and 43.3 kg,respectively, in the EU-25).
The meat market is very dispersed, largely obsolete and regulated under CAP.Producers that have modernized production lines and comply with high qualitystandards will benefit from EU entry and the slowly opening Asian market. The maintrend, which is inevitable in this industry, is consolidation, as economies of scale andvertical integration create long-term advantages over the competition.
0.0
10.0
20.0
30.0
40.0
50.0
60.0
70.0
80.0
90.0
100.0
2000 2001 2002 2003 2004 2005e 2006e 2007e 2008e
kg/per capita
Pork Beef Poultry Fish
Composition of meat and fish in Poland
Source: Agricultural Market Agency, Erste Bank
Company Report
Company Report Duda, February 2006 Page 21
Valuation and Recommendation
We employed two valuation tools to estimate the fair value of the company. The DCFis based on our forecasts for the years 2006-11. We used a discount rate based onWACC and a terminal value based on perpetuity. We discount all free cash flows for thefirm on December 31, 2005 and subtract the net debt. We then divide the equity valueper number of shares. Afterwards, we compound this by the cost of equity (with theappropriate number of months). We thus arrive at a target price that represents ourvaluation of the stock price as it is expected to be 12 months into the future. The DCFled us to a target price of PLN 16. The multiples comparison pointed out that, recently,the company trades with a premium in relation to its peers. We think that this is justifiedas Duda has better growth prospects.
Our estimation is based on the following assumptions:
z Livestock prices will decline by 6% in 2006
z Sales volume of pork will grow by 15% in 2006
z Duda will acquire/develop four distribution centers in 2006
z Employment costs will increase at CPI rate
z Other costs will remain stable in relation to revenue
z Depreciation rate will be 7.5%
z Perpetuity growth rate is 1.2%
z Risk-free rate is 4.6%, beta 0.6, equity risk premium 5%, debt risk premium 2%
Depreciation 20,687 24,187 22,262 23,821 25,488 27,272Capital expenditures 50,000 52,500 22,262 23,821 25,488 27,272Change in working capital 17,298 13,479 5,929 4,133 4,301 4,476
Free cash flow -251 11,464 55,538 56,766 60,597 64,608Terminal value 938,412PV of FCF -235 10,097 45,811 43,759 43,608 43,388Sum of PV of FCF 186,428PV of terminal value 630,203Enterprise value 816,631Non-operating assets 0Net debt at 31.12.2005 109,434Fair value at 31.12.2005 707,197Number of shares 48,200Fair value per share at 31.12.2005 14.7Cost of equtiy 7.6%Target Price 16.0
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Our target prices are established by determining the fair value of stocks, taking into account additional fundamental factors andnews of relevance for the stock price (such as M&A activities, major forthcoming share deals, positive/negative share/sectorsentiment, news) and refer to 12 months from now. All recommendations are to be understood relative to our current fundamentalvaluation of the stock. The recommendation does not indicate any relative performance of the stock vs. a regional or sectorbenchmark.
Important Disclosures
Specific disclosures:
Company Disclosure CommentDuda -- --
(4) Erste Bank and/or its affiliates has received compensation from this company for the provision of investment banking services within the past year.
General disclosures: All recommendations given by Erste Bank Research are independent and based on the latest company,industry and general information publicly available. The best possible care and integrity is used to avoid errors and/or misstatements. No influence on the rating and/or price target is being exerted by either the covered company or other internal Erste Bankdepartments. Each research piece is reviewed by a senior research executive, the rating is agreed upon with an internal ratingcommittee of senior research executives. Erste Bank Compliance Rules state that no analyst is allowed to hold a direct ownershipposition in securities issued by the covered company or derivatives thereof. Analysts are not allowed to involve themselves in anypaid activities with the covered companies except as disclosed otherwise. The analyst's compensation is primarily based not oninvestment banking fees received, but rather on performance and quality of research produced.
(1) Erste Bank and/or its affiliates hold(s) an investment in any class of common equity of the covered company of more than 5%.(2) Erste Bank and/or its affiliates act(s) as market maker or liquidity provider for securities issued by the covered company.(3) Within the past year, Erste Bank and/or its affiliates has managed or co-managed a public offering for the covered company.
(5) Erste Bank and/or its affiliate(s) expects to receive or intends to seek compensation for investment banking services from this company in the next three months.
