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Lukewarm Brew

The lack of growth in production volumes is a cause for concern for prospective investors of Tata Coffee…

Tata Coffee Limited (TCL) is one of the world’s larger integrated coffee plantation companies. It is present in every aspect of coffee making, from growing and curing coffee to manufacturing and marketing value-added coffee products. TCL owns estates where it grows coffee, processes the beans, exports green coffee, manufactures and exports instant coffee, and retails coffee under its own brands in the domestic market. It owns 19 coffee estates in Karnataka and Tamil Nadu.
Over the last seven-eight years, the company has entered into the packaging and distribution of coffee products, as Tata Tea has done. In 2006 it bought Eight O’ Clock Coffee of the US, which packages and sells coffee in that country.

Industry dynamics
Globally the demand for coffee stood at 133 million bags while consumption stood at 134 million bags in FY11. India is the world’s sixth-largest producer and accounts for 3.9 per cent of total production. Approximately 75 per cent of the coffee produced within the country is exported. The price of coffee depends heavily on supply from Brazil, which is the world’s largest producer. Last year the price of coffee rose approximately 1.5-2 per cent due to below normal production globally.

Strengths
Integrated coffee producer. Being an integrated coffee producer, TCL can take advantage of the myriad opportunities in coffee production as well as marketing. It cures coffee at its world-class mills and then supplies it directly to the world’s leading retail chains such as Eight O’ Clock Coffee (its subsidiary) and Starbucks (it struck a deal in January 2011 for supplying coffee beans to the latter’s operations in Asian markets).
TCL is also a bulk supplier of instant coffee, which it sells through its subsidiary, Alliance Coffee Ltd, which has clients in 20 countries. Finally, TCL also sells coffee directly to retail customers both in India and abroad through its in-house brands.
Strong presence in export market. In FY10 approximately 57 per cent of its standalone revenue and 86 per cent of its consolidated revenue came from exports and the rest from domestic operations. US, the world’s largest coffee consumer, is its primary market, followed by Russia. In the US it operates through its subsidiary, Eight O’ Clock Coffee. The latter procures its raw materials from TCL and sells it under its own brand name.
TCL is also present in other traditional coffee drinking markets like Russia and South East Asia. It is now in the process of entering new markets like Japan, Korea, West Africa, and UK where it intends to sell its instant coffee brands.
Eight O’ Clock. In 2006, TCL bought Eight O’ Clock Coffee through a special purpose vehicle (SPV) Consolidated Coffee Inc, USA for `1,015 crore. TCL holds 50.08 per cent in the SPV while the rest is held by Tata Tea (33 per cent) and Tata Tea (GB) Capital Limited (17 per cent). Eight O’ Clock is a leading player in the branded whole bean market and the category leader in the value-gourmet segment in the US retail market. It has significant distribution strength and accounts for approximately 67 per cent of the total volume of the commodity sold in the US retail coffee market.
In FY10, Eight O’ Clock contributed 70 per cent (`912) of TCL’s consolidated sales and 66 per cent of its consolidated profit (Rs 1,097).
Eight O’ Clock’s acquisition has proved to be a strategic masterstroke for TCL as it enabled the company to enter the retail coffee segment in the US. In one stroke, it also transformed TCL into a major global player.

Weaknesses
Too dependent on vagaries of weather. A major portion of TCL’s revenue comes from the cultivation of coffee. As is the case with all agricultural products, its production is susceptible to the vagaries of weather coditions. TCL produces two types of coffee — Arabica and Robusta. In the last 10 years, there hasn’t been a single instance when its production of coffee has increased in two consecutive years. Moreover, in the last 10 years the volume of coffee that the company produces has not grown significantly.
Poor pricing power. TCL has very little pricing power. The price of coffee is determined by international demand and supply conditions. The harvest in Brazil is its chief determinant. Lately, investment demand by commodity funds has also begun to influence its price. In 2010-11, the price of Arabica coffee shot up 100 per cent due to investment demand. This sort of volatility in prices due to extraneous factors has increased the risk of companies operating in this domain.
Exchange-rate fluctuation. Since more than 57 per cent of TCL’s income comes from exports, exchange-rate fluctuation has an impact on its bottom-line. In the past couple of years, the company has been booking profits from exchange-rate fluctuations, but this may not hold true in future as well.

Concerns
High debt. TCL took on debt of Rs 787 crore to fund its acquisition of Eight O’ Clock Coffee through its subsidiary Consolidated Coffee Inc, USA. As a result, in FY07 its consolidated borrowing shot up to Rs 919 crore from Rs 56 crore in the previous year. This pushed its consolidated debt-equity ratio to 2.74 from a meagre 0.33 one year earlier. It closed FY11 with an outstanding consolidated debt of Rs 743 crore (Rs 118 crore standalone) and a debt-equity ratio of 1.77 (0.29 standalone).
In FY11, the company paid out interest expense to the tune of Rs 50.2 crore, which was equivalent to 50.72 per cent of its cash flow from operating activities. It redeemed Rs 31.04 crore as the first instalment of redeeming its Rs 93.12 crore partly convertible debentures it had issued in 2006. Its interest coverage ratio stood comfortably above two at 4.39 (in FY11), up from 3.39 in FY10. Still the company’s outstanding debt obligations are significant and in turbulent economic conditions this could affect its bottom-line adversely.
Promoters pledging their stake. Tata Global Beverages (TGB) has got the majority stake in TCL with 57.48 per cent shareholding. According to a disclosure made to the Bombay Stock Exchange (BSE), in February 2011 TGB pledged its total stake in TCL. This is not a particularly worrying factor. Even in the past TGB had pledged shares in order to raise funds from lenders. Between February 2009 and January 2011, it had pledged its entire stake in the company.

Financials
Over the past three years (last five-year numbers are not comparable since new acquisitions have taken place within this period), TCL has expanded its consolidated top-line by 9.74 per cent (9.26 per cent standalone) on a CAGR basis and its bottom-line by 40.58 per cent (19.80 per cent standalone) yearly. The higher growth rate in topline and bottom-line may be attributed to the integration of processes from production to sales, and to the synergies derived from its subsidiaries. Its operating profits margin (consolidated) has improved from 14.17 per cent in FY09 to 18.20 per cent in FY11.
Its cash and equivalents amounted to Rs 19.88 crore (consolidated) in FY11, down from Rs 63.9 crore in FY10. Its equity investment in subsidiary companies amounted to Rs 145.7 crore in FY11.

Valuation
The company is currently trading at a 12-month trailing (TTM) price-to-earnings ratio of 27.04. Its trailing 12-month earnings per share (EPS) stands at Rs 36.36. TCL is trading at a premium of 5.82 per cent compared to its own five-year median PE. The stock is trading at a price-earnings to growth ratio (PEG) of 0.82 (calculated using three-year EPS compounded annual growth rate).
Valuation-wise the stock does not look very expensive. High debt and other concerns about the company appear to have got factored into the price.
The major reservation we have about the company is lack of growth in production volumes. Therefore, investors should approach this stock cautiously and enter it only when valuations correct further.