Arla focused on growth

Arla focused on growth

Arla Foods is stepping up the pace of its investment programme in high-growth emerging markets. The company is capitalising on booming demand in areas such as Asia, Russia and the Middle East and Africa. Given the slow-to-no growth environment in European dairy, the investment case behind Arla's decision to look further afield is clear. But what impact will this have on the group's margins? We caught up with CFO Frederik Lotz to find out more.

Arla Foods booked an impressive jump in sales for 2013 earlier this month, again propelled by growth in its global operations which outpaced sales expansion in Europe. Total sales were up 16.6%, the company revealed. In 2013, Arla's revenue grew 35% in Russia, 60% in China and 10% in the Middle East and Africa.

Arla has embarked on a strategy that aims to double exports of European products to growth markets outside the EU by 2017. Put simply, Arla hopes to increase its European milk supply, turn it into value-added dairy products and then export these to meet growing demand in global markets where there is a supply shortfall.

Arla CFO Frederik Lotz says the the Scandinavian dairy co-operative's 2013 results validate its strategic direction. "It shows that the strategy that we put forward is very much working. Really consolidating our north European footprint through mergers and acquisitions, building scale in our core markets on one side. And on the other side, really fast-forwarding our growth outside Europe with significant double-digit growth in key markets like the Middle East, Africa, Russia, China. We feel really good about this most of all because we are able to pay our owners, the farmers, record high price for the milk."

In order to drive growth in these key markets, Arla is stepping up investment in production. Earlier this month, the company announced it would pour DKK2.2bn (US$398.3m) into ten of its dairy sites for this year to boost production and target emerging markets. In total, DKK750m will be invested in production for Arla's "strategic growth markets" outside the EU - Russia, China, the Middle East and Africa. Last year, it spent DKK466m.

Emerging economies have long been the Holy Grail for manufacturers based in mature western markets. But, increasingly, sales growth in emerging markets is not enough. Expanding is a capital-intensive process and companies are more and more focused on generating strong returns from emerging market growth.

Lotz says Arla's profitability in emerging markets often comes in ahead of European margins.

"If you go back a few years [our margin was] definitely below [Europe] in emerging markets and we did already have good growth. But what has happened in the meantime, margins have really, really climbed up. With increased demand from the Chinese, from the Middle East and Africa, the price has been hiked up over the last two or three years. We have [therefore] seen margins come up significantly in the past few years."

He continues: "Today our margins outside Europe are absolutely rivalling what we see in Europe and more often than not actually leading European margins. And we expect that trend line to continue."

Improved margins in markets like Asia and the Middle East are being driven by rapid growth in demand, Lotz says. "It often goes hand in hand with growth that when you have really sharper territory and a significant under-supply in a market, those who can provide those products, that milk, do have a chance of making extra margin."

However, Arla's ability to charge a price premium - while also growing volumes - is also about the positioning of its products and the group's quality credentials.

Lotz explains: "This is more than just supplying the milk. For example, Chinese consumers [are most concerned] that you provide milk with a high quality. I am sure you are aware of the scares that have hit China in the past few years with melaimine and toxins in the milk. Even last year, there were global players with scandals relating to dairy products. As a co-operative, where we actually own the supply chain, I think we may have a competitive edge in that sense. We have more than 100 years of experience converting milk from the farm into highly value-added products. As long as you maintain quality, there are significant margins to be gained."

Arla generates 70% of its sales in Europe. But with sales growing faster outside Europe, Lotz says that emerging market revenues could ultimately account for a majority of group sales. "That is a very likely outcome," he says.

The company has no current plans to extend its membership of the co-operative to non-European dairy farmers. However, the group is looking at the possibility of establishing production facilities in its high-growth markets.

"We will continue to expand our export outside of Europe. But I do think we will increasingly build organisations and possibly even production outside Europe to be close to the consumers. I think over the few years you are going to see our strategy unfolding globally even more than you have seen until this point. But we have no intentions or plans to invest directly in dairy farms outside our core markets," Lotz says.

With higher margins to be made internationally and an increased proportion of sales being generated outside Europe, will Arla's profit margin - which stands at its target of 3% - rise?

Lotz plays down that suggestion, instead focusing on growing the "performance price" - the price Arla pays its co-operative members for their milk. Arla's performance price rose by more than 12% in 2013.

"We would expect [profit margins] to be fairly stable. I wouldn't exclude that we could see it creep up slightly over the next few years. But I think you should expect the profit target to remain fairly constant.

"What is important when it comes to the profit angle is the performance price - what can we pay the farmers for the milk they produce. We are expecting that trend line to continue upwards. But we also realise that we live in a market that is quite volatile so you should also expect in the short term to continue to see significant volatility in the prices we are able to pay, just as local commodity prices are quite volatile. But the trend line will continue to reflect the lack of supply globally."

Arla is witnessing strong growth in emerging markets. However, Europe's largest dairy co-operative is not alone in its desire to unlock the potential they offer. Other international dairy majors are eyeing expansion in the same regions are Arla - and local firms are upping their game in a bid to keep up.

Lotz is unconcerned by the growing competitive activity in the key markets that Arla hopes to milk. He believes the massive increase in demand leaves plenty of room for all comers.

"We expect that almost 3bn people in this world will move from relative povertyinto the middle income class over the next 20 years. We know from experience that when you start earning money at that middle income level, that is when you can start to afford dairy products. The market for supplying quality nutritious dairy products is just vast. It is a big playing field and there is room for many players.

However, Arla does benefit from some competitive advantages, Lotz argues. "I think the differentiating factors are going to be, of course, that you are cost-competitive. But that is more a licence to play. The licence to win is two-fold. One, strong brands, continued focus on innovation and branding. The other one is to keep on producing products that are high quality. As a co-operative with our history we are in a good place with both of those."

While emerging markets are an important growth platform for Arla, the dairy co-operative is quietly chipping away at another potentially significant profit stream: ingredients.

According to Lotz, Arla's ingredients business is "closing up" to be worth EUR500m (US$688.4m) annually. While Lotz says that is "still quite small" in the context of the group, Arla plans to have doubled it by 2017.

"It is a business that is really attractive. We are looking at very high margins in that business-to-business field and we don't see any indications of that changing. You will see that as we globalise you will also see that our ingredients business will start to unfold. This year, 2014, we are going to open up a very large lactose plant in Denmark that will give that business a significant boost. Ingredients is really one of our priorities going forward."

Click here for part one of the just-food interview with Arla CFO Frederik Lotz, in which he discusses the co-op's strategy in Europe.