Government Subsidies Are Always Needed — Sergei Mikhailov, CEO of Cherkizovo Group

August 18, 2014

Cherkizovo Group, one of Russia's largest food manufacturers, stated that restrictions on imports from Europe, USA, Canada, and other countries supporting sanctions against Russia will help the company's business. We met with Cherkizovo CEO Sergei Mikhailov before the presidential decree introducing the embargo (for more details see the insert), but even then we had a lot to talk about: meat manufacturers were among the main victims of Russia's accession to the WTO, and they had barely recovered from the resulting drop in prices for their products, when the pandemic of African swine fever (ASF), a dangerous disease that threatens pork producers with complete destruction of their stock, began to spread with new force. Earlier this year, ASF reached Europe through Belarus, which gave a real boost to Russian meat manufacturers: Rosselkhoznadzor banned pork imports from Europe in February, and domestic prices for meat began to rise. Due to the same ASF in several regions, including Belgorod Region, the Russian pork producing champion, pig populations on private farms were almost completely destroyed, which was also a help to large manufacturers.

Cherkizovo supplies Russian customers with Cherkizovo and Imperiya Vkusa sausage and ham, and Petelinka, Kurinoe Tsarstvo, Mosselprom, and Domashnyaa Kurochka poultry meat and ready-to-cook products. In the interview with Vedomosti, Mr. Mikhailov talked about the desire to move away from sales of non-branded meat and focus on the "name-brand" products, the meat content in sausages, the inefficiency of grain producers, and non-core projects of the members of the family of Cherkizovo's founder, Igor Babaev.

What level of profitability are you comfortable with in the long term?

A comfortable level of profitability for the company as a whole is an EBITDA margin of 15–20 %. In past years, the average was almost always above 15 %. But pork production and meat processing are cyclical markets, so profitability changes from year to year. The year 2013 was an anomaly: the group's EBITDA margin in Q1 of 2013 was only 7 %, but I wouldn't consider this level typical.

Do you think the changes in your profitability reflect general market trends?

We have four businesses: pork, poultry meat, grain, and meat processing, and of course our indicator is derived as the arithmetic mean. It's more correct to consider each division separately. The normal profitability range is 5–10 % for meat processing and

15–20 % for the poultry division. Pork production is a very volatile business: we've had returns of 40 % or even higher, and close to zero, as in the first half of 2013. Grain is still a new business for us, and we're seeing a normal level of 25–30 % there. The Russian grain market as a whole is very inefficient today, and efficient companies have a lot more resources.

It's hard for me to measure the market average, because all companies are different.

Profitability of our poultry division has historically always been higher than the market average, because we have strong brands like Petelinka, Mosselprom, and Kurinoe Tsarstvo and quite successful positioning on the Moscow market. We try not to work on the "exchange" (i. e., unbranded wholesale - Vedomosti) poultry market, which has been saturated in the last 2–3 years, so profitability has been under pressure. We know that many companies even operated at a loss.

In the pork industry, I think that profitability in the new modern pork complexes that have reached full production is very close: prices for grain and live pigs are similar for all of them.

Profitability in sausage manufacturing is largely determined by the positioning: this is a value-added product that is not exchange-traded, and brands and segments are all different for everyone, so I think the trend in profitability in the last two years has been generally upward.

There have been times when your profitability in the sausage segment has fluctuated around zero.

It was 2–4 % but never negative, and it's been higher in the last two years. I think it is the same for the market as a whole. This is because meat prices have finally stabilized; before that, we always had to contend with rising prices for meat. In the past year, on the contrary, we've seen a drop in meat prices, and meat processors have had a short holiday. Today, meat processors have to fight for customers once again and work with chains. The sausage segment has long been oversaturated, and it's falling at maybe 2–3 % per year, not growing. This is understandable, since sausage consumption in our country has historically been very high, and when the meat becomes more affordable, the consumer naturally chooses meat.

Does the fact that consumers may start saving in anticipation of a crisis have any effect on demand for sausages?

Sales of sausage products have been falling year by year, but this is more the result of a qualitative change in food consumption, that is, the shift to ready-to-cook products. It's still hard to say for our products as a whole. Perhaps retail feels the situation better, but the change in consumption is a major risk to our business. I still don't sense a pronounced downward trend in meat consumption. There may be some slowdown in growth. I wouldn't jump to conclusions that consumption is generally decreasing, although there is definitely a risk. I'd rather draw attention to the increase in prices for meat products which we're already seeing. This factor may cause a further drop.

Porcine epidemic diarrhoea is a real threat.

What share of pigs on private farms are you comfortable with as an industrial manufacturer?

Pork prices were very low last year, but we couldn't stop production. The piglets were born, grew up, and eventually the meat market was 300,000 tonnes higher, in spite of the collapse and a weekly drop in prices. We're seeing a decrease in stock on private farms each year, and volumes there no longer have a significant impact on the market. The share of private farms is currently about 25 % of meat production, and it will be 15 % in future. There are hardly any private farms left in the southern part of the country, but many regions are still struggling with them, because small farms generally don't promote safe meat production. The decreased number of small farms in the next few years will not be a significant market force. Their share will probably never be zero, but we can live with 10–15 %. The share of poultry on private farms will remain at 5-7 %, even with a very high level of industrial production.

Would you say that large manufacturers were the winners in the situation with ASF?

The story isn't finished, so it's hard to tell who won and who lost. There will never be any winners; the question is how many will be losers. This is an ongoing issue; what saves us is the fact that the concentration of animals in Russia is lower than that in other countries. If we're self-sufficient in pork, we will be less dependent on biological fluctuations than we are now. If we add another 5 million head, as a country we'll be free of this negative background. Low concentration, except in Belgorod Region, is our competitive advantage.

Will the draft bill on small farms, which sets equal conditions for pig breeding in private farming and industry, work?

It won't hurt, but how it will work will depend on its administration. It's a social and political issue. So far only Belgorod has actually managed to stop the replacement of small farms. There is no guarantee that they will not recover in other regions. But if you don't reduce the proportion of small farms, it will be impossible to deal with ASF. At some point, the loss will be much greater than the illusion that small farms are an advantage. At one time, Spain lost 70 % of its total production for a year and a half because of ASF.

Could the increase in pork prices in March and April (152.2 RUB/kg in mid-April, compared to 114 RUB/kg in early January) reduce consumption?

The classic situation hasn't changed: the higher the price, the more demand must drop. But consumption of meat products is influenced by other factors. Pork prices are an example. First, we must recognize that the pork industry still depends on imports, which are about 25–30 %. For some items, such as fat, which is 200–250 % more expensive today there is almost complete dependence, and we'll never manage to fully supply fat ourselves. It was imported mainly from Europe [from which supplies have been temporarily banned due to the ASF pandemic], but neither Brazil, nor Canada or America have the quantities of this raw material that we need. For other basic items, like bacon shoulder, ham, cold cuts, and sides, America is a major supplier for us today. But they've had a problem with porcine epidemic diarrhoea since Q4 of 2013. It's a new disease, and veterinarians still don't understand it. We're seeing what's happening in America, where all the pigs that are born [in the affected regions] die. This means that wherever this disease is, the production cycle has actually stopped. This has already caused a 10 % decrease in stock in America and has spread to Canada, being a major pork exporter, Mexico, Korea, and Japan. Supplies from Canada will also be cut off in the near future because of the disease. This is not a political issue, and there's a real danger of the disease spreading in Russia.

The situation with this disease is similar to ASF: if it spread to an industrial facility, would all the stock have to be slaughtered?

It's still not entirely clear. As there are no births at breeding facilities of the American pork complex that have had to shut down, and the mature stock has been slaughtered, so the production cycle has stopped. The saddest and most dangerous thing is that even after culling among new sows, the infection returns.

Is there a risk that this situation will also develop in Russia?

There is extreme risk if even a few truckloads of infected livestock are delivered. The disease has spread in just a few months in Mexico, Canada, and America, even though bio-security in these regions is higher than in Europe. We've repeatedly told our veterinary services that this has to be strictly monitored, because it's a real threat. It's believed that the disease is milder than ASF, but it's actually a mutation that occurs in America. There is still no vaccine against it, and it's very dangerous. As a result, pork prices in the United States have risen by 50 %, and the world market is also seeing growth. This is a biological factor. A rise in prices is inevitable in Russia for two reasons: first, the rise in world prices, and second, the weakening of the rouble. Business can't do anything about this. The answer is very simple: as with poultry, Russia has to resolve the issue with import substitution. For poultry, where the market is saturated and imports make up 5–10 %, we've seen no rise in prices until recently. As for pork, we're hostages to global trends.

If there's no intervention in time, the markets will regulate themselves.

How much extra income you received from the devaluation of the rouble?

It's obvious that devaluation should contribute to higher prices for meat. If the devaluation is large, we will be able to export poultry meat, because it will be very cheap. In general, moderate devaluation is a plus for our company: our products are more competitive when the rouble is weaker. I can't say how much more we've earned. When devaluation is 2–3 roubles, this is normal. But when the dollar is worth 50 roubles, consumers will notice.

Could devaluation of the rouble mean that there will be no major investments in livestock breeding?

There are very different trends here. If equipment is imported, capital expenditures will increase, which will affect return on a project, especially on its cost component. For investment projects it's more about the availability of money, its value and government subsidies, which in the past year and a half are still an open questions. Hardly any new projects are being considered, banks are reluctant to lend money, and the value of money is increasing. New production capacity, which is often the completion of projects already underway, is being commissioned much more slowly.

We believe that government subsidies for projects in the broiler meat segment should be ended. The decisive factor for investment in pork production is not the interest rate or the availability of loans, but in a stable affordable price for pork, which would allow to payback in 7–8 years. Now we're also thinking about whether to invest in new projects. If we had known that there would be no government subsidies, and that money would be less available, of course we would have built our pork complexes more quickly. Today we have no certainty. The past year has shown that the government has no effective mechanisms to handle surplus production: the price fell by 3–4 roubles each week, we were all helpless. There are essentially no mechanisms for regulating the market from within when the market is saturated or oversaturated. The government needs to take a closer look at the pork industry to see which projects are under construction or being commissioned, and their geography. There must be intervention, as is done for grain; and a stabilization fund must be created to deal with excess volumes. If projects continue to be subsidized, at some point we will reach a glut and the market will enter a phase of self-regulation, as happened last year. This is also possible, but it's painful.

Ludmila Mikhailova, Cherkizovo's Chief Financial Officer, said in early summer said that due to the devaluation interest on bank loans would increase by 1–1.5 %. Is this an estimate, or have your already received notice from lenders?

We see that the money is becoming more expensive, and that interest on new loans has risen by 1–2 %. I believe that the increase is even greater for smaller borrowers. In our case, state-owned banks are the main lenders, and they are certainly no exception, but they are usually more conservative. In many ways, this is understandable, because there are issues with liquidity and, of course, the cost of money for the banks themselves is increasing.

Last year the government owed you 650 million roubles in unpaid loan subsidies. How has this figure changed today?

We're seeing some flow of investment funds, and the Ministry of Agriculture is trying to make up the arrears to agricultural companies. But there is almost no flow of current assets. Therefore, our balance is almost unchanged; today it's somewhere around 750 million roubles.

What about other companies?

That depends a lot on the region where the company is located: for example, as far as we know, Voronezh and Tambov have one of the largest outstanding debts. Allocation of money doesn't solve the issue at the root of it. And some regions are not experiencing these difficulties. Why start new programs, if you haven't fulfilled the obligations for those already started?

Does it make sense for the government to opt out of interest rate subsidies?

I think the problem [of administration of this mechanism] can be solved, and will be solved. The main issue is prioritization and a more effective form of support. For us, as for a manufacturer, price and price stability is more important in terms of payback.

It would be more logical to transfer the financial resources the government has available in the form of permanent subsidies per kilogram of marketable meat. This would accelerate the return on investment projects and protect competitiveness. We've been actively discussing this idea for a year and a half. For example, when poultry production is increased, it creates a double problem: first, money is spent on subsidized loans, and then we face the problem of how to pay these loans back so that the product is sold at a reasonable price without cutting production. But if there is overproduction, the money may simply be lost. Therefore, we believe that a more reasonable form of support at this stage is balancing market prices and per kilogram subsidies that will ensure a return on projects.

Is there any need at all for constant government intervention in the agricultural sector? We have many efficient companies, and maybe they can already solve their problems on their own?

The form of support may be different, but it's always needed: agricultural markets cannot survive without tight regulation and coordination of actions by the government. If there's no intervention in time, the markets will regulate themselves. This will be a tough way: a decrease in production may be large, which is in the interests of agricultural enterprises, but not in the public interest.

The poultry market will be consolidated sooner or later.

Poultry populations declined last year for the first time in 12 years. Nevertheless, at this time you've started two major projects: new bird houses at Mosselprom and Eletsprom.

There has been so much uncertainty in the last 1.5 years that it was hard to predict anything. But when we make investment decisions, we're not focused on the price situation in the next year or two. We need to look further ahead, because the project will pay back in 3–10 years. In general, we understand that we're building a very efficient facility, and we see that economies of scale will reduce costs. Although the return on these projects is very constrained, we believe that that they will pay for themselves In particular, we expect to recoup our investments in Elets in 9–0 years. But, of course, we realize that the poultry market will change during this time. Many companies, especially small ones, will halt production. A company that produces 15,000 or 30,000 tonnes of poultry meat and a cluster that produces 60,000–90,000 tonnes have a completely different level of competitiveness. Today, companies that produce between 10,000 to 30,000 tonnes of poultry meat have a 25–30 % market share, but these companies are not competitive, mainly because of higher costs.

Will they be closed or will you take them over?

We believe that if they don't have a captive market and are not on an isolated market, such as Krasnoyarsk, where the nearest supplier is 700 km away, these companies will be closed. We're not interested

We can't make them efficient either. It's the same worldwide. An effective cluster in Brazil is the one that produces more than 150,000 tonnes. Each of our clusters has also reached 60,000-100,000 tonnes. This isn't the highest level of competitiveness, but it's acceptable. We see the transition point for ourselves as 60,000-70,000 tonnes in one cluster. The more the better. Everything below that would be at risk.

Your annual report states that you're investing heavily in the marketing policy for Petelinka. What share of the shelf price is marketing activity?

The entire marketing budget is less than 1 % of the company's revenue, not including relations with chains.

What discounts do chains give you?

Up to 10 % for poultry.

Why did you choose to acquire Lisko Broiler?

First, the purchase price was significantly below replacement value if we had built it ourselves from the ground up. Second, the asset was built competently enough and today it allows production of 75,000 tonnes of meat live weight, which keeps costs low. Third, we saw great synergy. Lisko Broiler dealt primarily with wholesale; the share of branded products was low, so we could use both our brand and our distribution. This acquisition will help us work more actively in the southern regions that we haven't reached yet. Now the poultry prices have finally started to increase, so the acquisition has been very successful over time.

Will you buy anything else?

We believe that the poultry market will be consolidated sooner or later. The question is how quickly. It's slowly reaching a healthy level of consolidation. We'll continue to look at trends. But there are not many good assets in either quality or scale. We will not consider small assets.

How far will consolidation go?

In Europe and America the top 3 pork manufacturer have between 40 to 60 % of the market. The top 3 in our country have far less, although we're catching up. I don't think we will ever catch up in sausages: this market is the most fragmented, but its' mature and well established. I think it will stay that way. The primary processing, slaughter, and ready-to-cook segments in the pork business may consolidate much faster, because there is a very small number of players, and it's a very specific business. Vertically integrated operators will dominate. As for poultry and pork, it's a matter of time.

The sausage market seems to be static, but rotation and cannibalization of brands and products are very active.

In 2006, you said that Cherkizovo intended to take up 10 % of the total meat market, then 20 %. Have you abandoned these plans?

We're committed to effective quality improvement; there's room to grow there. Right now we have a share of less than 10 % for all kinds of meat, except for poultry, where we have 13 %. Targets of 10–20 % within each market are still realistic figures.

Does this mean you will go to the Far East?

It's highly unlikely. The market is so large that it's more important for us to have a quality presence on targeted markets. For poultry in general, we have a 13 % market share, but in Moscow and Moscow Region it's much more: on the order of 50 %. It's more efficient to work when the market share is not spread out [all over the country], and there is a critical mass of presence in several markets. It's also not the last factor in the chains.

Domestic consumption is very low in the Far East, and it's not enough to justify investments in the region. The main focus of investment there is exports to Asia. China, Japan, and Korea consume different parts of a pig, which gives a certain synergy. The problem is that today construction costs in the Far East and the lack of infrastructure make these projects uneconomical and unprofitable.

Have you looked at the Crimea?

Crimea itself provides enough in our sector. They have poultry and sausage manufacturing there.

What direction seems more promising to you now deep processing or manufacturing chilled ready-to-cook products?

The consumer is not quite ready to buy finished product and just reheat them, but is willing to buy ready-to-cook products, which simplify preparation at home. There is also a psychological aspect. Studies show that consumers want to make their own individual contribution to preparation. Ready-to-cook products that are not ready-to-eat leave room for this identification. So this year we successfully launched a project for manufacturing case ready pork at the Cherkizovsky plant. We believe that because of our proximity to the consumer, we will have some of the highest quality pork projects on the Moscow market. Not all of these products are immediately ready for cooking; they're processed to varying degrees, like ground meat, chops, or whole pieces of meat. We have a similar line for poultry meat. This promising trend is gaining momentum.

It is more profitable than selling branded meat?

Profitability is higher than for a dressed chicken, but it has a different volatility: it's a value added product with loyal customers; and in a situation where there is a shortage of meat on the market, this added value is high. We understand that markets are cyclical, and at some point it will fall. Our strategy is to move to brands to stop competing on the chicken meat market. It's a much more stable niche with different pricing.

What share of your sales should ready-to-cook products have in the next 5–10 years?

For example, in Brazil you find almost no meat on sale; it's all partially or fully processed. Many people in Russia buy chilled natural products. I think this market feature will remain. Frozen products are falling behind, while chilled products are growing. Still, the niche for ready-to-cook products of varying degrees of preparation is underdeveloped. It shouldn't be 80 % as in Brazil, but in recent years it has been growing and will continue to gain momentum. We set a goal for the next five years to move to either branded chilled ready-to-cook products, or value added ready-to-cook products like Petelinka. We're setting the same goal for pork. We will gradually get out of the market for live pigs and save about 30 %; and we will generate added value within the company from the rest by manufacturing ready-to-cook products. We want to get away from the "exchange" and to focus on branded products.

Given the high price of pork, will processors switch to chicken or soy?

In the past two years a new factor has appeared on the market, which was not very noticeable earlier: industrial consumers have switched from pork to poultry, which has increased poultry consumption to 1 million tonnes per year. That is, of the 12 million tonnes of various kinds of meat that go into industrial processing, 1 million tonnes or more may be either pork or poultry. They switch purchases depending on the price, and this has an even greater influence on the market than import volumes.

So does the manufacturer switch from one sort of sausage to another? Or does the same kind of sausage have pork in it today and chicken tomorrow?

Both options. The sausage market seems to be static, but rotation and cannibalization of brands and products are very active. Everything ultimately depends on price, quality, and nutritional value, especially when we are talking about products in the low and middle price segments. That's where the price/quality is more important than the brand or other characteristics, so we can develop new products, like chicken roll or ham, for example. It will be cheaper than turkey or pork. There are also products that can be replaced: in regular and boiled sausages, where very often there are several kinds of meat, and you can play with proportions. But that doesn't mean deterioration of quality and taste everything is within reasonable and permissible standards. It's better to change the composition without compromising quality than to raise the price.

With the accession to the WTO, many of your competitors said that finished products would start coming here in large quantities. Have you noticed that we've started to import more sausages of various kinds?

The market share is negligible so far. But there are a number of factors here. First, these are products with high turnover, especially cooked sausages. Second is the negative attitude of consumers: they don't want to buy imported sausage. This is the result of experiments in the 1990s, when there were a lot of American, Polish, and Belgian sausages of questionable quality. Finally, it's also about logistics: there is a risk of distributing imported products, but it will not be mass distribution. Maybe gradually. Now the chains are trying to enter these categories through private labels, but there are veterinary and logistical risks.

I believe GMO can occasionally be used in grain farming.

You've started to breed turkeys. Do you really want to get away from being able to raise only chickens?

This is a niche project, with production of 40,000 tonnes, and it has no effect on the company globally. But we see synergy in meat processing, in the ability to replace other types of meat. We also see great prospects on the retail market. Our complex is located 300 km from Moscow; this is more profitable than for competitors. Our objective is to get into the premium segment, but we have no illusions. We believe that in the next year or two, the retail market will be saturated with turkey and even oversaturated. But the industrial consumption could easily reach hundreds of thousands of tonnes of turkey meat per year. When will large processors start consuming significant amounts of turkey? That depends on the prices for pork and chicken. Today, the price of turkey meat almost double the price of chicken, and that's not normal. But this is because industrial players still don't use this meat. The entire turkey market is currently 100,000 tonnes.

Is the high price a result of high costs or the desire for a high margin?

The cost of producing turkey is about 20 % higher than for chicken. But the market is protected, imports are virtually absent, and production is ridiculously low. Once it reaches 200,000–300,000 tonnes, industrial consumers will play a decisive role in pricing, and retail prices will start to decrease, maybe by 50 %. A very large fall in prices is inevitable within a year.

Because the market will be saturated?

The retail market will be saturated, and if it grows, it won't be at the same rates. In 5–7 years we might consume 3–4 kg per capita.

Are you planning to switch to duck, quail, and other exotic varieties of poultry?

I think we'll stick with turkey. It's clear and comfortable for us. We also have a strategic manufacturing partner the Spanish company Fuertes allowing us to focus more on synergy and sales.

Why did you get into grain farming? Why do you take on all the risks of growing grain? What proportion of grain consumed by the group is provided by domestic production?

Domestic production provide about a quarter of the amount the Group consumes, or 250,000 out of 900,000 tonnes. We would not want to be involved in this line as a whole: the risk is less manageable than in our other businesses, and this could adversely affect the value of the business. But we see great potential of efficient operators and a sufficiently high rate of return. The market is underdeveloped: it lags behind not only Europe, but even Ukraine. We see insecurities, ignorance, and lack of experience, but in another 5–7 year minimum it will all be gone. We now have yields higher than average: in Voronezh Region, the wheat yield averages 3.5 tonnes, but we had 5 tonnes. Once the average yield in Voronezh reaches 5 tonnes, we won't have anything to do there. Same with corn: the situation has turned around only in the last two years, but we need a harvest 3–4 times more than now. Then we can have affordable corn, and in the medium term it will be cheaper than wheat. In any case, for now we're in a better situation than the majority of market players. There is still a hidden synergy: our own logistics, transportation, grain storage facilities, and dryers greatly influence profitability. They also allow us to perform better than with the procurement from third parties. Within 5–10 years, we may be out of this business, or we'll outsource.

Are you planning to increase your yields by planting GMO?

GMO allows lower cost and risk. But I think we have a lot of reserves that we can use, for example, selection that allows us to get 8 tonnes of wheat per hectare. There is no unanimous opinion on the need for GMOs. We have no such plans as yet, and if we do, it will be in the medium term. I believe that GMO can be used occasionally in grain farming, for example, in soy, which is GMO almost worldwide.

What share of grain do you buy from Napko?

Approximately 10 % of the total consumption. This is no more than half the of Napko's production; they sell the rest