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Monday 23 October 2017

Kerry Group at a crossroads as dairy farmers feel the pressure

Kerry Group's international business may be thriving but closer to home its relations with milk suppliers are strained

Taoiseach Enda Kenny and the then Minister for Agriculture and Food Simon Coveney with food flavorist Aine Walsh in one of the Kerry Group food-development labs in Naas last year Photo: Frank Mc Grath
Taoiseach Enda Kenny and the then Minister for Agriculture and Food Simon Coveney with food flavorist Aine Walsh in one of the Kerry Group food-development labs in Naas last year Photo: Frank Mc Grath
Dan White

Dan White

Thirty years after it first floated on the Irish Stock Exchange, Kerry is at a crossroads. The firm has grown to become a genuine multinational but relations between the plc and the founding co-op and its milk suppliers have never been poorer.

Kerry was the first Irish dairy processor to float on the Irish Stock Exchange in October 1986.

The flotation did not proceed entirely smoothly. The co-op's umbrella body IAOS (now called ICOS) objected strongly to the flotation, arguing that selling shares to outside investors would dilute the co-operative ethos.

This was despite the fact that the original flotation still left Kerry Co-op with a controlling shareholding in the new plc.

Kerry's founding chief executive Denis Brosnan, never one to be constrained by tradition, ignored these objections resulting in Kerry being temporarily banished from the co-op ranks.

Admonitions from his fellow dairymen of how the flotation violated the "Rochdale principles" so beloved of co-op purists cut no ice with Brosnan.

When the success of the Kerry flotation became apparent, many of the other major co-ops quickly changed tack. Waterford and Avonmore (which merged to form Glanbia in 1997), and IAWS (now Aryzta) all floated in 1988, with only Dairygold resisting the siren call of the Stock Exchange.

Brosnan had set his heart on a flotation share price of 52p (66 cent). Irish Life's fund management arm, then by far the largest Irish institutional investor, was only prepared to pay 50p (63.5 cent). The conventional wisdom in the mid-1980s was that, without Irish Life's participation, no flotation could succeed. A stand-off ensued and the flotation went ahead successfully, at 52p, without Irish Life.

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For a young upstart to stand up to the giant Irish Life like this was unprecedented - Brosnan and Irish Life quickly made their peace. Irish Life went on to become one of the major investors in the new Kerry plc.

And a good thing, too. With the share price now at €64.50, someone who invested €1,000 in Kerry shares 30 years ago would now have shares with a value of almost €100,000, even if they hadn't re-invested their dividends.

Brosnan, who stepped down as Kerry chief executive at the end of 2001, and his successors Hugh Friel, then Stan McCarthy (pictured with chief financial officer Brian Mehigan), who took the reins in 2008, have created a genuine Irish multinational - a company that has used a combination of Irish raw materials and brains to build a world-beater.

Kerry's sales have grown from €337m in 1986 to €6.1bn in 2015, while its pre-tax profits have grown from €8m to €603m over the same period and it employs more than 23,000 people. Even after the recent fall in the Kerry share price, the group has a market capitalisation of €11.4bn, making it the third most valuable company on the Irish Stock Exchange after CRH and Ryanair.

Through a combination of organic growth and audacious acquisitions, Kerry is now the world's largest producer of food flavourings and coatings. As more and more food companies have been sold to private equity buyers, they are increasingly farming out the development of new flavourings and coatings to specialist producers such as Kerry. In 2015, over three-quarters of Kerry's sales and five-sixths of its trading profits came from flavourings and coatings.

This is a high-margin, high-growth business, with Kerry's flavourings arm increasing its trading profits by almost 12pc to €663m in 2015. That is a trading margin of 14.1pc, up from 13.7pc in 2014.

By comparison, Kerry's consumer foods division increased its trading profits by just 0.2pc to €126m in 2015 and its trading margin widened by 0.2pc to 8.5pc. Not bad, but not a patch on the margins and growth being achieved by its flavourings division. The performance of the two divisions diverged even further in 2016, with Kerry's interim management statement revealing that volumes at flavourings grew by 3.4pc and trading margins rose by 0.7pc in the first nine months of 2016, but volumes at consumer foods were up by only 2.2pc, and trading margins rose by just 0.3pc in the same period.

The geographic spread of the two divisions' sales is also completely different. While virtually all of Kerry's consumer foods sales are in Europe - with more than 70pc in the UK and most of the rest in Ireland - flavourings is a truly global business, with only a third of its sales in Europe, the Middle East and Africa, half coming from the Americas and the remaining sixth from Asia-Pacific.

All of which begs the question, why doesn't Kerry do the splits and hive off its flavourings division as a separate company? With its superior margins and stronger growth prospects, it would surely command a higher rating on the stock market than it does at present, yoked to a consumer foods division in the eye of the Brexit storm.

That's not how they see things in Kerry Group.

"We have a strong business [consumer foods]. It has been repositioned. The cost of entry was low and it is cash-generative. It is a highly valued business", said a Kerry spokesman.

But what about Brexit? Surely a business that makes most of its sales to UK multiples and food service operators must be feeling the chill wind of the post-Brexit fall in the value of sterling? Not so, according to the firm, which said: "The assets in Ireland substantially meet the needs of the Irish market, while the assets in the UK meet the needs of the British market. We are largely insulated from Brexit and the fall in the value of sterling.

"The two businesses have operated successfully side by side. They continue to drive the growth and development of the Kerry Group. We have a dual strategy. A lot of the talent that comes in at graduate level gets experience in both divisions. The board is confident about both divisions."

Long-term Kerry watchers are not convinced. "The focus of the company will be on its taste and nutrition [flavourings] business with a tilt, from a geographical standpoint, towards developing markets", said Liam Igoe of Goodbody Stockbrokers. "Kerry is capable of delivering at least 10pc annual earnings growth from organic developments alone. On top of that, acquisitions look set to play a bigger part for the Group.

"We reckon it could spend up to €4bn on new deals in the coming five years which, combined with the organic growth, could as much as double its earnings in the period".

This could cause Kerry's flavourings division to double in size over the next five years. This would result in the division having annual sales of close to €10bn and trading profits of around €1.5bn by 2020. Kerry has always been an acquisitive company, spending a net €888m on acquisitions in 2015.

Perhaps the greatest success of Kerry over the past three decades has been the way in which it has managed the sometimes divergent interests of shareholders and suppliers.

Of course a rising share price and seven spin-outs of rapidly appreciating plc shares to co-op shareholders since 1993 have been of enormous assistance in this regard. The rising share price also meant that the reduction in the co-op shareholding to under 50pc in 1997 was a far less traumatic event than it might otherwise have been. Now there are signs that this relationship is under stress as never before. The fall in the milk prices that followed the lifting of EU quotas in March 2015 has led to a number of Kerry milk suppliers taking legal action against the plc and McCarthy stepping down from the co-op board - the first time that the plc chief executive wasn't also on the co-op board.

Further complicating matters has been the recent move by the Revenue Commissioners to tax so-called "patronage" shares issued to Kerry milk suppliers as income, where they would be subject not just to income tax but also USC and PRSI rather than as capital gains, as had previously been the practice.

With the co-op still owning 13.7pc of the plc, each co-op share has an implied value of about €400 as against the par value of just €1.25 at which they were issued to suppliers.

Kerry increased its milk price to suppliers for August, September and October, which has taken some of the sting out of the milk price dispute. However, the row, currently in arbitration, isn't going to go away any time soon.

As Kerry faces into its second 30 years on the stock exchange, the founding co-op and milk suppliers will own an ever-decreasing share of the plc. Will McCarthy and his successors be able to continue to combine the two within one corporate structure? Or will they too be forced to split the two sides of its business, as rival processor Glanbia has already done?

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