Last year was a very good one for Nenagh-based co-op Arrabawn, with operating profits up a significant 60% to €4.4m – a €1.7m increase on the previous year. Earnings before interest, tax, depreciation and amortisation (EBITDA) were up 30% to €8.7m.

Turnover was back 3% to €213.1m, with the agri-trading division down 22% to €54.9m. While feed volumes were back 20% due to milder weather, average feed and fertilizer prices were down €37/t and €20/t respectively.

Turnover in the dairy division, which accounts for 74% of the business, was up 6% to €158.2m as a result of lower dairy market prices. Volumes increased 10% to 310m litres.

Operating margins increased from 1.3% in 2013 to 2.1% in 2014. This is a significant improvement considering that Arrabawn also paid one of the highest milk prices in 2014.

The co-op paid an average milk price of 38.27c/litre in 2014. And, according to the Irish Farmers Journal Milk Price League, throughout the summer and autumn last year, the co-op was consistently in the top three.

Operating expenses increased 2% to €44.1m. While increased volumes drove costs, depreciation was up 10% due to the increased capex (capital expenditure). Fuel costs were back 7% on the back of lower oil prices. Net profit before tax doubled to €3.6m. Shareholder funds increased €4.4m to €41.9m.

Outlook

The future of the Irish processing industry will undoubtedly centre on efficiency, where only the leanest and fittest will survive against much larger global competitors.

In the past Arrabawn has struggled, and this can be seen where the operating margin has ranged from 0.6% to 2.5%. Arrabawn has also underperformed in terms of the milk price delivered to farmers, paying an average of 1.35c/litre (4%) less than the industry average from 2009 to 2013, according to the Irish Farmers Journal/KPMG Milk Price Review.

While external global commodity markets are out of the co-op’s control, efficiency and costs are in its grasp. Arrabawn is getting its cost base under control. To survive and remain relevant to its 940 suppliers, it must continue to get its cost base down while keeping throughput up.

Cost analysis

Overhead costs excluding depreciation (€4m) amount to €40m (13c/litre). While wages account for one-third of the total, fuel costs have been the major issue. The co-op has been at a €2m disadvantage to others as it was one of the few remaining processors using oil to dry milk. At €6.2m (2c/litre), the Nenagh site accounts for almost 80% of the fuel bill. These burners, which were installed in the late 1970s, are inefficient.

Gas is set to arrive in May and €1.6m is being spent on new burners. Savings will come in two forms – burners are 20% more efficient and gas prices are 25% lower. The investment will pay for itself in one year, with cost savings equivalent to 1c/litre.

Milk supply analysis

Economies of scale mean Arrabawn must match supply with capacity to ensure efficiencies are maintained. With a total manufacturing capacity of up to 400m litres, it can process 1.6m litres per day at peak.

Last year the co-op processed 10% more milk (310m litres). Eighty per cent came directly from its own dairy farmers, with the balance coming from arrangements with other co-ops including Lakeland, Glanbia, Dairygold, Kerry, Tipperary and Monaghan.

So what will the future supply look like? In 2010, Arrabawn suppliers indicated they would grow output by 45% – an increase of 110m litres to 350m litres.

But with extra capacity now in the industry, milk from other processors may dry up.

The Lakelands supply will be critical for future volumes, as this accounts for the largest proportion (about 33%) of this supply. Based on a long history (2+5 years) of doing business together, and the catchment area, this arrangement looks secure.

Other processors’ supply may also remain as it provides flexibility to them during shutdown and maintenance periods.

While there is much talk of individual suppliers leaving, if some do, the overall impact may be minimal. For example, if 3% of suppliers leave, it would reduce supply by about 5-6%. While it is a complex decision and one that is highly individual, for those that leave, they walk away having invested in a co-op that now is in a much stronger position than three or four years ago.

Investments

Arrabawn has invested about €40m in capex in the last seven years. A total of €8.5m was invested last year, with €6.8m invested in an evaporator, a plant cleaning system and gas burners at Nenagh. There was an €8m investment in Kilconnell in 2005 and currently €1.5m is being invested in a pasteuriser which will lift capacity from 57m litres to 100m litres.

Most of the investment has come from cashflow. Last year, debt reduced by €0.9m in a year of significant (€8.5m) capital expenditure. Over the past two years, debt has reduced by €4.7m to €9.3m. With a debt to EBITDA of 1.06, debt is controlled and manageable.

These investments have effectively been paid for by farmers accepting a lower milk price, but as a result, the three key sites are now well invested with class-leading plant and equipment.

The benefits of this investment come on two levels – cost and added value.

Taking the lion’s share of the output, the Irish Dairy Board provides an international customer base at minimum cost. While routes to value are being created around whey permeate, smaller driers allow greater product (casein versus whey) mix flexibility – an advantage when playing in volatile global markets.

While the liquid milk business is highly cyclical, there are now only three players remaining, which is bringing stability back to the market. Supplying customers including Aldi and Musgraves, Arrabawn has about 15% of the liquid milk market.

How much is it worth?

This depends on who is writing the cheque. Arrabawn as a co-op is probably worth the most to its own dairy farmer shareholders.

Processing milk on behalf of its suppliers, without the milk supply, there is effectively no value in the processing assets.

With larger neighbouring co-ops building additional capacity, it is unlikely they would put much value on assets that are not required, ie they would be more interested in the additional supply to create greater economies of scale at their own expanded facilities. Therefore, assets would be discounted in any bid, holding a value only to the supply base.

There are three core areas in valuing this business – earnings (EBITDA), breakup value, and replacement cost of assets. While it is difficult to put an absolute value on Arrabawn, this analysis gives an indication of the co-op’s worth. Taking a conservative five-times earnings multiple for this capital-intensive, low-margin business and discounting for volatility, the business would have a minimum value of about €40m-€45m, or €6/share. Synergies may value it at six- or seven-times earnings.

With land, buildings, plant and machinery valued at €34m, all land is carried at historical cost and has never been revalued. The land bank alone is worth a conservative €5m. The feed business, based on its location and volumes, could be worth in the region of €7m to €10m.

Kilconnell may, however, prove to be the jewel in the crown. Its midwest location, state-of-the-art processing and scale give value to this low-margin business. Processing 100m litres at 2% margin and five-times earnings would value this business in excess of €15m and possibly closer to €20m.

Conclusion

Arrabawn has reduced its cost base, delivered efficiencies and this is reflected by its ability to pay one of the most competitive milk prices in the country last year.

Arrabawn is becoming increasingly competitive as the benefits and efficiency gains of its capital expenditure come into play.

With capacity in place, the next move could be to partner with other small co-ops in a collaborative approach. This would keep the identity of each co-op but provide greater operational efficiency and flexibility through scale and ultimately flow through in increased milk prices.

This is a long-term game and, considering such investment has been made by farmers, a long-term view may be required.