Earlier this year, the Securities & Exchange Commission allowed Fauji Foundation’s subsidiaries to inject additional equity of Rs11.7 billion in Fauji Foods Limited (FFL), the dairy and foods arm of Pakistan’s largest business conglomerate. The step will now take group’s equity investment in the dairy business to Rs30 billion, in just seven years since former principals – the Hayat Noon family of Shahpur – sold controlling share in the company - 75 percent - to the Fauji group.

In terms of gross value of sponsor investment, FFL stands at 3.5 times of the market leader, Friesland Campina Engro Pakistan. (FCEPL is the Dutch-controlled giant with the flagship processed UHT dairy brand “Olper’s”). Yet, in terms of turnover, the company is still one-sixth the size of FCEPL. Even so, FFL’s Rs12.4 billion net revenue as of CY22 overstates its market size. Although the company has doubled its rated capacity since acquisition, utilization has remained stagnant at 25 percent.

Industry insiders suggest that the company’s market share is no more than two percent of the total processed dairy market, while Dutch and Swiss giants – Friesland Campina and Nestle – together command 95 percent of the market. With capacity size half that of industry leaders, and three and a half times sponsor investment, it begs the question: why does FFL continue to struggle?

To be fair, the company was struggling even before the buyout in 2015. However, accumulated losses – which stood under half a billion rupees at the time of acquisition – have since risen to Rs 18.5 billion, indicating that the management under new sponsors has burned more equity than the other top five players in the market. Has the traditional management style of Fauji’s failed to succeed in a market dominated by foreign competitors?

It is possible. However, over the years, the sponsors have made efforts to course correct, bringing fresh faces both in the board and management. From five retired military officers on the board of directors – including chairman and chief executive – in 2015, the company has gone to four professional independent directors, and where the only veteran in senior management is the company secretary. External auditors have been upgraded to Big Three, while the workforce has been rationalized from over 1,500 personnel at its peak in CY17, to under 600 employees by end of CY22. Yet, profitability has continued to elude Fauji’s foray into dairy. Why?

Are the industry dynamics uniquely challenging? Of course, the processed dairy industry fell on hard times between CY15 – CY19. An onslaught of negative media campaign regarding UHT safety; use of powdered, skim milk and vegetable based fat; regulatory scrutiny by food safety authorities and the superior courts; along with unfavorable tax regime eroded both profitability and volume for players across the industry. However, profitability returned to the industry in a big way during the pandemic as unprocessed milk became less accessible, and zero-rated tax regime was subsequently restored in CY21. In fact, during CY22 the market leader FCEPL has witnessed growth in bottom line in dollar terms for the first time since CY15, indicating that the industry is finally finding its feet. But not FFL, which saw post-tax losses rise by 73 percent in the outgoing year.

Which brings us to the next question: what has kept the company in the red? Although the management points fingers at higher fixed costs, that alone does not explain the abysmal performance. Consider that the raw material and packaging cost alone eats up 80 percent of company’s topline, in an industry where the average rarely exceeds 70 percent. Significantly, the raw material & packaging cost stood at just 66 percent of topline under the previous management and shot up significantly post-acquisition. Given FFL operates in an industry where raw material prices are highly commoditized, why would the per unit cost of raw/unprocessed milk be significantly higher than competition?

Some strategic errors do come to fore such as unhinged desire for growth and expansion at the expense of profitability. Unlike other smaller dairy players such as Day Fresh and Prema, which maintain profitability by concentrating themselves in regional pockets and investing in niche segments such as pasteurized dairy, FFL convinced itself that it could succeed as a challenger brand. More importantly, instead of growing its share by investing in category development in a market which is still 90 percent informal, it sought to wrestle market share from the established brands through aggressive trade discounts and geographic expansion. The management also insisted on stretching its resources thin by diversifying too quickly into high margin but low volume categories such as cheese, jams, marmalades, chocolate dip, and flavored milk; and refusing to divest loss-making legacy categories such as tea whitener.

Which brings us to the most obvious – yet also most pertinent question: why has the Fauji group not gotten itself out of the jam, but instead insists on putting more money after bad. The group’s investment in the dairy business is made through the DAP and urea manufacturing holding companies, which are themselves publicly listed giants. The sponsor management’s insistence on pouring resources into a business that has failed to turn profit in turn deprives the minority investors out of their share in holding companies’ higher profits. And although the management made an unsuccessful attempt to sell controlling share to a Chinese investor in 2018, fresh sponsor investment of Rs11.7 billion during the current year when the macroeconomic headwinds are only set to take a turn for the worse, indicates that the Foundation has its heart set on staying put.

Is dairy a strategic investment for the Fauji Foundation? It is hard to say. The conglomerate has become country’s largest by concentrating its investment in industries such as power, gas, oil, energy, and fertilizer – segments where it either enjoys captive markets, state subsidies, or guaranteed returns. In fact, the group’s forays into other competitive markets – especially in food – such as Fauji Meat and Fresh n Freeze have also only accumulated losses. Yet, instead of backing off it has continued to integrate upstream, investing directly into leased farming. In fact, its business ventures from fertilizer, farming, to cereals and pastas have truly turned into a farm to fork enterprise, albeit financed by subsidized gas supplied on taxpayer dime.

So, are Fauji’s in it for the long haul? They must be, especially if you buy the theory that sponsors want to stick around in case Pakistan’s hostile macroeconomic environment drives foreign players out of the market. That’s a big bet to place, but then Fauji’s may be the only ones with the wherewithal and influence to make one. Does it says something about betting on the wrong horse? Only time can tell.