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Wimm-Bill-Dann Foods OJSC (NYSE:WBD)

Q2 2008 Earnings Call Transcript

August 28, 2008 9:00 am ET

Executives

Marina Kagan – Head of Public Affairs

Tony Maher – Chairman and CEO

Dmitry Ivanov – CFO

Analysts

Marat Ibragimov – Citigroup Smith Barney

Svetlana Sukhanova – UBS

Mlada Yegikyan – Goldman Sachs

Odile Lange-Broussy – Merrill Lynch

Margaret Kalvar – Harding Loevner

Brady Martin – Deutsche Bank Moscow

Durabindo Shergill [ph] – Charge Investment [ph]

Natasha Zagvozdina – Renaissance Capital

Operator

Good day and welcome to the Wimm-Bill-Dann Foods fiscal second quarter 2008 earnings conference call. For your information, today’s conference is being recorded. At this time, I would like to turn the call over to your host for today, Ms Marina Kagan, please go ahead madam.

Marina Kagan

Hello ladies and gentlemen and thank you for joining us to discuss the financial results for the first half of 2008 and the second quarter of 2008. After our presentation as always we will be happy to take your questions. I would ask that you please refer to the cautionary statements included in the press release covering any comments made during this conference call. Now I would like to hand the call over to our Chief Executive Officer, Tony Maher.

Tony Maher

Thank you Marina good afternoon to those of you joining us from Russia and Europe and good morning to participants in the United States. I would like to begin with an overview of our results for the first half of the year and as appropriate I will also discuss the dynamics of the second quarter. I will then review the progress we’re making in our strategic initiatives, discuss each segment of our business and then conclude with an update to our outlook for 2008 now that we’ve completed the first half of the year. I’ll then pass the call over to Dmitry to discuss the detailed financial results.

For the first half of 2008, we achieved strong double-digit revenue growth of 30% on a year-over-year basis to nearly $1.5 billion. Our organic growth continues to drive our solid performance with all segments demonstrating strong year-over-year improvements in revenue. We achieved these results despite the headwinds created by higher global food, raw materials and fuel prices, a slowing down in consumer demand in many segments, and slower economic growth. We also had an unseasonably cold summer which affected the sales in this period on many of our categories. Despite some improvement in Dairy sales at the end of February and March, volume recovery did not continue into the second quarter. However we see that there is relatively strong consumer demand for our brands testified by our increase in market share. The Russian Dairy market which is relatively low per capita consumption is a strong potential for growth. Moreover, there are several factors that make this growth even more attractive. The value of dairy products is now significantly higher than previously while our gross margins are gradually recovering to their historical high levels. We saw significant sequential improvement in gross margins in the Dairy Segment in the second quarter with a sales improvement of nearly 30% versus the same period a year ago. Sales in the Beverages Division were also up in double digits increasing over 22% and our Baby Food business continued to outplay our competitors. We have increased our market share and delivered topline growth of over 65% versus the first half of 2007. Overall, Wimm-Bill-Dann is very well positioned in each of our businesses and we are very optimistic about our ability to deploy brands, achieve greater market share in this dynamic Russian market delivering stronger market growth.

Gross profit in the first half of the year increased to $471 million almost 25% higher than in the same period a year ago. While overall gross margin declined slightly versus the first half of last year, I am very pleased with the profit recovery in the second quarter of the year. Our overall gross margin up just over 33% for the second quarter represents an improvement of over 300 basis points from the first quarter of 2008. Our EBITDA also improved in the first half of the year to nearly $184 million increasing almost 25% over the first half of last year. Our EBITDA margin of 12.3% for the first half of the year is down 50 basis points in comparison to the first half of 2007 reflecting the effect of significantly higher raw materials and upgrading costs countered by enhanced efficiencies across our business segments, higher selling prices and improvements in market share.

I would now like to turn to a broader picture and provide insight into several items in which we have received recently questions. Before doing so I want to emphasize that the specific items that I will cover today should be considered within the context of our long-term strategies. As I did in our last call, I will begin with milk prices. They have come down somewhat since their spike in January but they remain at challenging levels. We spent $156 million more on the procurement of raw milk in the first half of 2008 than we did in the first half of 2007. Let me also touch on the recent (inaudible) development around the classification of liquid milk as we discussed last quarter. These regulations come into effect in the middle of December and mandate that products marked milk should not contain any dry milk and that any drinkable milk that contains dry milk will be marked milk product or milk drink. While consumer perception of milk drink is still not clear and currency is the subject of extensive market research buyers, we are nonetheless targeting to produce all our high margin trends in milk and the high margin packaging in milk using only raw milk. We are also encouraged by the interest shown by the Russian government to our industry. A couple of months ago, first Deputy Prime Minister Victor Zubkov visited our flagship Lianozovo plant in Moscow to better understand the business. Team trips to other plants, farms, and supermarkets followed to help government officials better comprehend the industry and constraints for each part of the chain, from farmers to producers to supermarkets. Our sense is that the government also understands that the milk industry requires better support and we are currently discussing with them the idea of conducting an advertising campaign to support consumption.

I would next like to provide you with an update of our efforts to improve our route to market. Our investment in marketing increased in the second quarter as continue to work to enhance our already strong brand equity and drive continuous sales growth. As we discussed in the past, there is a degree of variability in spending in this area and our marketing cost will vary from month to month depending on the timing of various campaigns. Our efforts over the past year are bearing fruit. In the second quarter of this year, we were able to improve our traditional Dairy market share in value terms by 110 basis points to 34.9% as of April, May. We also added an additional 320 basis points of share in our Baby Food Segment versus the second quarter of last year. Our Baby Food market share by value stood at 18.4% as of March, April 2008.

Moving on to our transportation and warehousing costs, these increased significantly in the first half of 2008 in comparison to the same period last year primarily reflecting the challenges posed by higher oil prices. These costs did decline in the second quarter versus the first quarter of this year as we are working to improve our efficiencies in transportation. While oil and diesel prices continue to pose a challenge for us, we have made significant improvements in the Beverage and Dairy businesses by leveraging our modernized infrastructure. We have been able to mitigate costs by putting production closer to our key markets, for example, we have opened several new juice lines in Siberia where our juice sales are robust. Going forward however managing these costs will remain a challenge.

Turning to the operating results of each of our businesses, our Dairy Segment delivered strong first half 2008 results with sales increasing nearly 29% year over year to $1.1 billion. The growth in Dairy was driven primarily by pricing and offset somewhat by decline in volume. Gross margin in the Dairy Segment for the first half of 2008 was 28.3%, down 159 basis points in comparison to the same period last year. More important however gross margin was 30.1% in the quarter, up nearly 370 basis points over the first quarter of the year and down very slightly on a year-over-year basis despite the much higher raw milk prices that we are facing this year versus last. In the Beverage business we continued to make progress delivering sales growth of just over 22% for the first half of 2008 to $259 million driven by continued volume growth, favorable pricing and mix. Gross margin in the second quarter remained solid at 38% in line with the two previous quarters. The raw material cost pressures that we have discussed in our last call moderated somewhat as the second quarter progressed but remained significantly higher than a year ago. The juice market across Russia slowed down in the second quarter due to unseasonably bad weather but J7 maintained its strong double-digit growth and continued to gain market share.

Finally, we continue to be pleased with the performance of our Baby Food business. Sales increased 65% for the first half of the year to nearly $120 million. Both volume and pricing dynamics were very solid in comparison with the same period last year and we gained over 300 basis points in market share according to the latest research. As planned, we have launched (inaudible) brands and are now on store shelves. Building this category will take some time but so far it is performing as expected. Overall, the growth opportunities in Baby Food market continued to be robust and we continue to work on establishing strong brand equity and building market share across the categories.

Let me conclude my comments with an update on guidance now that we are through the first half of the year. We are very optimistic about the potential of all our business segments to sustain a strong growth and profitability that we have received as we continue to build our brand equity and market share, drive innovation across our product lines and continue to identify quarter operation efficiencies across our businesses. However we faced a number of headwinds over last year and we expect many of them to continue through the second half of this year. Given the current state of the market, high inflationary environment and deceleration of consumer demand, we believe it is prudent to give you the more conservative guidance than previously stated. Our revised guidance for the full year of 2008 is revenue in the range of $2.9 million to $3.1 billion and EBITDA in the range of $370 million to $395 million. The decline in our EBITDA guidance reflects the impact on our financial results of continued higher raw material prices, lower volumes and other higher input costs. We will continue to try and mitigate these factors by driving even greater efficiencies across the company. We continue to expect our effective tax rate to stay below 30% and CapEx at the range of revenue to be in the range of 7% to 8% for the year. I would also like to reiterate our expectations for 2010. We don’t believe that the current market softening or consumer slow down will have a significant effect on our long-term outlook for growth and profitability. Therefore for 2010, we continue to expect revenue of approximately $4.5 billion and EBITDA in the range of $630 million to $650 million.

Finally, despite the chances of the last year, the business has continued to perform very well. We continued to improve our market leadership across all our categories and increase our efficiency as a company. We do remain focused on delivering our commitment to position Wimm-Bill-Dann for long-term success.

I would now like to turn the call over to Dmitry for a more detailed discussion of our financials. Dmitry?

Dmitry Ivanov

Thank you, Tony. Let me begin with a detailed review of our sales results and gross margin performance. Wimm-Bill-Dann group sales increased 30% for the first six months of 2008 over the same period last year to $1.5 billion. For the second quarter of 2008, group sales rose 25.6% over the same period in 2007 to $760 million. These results were driven by strong double-digit topline growth across all three of our (technical difficulty) important segments highlighted by growth of 65% for our baby food segment in the first six months versus the same period last year.

Sales in the Dairy Segment increased 29% for the first six months of 2008 over the same period last year to $1.1 billion. For the second quarter of 2008, sales in our Dairy Segment rose 24% over the same period in 2007 to $550 million. The average dollar selling price for Dairy rose 37% to $1.40 per kilo for the first six months of 2008 over the same period last year. For the second quarter of 2008, the average dollar selling price increased 39% to $1.40 per kilo for the same period in 2007. These increases were driven primarily by increases in average ruble prices. Raw milk prices continued to be significantly higher for the first six months of 2008 over the same period last year both in Russia and across the globe. For the first six months of 2008, our raw milk cost increased 49% in ruble terms and 62% in US dollar terms compared to the same period last year. For the second quarter of 2008, our raw milk cost increased 37% in ruble terms and 50% in US dollar terms compared to the same period last year. Raw milk costs remain much higher on an absolute basis in comparison to last year. Gross margin in the Dairy segment was 28.3% for the first six months of 2008, a decline of 159 basis points over the same period last year. For the second quarter of 2008, gross margin in the Dairy Segment was 30%, a very slight decline of 38 basis points over the same period in 2007. More importantly, gross margin in the Dairy Segment improved 368 basis points in comparison to the first quarter of 2008 due primarily to lower raw material costs.

Sales in the Baby Food Segment increased 55% for the first six months of 2008 over the same period last year to $128 million. For the second quarter of 2008, sales in the Baby Food Segment rose 63.4% over the same period last year to $68 million. The average selling price in the Baby Food Segment increased 31.4% for the first six months of 2008 over the same period last year to $2.42 per kilo. For the second quarter of 2008, the average selling price in the Baby Food Segment rose 32% over the same period last year to $2.42 per kilo. These increases were driven primarily by increases in average ruble prices and change in mix. Gross margin in the Baby Food Segment was 47% for the first six months of 2008, an increase of 141 basis points over the same period last year. For the second quarter of 2008, gross margin in the Baby Food Segment was 46%, a slight improvement over the same period in 2007.

I will now turn to operating expenses and other components of the P&L. Total selling and distribution expenses as a percentage of sales were flat at 16% for the first six months of 2008 over the same period last year. For the second quarter of 2008, selling and distribution expenses were essentially flat at 17% over the same period last year. Marketing and advertising expenditures for the first six months of 2008 were $62 million or 4% of sales compared to $70 million or 9% of sales for the first half of 2007. For the second quarter of 2008, marketing and advertising expenses were $35 million or 4.6% of sales compared to $40 million or 6.6% of sales in the second quarter of 2007. On a sequential basis, marketing and advertising expenses increased from $27 million or 3.6% of sales. As Tony said in his comments, there is a suspected variability in spending on marketing and advertising based on the timing of particular activities and our spending levels should be considered on a long-term basis.

Transportation and warehousing costs for the first six months of 2008 were $77 million or 5% of sales compared to $56 million or 5% for the first half of 2007. For the second quarter of 2008, transportation and warehousing costs were $38 million or 5% of sales compared to $30 million or again 5% of sales in the second quarter of 2007. The growth of these costs reflects necessary spending to support our growth but also the significant increases in fuel prices. On a sequential basis, transportation and warehousing expenses decreased from $40 million or 5.5% of sales and these improvements reflect the efficiency improvement that Tony mentioned in his comments and the overall decline in oil prices in the second quarter of 2008 in comparison to the first quarter of the year.

General and administrative expenses increased 12% for the first six months of 2008 over the same period last year to $97 million. General and administrative expense as a percentage of sales declined 103 basis points to 6.5% for the first six months of the year in comparison to the first six months of 2007 reflecting our focus on improving efficiency of the business. For the second quarter of 2008, general and administrative expenses increased 23% over the same period last year to $55 million.

Financial expenses increased 19% for the first six months of 2008 over the same period last year to $37 million. For the second quarter of 2008, financial expenses increased 31% over the same period last year to $21 million. Our effective tax rate for the first six months of 2008 was 28.8%, a decline of 96 basis points in comparison to the same period last year. In the second quarter of 2008, our effective tax rate was 28.9%, a decline of 160 basis points in comparison to the same period last year.

Operating income increased 16% for the first six months of 2008 over the same period last year to $126 million. For the second quarter of 2008, operating income increased 10% over the same period last year to $63 million. Net income increased 19.5% for the first six months of 2008 over the same period last year to $79 million. For the second quarter of 2008, net income increased 9% over the same period last year to $37 million.

Turning to EBITDA, it increased 25% for the first six months of 2008 over the same period of last year to $184 million. Our EBITDA margin of 12.3% for the first six months of the year is down 50 basis points in comparison to the first six months of 2007 reflecting the significantly higher raw material costs and fuel prices in the first half of 2008 and our improvement in operating efficiencies across our business segments, higher selling prices and improvement in market share. For the second quarter of 2008, our EBITDA rose 21% over the same period last year to $93 million. Our capital expenditures excluding acquisitions in the second quarter of 2008 was $61 million [ph] compared to $69 million in the second quarter of 2007. This brings our total CapEx to $111 million for the first half of 2008, up from $93 million for the first half of last year.

Operating cash flow was very solid $116 million for the first six months of 2008 and net cash and investments were $148 million at the end of the second quarter of 2008, a decline of $56 million from the first quarter. We also refinanced our $250 million Eurobond loan that expired in May with a $250 million syndicate loan and replaced 8 billion of ruble denominated debt in April. Demand was very strong for these instruments and we achieved an attractive interest rate of 6.9, a significant improvement over the rate on our old debt. The total debt to EBITDA covenant as of June 30, 2008 was 2.1%.

With these I pass the floor back to Marina Kagan.

Marina Kagan

Operator, can we have the questions please?

Question-and-Answer Session

Operator

(Operator instructions) we shall take our first question from – Marat Ibragimov of Citigroup Smith Barney. Please go ahead.

Marat Ibragimov – Citigroup Smith Barney

My question is regarding Dairy prices. Could you please tell me what was the price increase in the second quarter of this year versus the first quarter of this year?

Tony Maher

Marat it is Tony. We took no pricing increase in Q2.

Marat Ibragimov – Citigroup Smith Barney

Yes. According to my calculations the volumes in the second quarter fell 9% year over year versus 0.4% in the first quarter also year over year. Could you please explain or maybe suggest something, why was there a volume decline in Dairy?

Tony Maher

The volume from what we saw right throughout the second quarter and indeed I would say June more than any other of the months in the quarter was volume in Dairy was down and as the quarter went on, I think weather had a piece to do with it. I think certainly things like kefir which responds very strongly to hot weather was down considerably but I think, quite honestly, overall demand as we understand it from AC Nielsen and other bodies that overall Dairy demand on a year-to-date basis is down some 10% or 12% is the number we are picking up from AC Nielsen. So, I think overall –

Marat Ibragimov – Citigroup Smith Barney

It is not only your problem it is the market, I just want to realize what –

Tony Maher

Yes, I understand and that is true. Yes, I think quite honestly, I mean Marat you live in Russia and you know that there has been a lot of price pressure not just in Dairy but practically right across the board and has been for about nine months or so in Russia and I think certain people in the income pyramid, if you like, are certainly have been feeling their disposable income stretch somewhat. So, I think what you are seeing is a result of that and our understanding is that there is quite a few categories across the sectors, FMCG sectors that saw a softening in demand as consumers basically felt a bit of a stretch for the first time in quite a few years.

Marat Ibragimov – Citigroup Smith Barney

Yes, I agree with you probably because the disposable income becomes shrinking because of the price increases in other food items.

Tony Maher

Indeed. I think it is not only that, it is in fuel for cars, and it is right across the board. I think this is probably one of the few major macroeconomic issues that Russia has been facing over the last practically 12 months, I guess more 9 months and we had year to date June, July we had something like 15% inflation and I suspect food inflation probably in the 20s and that’s part of the issue. Now, we are seeing at least are hearing perhaps a slowing down of that and that is good news all round.

Marat Ibragimov – Citigroup Smith Barney

I may further suggest that this is largely at the expense of high margin products. Am I correct?

Tony Maher

No. I seem to expect – I think certainly some high margin products certainly are doing better than others, it is a mix really. I think we have high margin products in traditional dairy also but certainly yoghurts, desserts and so on more than traditional dairy.

Marat Ibragimov – Citigroup Smith Barney

Could you possibly give some statistics on some higher margin brands for example on Domik v Derevne, how did they perform in volumes in the second quarter or in the first half of ’08?

Tony Maher

But I can’t give out directly volumes by brand but I can tell you Domik v Derevne is doing well. The traditional dairy products including Domik v Derevne, Vesely Molochnik and M have been doing rather well. In fact, if you take total traditional dairy, our market share of total traditional went up by 140 basis points and that includes Domik v Derevne, Vesely Molochnik, M and some other regional brands as well. But by and large our national brands are doing better. Our national brands are a bigger percentage of our business in the first six months of this year than they were in the first six months of last year. In fact, the stronger the brand actually the more robust the performance which is good news and is what we would expect actually as it is bit more impervious to pricing. We have got quite a few regional brands and especially outside of Moscow which would not be quite as strong. Also in volume, we stopped doing Private Label which was about three something percent of our volume, so that is also gone which was a positive thing because it was contributing something to (inaudible) cost in the past with recurrent pricing of raw materials we decided about Q4 last year to discontinue it and that has also reflected in the volumes of course.

Marat Ibragimov – Citigroup Smith Barney

Okay. Thank you very much. That’s all from my side.

Operator

Thank you. We’ll take our next question from Svetlana Sukhanova of UBS. Please go ahead.

Svetlana Sukhanova – UBS

Yes, good evening to everyone. Tony may I ask about your ERPS [ph] how often do you see they come from your sales, from your production, is it on day-to-day basis, month-to-month basis.

Tony Maher

No, in terms of revenue and so on, because we are not just in Russia, we are across ten countries, we have very robust information obviously in a month by month but in terms of let’s call it pretty decent information and pretty robust in itself but not maybe final on a week-by-week basis.

Svetlana Sukhanova – UBS

But so if we speak about volumes for Russia, we see volumes for Russia on a week-to-week basis, is it correct so we do not see daily volume?

Tony Maher

No, I did not say volume, I said revenue.

Svetlana Sukhanova – UBS

Okay and if I ask about volume –

Tony Maher

Volume is really more on a month-by-month basis. We have some indications and we know certain things, we know production numbers and stuff like that with absolute sales given that it is also lot of depots and Russia is essentially a big country and then you add in Ukraine and Central Asia and so on, we would not have final numbers that we can fully rely on until month by month.

Svetlana Sukhanova – UBS

Okay, if you had a terrible month’s sale in August, you will get to see it only by the end of August that your volumes (inaudible) products, do I understand correctly?

Tony Maher

Well, I think we –

Svetlana Sukhanova – UBS

If the volume sales are doing terrible you will get the data only in a month, do I get the point correctly?

Tony Maher

I didn’t say that. They are your words Svetlana.

Svetlana Sukhanova – UBS

Sorry?

Tony Maher

I said they are your words that is not what I said.

Svetlana Sukhanova – UBS

No. I am telling you, if you see in a month-to-month basis, yes –

Tony Maher

I said we see the detailed sales information on a month-by-month basis. You then interpreted that for some reason to say we had terrible sales –

Svetlana Sukhanova – UBS

No, I understand –

Tony Maher

Let me finish, let me finish. You said that if we saw terrible sales we will only know it at the end of the month, I didn’t say that. I said if we wanted the full detailed information then we would have that at the end of the month. That is very different to saying if we had terrible sales we would only know it at the end of the month. I didn’t create those words, you did.

Svetlana Sukhanova – UBS

Okay, so if you have some problems with volume you will see it immediately, do I understand you correctly?

Tony Maher

Svetlana, I don’t know what you mean by problems? I mean –

Svetlana Sukhanova – UBS

It’s like volumes are down significantly –

Tony Maher

Significantly yes.

Svetlana Sukhanova – UBS

Okay, cool, I understand it. Now, may I ask you about the second quarter (inaudible) which you have made today, it looks we had a previous conference call with you in early June which was almost like end of second quarter, may I ask you given you are always a very transparent company why you haven’t updated us about that you do (inaudible) ?

Tony Maher

Well, first of all, it is not just about the second quarter, our second quarter we feel is actually okay but there are many other issues which we feel going forward would give rise to some concerns about the back half of the year and it is not just about the second quarter, it is about the entire year. We certainly saw volumes going softer as in June than expected and we believe that is an industry thing and we see that some more market share figures also and when we made the conference call in June, not all facts and figures were available to us and in terms of sales and mix for example (inaudible) that kind of detail would not be ready until we do the accounts. So, quite honestly, if it was that easy to do the accounts, we should be doing the conference call for the second quarter sometime in July. We are doing it at the end of August for a reason, we don’t have the details.

Svetlana Sukhanova – UBS

I got your point, thank you very much for this. My last question is what is the risk of your shares profit warning [ph] which you might see this year, is there any risk of a certain profit warning for you this year (inaudible) you will decrease guidance.

Tony Maher

To your point Svetlana I believe we are a very transparent company and when we give guidance it is with the best intentions and with the best information we have. So the guidance is the guidance and that is it.

Svetlana Sukhanova – UBS

Okay, it’s not clear, so far –

Tony Maher

Svetlana, I have no idea where you are coming from, we have given guidance and what else do you want me to say?

Svetlana Sukhanova – UBS

I am asking what is the risk that you might decrease your guidance again? That is my question.

Tony Maher

Why would we be giving guidance if there was a risk for us to decrease it?

Svetlana Sukhanova – UBS

Because you decreased already your guidance for March. Okay, cool, I got your question; I think you answered my question. Thank you very much.

Operator

Thank you. We’ll take our next question now from Mlada Yegikyan of Goldman Sachs. Please go ahead.

Mlada Yegikyan – Goldman Sachs

Good evening Tony, I have a couple of questions if I may. I am slightly curious regarding your SG&A structure in the second quarter, I understand that some of the increases in the SG&A cost are more of a one-off given the seasonal increase in marketing although if I could just get once again the clarification, the number mentioned by Dmitry, I could not hear it correctly, exactly. But the question really is apparently the D&A expenses increased significantly quarter on quarter and there must be something else other than marketing, perhaps it is a labor cost, if you could just give us some idea of how the labor cost evolved quarter on quarter and maybe here in the second quarter. That’s the first question please.

Tony Maher

Dmitry, can you handle that?

Dmitry Ivanov

General and administrative expenses increased 12% for the first six months to $97 million. D&A expense, the root of D&A expense increase is the increase in fixed assets which was from $768 million on the beginning of the year to $850 million. It was a reconstruction and modernization of existing buildings and capacities (inaudible) production, the construction of land at the top of baby food production in August [ph] and these certainly had an impact on our amortization and depreciation.

Mlada Yegikyan – Goldman Sachs

Sorry, I didn’t ask for D&A, I didn’t ask for D&A, I asked for G&A, general and admin expenses mainly labor and marketing for the second quarter as a percentage of sales.

Dmitry Ivanov

The change year on year is $10 million driven primarily by currency exchange on approximately 9%, so it is the main explanation.

Mlada Yegikyan – Goldman Sachs

And quarter-on-quarter labor expenses I am asking for.

Tony Maher

Labor increase in the second quarter, we took our salaries up as we always do once a year and our salary increased towards the end of March the beginning of April. Salary increases approximately in G&A, approximately 20% Mlada in Q2 ’08 versus Q2 ’07.

Mlada Yegikyan – Goldman Sachs

So, this is more of I guess one-off versus something that – the increase which will be continued into the second half of the year, is that correct? Would that be fair to say?

Tony Maher

Last year we were taking salaries up as well, so certainly you will be seeing – you know, we give the salaries in the second quarter and we continue to pay those throughout the year of course. So, you will be seeing as you are seeing with inflation here, generally salaries are increasing in this market between 15% and 20% I think in some reports I even see higher.

Mlada Yegikyan – Goldman Sachs

Right.

Tony Maher

I think quarter to quarter, Q1 to Q2, you got to be a little bit careful because there are things like bonuses and so on and so forth that come in, in various quarters. The best way to looking at it is Q2 versus Q2 because it is a lot more comparable and the number there is about 20%, 21%.

Mlada Yegikyan – Goldman Sachs

Okay, I understand thanks. The other question that I had was on the gross margin, I see that the gross margin in the second quarter has actually extended quite a lot and I am wondering to what extent would you say this could be sort of sustainable into the next couple of quarters given that this apparently is a sign of the fact that the deterioration of sales mix is not as bad as we might have thought and the price increases still drive the gross margin expansion. So, would you think that this could be something sustainable or else do you even think of potentially decreasing prices to restore the volumes, what would be your take on that?

Tony Maher

We are entering a period, I guess, from September onwards when seasonally the price of milk has to go up as the supply side tends to sharpen a bit. As of August, the price of milk seems to be more or less in line with the price that we saw in July, slightly upward but very slightly. So, it very much depends on the big movers in the margins in dairy. So, really it is down to a bottle and a half instead of price of raw milk more than anything else. We do some obviously promotional activity but that is in the normal course of the business and we don’t see ticking prices down as we go forward. I also saw that the comparables on volume going forward are that bit easier as well because clearly when the major inflation came and pricing came in September, October last year, volumes also sharpened somewhat. So, I think the comparables get easier certainly in the last three months of the year, four months of the year. But we don’t see, we have no plans to take our prices down and the industry generally competitors and so on have been (inaudible) because there are other costs of course that have to be covered.

Mlada Yegikyan – Goldman Sachs

Thanks Tony. Just the final question on my behalf, you mentioned that there is a 10% to 12% decrease in demand in the Dairy market in the first half year, do you happen to have the exact figures for the volume decrease for the Dairy industry perhaps in the second quarter in the dairy and in juices the volume dynamics of the second quarter? Thank you very much.

Tony Maher

I don’t have the Dairy because it comes from Nielsen but certainly from what we understand it is pretty much a little bit higher, what we get from Nielsen is bimonthly so what we now currently have is up to April, May so that’s the number of 12% that has been reported by AC Nielsen and others as well, the Dairy Unions and some others are reporting even bigger numbers. In the case of juice, Beverages in the second quarter declined due to extremely bad weather as well as I guess some of the economic factors. I can tell you that what we understand is that juices generally in the second quarter grew somewhere in the order of 1% to 2%. It is what we are picking up from other sources not from Nielsen, from other sources. That is not our volume Mlada that is the industry.

Mlada Yegikyan – Goldman Sachs

Yes I understand. Thank you very much.

Operator

Thank you. We’ll take our next question from Odile Lange-Broussy of Merrill Lynch. Please go ahead.

Odile Lange-Broussy – Merrill Lynch

Good evening, I want to ask you a question on the apple concentrate crisis. As of now, do you have any outlook on the 2008 crop versus that will start I suppose towards the end of this year?

Tony Maher

Everything we believe, I mean, it is interesting we mentioned that as the quarter went on, the price of apples started to soften. Basically juice sales worldwide took something of a hit which of course drove less demand for concentrate. So, what we are seeing actually right now is the price of apple concentrate should be quite a bit lower than it was when the last crop was announced was effective was December, January last and the difference is quite a bit, maybe $300 or $400, and in some quotations even more a ton less, approximately 20%, 25%. So we now – orange juice also has come down. So it very much depends on what happens with hurricanes, so on a – hurricane trying around the southern states in the last couple of weeks. So, it depends if there is any crop damage done there. But general expectation right now is for key fruits, orange and apple, is that apple looking a bit lower than what we were looking at coming into this year and orange about flat.

Odile Lange-Broussy – Merrill Lynch

Okay. I want to move into the (inaudible) working capital. In the last conference call, you said that the one area that you needed to improve looking at the first half numbers versus first half ’07, you see a deterioration actually more than couple of percentage of sales and already in full year ’07 that was a deterioration versus ’06. Can you comment on that and, say, what kind of improvements you are expecting and what time horizon that would be on?

Tony Maher

Well, there are a couple of items which are I guess impacting it. First and foremost, we had this year more milk I guess than we needed in the second quarter, and that’s allowed us to build stuffs of cheese and so on that this time last year we weren’t to able to do. And that’s good news because in the wintertime, we can’t get enough milk and we are constrained by and constrained on our Lamber brand. So there is some value in cheese and there is also some – because again we were bringing in more milk than we needed, there were some extra stuffs of dry harder milk and butter that normally we actually buy in from outside. So there are some inventories there. As we go through the next six months, we will automatically reduce. And then there is also the inflationary effect, which of course year-on-year both in finished goods and in raw materials there are significantly higher values. The price of raw milk on its own, for example, $156 million is an indication of just the inflationary element there. But I still say there is no secret to affect our balance sheet. We have made some progress in some aspects in our Beverage business. We certainly reduce inventories and so on. And our Dairy business is where we have more work to do. So I hold to the position that it needs to be better and we are putting some effort in there to reduce it, but there were some items which actually are favorable over time around inventory build, which we did because of the excess milk that was coming to us in the last number of months.

Odile Lange-Broussy – Merrill Lynch

These improvements that you are speaking of that are still ahead of your estimate [ph] in the Dairy business. Can you (inaudible) more? Yes, go ahead – can you be slightly more specific as to what they would be and when they would come about? We are talking about some six-month horizon or is it a two-year horizon?

Tony Maher

Well, I would say it’s probably 6 to 12 months horizon rather than a two-year horizon.

Odile Lange-Broussy – Merrill Lynch

Okay. Thank you very much.

Tony Maher

Thank you,

Operator

Thank you. We’ll take our next question now from Margaret Kalvar of Harding Loevner. Please go ahead.

Margaret Kalvar – Harding Loevner

Yes. Hi, good morning. I would just like a little bit more color on the consumer picture in Russia. We hear from the retailers that there are strong increases in the average ticket, which seems to somewhat conflict with what you were finding in terms of consumers maybe pulling back even a little bit more on the higher margin products. We also hear that overall wage growth has been surpassing inflation growth, which should lead to higher consumer discretionary spending. I’m sitting here not many miles away getting a different picture from different sources and maybe you can reconcile that a little bit.

Tony Maher

Okay. Sure. Hi, Margaret. Well, first of all at retail, of course, given all that inflation, of course we are getting a higher ticket. And that’s exactly what you are seeing. So if you are looking at food inflation, and we believe the number is probably around 25%, could be up to 30%, then de facto even with these retailers not opening new stores and I saw some of those – I’ve obviously seen some of the results have been announced by a number of our customers. And if you remember the numbers store-for-store sales and so on and so forth, the higher ticket is inflation and maybe probably even diluted somewhat I think. And certainly if I look at some results that have come out in the last couple of weeks, we think we saw the same thing and I think it’s very easily explained by just the cost of many, many items, and not just food items indeed, general grocery items from detergents and anything else that you may want to think about.

Margaret Kalvar – Harding Loevner

So it’s not real basket growth, it is inflation?

Tony Maher

Absolutely not. I think I’d be very happy to sit down with you and go through the numbers. If you work them out and you take inflation and certainly food inflation and so on, it’s well reported to be far more like 25% than 15%. And you work it through, I think you’d come to the same conclusions I’ve just given you.

Margaret Kalvar – Harding Loevner

Okay. What about the argument that incomes are growing faster than overall inflation?

Tony Maher

I think just average results are for the things, I think if I take the regular households, you know, if you take income pyramid at the top end, maybe they are, but I think if you take the income pyramid sort of the lower middle income and the majority of the population, I don’t believe that’s true. In fact, I’ve seen obstacles only the last couple of weeks that for the first time since 1999, 2007 was the first year since 1999 where real incomes for people in the population did not surpass inflation.

Margaret Kalvar – Harding Loevner

Okay. Thanks very much.

Tony Maher

Thank you, Margaret.

Operator

Thank you. We’ll take our next question from Brady Martin of Deutsche Bank Moscow. Please go ahead.

Brady Martin – Deutsche Bank Moscow

Hi. Just a couple of quick questions. One, on the CapEx, I mean it seems like what you spent in the first half, it was certainly in line with your guidance for the year in terms of percent of sales. What were you spending it on primarily? I mean, is the $112 million, what was the focus? I mean, no acquisitions. What are you exactly spending it–?

Tony Maher

There are a number of items, which are ongoing from new production lines. Baby Food, for example, we announced sometime ago that we – in fact, last August we announced that we were extending our line in Kursk, our plant in Kursk, because sales of Baby Food are clearly well, well ahead of our expectation. The new lines we talked about in Siberia for juices, which is saving us quite a lot of money in terms of getting to market at cheaper prices given the transport costs, there are some new machines for – on some high value end of our Dairy, which will start producing in the back half of this year, which I don’t want to get into too much detail on, but that’s how it progresses [ph]. Also some maintenance CapEx. We’ve got many factories and that’s got to be dealt with. And the finishing of our Baby Food factory in Omsk as well, which was $15 million, up to $18 million investment. So there are many things. And that – if you are running a business outside, you’ve got to spend CapEx on. And I think I’ve given you the broad version on what the big items were.

Brady Martin – Deutsche Bank Moscow

Right. Also just wondering – just a clarification on your debt situation, it says about 2.1 times EBITDA now. What is your – you have like a substantial cash balance right now, do you expect to be taking on additional debt later in the year, or do you think this will be reduced, or do you think this 2.1 will be where you will be at by the end of the year?

Tony Maher

Well, it probably most depends on whether we find some opportunities that will add long-term value to our business through acquisitions and so on, whether we take on additional debt or not. For the purposes of ongoing business, we don’t need to take on additional debt. We’ve got surplus cash right now. So it’s contingent upon some opportunities that we are always looking at opportunities to acquire businesses that can be accretive to us. But – and right now actually many of these opportunities have got somewhat cheaper. So I guess it’s kind of contingent upon anything that may occur between now and then. But in a normal course of business, we would not be taking on more debt, no.

Brady Martin – Deutsche Bank Moscow

Right. Okay. And then maybe just a follow-up on this question of acquisitions, your – you said your traditional dairy share, now it’s almost very close to 35% threshold. Do you now have to get permission from the anti-monopoly service for any acquisitions that you make in dairy?

Tony Maher

We’ve always had to get permission for anti-monopoly service for any acquisition that we make.

Brady Martin – Deutsche Bank Moscow

Okay. So you don’t expect there would be any difference now in your ability to expand through acquisitions than a year ago when your share was lower?

Tony Maher

I don’t see that. I think the anti-monopoly always – and it’s no different than anti-monopoly in other countries. Certainly in my experience of Western Europe, you will have to do a significant amount of filing to do an acquisition irrespective of what share you held. And you’ve got to go through various things and satisfy them that it’s in the best interest of the overall market and so on. And that’s always been the case here too. And I don’t see – really I don’t see any difference there.

Brady Martin – Deutsche Bank Moscow

All right. Okay, all right. That’s all the questions I had. Thank you, Tony.

Tony Maher

Thank you, Brady.

Operator

Thank you. We’ll take the next question from Durabindo Shergill [ph] of Charge Investment [ph]. Please go ahead.

Durabindo Shergill – Charge Investment

Hi. I want to get some sense of what your expectations for raw milk prices are in the second half of the year and going forward into ’09? Is there some seasonality in the pricings? And would you expect some kind of moderation in ’09?

Tony Maher

It’s difficult to say about moderation in ’09. I think we’ve seen some moderation as we went through this year, which was obviously positive. More moderation I guess than we had predicted at the start of the year to be fair. We do see some increases coming in the back half of the year. We always do, because clearly there is a very big seasonality in milk supply in Russia. The question is, to how much will that be? We believe now that the price of milk in, let’s say, November, December when it peak last year, November, December and January this year should be lower than it was last year. But how much lower is still a question mark very much depending upon supply, as you can imagine, and indeed upon demand. So I think going forward into ’09, there are many new things, including the new milk legislation and so on, and indeed, again, consumer demand, but also one has to say there’s new milk production being added as well. And that’s also a favorable side of it. So I think the turmoil that we saw in 2007, not just in Russia but right across the world in milk prices, there really is no reason to expect that that will reoccur, notwithstanding the fact that milk prices in Russia are today one of the highest certainly in Europe. So I think prices here are, relatively speaking, at a high level already. But it really is something that as we go forward, we obviously are taking care to manage. We have about far more contracts today with farms than we had this time last year, and that could be slush [ph] to us in getting predictability. So there are some favorable things that went around a year ago, but we are going to (inaudible) the supply of milk is shorter than it would be, let’s say, over the last four months or five months.

Durabindo Shergill – Charge Investment

Could you tell me what the difference in the first half and the second half of ’07 was in prices, kind of what the count [ph] was?

Tony Maher

I think we made that public already, but I think the number, if I remember rightly, is probably about 40 something percent if you take the first six months, and let’s take December. So the peak – December-over-December was about 40-odd percent higher than prior year and it was $90 something million impact on cost line in Q4 alone. So it was enormous 2Q 2007. No, it has not come back. It’s still very high right now compared to this time last year, but the big peak really was in the last four months of last year. That was when the real inflation came.

Durabindo Shergill – Charge Investment

And what do you think of the fundamental driver here of these costs increases because that seem very extreme? Is it just input cost pricing or is there a problem with supply in Russia?

Tony Maher

Well, there is – I mean, the Russian agricultural sector is really already getting back on its feet after years of decline driven by government programs and programs driven by us over the last number of years. So, the production is increasing, but it’s from a level that being in pretty long-term decline from the days of – the latter days of the Soviet Union. The situation in milk is well known from last year, and I think maybe we can brief you because many maybe of the other callers are more familiar with it. But literally there was a worldwide price increase in milk last year starting in the United States, and that has spread right across into Europe and into Russia in the back half of the year. Now, what’s happened subsequently is the price of milk – dry milk, especially which is the traded commodity has started to, has started in – early this year started to come down from about $5,000 come down to about $3,000. It’s still actually holding down there. The price of dry milk is not going back up, especially in Europe. So I think the fundamentals have changed a little bit in terms of the globally traded commodity, which is skimmed milk powder. And that is enough an effect in the price of raw milk because one of course comes from the other.

Durabindo Shergill – Charge Investment

Okay. Just one last question. Do you see any chances of any sort of government restrictions on pricing or–?

Tony Maher

Well, I guess the governments are certainly trying to fight inflation. And in that respect, I guess they are concerned about any price increases, but so far, we haven’t witnessed any price controls or anything of that nature. I think we haven’t shared with anybody else other than maybe the non-MCG market, which is another story on coking coal or whatever. But certainly in our type of business, we haven’t witnessed any price controls or whatever. But certainly I guess for sure they have an interest in ensuring that there isn’t any I guess some fair advantage being taken [ph] of consumers through companies taking on fair price increase. But other than that, nothing per se, no.

Durabindo Shergill – Charge Investment

Okay. Thank you very much.

Marina Kagan

Okay. We will take one more last question.

Operator

Certainly. Thank you. We’ll take our last question now from Natasha Zagvozdina of Renaissance Capital. Please go ahead.

Natasha Zagvozdina – Renaissance Capital

Good afternoon. Just my last question. In fact, it’s a question about the guidance, which is reaffirmed for 2010. My question is whether you expect more of a volumes recovery over time or ability to price stronger given the brand, the distribution, your market presence in key segments, or maybe you expect a more dynamic growth in one of the segments, for instance, Baby Food. Can you elaborate a little bit on that?

Tony Maher

Hi, good afternoon, Natasha. Our Baby Food business is growing very strongly with revenue of 65% and strong market share growth. So, we continue to expect to see that going from strength to strength. We have little doubt that the Dairy business, which really is the only business where we are really seeing any kind of volume decline. Our Beverage business is growing. In fact, even our water business increased in the second quarter despite the very poor weather. So that area – but we do see, quite honestly, given the (inaudible) levels here, we see absolutely the volume returning and it’s not – it doesn’t require much of a percentage growth really to get the turnaround. So we see that coming back. And I think it’s volume driven. Of course, it’s also some driven by brands and branding, but volume is where we see the turnaround to being the catalyst for the guidance we’ve given for 2010.

Natasha Zagvozdina – Renaissance Capital

And maybe couple of questions just to reconfirm the numbers if you give them I was listening. Did you give us your estimated value of market share in the Baby Food and Juice as well as in Dairy?

Tony Maher

We did give the market share in relation to Baby Food.

Natasha Zagvozdina – Renaissance Capital

Can you look at that please?

Tony Maher

Sure. 18.4% is as of March, April, which is the value share. And it’s more in volume, because again remember – it’s more in volume because we’ve just launched a formula, which is very high, and we haven’t been in that market up till now, very high value. In relation to Beverages, it’s about 18%.

Natasha Zagvozdina – Renaissance Capital

Thank you very much. That’s all the questions from me.

Tony Maher

Thanks, Natasha.

Marina Kagan

Ladies and gentlemen, thank you very much for joining us today on our call. Should you have any further questions, please do not hesitate to contact us. The replay of this call will be available for the next week. All the information can be found on the invitations that we sent to you or on our website. But for now, good bye from all of us here in Moscow.

Operator

Thank you. That will conclude today's conference call. Thank you for your participation, ladies and gentlemen, you may now disconnect.

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