Will you be LUCKY!

It is good to see that this year we have seen several IPOs on CSE after a couple of years of poor performance. Arguably, the IPO market suffered due to several reasons (when everywhere else IPO markets thrived!). However, a review on the Lankan IPO market is not the topic of discussion in this post. But, I thought of shedding some light on the recently announced IPO by a dairy company, Lucky Lanka Milk Processing Co. Ltd (a yogurt manufacturer and known in every nook and corner in the country!).At the outset, I’d like to highlight some of the biases that may come in the way of my assessment. I’m a capital market participant myself (in the IB space) and my views may be biased therefore (natural I guess!). Secondly, I’m not an expert in the dairy sector nor did I ever run a dairy company (somehow around 2010, I had the privilege to meet with the founder/chairman of Lucky and witness the manufacturing process at their plant in down south. Moreover I have consumed their products). Third,I’m always skeptical when it comes to valuations (you may say I’m a pessimist!).Finally, I prefer to look at valuations of companies (arriving at an intrinsic value based on company fundamentals) rather than pricing. That said I couldn’t resist touching this valuation and writing something up about it.

Lucky: the success story

Lucky is a classic Lankan example of entrepreneurial success and hence I like the company as a business. Lucky stands out as a proud business started and succeeded as a non Colombo-centric business. It can be lined up along with other proud names like Harischandra Mills, Nippolac Paints, Freelan all of which commenced in Southern Sri Lanka and have now become island wide operators known to every household. 

Started off some 23 years ago as a homestead business, today Lucky stands out as one of the formidable players in the yoghurt/dairy market in Sri Lanka and have so far succeeded as a family owned business competing with the likes of Fonterra Lanka. The Company is engaged in the process of collection of locally produced fresh milk from rura lvillage farmers and process yoghurt and other milk products and distribute island wide underthe brand name ‘LUCKY’. The Company currently has a processing capacity of 20,000 litres of fresh milk a day (p. 25, Prospectus).

Lucky has increased its revenue significantly over the last five years though earnings have been so volatile. The earnings volatility explains the strength of competitiveness in the market and the entailing cost structures to deal with it. On top of that, being a private entity the bulk of funding for expansion for LLMP has so far come from bank funding and as a result there had been a huge drain in profits in the form of interest expenses. In the short term the IPO funds will give the company some comfort as they will be paying down almost all the debt on the balance sheet. But, my guess is that in the long run they will have to continuously tap the bank funding avenue given the nature of the industry and in order to stay afloat in a highly competitive market. Hence, in my valuation I assume the same debt to equity ratio to continue in to the future and hence my cost of capital assumption is based on that premise as well.

The recent trend in the revenue mix of the company also suggests that in the yoghurt market they are facing stiff competition and as a result they have tried to diversify away income by moving from just being ayoghurt seller to dairy company. For instance,the revenue from fresh milk sales has soared from 10% of the total revenue in FY12 to 30% by FY13. And going forward the company intends to increase the sale of fresh milk through the ‘GedarataKiri’ project (p.40, Prospectus) and to increase franchising income from Colombo. However, the question is that; would they be able to reduce pressure on margins with these strategies. My judgment is that LLMP won’t be able to charge higher margins for a long time with the addition of these other sources of incomedue to either the value addition from these segments would be almost non-existence(especially in the fresh milk category) and/or the other players can easily imitate the other strategies like franchising.

Dairy market in perspective

Before talking about the valuation, thought it fit to look at the bigger picture as it will define the drivers of value for LLMP. As I mentioned previously, LLMP is a yoghurt manufacturer whose revenue is predominantly generated from sale of yoghurt. However, as evidenced from the Prospectus and the accompanying numbers they are now evolving to be a dairy company with other types of milk based offerings. (But it will continue to be a yoghurt company in my definition since bulk of their revenue will come from that segment in to the future as I believe)

The total market for milk and milk products in Sri Lanka is c. LKR 56.1 billion. Market share of the main players is as depicted in the graph below. Out of the total market demand, c. 70% was sourced from imports while the rest was locally met. The incumbent governments have continuously spoken about self-sufficiency in dairy sector and made slow progress toward that direction. 

(others segment includes all others including many other players)

The current yoghurt market in Sri Lanka is a very competitive and highly fragmented market. The majority market share is enjoyed by a few large players (like Kothmale Holdings, CIC Agri, Lanka Milk Food, Milco, Pelwatte Dairy and Fonterra Brands Lanka). Most interesting thing about all these players is that they are all part of larger conglomerates in Sri Lanka and as a result they are financially very well geared to face any type of competition that they come across. (Not forgetting the fact that one of the main players is an MNC and the other one, Milco, is a state owned entity who is the largest milk collector in the island.) CIC also is a listed entity with a target of penetrating in to yoghurt market aggressively.
(targeting a market share of 20%). I present some interesting statistics below: (please note that there are discrepancies in the numbers presented on these corporate websites)

Supply side behavior

The total milk production in Sri Lanka in 2013 was 319.8 million litres, a yoy growth of 6.8% as per the Central Bank of Sri Lanka. Also the formal sector milk collection increased by 28%. Have a look at the milk production trends in Sri Lanka.

(Source: Central Bank of Sri Lanka)

The increased milk supply is a result of several measures introduced by the government to incentivize the local dairy market, especially the farmer community. Some of these measures include the imposition of higher tariff on imported milk, implementation of minimum average farm gate prices of liquid milk to LKR 65.00 per litre in 2012. (see the table below) Further, the crisis in New Zealand also contributed substantially to the growth in the local industry and the local companies engaged in the dairy industry. (total milk and milk products imports dropped 4% yoy to LKR 37.6 billion in 2013) 

(Source: Lanka Milk Food annual reports, Dept. of Animal Production & Health) 

Supply side constraints are as follows (as per the industry participants, as revealed in Kothmale financial report FY14):

-      -  Limited availability of land for cattle raising;

-       - Lower animal productivity;

-       - Insufficient farmer capacities;

-       - Lesser feed and inferior quality feed;

-       - Ramshackle infrastructure; and

-       - Absence of long term action plan and public-private collaboration to develop the industry.  

It is estimated that the daily national requirement for fresh milk is c. 1.7 million litres while the domestic production is c. 390,000 litres. In the short to medium term this will continue to exist given that supply increases are very hard to come by. (for instance, over the last 4 years the industry was only able to increase the production by 86.5 mn litres, an average annual increase of c.20.63 mn litres) If the country needs to be self-sufficient in milk the industry will have to add a further 650 mn litres to the current levels and assuming the average annual increase of 20.63 mn litres it will take the country approx. 32 years to be self-sufficient in milk!!!. 


The Demand side

It is understood that currently Sri Lanka's per capita milk consumption is c.135 ml/day which converts to c. 972 mn total annual consumption. Some interesting thoughts can be found in some of the articles that appear on certain web sites. Current, worldwide per capita consumption levels can be found on this map, which I guess give an understanding where Lankans are compared to other developed markets.

The Offer

Approximately 67% of the funds raised through the IPO will be utilized to settle current borrowings and the balance will be invested in capex for expansion purposes and market development via brand building. The proposed offer consist of a voting (76% of the offer) and non-voting shares (24% of the offer) to raise LKR 300 mn. The issue will dilute the current shareholders down to 78% if fully subscribed.

The valuation task

In attaching a value to Lucky, I have used two methods. Firstly, based on projected FCFF using my own assumptions (which anyone could argue otherwise!) and secondly based on FCFF stable growth model assuming that Lucky is now in stable growth stage (again anyone may be against me assuming LLMP a stable growth company).

Method 1 

Revenue - My judgment is that LLMP’s revenue will grow at 7% (it’s now reached the stable stage where double digit growth wouldn’t be possible now) over the next three years and thereafter grow at 6% (in line with potential economic growth).

And also they won’t be able to improve their current market share of around 2% but maintain it at the same levels in year 10 as well. (assuming the market will grow from LKR 56.1 billion to LKR 72.1 billion assuming a CAGR of c. 3%)

EBIT margin–I assume that over the next five years the company will maintain an EBIT margin of 9.68% which is similar to the EBIT margin they recorded in FY14 and also similar to EBIT margin achieved in FY10. I’m assuming that they will enjoy first mover advantages in ‘Gedarata Kiri’ project, franchising model of Lucky Milk Bar and the retail TukTuk network. Afterwards, the EBIT margin is assumed to come down to 8% which is the average they have hit under normal conditions. The reasoning behind this is that the existing competition will start playing in the same lines to ward off Lucky’s competitive strengths. (it won’t even take three years for competitors to introduce all those business lines since the investment requirement is not that high in these areas)
Moreover, from a broader perspective the demand supply mechanics (as mention in the industry analysis) will exert upward pressure on prices of local fresh milk. So, margin upside will be potentially reduced.

Investment – In order for the company to achieve the incremental revenue as I have forecasted, the company will have to invest in capex (including maintenance capex). In the first three years, I anticipate a very high sales to capital ratio as the IPO will provide them with funding. From 4^th year upto 8^th year, I expect the sales to capital ratio to come down to an equivalent level of FY13 and then to further come down to FY14 levels thereafter.

Voting rights – The investment bankers managing the IPO have given a 50% discount to the non-voting shares over the voting shares. So in my valuation also I’m applying the same and justifying it on the basis that the Board of Lucky is headed and will be headed by Mr Keerthi who is also the Chief Executive Office of the company. So the minority shareholders will have less of a say and non-voting shares will be heavily discounted (if you believe otherwise please try it). 

Taxation – Since the Prospectus didn't give clear guidance as to what will happen as the tax break currently enjoyed by LLMP expires, I'm assuming the normal rate of 28%. (my valuation will change if I change the applicable corporate tax rate). It is though, likely that they will enjoy a 10% concessionary rate as the government is promoting the lankan Dairy market and set up an ambitious target of being self-sufficient in 2016! Further, if the proposed IPO is fully subscribed, they will also enjoy a 50% reduction in corporate taxes for a period of three years (subject to them fulfilling the criteria).  

Valuation – With all my assumptions, I arrive at a value for the equity of LKR 780.75 million after considering IPO proceeds. Dividing that value by the post-IPO potential shares of 200,028,410 lead me to a per share value of LKR 3.90 for a voting share and after discounting, non-voting per share value comes to LKR 1.95.

Method 2

Valuation – based on the assumptions that I used in the FCFF stable growth model, the company’s voting shares are valued at LKR 3.17 and non-voting comes at LKR 1.59 applying the same 50% discount. 

Pricing Lucky

In order to do the pricing of LLMP, I used a pricing metric of price/sales which was derived from Precedent Transactions that took place in 2012 and 2013. Here, I picked up a company (Richlife Limited) which is exactly similar to LLMP and a main competitor to LLMP. In 2012, Renuka Agri Foods acquired a 76% stake in Richlife for a consideration of LKR 505 million and the balance stake of 24% was later acquired in 2013 for a consideration of LKR 100 mn.As per the Renuka Agri Foods annual report 12/13, they reported revenue of LKR 831.6 million and made negative earnings. Based on revenues, the 2012 transaction is at p/s of 0.8x and 2013 pricing is at p/s 0.5x. Applying the 0.8x p/s to LLMP forecasted year 1 revenue gives an equity valuation of LKR 766.5 million (per share price of LKR 3.83 for voting and LKR 1.92 for non-voting).If I apply the low end of 0.5x, it leads to an equity value of LKR 480.6 and thereby per share prices of LKR 2.40 and LKR 1.20 for voting and non-voting respectively. 

Multiples analysis

Given below are statistics relating to some of the comps that I could find info from CSE and other publicly available sources. Please note that of Lanka Milk Foods, only the segment results of liquid milk and other (which represents 31% of the total revenue) have been given as the other segments involve the import and distribution of milk from New Zealand and agriculture.

Depicted below are the ratio analysis of the comps above.

Traded multiples
Presented below are the traded multiples of Kothmale (CSE:LAMB) and Lanka Milk Foods (CSE:LMF).

 Applying the 15.4x P/E to forecast year 1 earnings gives me a price of LKR 5.16 for a voting share. 

Assuming a forward or forecast year 1 book value and applying the same average multiple as LAMB generates a price for the share of LKR 6.91.

Lucky: as an investment

Now I come to the point, I like the company as a business and give the full credit to what they have achieved so far but I don’t like the company as an investment (at the prices it is offered) as I’m not convinced with what the numbers and the story says. More over as an investor I don’t want the company to place social objectives before commercial objectives using my money if I become an investor when it is listed. “The company always carries the social objectives, which beyond the commercial objectives according to the company's vision” (p.30, Prospectus) I wish they change their vision to a more investor friendly one as it is now becoming a publicly listed company.

The bottomline

The numbers seem to suggest that the investment bankers and the company have overpriced LLMP (which is obvious & i don't blame them). Or I may be missing something critical (like tax, until it is confirmed) that they are privileged to have access as per their relationship as the client and the IB. However, I have to be confined to what is currently available in the public domain. 

End of the day it does not matter what I have to say since LLMP will be taken up like all other companies that came for IPO because the investors will be probably willing to pay for what it is offered at. And I don't have any personal problems with the company and wish them all the very best.