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September 13, 2011

Lasco Manufacturing Limited

Strong revenue growth, improved margins & tax break

Mario Ahjahorie

Financial Analyst

mahjahorie@scotiadbg.com

BUY

Price at Sept 13, 2011 $9.00

Price Target $10.50

52-Week Range $2.50 – $9.55

Company Overview

Lasco Manufacturing (LASM) is a company which was formed over a year ago and is the product of two long standing subsidiaries Lasco Food Proccessor’s Limited and Lasco Food’s Limited which together produce Soy and Milk based products. The amalgamation of the entities was in anticipation of their initial public offering and their combined product lines include:

1. Lasco Whole Milk 2. Lasco Readi Milk 3. Lasco Food Drink 4. Lasco Lasoy Lactose Free 5. Lasco Oats Porridge 6. Lasco Milky Soy

Company’s Board and Management The company’s board and management have both its strengths and weaknesses. Amongst the good are the qualifications and experience of the board and management in the sector they operate. The allegiance (marriage) between the Chairman (Lascelles Chin) and Managing Director (Dr. Eileen Chin) are key weaknesses of the board and management structure. Potentially the board could make strategic decisions in favour of management instead of all shareholders. Additionally, the presence of 2 out of 5 non-independent directors is unfavourable as it fails to include a mechanism which is protective of the rights of minority shareholders. Business Model and Strategy The company attempts to deliver low cost products to suit the needs primarily of the Jamaican market. The company imports the raw materials, add flavours and packages them for distribution at retail and wholesale chains. Margins are moderately positioned as the company tries to keep product costs low for its consumers.

Key Metrics Q1 2010 Q1 2011

Gross Margin 29% 31%

Operating Margin 19% 19%

Net Margin 12% 19%

Debt-to-Equity 0% 0%

Current Ratio 95% 62%

ROE 8% 18%

ROA 29% 31%

Book Value $0.86 $2.54

EPS (Last 4Q) $0.73 $1.22

Trailing PE 8.48X 7.37X

PBV N/A 3.55X

Figure 1: Lasco Manufacturing Timeline

Figure 2: Shareholder Breakdown

Shareholder % Stake

Hon. Lascelles A. Chin, O.J. 80%

Wayne Chin 0.4%

Connected Parties* 8%

Public Investors* 12% * - Based on Sep 2010 prospectus

Figure 3: Board of Directors

1988 Lasco Group

founded

1994 Incorporation of

Lasco Foods

May 2010 Renamed to Lasco Man.

Sep 2010 Initial Public

Offering

Oct 2010 Listed on the JSE

The Hon. Lascelles A. Chin, O.J.

Chairman

Dr. Eileen Chin

Anthony Chang

Lester Spaulding

Prof. Rosalea Hamilton

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Business Environment

Lasco Manufacturing is a Distributor Lasco Manufacturing interestingly is a misnomer for a company which is primarily considered a distributor, according to data collated from the Statistical Institute of Jamaica (STATIN). The Retail & Wholesale Industry, which LASM is a part of, is one of the largest contributors to the economy, however, it contracted for all quarters in 2010 and in the first quarter of 2011. Commendably, Lasco has been able to operate counter to this trend growing revenues an impressive 15% for 2011.

Similar to all manufacturing companies in Jamaica, Lasco faces the risks of fluctuations in raw material costs and the impact of escalation in inflation and the exchange rate on operating costs. Historically, the exchange rate has exhibited a significant amount of volatility but has settled in recent times around the $86 mark, assisted by the IMF standby agreement. Similarly, the inflation rate has abated compared to previous periods and is targeted at single digit in 2011. The relatively benign inflation outlook coupled with a weak labor market should enable the company to control its operating expenses for the foreseeable future.

High Electricity Costs – Not a Problem Unlike other manufacturing entities, an examination of Lasco’s financial data shows that high electricity cost is not a major problem for Lasco. This might be due to the fact that LASM is not involved in extensive manufacturing as alluded to above. The company’s production process results in utility costs (including electricity) accounting for a mere 5% of operating expenses.

Economy weak, Lasco strong Producing for local consumption is challenging given the weak economic background. The economy eked out a growth rate of 1.5% for Q1 March 2011, after 3 years of contraction. It means consumers’ spending power is still lukewarm as the growth rate was not enough to make a meaningful dent on the unemployment rate.

Fortunately for Lasco, their products are positioned at the lower end of the spectrum, which allowed them to benefit from a shift in consumer spending habits. On the flip side, a recovery in the economy could see consumers shifting away from Lasco products. To combat this, the company will have to ensure their products are not branded only as low cost alternatives but also as high quality products when consumers regain their

Figure 4: GDP Economy vs GDP Distribution

Figure 5: Inflation - Reducing

Figure 6: Exchange Rate - Stabilizing

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11

GDP - Economy GDP - Distribution

Distribution GDP lagging Overall GDP rebound

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

Apr-08 Oct-08 Apr-09 Oct-09 Apr-10 Oct-10

Inflation rate has abated and stabilized, allowing companies

like Lasco to better control operating costs

65

70

75

80

85

90

95

100

01-Apr-08 01-Oct-08 01-Apr-09 01-Oct-09 01-Apr-10 01-Oct-10

Jamaican Dollar exhibiting stability since 2009. Lasco therefore benefits from stable raw material costs.

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spending ability. Industry Specific Factors or Trends

Major Competitors Lasco Manufacturing’s main Competitors in the food drink and powder milk industry are:

1. Gracekennedy 2. Nestle 3. Seprod

And while the company's products have a presence in 18 countries outside Jamaica, its international sales account for a minor nine per cent of revenues.1 According to the company, they have an estimated market share of 73% in fortified drinks which comprise Lasco food drink and Lasoy. While for whole milk powder, the company estimated an 85% market share and 29% of the infant formula market. Oligopolistic Industry Two common measures of industry competitiveness are the Herfindahl-Hirschman Index (HHI) and the Four Firm Concentration Ratio. Based on data gathered, the HHI exceeds 5,329 which is extremely high and indicates an industry which is not very competitive. Similarly, the four firm concentration ratio which measures the market share of the top four firms exceeds 70%. This reading (above 60%) confirms an oligopolistic industry, which is dominated by Lasco. Industry Profit Margins – LASM ranks 3rd Lasco currently has the third most attractive net profit margin of all the manufacturing and distribution companies identified on the JSE, which include those listed on the junior and main market. Although the company primarily markets low priced products, they are still able to generate strong margins compared to its peers.

Figure 7: Foritified Drinks

Figure 8: Whole Milk Powder

Figure 9: Infant Formula

Figure 10: Industry Margins

1 http://jamaica-gleaner.com/gleaner/20100804/business/business1.html

Lasco Man. 73%

SEP, GK, Nestle &

Other 27%

LASM 85%

SEP, GK,

Nestle & …

LASM 29%

SEP, GK, Nestle &

Other 71%

26%

19%

14% 13% 12%8% 7% 5% 5% 4%

2%

-3%

-20%-20%

-10%

0%

10%

20%

30%

CA

R

SALF

LASM

JAM

T

LAS

SEP

BP

OW JP

JBG

GK

CP

J

DG

CC

C

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Figure 11a: Porter’s Model – Five Industry Forces

Competitive Force Risk Rationale

Threat of New Entrants High Lasco has economies of scale, brand loyalty and a dominant market position. However, with no major impediments to entering the market, there is a high risk of potential entrants. Already there are formidable competitors such as Seprod, GraceKennedy and Nestle.

Bargaining Power of

Suppliers

Low The company sources its raw materials (powdered milk) outside of

Jamaica and their supplier(s) operate in a competitive market. The

Herfindahl–Hirschman Index (HHI) and Four Firm concentration

ratio would therefore be very low for the suppliers.

Bargaining Power of

Buyers

Low Buyers are not concentrated as the target market is mostly retail.

Therefore, measures such as the four firm concentration and the

Herfindahl–Hirschman Index (HHI) would be low for customers.

Availability of Substitutes Medium Again, there a number of substitutes on the market but none which

are able to compete on pricing like Lasco. In fact, Lasco’s products act

as substitutes in the infant formula market, in addition to their 29%

market share of the infant formula market.

Rivalry Among

Competitors

Medium Competitors such as GraceKennedy, Seprod & Nestle have not been

able to make a significant dent into lasco’s market share of powder

milk (73%) and fortified drinks (85%). However, Lasco as a recent

entrant in the infant formula market only has 29% market which is

still a strong position

Figure 11b: Porter’s Model

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PEST Analysis of Jamaica

Figure 12 Political Economic

Complex taxation regime

Legislation only enables one power company

Lack of unity across Caricom

Slow implementation of government policies

High crime rate

Weak local conditions

Tepid global growth

High electricity costs

High cost of capital

Social-Cultural Technological

Consumer brand preferences

Inefficient workforce

Employee theft

Dated production processes

Archaic distribution arrangement

SWOT Analysis of Lasco Manufacturing

Figure 13 STRENGTHS WEAKNESSES

Dominate the powdered milk market

Well recognized brand locally

Company is more distribution oriented, a positive

considering high manufacturing costs in Jamaica

Products have a stigma of being low end

Concentration in one product type (powdered milk)

Low regional diversification, revenues concentrated

in Jamaica

Alliance between Chairman and Managing Director

OPPORTUNITIES THREATS

Tax break from listing on the JSE for the next 10 years

Stronger profit growth to fund retooling and business

expansion

Though Lasco benefits from weak demand,

continued weakness in the Jamaican economy could

impact them.

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Financial Statement Analysis – June 2011 (See Appendix 1)

Financial Performance – Very profitable Quarter Lasco’s first quarter ended June saw the company increase Revenues 24% to $784 million. This was achieved amidst a weak economic environment which saw the company’s low cost products reaping gains combined with greater visibility from the JSE Listing. The company’s Gross Profit surged 33% to $247 million as the company expanded its Gross margin ratio from 29% to 31% combined with revenue growth. Operating Expenses climbed 44% in the quarter to $102 million and was driven by plant expansion and the restructuring of the company. The effective taxation rate was 0% as the company has benefitted for the quarter from the tax break enjoyed from listing on the JSE Junior Market. Net profit rocketed 92% to $151 million for the quarter due to the combined effect of: a 15% growth in Revenues, 3% expansion in gross margins and a tax break. Balance Sheet Strength – Very Liquid The company’s total assets stood at $1.01 billion based on an equity base of $861 million. The equity base expanded 86% through raising ordinary share capital in addition to the full year retained earnings. (See Figure 15) The company’s long-term-debt to equity ratio stands at 0% after paying off its debts but is likely to surge in coming quarters as the company seeks to borrow J$1.12 billion for relocation, modernization and expansion. The company also maintained very healthy Liquidity ratios for the quarter. The current ratio stood at 5.6 times versus 2.0 times a year earlier. Closer inspection to identify if inventories were skewing the ratio, showed an equally strong Acid Test Ratio of 4.1X which was well above the prior year’s 1.6X.

Figure 14: Income Statement Highlights

Income Statement June 2010 June 2011 % Change

Revenues 634,715 784,554 24%

Gross Profit 185,565 246,916 33%

Operating Expenses 70,958 102,295 44%

Net profit 78,802 150,987 92%

Figure 15:Balance Sheet Highlights

J$‘000 June 2010 June 2011 % Change

Total Assets 935,367 1,009,924 8%

Current Assets 935,367 829,492 -11%

Inventories 188,517 219,493 16%

Cash & Equivalents 272,427 150,274 -45%

Equity 330,964 981,233 196%

Figure 16:Key Ratios

J$‘000 June 2010 June 2011 % Change

Gross Margin 29% 31% 8%

Net Margin 12% 19% 55%

Current Ratio 2.0 5.6 180%

ROE 1.6 4.1 158%

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DuPont Analysis (ROE Decomposition) With one year of comparative data, we are able to estimate that Lasco’s improved ROE was driven by an improvement in net profit margins - which follows from the improved gross margins discussed earlier. Financial leverage declined as the company cleared its loans and the corresponding reduction in interest expenses assisted in the improvement of Net Profit Margin. Industry ROE Comparison – Lasco is 2nd best Compared to other manufacturing companies in Figure 18, only one other company (CPJ) has a better ROE and earnings growth rate than most companies over the last 5 years. A very high ROE and growth rate makes us undoubtedly have to classify Lasco as growth company. Cash Conversion Cycle Although the company’s balance sheet suggests that the company has very good liquidity, it is also important to measure the amount of working capital tied up in receivables, inventory and payables. Figure 19 shows that Days of Inventory, receivables conversion and payables conversion all increased over the period. This suggests the company extended its credit terms to customers, expanded its inventory base and lengthened the time it took to pay trade creditors. As a result, the rate of conversion of working capital to cash increased significantly from 16 days to 111 days. This is actually an unfavourable trend as it means the company is taking longer to convert its working capital to cash. In addition the trend is unsustainable and we expect a flat to reduced cycle next year.

Figure 17: ROE – Dupont Analysis

ROE – Dupont Analysis YE 2010 YE 2011

Asset Turnover 2.29 2.22

xFinancial Leverage 2.87 1.61

xNet Profit Margin 6% 14%

=ROE 37% 48%

Figure 18: ROE Comparison

Figure 19 :Cash Conversion Cycle

Cash Conversion Cycle YE 2010 YE 2011

Days of Inventory 45 54

Days of Receivables 31 87

Days of Payables 60 31

Cash Conversion Cycle 16 111

DG

GKJBG

JP LAScelles

SALFSEP

LASM

JAMT

BPOW

CPJ

-10%

0%

10%

20%

30%

40%

50%

60%

70%

-40% -20% 0% 20% 40% 60%

RO

E (C

urr

en

t)

5 Year Growth Rate *

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Projections & Valuations

Dividend Policy The company has been listed on the exchange for less than a year and therefore has no record of dividend payments. However, in LASM’s prospectus, management has indicated a commitment to paying out no less than 15% of earnings, subject to the company’s need for reinvestment. For their first financial year ended March 2011, the company paid dividends of $0.15 which equated to 14% of earnings, marginally below the company’s target payout rate. Based on the current price, this equates to a dividend yield of 2.4%. Profit Projections For the year ending March 2012 we expect Lasco manufacturing to generate revenues of $3.56 billion with gross margins at 31%. Additionally, the company will pay zero taxation and net profit should amount to $552 million (EPS:$1.43) or 37% above the prior year. Based on the dividend policy highlighted above we expect a dividend per share $0.21. Intrinsic & Relative Valuation Based on the company’s stated dividend policy and adherence to date, it is appropriate to utilize a dividend discount model (DDM) to value the company. In this case we use a two stage model for an initial growth phase which is expected to last 10 years and stabilize thereafter. Based on the company’s expansion plans, we expect profit growth of approximately 25% for the next 10 years which should taper off to 10% thereafter. The intrinsic valuation therefore emerges at $10.50 using the DDM. Additionally, based on trailing earnings, the company’s PE is much lower than most market participants as illustrated in Figure 22. From the chart, the stock is below the PE line which suggests the stock has been undervalued by the stock market.

Figure 20: One year profit projection

Mar 2010

Mar 2011

Projection 2012

Revenue 2,587,621 2,969,611 3,563,533

Gross Profit 688,335 934,501 1,121,401

Op Expenses 559,530 426,574 477,762

Op Profit 197,181 555,573 686,519

Finance Cost - 37,701 134,400

Pretax Profit 197,181 517,872 552,119

Taxation 53,077 116,671 -

Net Profit 144,104 401,201 552,119

Figure 21: Dividend Discount Model

Dividend Discount Model

Cost of Equity (CAPM) 16.20%

First Phase Growth Rate 25.00%

First Phase Growth Period 10 Years

Final Phase growth rate 10.00%

Figure 22: Relative PE Valuations

Source: proprietary research

CPJ

SALF

LASM

JBG

CAR

SEP

GK

LAScelles

0.0

4.0

8.0

12.0

16.0

0% 10% 20% 30% 40% 50%

P/E

5 Yr Growth Rate (%)

OverValuedOverValued

UnderValued

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Market Activity & Technical Analysis

Volumes Traded – Strong Investor Interest In Figure 21 to the right, the orange bars confirm consistent level of trading activity and by extension investor interest. Peak volumes were reached in November 2010, shortly after the stock became listed. The stock traded 190 days out of a possible 218 days with an average daily volume of 167 thousand units. The stock therefore has strong liquidity and investor interest.

Share Price - Soaring Since listing the share price has appreciated 251% from an IPO price of $2.50 to a recent closing price of $8.79. The stock appreciation is correlated with strong earnings throughout the period and a generally euphoric reception to junior market listings to date.

Bid/Ask Analysis - Bullish In Figure 22, share liquidity is confirmed by a tight bid/ask spread of $8.60/$8.80. Currently, the stock is also heavily demanded based on the structure of the bids and asks. The most significant volumes are bid at $8.35 with a volume of 576 thousand units. On the other hand, the lowest significant Ask is for 60 thousand units at $10. Significantly stronger bid volumes suggest that the price will appreciate as bidders increase their bids to acquire LASM shares.

Simple Moving Averages (SMA) - Bullish The simple moving averages (Figure 21) indicate a fairly bullish trend on the stock. A strong bullish signal arose when the 20 day SMA broke above the SMA 5o and SMA 100 in April 2011. Since then the market price has surged from $6 to a peak of $9. Confidence in this trend is also asserted by stable and consistent trading volumes.

Fibonacci Retracements – Trading above support Fibonacci retracements (Figure 23) are one of the most widely used technical indicators and are used to identify resistance and support levels of a security. Lasco has rallied since inception to a high of $9.50 and has pulled back since hitting its peak. The first support level is found at $7.94 or at the 76.4% Fibonacci line which corresponds to a previous peak. The next support level which is considered a major support one is found at the 61.8% of the peak to trough, which is at $6.97. Notable, the stock also found support around $6.97 after a pullback from a $7.95 peak.

Figure 23: LASMPrice, Volume & SMA’s

Figure 24: Bid-Ask Analysis (August 31, 2011)

Bid Ask

Volume Price($)

Price ($)

Volume

11,600 8.60 8.80 1,503

15,666 8.40 9.00 2,250

576,054 8.35 10.00 60,281

30,000 8.30 12.00 4,850

700 8.12

Source:Bloomberg

Figure 25: Fibonnaci Retracement of LASM

0

1

2

3

4

5

6

7

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

10.00

Oct-2010 Jan-2011 Apr-2011 Jul-2011

Vo

lum

e

ClosePrice SMA 20 SMA 50 SMA 100

$8.790

100% ($9.50)

76.4% ($7.94)

61.8% ($6.97)

50.0% ($6.19)

38.2% ($5.40)

23.6% ($4.43)

0.0% ($2.87)

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

10.00

Oct-2010 Jan-2011 Apr-2011 Jul-2011

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Conclusion & Recommendation

Economy Weak but Lasco Benefits

Lasco Manufacturing Limited is the largest producer of fortified drinks and powdered milk in

Jamaica. Even though the company exports to other regions, its revenue generation is concentrated

in Jamaica. Interestingly the Jamaican economy has been undergoing a severe contraction since

2007 and the implication is that consumers spending ability would have been hampered. However,

throughout the downturn, the company has managed to significantly increase revenues and we

attribute this to fact that the company’s low priced products are able to capitalize on a shift on

consumer spending habits.

Dominate the Sector

Lasco dominate the Sector with their fortified drinks and powdered milk which account 73% and

85% of the market respectively. Notably, these products act as substitutes for infant formula in

Jamaica but Lasco has its own brand of infant formula which claims 29% of that market. It

highlights the dominant position the company enjoys, and the key seems to be that the company

identifies that they are operating in a weak economy and therefore try to offer low cost products.

Operating Very Profitably

Although the company offers low priced products, they still enjoy reasonable margins. Gross

margins were 31% as at March 2011 while net margins were 14%. This actually puts Lasco

amongst the top three manufacturing and distribution companies in Jamaica based on these

profitability measures. The companies ROE and growth rate are also amongst the highest of all

the listed companies in Jamaica and highlights the company’s strong profitability.

Aggressive Expansion Plans

The company’s first expansion plan was to become listed on the JSE Junior market to expand its

visibility and to take advantage of a 10 year tax break from listing. In the next few quarters, the

company has disclosed an ambitious $1.12 billion plan to relocate, modernize and expand its

plant in White Marl, St. Catherine. The move is expected to increase production capacity,

operational efficiency and allow the company to broaden its product portfolio. The company’s

expected payback period is 4 years and we expect these activities to be key drivers of profitability

going forward.

Valuation and Technicals favourable

The expected dividend yield based on the current price and next year’s earnings is 2.4%. The

intrinsic valuation based on this growing stream of dividends is $10.50 or a potential capital

appreciation of 21%. An examination of technical indicators such as the Simple Moving

Averages, Volumes traded, Bid-Ask spreads and Fibonacci retracements all suggest a very bullish

trend which is strongly supported technically. With the expected capital appreciation of 21% and

a consistent dividend stream, Lasco Manufacturing is recommended as a BUY.

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Appendix 1

$'000 YE March 2010 YE March 2011 Q1 June 2010 Q1 June 2011 YE March 2012 Projection

Income Statement

Revenue 2,587,621 2,969,611 634,715 784,554 3,563,533

Cost of Sales 1,899,286 2,035,110 449,150 537,638 2,442,132

Gross Profit 688,335 934,501 185,565 246,916 1,121,401

Other Income 68,376 47,646 6,949 6,710 42,881

Operating Expenses 559,530 426,574 70,958 102,295 477,762

Profit from Operations 197,181 555,573 121,556 151,331 686,519

Finance Cost - 37,701 5,354 344 134,400

Profit Before Taxation 197,181 517,872 116,202 150,987 552,119

Taxation 53,077 116,671 37,400 - -

Net Profit 144,104 401,201 78,802 150,987 552,119

Balance Sheet

Property, Plant & Equipment 142,273 192,055 - 180,432

Current Assets 988,866 1,145,493 935,367 829,492

Total Assets 1,131,139 1,337,548 935,367 1,009,924

Current Liabilities 458144 463,939 471,440 149,244

Non-Current Liabilities 278,346 31,598 262,791 31,598

Long Term Debt 262,760 - 247,205 -

Equity 394,649 830,246 330,964 981,233

Ratios

Gross Margin 27% 31% 29% 31% 31%

Operating Margin 8% 19% 19% 19% 19%

Net Margin 6% 14% 12% 19% 15%

LTD-to-Equity 67% 0% 0% 0%

Financial Leverage 2.51 1.38 2.83 0.85

ROE 37% 48% 95% 62%

ROA 15% 35% 8% 18%

DPR - 0.14

Current Ratio 2.2 3.0 2.0 5.6

Acid Test Ratio 1.8 1.9 1.6 4.1

Per Share Data

Earnings Per Share

1.04 0.20 0.39 Book Value Per Share

2.15 0.86 2.54

Revenue Per Share

7.7 1.6 2.0 Dividends Per Share

0.15