Cargills Ceylon INITIATING COVERAGE

COMPANY REPORT
HOLD EQUITY RESEARCH-SRI LANKA
CARG SL EQUITY
12 Month Target Price: LKR 211
Consumer Staples - Food Retail
Current Market Price: LKR 200
Upside: 5.3%
Date: 6 February 2019

Outlook predicated on consumer sentiment Key Stock Data

during election year… (LKR Mn) FY 2016 FY 2017 FY 2018 FY 2019E
Revenue 71,017 84,191 91,293 97,323
Investment Case EBIT 3,463 5,091 6,263 5,343
FMCG consumption beginning to show signs of recovery
Net Profit 1,691 2,284 3,331 2,328
We issue a HOLD recommendation on Cargills as consumers adopt a ‘wait EPS 6.60 8.92 13.01 9.10
and see’ approach for 2019. FMCG volumes experienced an encouraging Change in EPS 181.8% 35.1% 45.8% -30.1%
positive growth in 4Q 2018. However, with parliamentary elections
Debt/Equity 79.3% 110.0% 87.0% 89.7%
scheduled for the end of 2019, any unforeseen or undesirable outcomes can
EBIT Margin 4.9% 6.0% 6.9% 5.5%
have a detrimental impact on consumer sentiment and consequently
Cargills’ operational performance. ROE 12.3% 15.8% 21.4% 13.6%

Valuation
Stock price has remained steady over the last 52 weeks
indicating that market price is close to intrinsic value
Our 12-month target price of LKR 211 represents a 5.3% upside from the
current market price of LKR 200. Therefore, we establish a HOLD rating on
Cargills. We used a combination of SOTP DCF valuation and relative valuation
to arrive at our target price. The stock, however, is trading at a PE multiple of
23.9x, which is above its 2-year average of 18.3x.

Catalysts
The main industries that Cargills operates in are significantly
underpenetrated
In the long run, Cargills’ main operating industries have attractive growth 05-Feb-19
potential as they are presently largely underpenetrated. Long-term growth is Next Results Feb-19
predicated on urbanization and growth in household incomes as Sri Lanka Market Capitalization (in LKR mn) 51,200
transitions into an upper-middle income country. With these industries still
Shares Issued 255,999,927
in their growth phases, there is plenty of room for all players to grow.
Public Float 20.3%
Free Float 10.1%
Comment 52-week High/Low 209.9/175.0
Cargills’ low free float has illiquidity implications which may
Average Monthly Volume 600,112
result in large price swings
Trailing 12M EPS 8.38
Cargills’ low free float of 10.1% implies significant illiquidity for the stock.
Relatively large trades can result in significant price changes that are Current P/E Ratio 23.9x
unrelated to the fundamentals of the company. Furthermore, sluggish price Current P/B Ratio 2.9x
movements can prevent the market price from efficiently responding to Largest Shareholder - CT Holdings PLC 70.2%
changes and reaching our forecasted target price.
*Source of table data: Bloomberg, CSE, JBS Research

Analyst: Nishara Sangapalaarachchi – nisharas@jb.lk Corporate Governance Score

Important disclosures are included in page 69 of this report
Produced by: JB Securities
Distributed by: Jefferies Group LLC,
including Jefferies LLC in the U.S. and
Jefferies Hong Kong Limited in Hong Kong

150, St. Joseph’s Street, Colombo 14, Sri Lanka. T: +94 11 2490900, E: jbs@jb.lk, W: www.jbs.lk February 2019
 CARGILLS CEYLON PLC

Table of Contents
Investment Hypothesis .......................................................................................................................... 3
Business Description .............................................................................................................................. 8
Financial Snapshot ............................................................................................................................... 10
Top 20 Shareholders ............................................................................................................................ 12
Industry and Competitive Analysis ...................................................................................................... 13
1. Modern Retail .......................................................................................................................... 15
1.1. Industry Analysis .................................................................................................................. 15
1.2. Competitive Analysis ............................................................................................................ 21
2. Frozen Confectionery ............................................................................................................... 26
2.1. Industry Analysis .................................................................................................................. 26
2.2. Competitive Analysis ............................................................................................................ 29
3. Dairy ......................................................................................................................................... 30
3.1. Industry Analysis .................................................................................................................. 30
3.2. Supply Analysis ..................................................................................................................... 36
3.3. Competitive Analysis ............................................................................................................ 39
4. Quick Service Restaurants........................................................................................................ 41
4.1 Industry Analysis .................................................................................................................. 41
4.2. Competitive Analysis ............................................................................................................ 47
5. Processed Meats ...................................................................................................................... 52
5.1. Industry Analysis .................................................................................................................. 52
5.2. Competitive Analysis ............................................................................................................ 57
Valuation .............................................................................................................................................. 60
Sum of the Parts Discounted Cashflow ............................................................................................ 60
Relative Valuation ............................................................................................................................ 63
Sensitivity Analysis ............................................................................................................................... 63
Stock Price Analysis .............................................................................................................................. 64
Corporate Governance and Management Analysis ............................................................................. 65

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Investment Hypothesis
We initiate coverage of Cargills Ceylon PLC (CARG) with a HOLD rating, based on our 12-month target
price of LKR 211. This represents an upside of 5.3% based on the market price of LKR 200 as at 6
February 2019. Our target price was obtained via a combination of the sum-of-the-parts discounted
cash flow approach and relative valuation approach. CARG is currently trading at 23.9x its trailing 12-
month earnings. Based on our target price and forecasted earnings, we estimate a forward PE of 23.2x.

We believe that the CARG’s fundamentals will perform reasonably well going forward, given the
attractive prospects of their operating industries and competitive positioning. However, the market
price has been hovering near LKR 200 for the majority of the last 52 weeks, leading us to believe that
the intrinsic value is near LKR 200. Furthermore, the stock exhibits low liquidity with a large
percentage of the shares outstanding being tied up with the parent company, CT Holdings PLC, CARG’s
chief executive officer (CEO), Ranjit Page, and other large institutional investors such as the state-run
social security scheme, Employees’ Provident Fund. A free float of 10.1% can result in wild price swings
for reasons unrelated to fundamentals.

The three main industries that Cargills operates in; modern retail, consumer discretionary FMCG, and
quick service restaurants have attractive growth potential as they are presently largely
underpenetrated. Industry growth is predicated on household income growth and urbanization as Sri
Lanka is on the brink of achieving upper-middle-income status. However, in the short run, these
industries are largely affected by consumer confidence as they are discretionary purchases. With
parliamentary elections scheduled to take place towards the end of 2019, any unforeseen or
undesirable outcomes can have a detrimental impact on consumer confidence and consequently
topline growth.

Modern Retail
Outlook for modern retail industry buoyed by nascent stage of modern retail industry…

Sri Lanka’s modern retail penetration continues to hover around 18%-20% and has been improving at
a lethargic pace. This penetration rate significantly lags those of regional peers that have similar
socioeconomic characteristics (approximately 40%). Furthermore, the modern retail penetration rate
in the capital city Colombo, where the concentration of modern retail supermarkets is the highest, is
still relatively low at 35%. This paints a positive future for modern retail as there exists plenty of room
for industry growth in the long run. Modern trade offers a significant value proposition relative to
general trade, e.g. modern trade provides ample parking space. Therefore, trends such as
urbanization and rising penetration of motor vehicles amongst households will aid the shift from
general trade to modern trade.

The modern retail industry, however, is highly susceptible to consumer confidence, which in turn is
affected by the economic and political environment. During 2018, customer purchasing power was
tightened. Consequently, the two largest modern retail players, Cargills and Keells, witnessed an
unprecedented decline in average basket values. The management of Keells attributed this to a
reduction in types of categories purchased as well as reduction of items within categories

Cargills maintains its advantage of wide geographic coverage despite deteriorating market share and
changing competitive landscape…

Cargills, the current market leader in modern retail, continues to expand its retail footprint across the
island. In response to the change in competitive dynamics that is currently shaking up the modern
retail industry, Cargills launched a new store format in mid-2016 that rivals the modern store format

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of Keells, the second largest modern retail chain. Cargills’ new format includes more parking spaces
as well as more emphasis on fresh produce and bakery products.

Despite maintaining market leadership, Cargills has been losing share to Keells. Furthermore, during
the year the modern retail industry saw two new entrants, thus changing the status quo of the
industry (which largely comprised four main players Cargills, Keells, Arpico and Laugfs). The new
entrants attest to the attractiveness of the modern retail industry. SPAR, the first international
supermarket chain to operate in Sri Lanka, is a joint venture between SPAR South Africa and a leading
local confectionery manufacturer. SPAR’s offerings include fresh produce, bakery products and hot,
ready to-eat-meals which leverage on the growing emphasis that time-pressed consumers place on
obtaining convenient meals. Softlogic’s Glomark, the second new entrant, is positioned to garner a
premium perception. The outlet size is larger and holds a broader range than Cargills and Keells. The
expansion of these new entrants will be initially limited to the Western province.

We do not expect these new entrants to pose a significant threat as the modern retail industry can
accommodate new players due to under penetration. Furthermore, incumbents such as Cargills and
Keells enjoy first-mover advantage by securing prime locations in major towns and cities, which is
crucial to maintain healthy footfall.

Cargills’ retail segment is also expecting to invest USD 15mn in setting up a distribution warehouse in
FY 2019 with completion expected after 12-15 months. This new warehouse is expected to serve the
increasing capacity needs required by their aggressive outlet expansion plans.

Dairy
Significant growth potential due to low dairy self-sufficiency levels of 40% is hampered by stringent
price controls…

Per capita dairy consumption is 55 kg which is approximately half the global average. We expect the
demand for dairy to continue its upward trajectory, supported by rising incomes and continued
urbanization. At present, the dairy industry is dominated by full cream milk powder which accounts
for 77% of total dairy expenditure. Milk powder will continue to dominate fresh milk for at least the
next five years. However, we expect a gradual shift from milk powder to fresh milk and further growth
in underpenetrated segments such as yogurt, drinking yogurt, butter and cheese.

Currently, local milk production significantly lags demand, resulting in imports meeting 60% of total
dairy demand. The import bill for dairy products amounted to LKR 48 billion in 2017. This bill is
susceptible to exchange rate volatility and has an unfavorable impact on current account.
Consequently, the government has placed emphasis on achieving self-sufficiency. Steps taken to
achieve this goal include importing high-yielding cows to rectify poor milk yields. Furthermore,
controlled farm gate prices (the price that dairy farmers receive for supplying milk) were increased to
encourage increase in supply of milk by dairy farmers. Local milk production has been growing at a
CAGR of 10% since 2010.

However, the dairy industry is subject to a plethora of government policies and thus vulnerable to
changes in government. Milk powder is deemed to be an essential consumer staple and is therefore
subject to maximum retail prices (MRP) despite being imported and thus facing various pressures
from global milk powder market prices and exchange rate volatility. Consequently, large milk powder
importers are reporting losses. On the other hand, liquid milk supplied by local dairy farmers is subject
to a minimum farm-gate price in order to boost farm incomes and motivate local milk production.
However, increases in farm gate prices drive up the retail prices of fresh milk, thus contributing to the
dominance of milk powder relative to fresh milk.

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The path to achieving self-sufficiency and unlocking the industry’s growth potential is predicated on
the policies governing prices, as well as creating an environment that encourages investment in
technology and know-how to boost local milk production. We believe that achieving self-sufficiency
is in the distant future and therefore price controls need to be reconsidered in order to ensure the
affordability of dairy.

Competition within the dairy segment is fragmented, with many players competing for shelf space…

Cargills (through its subsidiaries including Kotmale) is the third largest milk collector, following the
state-owned Milco, and multinational company Nestle. Kotmale has products in most major sub-
segments of the dairy industry, including fresh milk, flavored milk, ice-cream, yoghurt, drinking
yoghurt, curd, butter, cheese and fresh cream. However, Kotmale has actively avoided the milk
powder segment due to their focus on value-added dairy.

Ambewela, a brand of Lanka Milk Foods PLC, is currently the brand leader of the growing fresh milk
segment. The milk is sourced from their own farms as opposed to collecting milk from dairy farmers.
Consequently, they are able to control the quality and yields of the milk used in their dairy products
(fresh milk, flavored milk, yoghurt, butter and cheese). Fonterra’s Anchor brand dominates the milk
powder segment and the yoghurt segment.

Competition within the industry is fierce due to the lack of any significant product differentiation,
which has resulted in poor brand loyalty. However, given the ample space available in the dairy
industry, we expect all players to be able to grow without compromising market share.

Frozen Confectionery
Frozen confectionery volumes grew in 2018 despite tough conditions…

Sri Lanka’s consumption of frozen confectionery is approximately 2 liters per capita, indicating under
penetration. Frozen confectionery is perceived as an indulgence and therefore faces high income
elasticity. Therefore, the key to further growth in this industry is continued increase in household
income and urbanization. The threat posed by health-conscious consumers that is currently observed
in more developed countries, is expected to be subdued in the local context given the infrequent
consumption of frozen confectionery. Furthermore, we expect an improvement in the availability of
frozen confectionery following an increase in cold-chain penetration amongst retailers.

Cargills’ frozen confectionery segment attains market leadership position through strength in its
impulse range…

Cargills, through its brands Magic and Kotmale, has overtaken long-standing market leader Elephant
House in the frozen confectionery market. This was achieved via the launch of new products, primarily
within the high-margin impulse range segment, where Cargills continues to dominate.

Cargills further banks on its superior taste which is delivered by using fresh milk as opposed to the
skimmed milk powder and vegetable fat used by Elephant House.

Quick Service Restaurants (QSR)

A positive outlook for QSR meals as consumers seek convenience in obtaining meals due to busier
schedules…

Rising household incomes and urbanization support the continuation of the QSR industry’s growth
trajectory. Presently QSR meals are consumed as an indulgence. Consequently, they are consumed
less frequently, often once or twice a month. This contrasts with developed countries, where QSR

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meals are perceived as cheap and low-quality, and are therefore targeted towards low-income
households. Furthermore, the unhealthy nature of QSR meals and rapidly ageing population are not
a significant threat in the short run due to their low penetration and low frequency of consumption.
They may be of concern in the longer run, however.

KFC is the present market leader within the intensely competitive QSR industry…

Kentucky Fried Chicken’s (KFC) signature menu item is its deep-fried chicken seasoned with herbs and
spices. This menu item has emerged as a local favorite, given that chicken is the most widely
consumed meat type in the country. The apparent popularity has also been recognized by KFC’s two
main competitors, McDonald’s and Burger King who have rolled out menu items that emulate KFC’s
fried chicken.

KFC leads the industry with the highest annual revenues in the last financial year. However, Pizza Hut
is the leader in outlet footprint and McDonald’s is the leader in revenue per outlet.

KFC’s menu is relatively more affordable and has a greater value proposition, which is an important
factor in an industry where consumers are price-sensitive.

Processed Meats
Processed meat volumes gaining momentum due to changing consumer lifestyles where more
emphasis is being placed on convenience…

Similar to the other industries that Cargills has a presence in, processed meats are underpenetrated,
given their current perception as an indulgence product. The majority of the population consume
carbohydrate-led diets and source their protein from fish and lentils. Under-penetration of meat is
largely due to the relative unaffordability of meat as well as faith-based abstinence. However, with
rising household incomes and urbanization we expect meat consumption to grow. Recent growth in
processed meat volumes has been attributed to changing consumer lifestyles. With rising dual-income
households and busier consumers, more value is placed on the relative ease of preparing processed
meats for meals.

Competitive landscape in the processed meats industry is fragmented, with Keells Food Products
leading due to its brand value and history…

Keells Food Products, through its brands Krest and Elephant House, is currently the market leader.
Cargills follows behind, with its four brands that capture a large area of the market: Goldi, the mass-
market brand, Sam’s, the brand targeted towards children, Cargills Finest, the premium brand and the
newly launched brand, Island’s Finest which focuses on processed seafood. New players that have
entered the market via forward integration, such as Bairaha and Pussalla, pose a formidable threat.

Agrifoods and Confectioneries

Condiments, jams, juices and confectionery have a positive outlook, hinged on rising household
incomes and continued urbanization…

Cargills’ agrifoods portfolio consists of sauces, jams, fruit juices and fruit nectars, whilst its
confectioneries portfolio consists solely of biscuits. Both portfolios operate under the brand ‘Kist’.

Products in these portfolios are consumer discretionary goods and therefore, similar to Cargills’ other
FMCG segments, will face a positive outlook given an upward household income trajectory and the
spread of urbanization.

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The sauces segment, which is the largest constituent of the agrifoods portfolio, is still in its growth
phase and thus has greater growth potential, particularly through the hotels, restaurants and catering
(HoReCa) channel. Competition in this sub segment is fragmented, with Edinborough emerging as the
market leader in the HoReCa channel. Cargills’ Kist sauces have the highest tomato content within the
sauces industry.

Fruit juices and fruit nectar volumes are growing strongly, leveraging on urbanization. However, the
industry faces significant risk from government policies due to their relatively high sugar content.
Currently, juices and nectars are required to place a color-coded label that informs consumers that
sugar content is either high, medium or low. At the moment they do not fall under the jurisdiction of
the ‘sugar tax’, but we expect a high probability of juices and nectars incurring the sugar tax given the
success experienced in curbing carbonated soft drink (CSDs) consumption. When implemented on
CSDs in November 2016, volumes declined as much as 30%.

The confectionery portfolio is another segment with high growth potential given the popularity of
biscuits amongst households. On the other hand, the jams industry has reached maturity and thus has
limited growth potential.

Risks to recommendation
Risks to our HOLD recommendation
Upside Risks Downside Risks
Our target price is highly sensitive to Extension of sugar taxes and towards other
government bond yields, which we employ as sugary beverages will have a detrimental
our risk-free rate. A 50-bps decline in the 5- impact on Cargills FMCG volumes, revenues
year govt. bond will change our HOLD and thus profits. Impact may be limited as they
recommendation to a BUY. This risk is quite constitute a smaller proportion of group
high as bond yields are currently on the decline. revenues.
Cargills’ stock faces significant illiquidity due to low free float of 10.1%. The implications of low
free float are two-fold: relatively large trades can result in significant price changes that are
unrelated to the fundamentals of the company. It can also lead to sluggish price movements thus
preventing the market price from responding efficiently to changes and reaching our forecasted
target price.
The results of the upcoming presidential election in 2019 will have either a positive or negative
impact on consumer confidence. Cargills’ main operations are highly sensitive to consumer
confidence.

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Business Description
Cargills Ceylon PLC (CARG) is a group of subsidiaries and associates with primary operations in the
modern retail, fast-moving consumer goods (FMCG), and quick-service restaurants industries. It is
currently listed on the Colombo Stock Exchange and is the 12th largest public company by market
capitalization.

Figure 1 Source: Company Data, JBS Research

At present, Cargills Ceylon operates the largest and oldest modern supermarket chain under the
brand, ‘Cargills’, and is the market leader in frozen confectionery through the brands ‘Magic’ and
‘Kotmale’. The Kotmale brand extends to other dairy segments such as fresh milk, yogurt and cheese.
Other FMCG goods that the Group manufactures and distributes are processed meats, sauces, jams,
fruit juices and fruit nectars. Cargills Ceylon is also the country’s sole franchisee of US-based fast food
chain Kentucky Fried Chicken (KFC). KFC is the market leader in terms of total revenues.

After its inception in 1844, Cargills Ceylon PLC went by the name ‘House of Cargills’ and initially
operated as a general warehouse, import and wholesale business. It was incorporated as a Public
Limited Liability Company on 1 March 1946. In 1981, it was acquired by its current parent company,
CT Holdings PLC, who now holds a stake of 70.2% in Cargills Ceylon PLC. The first Cargills supermarket
was opened in 1983 at Staple Street which is now the flagship outlet occupying a prime location in
the capital city, Colombo.

Since then the Group has undertaken a series of acquisitions that have opened the gates to new
industries, including the acquisition of the franchise license for KFC, and the acquisition of Miller
Limited that enabled consolidation of its marketing and distribution operation. In 2010 the group
acquired the dairy company, Kotmale PLC, and in 2011 the confectionery company, Diana Biscuits.

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Furthermore, Cargills Ceylon PLC forayed into the financial services industry by securing a provisional
commercial banking license from the Central Bank of Sri Lanka. Cargills Bank is currently an associate
company of Cargills Ceylon, wherein the latter holds a 39.7% stake. A detailed view of the group’s
holding structure is presented in Figure 1.

Modern Retail
Cargills is currently the market leader in the modern retail industry, with 371 outlets and an island
wide presence. Cargills operates under two main store formats, ‘Cargills Food City’ supermarkets and
the smaller ‘Cargills Food City Express’ convenience stores.

Cargills, along with its major competitors, has been rapidly expanding its outlet count given the
lucrative potential of the significantly underpenetrated industry. Cargills opened 11 outlets in 1H FY
2019 and 38 outlets in FY 2018. The intensifying competition and changing consumer lifestyles
resulted in Cargills Food City rolling out a new layout. These entail larger floor space relative to the
traditional format, equipped with more parking space. Furthermore, an increasing emphasis is being
placed on fresher categories including in-store bakeries. The company will persist with this larger
format where appropriate, going forward. The retail segment is also currently investing USD 15mn in
a distribution warehouse to serve the increasing capacity needs required by their aggressive outlet
expansion plans.

Fast Moving Consumer Goods (FMCG)

Dairy
CARG expanded its breadth across the dairy industry through the acquisition of Kotmale PLC in 2010,
thus entering the fresh milk, yogurt, drinking yogurt, butter and cheese sub-segments. In 2017,
Kotmale launched a new plant which was the country’s first fully integrated dairy processing facility.
Today, Cargills is the third largest milk collector, right behind state-owned Milco and multinational
Nestle. Facilitating the dairy supply chain are 700 milk collection points and 22 milk chilling centers.

Frozen Confectionery
The acquisition of an international ice-cream factory previously owned by Unilever’s Wall’s in 2002
led to the genesis of CARG’s frozen confectionery segment. Cargills’ Magic commands market
leadership in the frozen confectionery market, having recently acquired the title from industry
veteran, Elephant House. The unique selling point that Magic holds over Elephant House is that their
ice-creams are made from fresh milk as opposed to the vegetable fat and milk powder used by the
latter.

The frozen confectionery portfolio is segmented into take-home range, impulse range and premium
range (under the brand line Magic Heavenly). Magic’s strategic focus is flavor innovation.

Processed Meats
Cargills gained entry into the processed meats business through the acquisition of an industry
incumbent, Goldi. The processed meats portfolio comprises sausages, meatballs, bacon and luncheon
meats organized under three brands: Goldi, its mass-market brand, Sam’s, which is targeted at young
children using bite-sized products, and Cargills Finest, its premium range. They also recently launched
a processed seafood brand, Island’s Finest.

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Agrifoods
The agrifoods segment is manufactured and distributed under the brand Kist. The Kist portfolio
includes, sauces, jams, fruit juices & nectars and cordials as well as biscuits through the acquisition of
Diana Biscuits.

Distribution
In 2008, Cargills acquired Millers Limited thus enhancing their marketing and distribution operation.
Millers is one of the oldest distributions and logistics operations in the country and is the island-wide
distributor for renowned international brands such as Kraft, Cadbury, Oreo, and Toblerone, amongst
others.

Quick Service Restaurants

Cargills is the sole franchisee of US-based global fast food chain, Kentucky Fried Chicken (KFC), having
obtained the franchise license in 1996. KFC’s menu revolves around its specialty deep fried chicken.
The outlet footprint is currently at 35 and is expanding beyond the Western province into
underpenetrated areas where encouraging growth trends are seen. KFC is currently the market leader
in the local QSR industry based on total revenues.

Financial Services
Cargills Ceylon PLC obtained a provisional commercial banking license from the Central Bank of Sri
Lanka in 2014 that resulted in the launch of Cargills Bank. Currently the former holds a 39.7% interest
in the latter. Cargills Banks operates 19 branches and 16 ATMs which are spread out across the island.
Furthermore, they are able to leverage on the 350+ supermarkets operated by Cargills by providing
services at the point of check out, thus widening their reach.

Cargills’ holding in Cargills Bank is expected to dilute following the raising of capital by Cargills Bank.

Financial Snapshot
Group
in LKR millions FY 2015 FY 2016 FY 2017 FY 2018 1H FY 18 1H FY 19
Revenue 61,631 71,017 84,191 91,293 45,506 47,730
YoY Growth 9.8% 15.2% 18.6% 8.4% 4.9%

Gross Profit 5,647 7,979 10,049 10,574 5,501 5,204

Gross Margin 9.2% 11.2% 11.9% 11.6% 12.1% 10.9%
Net Profit 247 1,691 2,284 3,331 2,370 1,265
Net Margin 0.4% 2.4% 2.7% 3.6% 5.2% 2.7%

Total Assets 37,418 42,211 49,303 52,792

YoY Growth -4.9% 12.8% 16.8% 7.1%
Table 1 Source: Company Data, JBS Research

The Group posted revenue of LKR 91.3bn in the financial year 20181, representing YoY growth of 8.4%.
The main contributor to group revenue is the retail segment. This segment recorded revenue of LKR

1
The financial year began on 1 April 2017 and concluded on 31 March 2018

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72bn thus accounting for 79% of total group revenues. The retail segment experienced YoY growth of
8.4% as well.

Group profit for the year was LKR 3.3bn, representing YoY growth of 45.8%. This acceleration was
primarily the result of a gain on disposal of property, plant and equipment of LKR 1bn, which was
recorded in the ‘Other’ segment. This is deemed to be an extraordinary item and unlikely to be
replicated in FY 2019, hence it will result in a necessary decline in profits YoY. Retail continues to be
the main contributor to bottom line as well, however accounting for a much lower share than it did
to revenues due to low margins in the modern retail industry.

Segmental Analysis
FMCG exc. Kotmale,
14.6%

Revenue Retail, 78.9% Restaurant, 4.0%

Kotmale, 2.5%
Restaurant, 6.1%

Operating FMCG exc. Kotmale,

Retail, 39.9% Other, 19.1%
Profit 30.1%

Kotmale, 4.8%

Figure 2 Source: Company Data, JBS Research

in LKR millions FY 2015 FY 2016 FY 2017 FY 2018 1H FY 18 1H FY 19

Retail
Revenues 45,293 49,351 55,450 66,435 35,878 37,619
YoY Growth 9.0% 12.4% 19.8% 8.4% 4.9%
Operating Profit 934 1,681 2,647 2,502 1,613 860
Operating Margin 2.1% 3.4% 4.8% 3.8% 4.5% 2.3%
FMCG
Revenues 9,979 12,755 14,487 15,659 7,793 8,239
YoY Growth 14.8% 27.8% 13.6% 8.1% 5.7%
Operating Profit 707 1,657 2,117 2,183 1,353 1,198
Operating Margin 7.1% 13.0% 14.6% 13.9% 17.4% 14.5%
Restaurants
Revenues 2,301 2,812 3,269 3,614 1,835 1,871
YoY Growth 6.7% 22.2% 16.2% 10.6% 2.0%
Operating Profit (69) 125 267 382 219 200
Operating Margin -3.0% 4.4% 8.2% 10.6% 11.9% 10.7%
Table 2 Source: Company Data, JBS Research

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The modern retail segment has seen revenue slowdown particularly in the first half of the current
financial year, driven by a combination of factors, the main contributor being poor consumer
sentiment. The modern retail industry is susceptible to consumer confidence and the economic cycle.
Although footfall has increased marginally, there was a decline in the average basket value as
consumers purchased fewer categories and fewer items within a category.

The deceleration in revenues has also been witnessed in FMCG and restaurants. This trend is even
more pronounced in restaurants as KFC meals are deemed to be a more affluent consumption relative
to the other segments and therefore more sensitive to consumer confidence.

Top 20 Shareholders
Change since
2Q FY 2019 % 1Q FY 2019
CT Holdings PLC 179,713,417 70.20% -
Mr. V.R. Page 17,335,169 6.77% 192,205
Employees' Provident Fund 8,407,333 3.28% -
Odeon Holdings (Ceylon) Pvt. Ltd. 5,511,909 2.15% -
Mrs. M.M. Page 5,191,023 2.03% 32,077
Ceylon Guardian Investment Trust PLC A/C No. 1 4,772,229 1.86% -
LF Ruffer Pacific and Emerging Markets Fund 3,970,920 1.55% -
Citi Bank New York S/A Norges A/C No. 2 3,466,151 1.35% 2,468,799
Tundra Frontier Opportunities Fund 2,609,579 1.02% -
Butterfield Trust (Bermuda) Limited 1,551,429 0.61% -
Mellon Bank N.A. - Florida Retirement System 1,487,771 0.58% -
Bank of Ceylon A/C No. 1 1,484,129 0.58% -
JB Vantage Value Equity Fund 1,031,737 0.40% -
GF Capital Global Limited 1,016,000 0.40% -
The Associated Newspapers of Ceylon Limited 914,103 0.36% -
Ceylon Investment PLC A/C No. 2 720,502 0.28% -
Sir Chittampalam A. Gardiner Trust 643,474 0.25% -
Ceylon Guardian Investment Trust PLC A/C No. 2 521,771 0.20% -
Mr. J.C. Page 520,000 0.20% -
Mr. P.E. Muttukumaru 480,000 0.19% -
Table 3 Source: Company Data

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Industry and Competitive Analysis

We break out Cargills’ operations into five main industries; modern retail, dairy, frozen confectionery,
quick service restaurants, and processed meats. It also has a presence in sauces, juices, jams
(collectively classified as Agrifoods) and confectionery. We do not analyze these industries separately
as their demand is largely predicated on household incomes and urbanization which also drive the
main industries.

The following table summarizes the key positive and negative factors of each of the five main
industries uncovered by our research. These factors will be elaborated in further detail in the sub-
sections to follow.

Positive Factors Negative Factors

Industry is highly susceptible to
Modern retail penetration is low at
consumer confidence, and therefore
~18%-20% indicating plenty of scope for
performs poorly during volatile
improvement.
economic and political environments.
Upward trajectory of household
New entrants are heightening
incomes will boost footfall and average
competition.
basket values (ABV).
Better value proposition through wider Keells is gaining market share at the
product offerings and more parking expense of Cargills, through clear
Modern Retail space. branding strategies and rapid expansion.
Rising motor vehicle population
facilitates shift from general trade to
modern trade.
Continued urbanization to aid shift from
general trade to modern trade.
Cargills is the current market leader,
with the widest geographical presence
Current per capita consumption is low at Emerging trend of health-conscious
2.0 liters, indicating scope for consumers may hamper demand for
improvement frozen confectionery. Impact is limited.
Room for growth in cold chain
Frozen penetration amongst retailers,
Confectionery improving availability of frozen
confectionery
Cargills is the new market leader
through its strength in impulse range
frozen confectionery.
Cargills’ Magic commands superior
flavor over Elephant House by using
fresh milk as opposed to vegetable fat.

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Positive Factors Negative Factors

Dairy is a vital part of a balanced meal. Milk powder is subject to maximum
Growth in household income will further retail prices that hamper free market
increase demand for dairy forces and allocative efficiency.
Demand is currently shifting from low- Farm gate prices for liquid milk are
margin milk powder, to high-margin subject to floor prices that push up final
fresh milk retail prices of dairy products.
Dairy
40% of dairy demand is met by local Industry is dominated by smallholder
imports, indicating potential for farmers whose cow milk yields are
improvement in self-sufficiency inherently low.
Leverage on emerging health-conscious
trend due to nutritional benefits of
dairy.
Cargills has a wide and strong presence
in the dairy industry through its brand,
Kotmale
QSR meals are perceived as an
indulgence consumption. Scope for QSR meals have wide negative publicity
improvement in poor penetration with for their unhealthy nature.
growth in incomes.
Third-party food delivery apps such as
Quick Service Continued urbanization bodes well for Uber Eats widen consumer choice,
Restaurants QSR meal demand. which may threaten take-away and
delivery sales of QSR chains.
Increasingly time-pressed population
emphasizes the need for convenience
which is the epitome of the QSR
industry.
KFC is the market leader in terms of
revenues and its flagship product, deep-
fried chicken, is a local favorite.

Meat consumption in the country is

Faith-based abstinence from certain
amongst the lowest in the world,
types of meat have restricted their
indicating plenty of room for
demand
improvement.

Urbanization will shift dietary habits

Processed Meat prices are relatively unaffordable
that allow for consumption of processed
Meats due to high animal feed prices.
meats.
Increasingly time-pressed population
Processed meats have been deemed
emphasize on the need for convenience
carcinogenic (potential to cause cancer)
which bodes well for processed meats
by WHO.
demand.
Cargills has a wide presence in the
processed meats industry via its four
brands.
Table 4 Source: JBS Research

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1. Modern Retail
1.1. Industry Analysis
1.1.1. Average basket values are expected to increase
Rising household incomes permit the purchase of more products as well as higher value
products
Household incomes have experienced strong growth
120,000 12%
1H 2018 E
Household Income (in LKR)

100,000 10%

80,000 8%

60,000 2009 - 2016 CAGR 6%

2016
40,000 4%

20,000 2%
2009
- 0%
A B C D E
% of
9% 24% 28% 23% 16%
households

Figure 3 Source: Lanka Market Research Bureau, JBS Research

Socioeconomic class (SEC) A & B households have experienced high growth in income in the past
(Figure 3). These SECs make up the primary target market of the modern retail industry. They already
purchase the majority of the retail FMCG goods that they demand, and face relatively less price
sensitivity to consumer staples, which also form a lesser proportion of their total expenditure. Further
growth in their disposable income will push them to purchase more premium, high value retail goods
thus inflating their basket values.

Disposable incomes for SEC C & SEC D households have grown steadily too. These households
generally conduct their shopping at small and medium modern trade outlets (SMMT) such as Sathosa
or general trade outlets. Their consumption baskets largely comprise consumer staples. Future
increases in their disposable incomes will drive them to visit modern trade outlets and expand the
range of items within their basket to include more indulgence consumer goods. These households are
key to future growth in modern trade footfall.

Modern trade presently accounts for approximately 18%-20% of the total retail market, indicating its
low penetration and future potential. Its penetration rates are also much lower relative to regional
peers such as Taiwan (43%), Malaysia (49%), Thailand (40%) and Singapore (70%).

Sri Lanka ranked 12th on AT Kearney’s Global Retail Development Index 2017, a further attestation to
the attractiveness and development potential of the retail industry. Sri Lanka’s ranking has remained
constant at 12th with a score of 51.8 despite acknowledgement of “sluggish GDP growth, lower

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remittances and moribund export markets.”2 Topping the index for 2017 was India (71.7) followed by
China (70.4) and Malaysia (60.9).

Consumer confidence hit a near 10-year low in August 2018

70
Consumer Confidence Index

60

50

40
Declines in modern retail ABVs were
witnessed; an unnprecedented phenomenon
30
Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17 Jan-18 Mar-18 May-18 Jul-18 Sep-18 Nov-18
Figure 4 Source: Nielsen Sri Lanka, JBS Research

The year 2018 was a poor one for modern retail as pessimistic consumers experienced a pinch in
purchasing power. This was brought about by a volatile operating environment including a
constitutional crisis in late 2018. By the end of September 2018, both Keells and Cargills, the country’s
two largest modern retail players, witnessed an unprecedented decline in average basket values. This
decline was comprised of declines in the variety of categories purchased as well as declines in
purchases within a category. Figure 5 also indicates that 2017 and the first half of 2018 saw negative
growth in general trade volume which can be accounted for by poor consumer confidence due to
slowing household income growth. However, the final quarter saw a strong rebound in FMCG
volumes.

Rebound in FMCG consumption

15%
10%
5%
0%
Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
-5%
-10% 2016 2017 2018

-15%
-20%
Price inflation Volume growth Total growth
Figure 5 Source: Nielsen Sri Lanka, JBS Research

Modern trade captures a greater share of the wallet by offering more diverse categories and
varieties relative to general trade.
Modern trade offers a far more diverse range of goods and services categories including groceries,
household items, fresh meats and produce, bakery items, and in some cases hot meals, pharmacies
and banking services. The general trade offering, in most cases, is restricted to groceries and
household items, due to limited shelf space and lack of appropriate refrigeration facilities to store
fresh categories. Consequently, modern trade captures a relatively larger share of the wallet.

2
AT Kearney

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Furthermore, modern trade offers a more diverse variety of brands for a given product, empowering
the customers with more choice.

The wider offering of modern trade is a catalyst in driving up its basket values. Customers, who are
drawn into an outlet for the fresh produce or bakery items, tend to make other purchases on impulse.
Furthermore, fresh meats and produce carry higher margins as they are not restricted to maximum
retail prices (MRP). Figure 6 depicts that the contribution fresh produce and meats make to the
revenues of a leading modern retail player, has been increasing in importance.

Fresh produce & meat make a sizeable contribution to revenue

Other, 4%
100%
Liquor, 11%
80% Chilled Items, 11%

60%
Groceries, 56% 57%
40%

20%
Fresh Produce 24%
& Meat, 18%
0%
2013/2014 2016/2017

Figure 6 Source: Ceylon Cold Stores management, JBS Research

Consumer staples face inelastic demand and are thus less susceptible to price inflation
Volumes of consumer staples can withstand price inflation

-0.2 Feminine Care

-0.5 Baby Care
-0.7 Cooking Oil
-0.7 Soaps
-0.9 Food
-1.0
Diapers
-1.3
Shampoo
-1.5
Private Labels
% change in volume in response to 1% change in price
Figure 7 Source: Nielsen Sri Lanka

Consumer staples such as basic foods (including items such as rice, vegetables, tea powder, and milk
powder) face inelastic demand due to their essential nature. Thus, in a high inflationary environment,
values of shopping baskets that largely comprise consumer staples will rise due to the positive price
effect dominating the negative volume effect.

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Increase in household penetration of motor cars which enhances grocery carrying weight

7,000 Motor vehicle population on the rise

Population of motor vehicles (in '000s)

6,000
Motor cycles Motor tricycles Motor cars
5,000

4,000

3,000

2,000

1,000

-
2012 2013 2014 2015 2016 2017

Figure 8 Source: Department of Motor Traffic, JBS Research

The availability of motor vehicles to make shopping trips enhances the weight of goods that can be
purchased in a single trip. Prior to obtaining a motor vehicle, households would often travel to retail
outlets using cheaper forms of transport such as buses or by foot, which restricts the feasible grocery
weight in a single trip.

The population of motor vehicles has been increasing over the past few years as illustrated above.
This is the result of an influx of first-time buyers into the market. The expansion largely comprises
motorcycles, followed by motor tricycles and small motor cars (less than 1000cc engines). This rising
population of motor vehicles has been aided by attractive financing options. Of the motor cars that
were registered in 2018, 55.4% were purchased via a financing scheme, and the comparable statistic
for motor tricycles and motor bicycles are 59.9% and 67.1%.3

Average daily drops and pick ups at major super markets

Monday
Pick Ups Total
Tuesday Drops Total

Wednesday

Thursday

Friday

Saturday

Sunday

0 200 400 600 800 1,000 1,200

Figure 9 Source: PickMe, JBS Research

3
Department of Motor Traffic

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There has also been an emergence in the availability of convenient taxi hailing apps such as PickMe
and Uber that compete with the ubiquitous 3-wheeler which continues to remain a popular form of
taxi transport.

The retail industry stands to benefit from these positive mobility trends, as average basket values will
be enhanced through an increase in the number of items purchased.

1.1.2. Modern trade footfall is expected to increase

Urbanization opens up new, viable geographic areas

Urban population proportion

Sri Lanka 44%

Batticaloa 39%

Vavuniya 42%

Puttalam 43%

Galle 50%

Kandy 57%

Kalutara 62%

Gampaha 67%

Colombo 91%

Figure 10 Source: Institute of Policy Studies (IPS) of Sri Lanka, JBS Research

Urbanization has opened up positive prospects for modern trade, whose target segment is the urban
population, due to their relative sophistication and demand for a wider variety of products.

In recent times, the population in urban areas has been rising. The number of cities that exhibit urban
characteristics is increasing as well. These factors have contributed to the country’s urbanization
process. The extent of the country’s urbanization, however, cannot be captured by official statistics
provided by the Department of Census and Statistics, which is largely underestimated at 18.2%. A
study conducted by the Institute of Policy Studies (IPS) using alternative definitions of an urban area
puts the proportion of urban population at 43.8%.

At present, the modern trade industry is largely confined to the Western province, but as Figure 10
illustrates, other large cities are becoming more viable to sustain modern trade with healthy footfall
and basket values.

Increase in frequency of visits

a) Benefits provided by loyalty card schemes will encourage repeat visits
A loyalty card member has access to a range of benefits including the accumulation of points that can
be subsequently redeemed to purchase items, as well as discounts. These schemes are designed to
build loyalty amongst customers and thus ensure that the customers will continue to purchase items
from the associated modern retailer.

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The benefits of loyalty cards are two-fold, with the loyalty card system also providing the supermarket
chain a valuable database which can be used to gauge current consumer trends and thus tailor
strategies accordingly to ensure repeat visits.

b) Wider offering range of modern trade will attract top up or monthly shopping which have
higher ABVs
The motive behind a customer’s visit to a retail outlet can be sub-divided into three broad categories:
pantry re-stocking, which occurs on a monthly or even weekly basis and involves replenishing the
entire kitchen pantry. A pantry top-up is the replenishment of some major categories in the kitchen
pantry. An urgent pick up involves purchasing an item that is needed immediately.

According to Nielsen Sri Lanka, approximately 35% of visits to a modern trade retail store are to
conduct a pantry top-up, 35% are to conduct pantry re-stocking and 24% are for an urgent pick-up.

The wider and more diverse offerings provided by modern trade make it an attractive channel for
pantry restocking and pantry top-ups. These types of shopping visits bring in larger average basket
values. However, the convenience offered by roadside general trade outlets with a store clerk to assist
in retrieving the product makes general trade the more attractive channel for urgent pick-ups.

c) Modern retail players are in a better position to offer discounts and other incentives.

Discounting has a sizeable impact on sales

Buy 1 get 1 free 75%

Buy 3 for price of 2 40%

Buy 1 get 50% off second 25%

25% price cut 15%

Change in average one week's sale for a particular brand

Figure 11 Source: Nielsen Sri Lanka

Modern trade players are in a better position to offer discounts and draw traffic into the outlets. This
is because their outlets operate on much larger square footages and SKUs relative to general trade,
and consequently their retail volumes are much larger. One of the tactics that modern trade outlets
can afford, and thus employ, is to create loss leaders on basic consumer staples to draw customers
into the outlet. The losses are then recuperated through the impulse purchases that occur once the
customer is in the supermarket. Forty-six percent of purchase decisions are made in-store according
to Nielsen Sri Lanka.

The impact of discounting and promotion on retail sales varies according to the type of discounting
offered.

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1.1.3. Potential threat from alternative grocery retail channels may emerge in the medium
term
The current local players in the supermarket sub-segment of the modern retail industry may face a
potent threat from alternative channels such as hypermarkets and online retailers.

Currently, the veteran hypermarket operating in the country is Arpico Supercenter. In late 2018 a new
hypermarket player, Glomark (a brand of Softlogic), entered the retail industry given its attractive
potential. As disposable incomes and consumer sophistication improve, hypermarkets become
increasing viable. Threat to hypermarkets can emerge from incumbent local players, or from foreign
chains such as French-based Carrefour and Abu Dhabi-based LuLu. However, difficulty in obtaining
suitable land may constrain hypermarket penetration.

The threat posed by online grocery retailers is nascent at present but may rise in significance going
forward. At present, the country’s largest online retailers - Takas.lk, Wow.lk and Ikman.lk - are focused
on consumer electronics and cars.

1.2. Competitive Analysis

1.2.1. Intense competition between top three modern retail players
Cargills remains the market leader, but its market share is gradually deteriorating

Revenue composition of Top 3

2012 2018

Arpico, Arpico,
18% 18%

Cargills,
Keells,
Cargills, Keells, 54%
19%
63% 28%

Figure 12 Source: Company Data, JBS Research

For much of the country’s modern retail history, competition has been concentrated among three
dominant players; Cargills, Keells and Arpico, with Laugfs a distant, but competent fourth player.

Cargills continues to be the market leader by both store count and revenues, followed by Keells and
the hypermarket, Arpico. At the end of 2018, Cargills led with an outlet count of 371, followed by
Keells with 91, Arpico with 48 and Laugfs with 37. However, Cargills’ leadership position is being
eroded due to changing competitive dynamics as Keells establishes itself as a potent threat, and new
entrants challenge the industry’s long-standing competitive structure.

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Cargills relies on two store formats to facilitate its aggressive expansion

Cargills operates two supermarket formats: ‘Cargills Food City’, the dominant and larger format
(4,000+ square foot of customer facing space on average) and ‘Cargills Food City Express’, the
convenience store format (2,000 square foot of customer facing space on average). Approximately
62% of the total outlet count is accounted for by the Cargills Food City format. The smaller Cargills
Food City Express outlet incurs much lower operating expenditure due to the absence of certain
categories (for example chilled meats). This format is launched in areas outside the Western Province
where urbanization rates, and thus footfalls, are much lower. Thus, the Express format enables Cargills
to achieve its wide geographical presence.

In mid-2016, Cargills revamped the outlook of Cargills Food City supermarkets by emphasizing on
larger retail shopping space and more parking. This new format competes with Keells which rolled out
its own larger-store format with a ‘freshness’ focus.

Due to Cargills’ large outlet footprint, it does not intend to convert all its stores to this new format as
Keells had done. Instead it aims to convert the stores in locations that make economic sense for a
larger outlet, whilst its new outlets will be of the new format.

Figure 13 Source: JBS Research

Keells launched a re-branding project to reiterate its focus on freshness

Keells’ unique selling proposition over the market leader, Cargills, is its focus on freshness and
nutrition. In 2018 Keells’ re-branding project continues to reiterate this strength.

In the majority of the categories, such as groceries and household & personal care items, retailers are
on an equal footing in terms of offering, due to the standard nature of such products and their
relatively longer shelf lives. Scope for differentiation exists in more perishable categories such as fresh
meats & produce, bakery as well as services provided.

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During the previous financial year, Keells underwent a change in its supermarket outfit, where the
theme color shifted from bright red to bright green, thus setting Keells apart from Cargills. The new
color is also associated with the perception of freshness. The inside layout was changed such that
more space was allocated to fresh offerings such as fruits & vegetables, meats as well as bakeries
which began offering hot meals. The hot meal offering leverages on the ongoing lifestyle changes
where home-cooking is diminishing with growth in dual-earning households and preference shifting
towards eating out. Cargills currently does not offer hot, ready-to-eat meals.

Figure 14 Source: Whippet website

Arpico captures a larger share of the wallet through a more diverse category offering
Arpico captures a larger share of the wallet by operating as a hypermarket with additional offerings
such as home improvement products and electronics. This is in contrast to Sathosa, a small medium
modern trade (SMMT) chain, that has a narrow offering and caters to a different target market. Arpico
also competes more directly with Cargills and Keells through its supermarket chain operating under
the banner ‘Arpico Daily’.

1.2.2. Cargills continues as the most valuable brand amongst retailers

Brand Value (in Brand

Brand Ranking 2018 2017 Change
LKR mn) Rating
Cargills Food City 10 9 -1 17,947 AA+
Keells 14 20 +6 11,552 AA+
Arpico Supercenter 22 22 - 6,424 A+
Table 5 Source: LMD

Amongst the main modern retailers, Cargills commands a much higher brand value relative to its
peers, Keells and Arpico as per the annual study conducted by Brand Finance Lanka and published by
LMD. This is due to its wider presence throughout the island.

However, Cargills Food City has been dropping down the rankings since reaching its peak of number
4 in 2013. On the other hand, Keells has been gaining significant traction.

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1.2.3. Cargills’ geographic footprint is more spread-out relative to Keells.

Cargills
Keells
Arpico

Retail footprint in Colombo

Figure 15 Source: Supermarket websites, Google Maps, JBS Research

Cargills has the largest retail footprint in the modern retail industry. By December 2018, Cargills
continued to lead the retail footprint with an outlet count of 371, followed by Keells with 91, Arpico
with 48 and Laugfs with 37.

Cargills is also pursuing an acceleration in outlet openings with 32 outlets expected to be launched in
FY 2019 and a target of 50 outlet launches in FY 2020. This is similar to Keells’ outlet acceleration plans
with a target of 40 outlet launches in each of FY 2019 and FY 20204.

Cargills has always focused on maintaining a presence in all 25 districts of the country. Keells and
Arpico, on the other hand, have focused on the Western province (Colombo and Gampaha district)
where a large proportion of urban dwellers reside. Despite the skewed interest towards the Western
Province, modern penetration is still underwhelmingly low with a rate of approximately 22% in

4
Keells targeted outlet launches in FY 2019 was recently revised downwards from 40 to 19.

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Western Province and approximately 33% in Colombo5, underscoring significant potential.

Furthermore, household income is the highest in the Colombo and Gampaha districts, thus allowing
for higher average basket values.

A pitfall of this strategy, however, is the increased revenue cannibalization due to overlapping of
customer catchment areas. Furthermore, Cargills may have gained a first-mover advantage by
entering locations that may soon become viable for others to enter due to rapid urbanization. Such
advantages include securing prime outlet locations and capturing a customer base who become
familiar with the product placement within the outlet and make habitual visits.

Mean monthly household expenditure & income

Colombo
Gampaha
Kalutara Western province
Galle
Puttalam
Hambantota
Kurunegala
Matale
Kandy
Matara
Jaffna
Nuwara Eliya Expenditure Income

- 20,000 40,000 60,000 80,000 100,000 120,000

in LKR

Figure 16 Source: Household Income & Expenditure Survey, JBS Research

1.2.4. New players are entering the modern retail industry and intensifying competition
With favorable trends such as expanding middle class and rising disposable incomes, modern retail in
Sri Lanka is viewed as a lucrative industry to enter. This has already been realized through the display
of international interest.

The first international supermarket chain to enter Sri Lanka’s modern retail industry is SPAR. This was
achieved through the joint venture between Ceylon Biscuits Limited, a leading confectionery
manufacturer in Sri Lanka, and SPAR South Africa. SPAR International is a group of independently
owned and operated retailers and wholesalers, with a presence in 48 countries. In early April 2018,
the first SPAR supermarket was set up in the vicinity of Colombo.

The SPAR outlet is approximately 10,000 square feet, which is similar in size to the outlets operated
by Keells, and larger than the traditional Cargills outlet. Its offerings include fresh fruits & vegetables,
fresh meats, in-store bakery and a cafeteria offering hot, ready-to-eat meals. It also offers SPAR’s own
brand products, sourced internationally. However, they are priced higher relative to similar local
products as they incur import tariffs.

5
Industry expert

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According to SPAR International’s website, SPAR plans to launch 50 retail outlets in Sri Lanka by 2023.

Another formidable entrant into the industry is Softlogic PLC, a diversified conglomerate in Sri Lanka.
Softlogic launched its own supermarket chain under the brand ‘Glomark’, in order to complement the
group’s already established retail arm which includes consumer electronics, branded apparel,
furniture and restaurants. Furthermore, it has an established loyalty card network which will be rolled
out into its supermarkets.

Its first outlet was launched in mid-November 2017. In 4 years, they expect a total store count of
between 40 and 50 outlets.

The perception that Softlogic is trying to achieve with its supermarkets is a premium modern retail
experience with advanced technology. In addition to the basic product range of a conventional
supermarket, Glomark’s offerings include bakeries and hot, ready-to-eat meals, as well as electronics
stemming from Softlogic Holding’s retail segment portfolio.

Softlogic’s strategy in modern retail is to maintain large outlet sizes rather than a large retail footprint
and a wide geographical coverage. According to Softlogic management, the outlet sizes will average
12,000 – 13,000 square feet.

Figure 16 Source: JBS Research

These new entrants will maintain their focus on the Western Province, and Colombo in particular,
where the established modern retail players are largely concentrated.

2. Frozen Confectionery
2.1. Industry Analysis
We have defined the frozen confectionery market to include the main sub segments of ice creams,
popsicles, frozen yogurt, frozen custard, sherbet and sorbet.

2.1.1. Improvement in affordability of frozen confectionery

Growth in household incomes for SEC C & D will widen target market for frozen confectionery

Persistence of frozen confectionery is low amongst households that fall under the SEC C & D
classification, due to the majority of the income still being spent on consumer staples. As incomes of
these households grow (Figure 3), the affordability of consumer discretionary goods such as frozen
confectionery starts to improve. The expected improvement is magnified, as SEC C & D constitute 51%
of household population.

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Households in SEC A classification offer opportunities for premiumisation in the industry. Affluent
customers will seek premium frozen confectionery, which is based on more natural or high-quality
ingredients, and carries a higher margin.

Per capita consumption of frozen confectionery is approximately 2.0 liters. This is an improvement
from the 1.7 liters observed in 2012. The comparable statistic for its regional peers is 3.0 liters for
China, 0.4 liters for India and 1.9 liters for Malaysia.

2.1.2. Distinctiveness of frozen confectionery reduces its substitutability

Frozen confectionery offers unique properties that other desserts cannot easily match
Frozen confectionery is consumed at much colder temperatures relative to other desserts.
Consequently, it caters to a specific consumer desire that cannot be satiated by other desserts. It is a
form of indulgence that is also able to provide a refreshing contrast during hot weathers. This hard-
to-match feature of frozen confectionery reduces its substitutability and lowers its cross elasticity of
demand with other desserts.

Impulse frozen confectionery segment buoyed by growing demand for convenience of on-
the-go consumption

The impulse range differentiates itself from the take-home pack by allowing the convenience of
immediate consumption to satisfy a consumer craving. It is made available on sticks, in cones and in
single-serving cups and are either dairy-based or water-based novelties. Majority of the other
segments in the dessert industry do not offer such convenience, thus strengthening frozen
confectionery’s relative position.

The local frozen confectionery industry, however, is currently dominated by the take-home packs. The
volume ratio between take-home packs and the impulse range is approximately 70:30 whereas the
comparable statistics for Thailand and Malaysia are 8:92 and 56:44, respectively. The ratio is expected
to improve towards the higher-margin impulse range going forward.

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Frozen desserts are versatile

Frozen desserts enjoy versatility, with an extensive range of flavor possibilities. They can further be
combined with other desserts (e.g. cakes and pies) to enhance the consumer’s consumption
experience. Consequently, frozen confectionery can be viewed as a complement for other desserts.

Until more recently, the local ice cream industry has been limited to the classic flavors but has begun
to see expansions in the ‘flavor universe’, initiated by the larger industry players (Magic and Elephant
House). Examples of more innovative flavors by global players include Bourbon Pecan Pie (Ben &
Jerry’s), Pistachio (Ben & Jerry’s), Cheesecake Brownie (Ben & Jerry’s), Green Tea (Haagen Dasz),
Toasted Coconut Caramel (Haagen Dasz), White chocolate raspberry truffle (Haagen Dasz) and many
more. This demonstrates the large potential for local players to innovate, which will be aided by an
increase in consumer sophistication.

2.1.3. Change in consumer lifestyles

Increase in penetration of motor vehicles and refrigerators will increase potential for take-
home ice cream packs.
Consumption of take-home packs is predicated on the availability of a refrigerator, a mobility vehicle
and proximity from place of purchase to place of refrigeration. If ice cream melts and refreezes, it
crystallizes, thus severely compromising the texture and diminishing the consumption experience.

Refrigerator penetration is low (52.9%), even in the urban areas (62.3%)6. Consequently, the average
household’s ability to purchase take-home ice cream packs is limited. This poor statistic, however,
underscores scope for improvement, which will translate into potential increases for take-home pack
volumes.

The cost of purchasing an entry level refrigerator with a freezer compartment is approximately LKR
60,000. Rising household incomes and the availability of attractive financing options such as hire
purchase will improve the refrigerator penetration. A typical financing structure for an entry level
refrigerator could include a down payment of approximately LKR 14,333 and equal installments of
approximately LKR 1,911 over 15 months. The monthly electricity cost roughly amounts to LKR 850.

As depicted in Figure 8, there has been an exponential growth in motor vehicle ownership. This is a
positive trend for the industry, as it facilitates quick transportation of frozen confectionery.

Increasing health consciousness may inhibit growth in demand, although impact is currently
negligible.
There is currently a surge in health-conscious consumers amongst the urban population, as indicated
by the rise in number of gyms and gym memberships, as well as the emergence of foods that target
health conscious consumers. However, we expect this trend to be of more concern in the long run, as
presently frozen confectionery is an indulgence that is consumed infrequently, and the health-
conscious trend is still relatively nascent, limited to SEC A households in Colombo.

Many desserts are unhealthy due to their sugary content, with ice creams often considered relatively
unhealthy due to the inclusion of sugar and fats from dairy. Consequently, this new trend will see ice
cream manufacturers being pushed to amend their products to meet healthier standards. In
developed countries, where the health-conscious consumer segment is more prominent, the frozen

6
Lanka Market Research Bureau

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confectionery industry has already begun to see frozen yogurt gaining traction at the expense of ice-
creams.

The population above age 50 is growing at rates faster than the national population. This phenomenon
of ageing population is further elaborated in section 3.1.3. As senior citizens are more susceptible to
diabetes, their consumption of sugary foods such as ice-cream will begin to decline.

2.1.4. An increase in penetration of cold chain amongst retailers will improve the availability
of frozen confectionery
Frozen confectionery requires cold storage at the location of sale. However, the penetration of
appropriate cold chains amongst retailers is low and concentrated in urban areas.

Presently the retail industry is dominated by the general trade segment, with modern trade
accounting for only 18%-20% of the industry. The proportion of general trade outlets that are
equipped with refrigeration facilities is low, particularly beyond the Western province. Consequently,
most of the retail outlets cannot carry frozen confectionery.

The majority of the modern retailers are equipped with cold chain facilities. However, this retail
format is relatively concentrated in the Western province. We expect the modern retail industry to
face strong growth and spread out geographically, thus increasing the distribution potential of frozen
confectionery.

2.2. Competitive Analysis

2.2.1. Cargills overtakes Elephant House to gain market leadership position
The frozen confectionery market is dominated by three large players: Elephant House, Cargills
(through its brands Magic and Kotmale), and Highland. In 2016, the size of this market was estimated
at 40 million liters per annum of which 52% was captured by CCS’s ice cream segment. However, in
2018, Magic overtook the industry veteran, Elephant House, to become the new market leader. This
achievement hinged on new flavor innovation as well as more focus on the impulse range segment.

2.2.2. Magic and Elephant House commands price premium in basic flavors
(in LKR) Vanilla Strawberry Chocolate Fruit N’ Nut
Elephant House 280 290 290 365
Magic 270 290 290 370
Kotmale 260 270 270 360
Highland 260 270 270 365
Table 6 Source: JBS Research

2.2.3. Both Magic and Elephant House have an extensive flavor range

Despite vanilla being a popular and timeless flavor, the increasing sophistication of urban consumers
has placed pressure on frozen confectionery players to bring new and innovative flavors into the
market. Both Elephant House and Magic have expanded their flavor portfolio, releasing new flavors
every year, including limited edition flavors during festive seasons. Both players have also launched
premium ranges. According to our research, Magic currently has 39 flavors followed by Elephant
House with 35 flavors.

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3. Dairy
3.1. Industry Analysis
We define the dairy industry to include animal milk, and other products that are derived from animal
milk such as butter, cheese, yogurts and ice-cream. Global demand for dairy is expected to increase
by 2.5% per annum according to Deloitte, driven by rising incomes and urbanization in emerging
markets.

3.1.1. Affordability of value-added dairy products signals scope for improvement to

facilitate shift away from milk powder
Household incomes are on the rise
As analyzed in previous sections, household incomes across all SEC classifications have been
accelerating over the past few years. This is an encouraging sign for the dairy industry. The dairy target
market is synonymous with the total population since dairy is an important constituent of a balanced
diet. We believe that there is potential for further increases in dairy spending following continued
rises in household income. For SEC A and SEC B households, higher incomes enable a switch towards
more value-added dairy products such as fresh milk, flavored yogurts, drinking yogurts and cheeses
etc. For SEC C, SEC D and SEC E households where dairy penetration is poor (or non-existent in the
case of some SEC E households), higher incomes will enable them to increase their consumption of
dairy.

Noticeable shift in dietary habits

35%
% of average monthly food expenditure

Dairy Meat
30% Fish & Dried Fish Vegetables
Rice & Bread
25%

20%

15%

10%

5%

0%
1986 1991 1996 2002 2005 2007 2010 2013 2016

Figure 17 Source: Department of Census and Statistics, JBS Research

Rising incomes are also spearheading changes in the population’s diet. The above figure implies that
over the last 30 years there has been a significant decline in carbohydrates’ share of the stomach (rice
and bread). There have been simultaneous improvements in the penetration of proteins (meat and
fish) and dairy. With continued rise in incomes, we can expect households to seek increases in their
calorie intake, which is presently low. This will result in further improvements in the penetration in
high-calorie categories such as protein and dairy at the possible expense of declines in carbohydrates.

The dominant form of dairy consumption is powdered milk as opposed to liquid milk. This is due to
milk powder’s longer shelf life, no refrigeration requirements and relatively cheaper cost (in liquid

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Shifting away from milk powder to fresh milk

Fresh milk, 2%

2007 Milk Powder, 86%

2016 Milk Powder, 77%

Fresh milk, 4%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Yoghurt/Curd Butter Cheese Other

Figure 18 Source: Household Income & Expenditure Survey, JBS Research

milk equivalent terms). However, consumption is gradually shifting away from milk powder with rising
household incomes, as consumers focus on high-margin dairy products such as fresh milk and yogurt.
Ambewela, the market leader in fresh milk, witnessed a 10-15% volume growth during 2018 and
expects this trend to continue, according to management.

Improvement in local dairy consumption

300
Dairy consumpion per capita (in kg)

60

250 50

200 40

150 30
Global average = 111.3 kg
100 20
55.5
50 10

0 0
Australia

India
Canada

Indonesia
Mexico
New Zealand

Brazil

Japan

Taiwan
China
United States

Philippines
Sri Lanka

Figure 19 Source: CLAL, Department of Animal Production and Health, FAO, JBS Research

Although Sri Lanka’s per capita consumption of dairy (~55.5 kg) is above some of its peers, it is still
half the level of the global average, underscoring room for further increases. There has already been
significant growth in per capita consumption from the ~35 kg observed in 2008.

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Dairy prices are currently subject to a multitude of politically-sensitive policies

a) Retail prices of milk powder are subject to maximum ceiling prices to ensure affordability

450
Milk powder prices are controlled amidst volatile global prices
400
350
Price/Cost per 400g

300
250
200
150
100
50
-
Apr-11 Apr-12 Apr-13 Apr-14 Apr-15 Apr-16 Apr-17 Apr-18
Global Price MRP

Figure 20 Source: Department of Census & Statistics, Bloomberg, JBS Research

Milk powder is deemed to be an essential item and therefore its price is controlled by the Cost of
Living Committee and Consumer Affairs Authority, to ensure affordability. Given that majority of the
country’s milk powder consumption is fulfilled via imports, global milk powder prices, as well as
exchange rate volatility aid the authorities’ decision-making process.

The price control makes milk powder significantly cheaper than alternatives, thus contributing to its
dominance in dairy consumption. At present, 400g of milk powder (which is 3.4 liters in liquid milk
equivalent terms) is priced at LKR 345. This implies that 1 liter of milk powder (LME) costs LKR 100
compare to UHT fresh milk that is priced at LKR 220. These price controls are hampering the necessary
switch from milk powder to fresh milk.

The price control formulas demonstrate flaws. Consumers do not always fully benefit from declines
in global milk powder prices. The decrease in the control price of milk powder from LKR 386 to LKR
325, represents a decline of 16% (red triangle) whilst global milk powder prices more than halved.
Furthermore, the more recent 6% increase (green triangle) in control milk powder price to LKR 345
was followed by declines in the global milk powder prices.

At present, many large milk powders importers are making losses as the price control fails to
accommodate global milk powder costs. Importers of milk powder are further squeezed from the
cost-end via taxes on imports (which varies contingent on global milk powder prices) and CIF. In June
2017, import duties on milk powder were slashed from LKR 225 (20%) to LKR 2 due to recovering
global milk powder prices. Presently, import duties are LKR 15.

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b) Farm gate milk prices are subjected to floor prices to encourage local production,
hampering the affordability of fresh milk

Unwarranted acceleration in farm gate prices

70

60

50 LKR 31.79
LKR per liter

40

30

20

10

0
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Figure 21 Source: Department of Animal Production and Health, JBS Research

Dairy farmers receive a minimum (farm-gate) price per liter of milk supplied, thus guaranteeing farm
incomes. In 2017, the average farm gate price per liter of milk was LKR 66.48, which significantly
exceeded the average cost of production per liter of LKR 34.69 7. According to industry sources, the
current farm-gate price ranges between LKR 75 – 90. This is almost double the price received by a
New Zealand farmer, indicating that local farm gate prices are too high.

Locally produced milk is largely used for value-added dairy products such as UHT milk, flavored milk,
yoghurts, cheeses and ice cream, since majority of the milk powder demand is met by imports. High
farm-gate prices for milk push up the cost of production for these dairy products and subsequently
the final retail prices. Therefore, high farm gate prices contribute to the current price differential
between milk powder and fresh milk that deters fresh milk consumption.

3.1.2. Changing consumer lifestyles has sparked a favorable shift in consumer diet
Urbanization aids the shift from powdered milk towards fresh milk and value-added dairy
products.
As depicted in Section 1.1.2, urbanization has been improving in cities other than the highly-urbanized
capital, Colombo, thus opening new geographic markets. This bodes well for the dairy industry, as an
outcome of urbanization is increased consumer sophistication, which will subsequently raise demand
for value-added dairy products.

At present, fresh milk and other value-added dairy products are perceived to be more affluent
relative to milk powder. A contributing factor to this perception is the significant price differential that
was described in the previous section that makes milk powder more affordable. Fresh milk also
commands a much superior taste. Other dairy products, such as yogurt and cheeses are significantly
underpenetrated, with consumption being concentrated in urban populations.

7
It should be noted that data obtained from government departments may be subject to inaccuracies

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Dairy products deliver a wealth of health and nutritional benefits that bode well for demand
a) Health-conscious consumer cohort is expanding
As discussed in the demand drivers for frozen confectionery (Section 2.1.3), there is an emergence of
a health-conscious trend. This bodes well for the dairy industry due to the wealth of nutrients they
provide and their importance in composing a balanced diet. At present this consumer cohort is
relatively niche, as they are more prevalent amongst SEC A households which only account for 8% of
total households. Therefore, impact on the dairy market attributable to increasing health-
consciousness may only be marginal in the short run.

Milk and other dairy products are rich in nutrients. They are a vital source of calcium, vitamin D,
protein, riboflavin, phosphorus, vitamin B and potassium. Together they promote strong bones and
teeth, body growth, healthy blood pressure, red blood cell production, good vision, healthy skin and
metabolism.

Furthermore, there are different variants of milk based on percentage of fat contained. Common
variants of milk based on fat percentage include whole milk (~ 3.5% fat), semi-skimmed milk (~ 1.5%
fat) and skimmed milk (< 0.3% fat). Regardless of the fat percentage, the essential nutrients including
protein, calcium and vitamin D are present, thus allowing the individual to achieve health goals (such
as weight loss, weight gain, muscle-building etc.).

b) Regulations and sugar taxes to promote healthy consumption may expand to include
value-added dairy products
The current government has emphasized on the health and well-being of the population by deterring
consumption of unhealthy foods in favor of healthier foods. Some ready-to-drink dairy beverages
have high added sugar content and are thus susceptible to adverse health-based policies.

Under the current government, various policies and taxes have been implemented to inform
consumers of their purchases as well as discourage unhealthy consumption. This includes a ‘traffic
light system’ that indicates the sugar content using a color code. (Red for sugar content >11g, amber
for sugar content between 2g and 11g and green for sugar content less than 2g)8. Currently RTD dairy
products are exempt from the traffic light system.

Furthermore, in late 2017, an excise tax on sugar content was imposed on carbonated soft drinks that
resulted in their prices jumping as much as 40%. Consequently, CSD industry volumes have fallen
sharply by as much as 30%.

Given the success of the laudable sugar tax on CSDs, there is significant potential for this tax to be
extended to non-CSD drinks and confectioneries. This will impact value added dairy drinks as well. For
example, Milo, a popular malt-based dairy beverage of Nestle has a total sugar content of 16.7g in a
single serving (180ml) of which 8.5 g is sucrose.

On-the-go lifestyle emphasizes the need for convenient packaging

The increasingly time-pressed schedules of consumers require the dairy industry to adjust its form of
offerings. This includes convenient packaging tailored for individual consumption on the go, such as
single-consumption milk packets. Even within the yogurt sub-industry, there is a slight shift away from

8
Grams of sugar per 100 ml. Source: Ministry of Health, Nutrition and Indigenous Medicine.

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spoonable yogurts towards drinking yogurts due to the convenience in consuming the latter over the
former.

3.1.3. Seismic shifts in demographics are a potential tailwind due to importance of dairy
for senior citizens

Population above 60 is projected to accelerate

25,000

20,000 27.6%
Population ('000s)

0-14 15-59 60+

15,000

55.1%
10,000
7.3%

5,000 52.6%

40.1% 17.3%
-
1950 1975 2000 2025* 2050*

Figure 22 Source: United Nations Population Division, JBS Research

Dairy is a vital component of a balanced diet. This results in the dairy target market being synonymous
with the entire population as discussed earlier. However, the intake of dairy is more important for
growing children and senior citizens. The current rapidly ageing population is therefore expected to
have a marginally favorable impact on dairy demand.

The population above 50 are at risk of developing osteoporosis, a condition that results in loss of bone
mass or density thus weakening them. Women over the age 50 are 4 times more likely to develop this
condition. Thus, dairy products play a particularly important role for this age group by providing the
necessary calcium and protein that improve bone health and density, and thereby reducing the risk
of osteoporosis.

Currently the proportion of the population above 65 is slightly above 10% of the total population
which is high compared to neighboring country India (where the respective statistic is 6%). According
to projections made by UN, this proportion is expected to significantly increase to 12.3% in 2025 and
21.3% in 2050. Furthermore, the growth in population is expected to decelerate due to lower birth
rates (the number of live births per 1,000 people declined from 18.6 in 2006 to 15.3 in 2016.), thus
seeing a projected decline in the population in age group 0 – 14 from 2025 onwards.

Calcium in dairy products is also vital for growing children to strengthen their bones and teeth as their
bodies grow. Although the population with ages 0 – 14 is expected to decline, it is not a cause of
concern for the dairy industry, as dairy is still vital for all ages.

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3.2. Supply Analysis

3.2.1. Government emphasis on achieving self-sufficiency in dairy to curb the level of
imports
Dairy self-sufficiency rate is low compared to region

North America
108% Europe Asia
111% 90%

Central America
78% Africa
83%
Sri Lanka
South America 40%
101%
Oceania
309%

Figure 23 Source: International Dairy Foods Association, JBS Research

Local dairy production meets only 40% of local consumption, a slight decline from the 42%9 that was
observed in 2016. This is significantly low compared to the Asian region which averages 90% self-
sufficiency. This shortfall in dairy supply is met by imports, primarily from Australia and New Zealand.
The over-reliance on dairy imports places a strain on the current account particularly during periods
of currency depreciation. Consequently, the government has indicated a goal of achieving dairy self-
sufficiency.

The lack of dairy self-sufficiency is a relatively recent phenomenon, as Sri Lanka had self-sufficiency
levels of ~80% in the 1970s (prior to the opening of the economy in 1977). The decline in self-
sufficiency occurred due to the opening of the economy that allowed consumers access to higher
quality dairy products, which resulted in dairy demand surpassing local dairy supply. In 2017, the
country imported 99.8 million kilos of milk and milk products, growing at a 5-year CAGR of 2.7% (in
per capita terms this translates to 4.4 kilos). The import bill on dairy amounted to LKR 48.1 billion10.

An exemplary success story of boosting dairy self-sufficiency belongs to Qatar, rapidly growing from
24% in May 2017 to 84% by mid-2018 (sparked by the siege imposed by its neighbors). This was aided
by private sector investment projects and assistance from the relevant ministry.

Local milk production so far has demonstrated a rising trend (Figure 24). This is partially attributable
to increases in farm-gate prices that encourage local dairy farmers to increase milk supply, and the
selling and distribution of high-yielding cows that were imported by the government.

9
A rate greater than 100% indicates that the country or region is a net exporter of dairy
10
Department of Animal Production and Health, Central Bank of Sri Lanka

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Local Milk Production Litres (mn)

500 Local milk production on the rise

400
Buffalo Milk

300
Cow Milk

200

100

-
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Figure 24 Source: Department of Animal Production and Health, JBS Research

3.2.2. Excess in milk production over milk collection

500
Milk: Production vs. Collection
450
400
350
300
Million Litres

250
200
150
100 52.5% 51.5% 54.2% 50.8% 58.7%
50
-
2013 2014 2015 2016 2017

Figure 25 Source: Department of Animal Production and Health, JBS Research

Although milk production has been leading an optimistic trend, milk collection (by the 14 main milk
processors in the formal market) only account for just over half of the total milk production.
Furthermore, of the total milk collected, roughly half is purchased by the two largest milk processors
(Milco for its brand Highland, and Nestle).

Due to majority of the milk powder requirements being met by imports, local milk production is largely
collected by milk processors for the production of value-added dairy products (fresh milk, yoghurts,
cheeses and more). However, with farm-gate prices pushing up costs of production, final retail prices
of these products are high, and deemed relatively unaffordable (Figure 21). This shrinks the market
size for such products, ultimately being too small to absorb the total local milk production.

Liquid milk is highly perishable and requires rigorous storage conditions for safe consumption.
Therefore, local dairy processors face two options with surpluses in milk collected; dispose of it or
convert it to milk powder. The maximum retail prices on milk powder disincentivize the latter option.

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3.2.3. Industry currently dominated by smallholder dairy farmers, thus stalling the progress
of local milk supply growth
Smallholder dairy farmers lack scale efficiencies and technology
Small holder dairy farmers dominate the industry with approximately 300,000 registered farms
supplying 90%11 of the total milk collected. Such farmers operate on a much smaller scale with usually
3 to 4 cows, and lack the knowledge and training required for dairy farming. Furthermore, given the
perishable nature of animal milk, adequate storage facilities are required to keep the milk fresh.
However, majority of the smallholder dairy farmers lack these storage technologies resulting in milk
being discarded.

An exemplary local large-scale dairy farm that demonstrates the benefits of large-scale farming is the
Ambewela farm (owned by Lanka Milk Foods PLC), with approximately 2,100 cattle of Ayrshire and
Friesian breeds. The milking process at the Ambewela farm is completely automated. Furthermore,
grazing lands are cultivated with ryegrass (which is high in protein) and the cattle are fed with
scientifically-formulated feed to enhance yield and quality of milk.

There has been increased interest in commercial dairy farming within the local industry as indicated
by investments. Watawala PLC, a large agri-business, recently entered the dairy industry by investing
in 1,200 cows that generate an average of 13,000 liters of milk per day (11 liters per cow).
Furthermore, Lanka Milk Foods PLC is investing LKR 2 billion in the machinery of its Ambewela farm
that will boost milk production levels.

Dominance of smallholder dairy farmers contribute to poor milk yields

The lack of technology adopted by smallholder dairy farmers also contribute to the problem of low
milk yields that is prevalent in the local dairy industry. Presently such farms yield on average 3 to 5
liters of milk per cow in a day. This is significantly low compared to milk yields in New Zealand that
average between 30 to 50 liters12.

Poor milk yields are the result of low-cost production techniques as well as the breed of cows.
Smallholder farms tend to engage in low-cost production techniques due to lack of profitability in
adopting advanced technologies. For example, hand milking is the current practice as opposed to
employing milking machines which generate higher milk yields in a shorter time period. Furthermore,
the cattle are fed normal grass as opposed to the proper feed that is required due to higher costs of
the latter. This dampens cow milk yields.

Ambewela on the other hand, uses milking machines and carefully formulated cow feeds and
therefore generates milk yields of approximately 25 liters per cow in a day, thus demonstrating the
importance of large-scale dairy farming.

11
Newspaper article
12
Local industry expert

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3.3. Competitive Analysis

3.3.1. Cargills, through its brand Kotmale, commands a wide presence in the fragmented
dairy industry

Dairy Categories Kotmale Ambewela Highland Anchor Nestle RichLife Pelwatte

Parent Company Cargills Lanka Milk Foods Milco Fonterra Nestle Renuka Pelwatte
Fresh Milk
Flavored Milk
Powdered Milk
Yoghurt
Drinking Yoghurt
Curd
Butter
Cheese
Fresh Cream
Table 7 Source: JBS Research

The largest sub-segment of the dairy industry is the milk powder sub segment which accounts for
approximately 77% of total dairy expenditure. Fonterra, through its brands Anchor and Ratthi, is the
market leader of the milk powder segment, importing their milk powder from the Oceania region.
Competition in this segment is quite subdued due to capped retail prices. Many large milk powder
brands are making losses and on the brink of exiting the milk powder market.

Yogurt and curds account for the next largest share in household dairy expenditure. The local yogurt
preference is for set yogurt (in which gelatin is added causing the resultant texture to resemble jelly).
Market share results for yogurt brands are largely varied with both Anchor and Highland vying for
market leadership.

Ambewela is currently the market leader of the fresh milk sub-segment. Their management attributes
this leadership to their own two farms (Ambewela and New Zealand farms) from which they source
milk. This enables more stringent quality control as opposed to their competitors who collect milk
produced by smallholder dairy farmers which is often inconsistent in quality.

Figure 26 Source: JBS Research

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3.3.2. Poor brand loyalty in the dairy industry has resulted in competitive pricing in major
segments

Dairy Categories Kotmale Ambewela Highland Anchor Nestle RichLife Pelwatte

Fresh Milk 220 220 200 220 220 220
Flavored Milk 45 50 35 45 40 50
Powdered Milk 295 345 345 345
Set Yoghurt 35 35 35 35 35
Drinking Yoghurt 70 75 70
Table 8 Source: JBS Research

The UHT-treated fresh milk segment has little scope for differentiation and thus fails to garner brand
loyalty. This restricts the ability to charge a price premium, as all brands (except Highland) charge LKR
220 per liter. Tetra packaging accounts for a sizeable proportion of the final retail price (as much as
20% according to industry sources).

A similar observation is seen in the set yoghurt market, where all brands price their standard 80 ml of
set yogurt at LKR 35.

However, the flavored milks and flavored drinking yogurts have better scope for differentiation,
resulting in pricing differentials between brands. Kotmale’s flavored milk is priced in the mid-range.

3.3.3. Market leader, Ambewela is growing rapidly relative to Kotmale

Ambewela growing faster than Kotmale YoY growth

4,500
9.1%
4,000 15.9%
3,500
Revenue (in LKR millions)

37.4%
3,000
2,500 10.6% 8.6%
13.9% 15.9%
2,000 22.1%
-35.5% 6.0%
1,500
Ambewela
Kotmale

1,000
500
0
2013 2014 2015 2016 2017 2018

Figure 27 Source: Company Data

Ambewela and Kotmale are both listed stand-alone dairy companies. As expected, Ambewela13 is
much larger than Kotmale (in revenue terms) given that it is the market leader in fresh milk and
controls a sizeable share of the yogurt market. Furthermore, Ambewela has been growing at a faster
rate as well.

13
Revenues from powdered milk are excluded from Lanka Milk Foods to determine the revenues generated by
the Ambewela brand that operates in the fresh and value-added dairy segments.

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4. Quick Service Restaurants

4.1 Industry Analysis
We define a quick-service restaurant (QSR) to be a restaurant that serves fast food full meals with the
speed of service being a priority. The typical format of a QSR is to have a menu displayed behind the
counter, consumers paying for their meals upfront and minimal table service.

4.1.1. Affordability of QSR meals is improving

Household incomes of target market are on the rise
As discussed in earlier sections, household incomes have been rising across all SECs (Figure 3). The
impact of increasing household income across the SECs on the QSR industry is two-fold. Firstly, it
allows the main target consumers of QSRs to increase their consumption occasions (for e.g. increase
the number of occasions they consume meals from QSRs in a month). Secondly, it expands the
boundaries of the QSR target market, as households for which QSR meals were previously out of
reach, may enter the market. We define the target market to largely comprise of SEC A and SEC B
households. SEC A households have a wider choice of out-of-home meal options due to better
affordability. The QSR target market makes up 33% of the total household population.

QSR meals are generally perceived as an indulgence and thus consumed on occasion. The average
frequency of QSR consumption is approximately once a month, with the more loyal consumers making
purchases once a week. Therefore, the QSR industry is under-saturated with plenty of room for
improvement. A continued increase in household incomes will significantly improve the consumption
frequency amongst current customers.

The perception of fast food in developed countries is significantly different, where such meals are
typically viewed as cheap and of poor quality. In such countries, QSRs typically target lower-middle
income and low-income households, where consumption frequency often ranges between once a
week to a couple of times per month.

In the current local operating environment, however, consumers are witnessing tightened purchasing
power. Many international QSR chains have witnessed a decline in transaction volumes due to poor
consumer confidence.

QSR meals cost more than home-cooked meals but are an affordable form of out-of-home
consumption
Style Sample Size Average Cost for two14
Fine Dining 29 5,224
Casual Dining 35 3,071
Café 13 2,500
Fast Food 7 1,500
Street kiosks 6 400
Table 9 Source: Zomato, Yamu, JBS Research

14
Prices were obtained from a sample of 77 restaurants from Zomato, a popular restaurant search and discovery
platform. Zomato computes its cost for two using 2 mid-ranged appetizers, 2 mid-ranged mains, 2 beverages
and 1 mid-ranged dessert.

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The default choice for obtaining meals for a typical household is via home-cooking, primarily due to
its perceived lower cost. However, once the opportunity cost of time spent travelling to grocery stores
to obtain ingredients and subsequent preparation of the meal are factored in, the economics of home-
cooking are not advantageous.

Amongst the choices of out-of-home meals available to a typical household, fast food served by QSRs
is relatively inexpensive. This is important given a largely price-sensitive population. The most
inexpensive form of out-of-home consumption is the plentiful stand-alone street kiosks, popularly
referred to as buth kade in the local language. They serve rice and curry, hoppers, string hoppers and
other traditional food with the aim of emulating home-cooked meals minus the hassle of preparation.
Prices of a single serving can range between LKR 150 – LKR 250.

At the other end of the spectrum are fine-dining and casual-dining establishments, whose presence
has grown exponentially in the past few years and are only concentrated in the urban areas of
Colombo. Given their pricing range, they typically target SEC A households and thus have little overlap
with the QSR target market.

QSR meals are relatively expensive on a PPP basis, as revealed by the Big Mac Index 15

Sri Lanka's Big Mac is priced relatively higher in July 2018

90,000
Switzerland
80,000 Today June 2018
USD 3.23 USD 3.64
GDP per capita (in USD)

70,000 Qatar
Singapore United States
60,000 Denmark

50,000 Hong Kong Australia Canada

UAE Britain
Japan
40,000
Kuwait
30,000 Bahrain

20,000 Czech Republic

Turkey Saudi Arabia
Mexico Hungary Brazil
10,000 Russia China Thailand
Malaysia Philippines
VietnamPakistan Sri Lanka Regional peers
- Indonesia India
1.5 2.5 3.5 4.5 5.5 6.5
Big Mac Price (in USD)
Figure 28 Source: The Economist, World Bank Data, JBS Research

It is observed that QSR meals in Sri Lanka are approximately 20% - 40% more expensive given its GDP
per capita, using McDonald’s signature product, Big Mac, as a proxy. Furthermore, QSR meals in Sri
Lanka are priced above its regional peers, with the exception of Singapore. This implies that QSR meals
are not as affordable as they should be.

However, there are various factors that may hinder a perfect comparison of Big Mac prices. The
primary factor is the exchange rate volatility, as Big Mac prices are converted from their respective

15
The Big Mac Index is a currency comparison tool developed by The Economist. Its intended use is to gauge
the country’s exchange rate purchasing power parity using a standardized item such as the Big Mac. It is a back-
of-the-envelope calculation of the implied currency valuation. For example, in July 2018, according to the Big
Mac prices in Sri Lanka and United States, the implied exchange rate is USD 1= LKR 105.26, however, the current
spot rate was LKR 159.27 loosely suggesting that the Sri Lankan rupee is 33.9% undervalued.

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local currencies to the US Dollar. The Sri Lankan rupee experienced an unusually large depreciation
against the dollar in 2018, at ~17.4%. Based on the current exchange the Big Mac would now be priced
at USD 3.23. Furthermore, in adherence to global McDonald’s standards, ingredients must be
imported which result in Big Mac prices varying according to the respective country’s import duties.
Beef consumption is constricted in some countries such as India and Sri Lanka, making the beef-based
Big Mac relatively unpopular.

Big Mac price outpacing inflation

600

500
Big Mac Price (in LKR)

400

300

200

100 14-year CAGR = 10.7%

Figure 29 Source: The Economist, JBS Research

The Big Mac can also be used as a proxy for movements in average fast food prices offered by
international QSR chains. The above figure shows that fast food prices have seen a rapid escalation.
The Big Mac however serves as a weak proxy, as it is a beef-based product for which the beef is
imported and thus subjected to import duties. According to McDonald’s Sri Lanka management, only
30% of their sales volume is attributable to beef products, whilst the McSpicy chicken burger (LKR
530) claims the highest selling menu item.

4.1.2. Consumer lifestyles are changing

Urbanization spearheading shifts in consumer tastes
As discussed in section 1.1.2, Sri Lanka is currently experiencing an accelerated urbanization process,
which plays a significant role in bolstering the QSR industry. A characteristic of urbanization is
changing lifestyles brought about by increased international exposure through media influence and
foreign travel. The implication for the QSR industry is that the increasingly cosmopolitan consumers
wish to expand their palate beyond traditional local meals as they seek new food experiences such as
foreign cuisines. International QSR chains act as a gateway for international cuisine experiences as
consumers are able to experience imported menus at relatively lower costs.

Currently, the standard Sri Lankan meal is dominated by carbohydrates such as rice, string hoppers
and hoppers, with vegetable curries and meat curries serving as accompaniments, as demonstrated
in Figure 30. The urban population is more curious to trying new more varied cuisines, including fast
foods such as burgers and pizzas, whose flavor profiles are different from the traditional meals.

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Figure 30 Source: Instagram user nisha_tucker

The importance of urbanization for increasing the penetration of international fast food is recognized
by QSR chains as they are largely located in the urban areas of major cities such as Colombo, Gampaha
and Kandy (Figure 33). Although consumers seek international meal experiences, a degree of
localization is necessary. Many localized menu items are spicier due to the population’s inherent
inclination towards spice. Many QSR chains also include their version of the traditional ‘rice and curry’
which has proven to be popular. According to KFC management, 20% of their revenues arise from rice
menu items.

On-the-go lifestyle emphasizes the need for convenience in meal consumption

a) QSRs provide various means of off-premise dining for the convenience of a relatively busy
population.
Over the last decade, the urban population has experienced an increasingly time-pressed schedule. A
larger proportion of an individual’s day is spent working and traveling and there is an increase in the
number of dual earning households. Consequently, consumer lifestyles have changed with more
emphasis on obtaining convenience to accommodate their schedules. This change bodes well for the
QSR industry as their primary objective is to offer meals that focus on convenient packaging and
speedy service. QSR chains also facilitate off-premise consumption via take-away, drive-throughs and
delivery. Although QSR meals play a vital role in aiding convenience, we believe that at present,
consumers purchase such meals with more weighting placed on its indulgence factor rather than its
convenience factor.

The proportion of the workforce working more than 40 hours a week increased from 63% in 2011 to
69.3% in 3Q-2018. This is indicative of a workforce that spends more time at work and travel, thus
reducing their hours spent at home. Furthermore, the urban female labor participation rate has
increased from 30.6% in 2012 to 34.2%16 in 2017, which demonstrates that the number of women
choosing to manage the household on a full-time basis including the preparation of meals, is
diminishing. This contributes to a rising demand for out-of-home meals.

Many QSR chains have product offerings that allow consumption on the go. For example, hamburgers
are constructed such that all the ingredients are tightly sandwiched between two buns which allows

16
Sri Lanka Labour Force Survey

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consumption with minimal mess. This contrasts with traditional meals of rice and various curries
which is rather dispersed and often consumed by hand.

Another value proposition of the QSR industry is its ability to provide off-premise dining due to the
ease of eating of their menu offerings and packaging that aid carriage. Off-premise dining is facilitated
through take-away, drive throughs and delivery, and form an integral part of sales volumes for QSR
chains. According to industry sources, delivery accounts for ~30% of McDonald’s sales volumes, and
roughly half of Pizza Hut’s sales. KFC’s delivery volumes are still nascent, accounting for only 8% (39%
of the transactions are packed as take-away), but on the rise. Pizza Hut’s relatively larger proportion
of delivery sales are due to its three delivery hubs and conscious effort to focus on delivery-based
transactions.

Some QSR chains such as McDonald’s, Burger King and Subway offer a breakfast menu that starts
serving as early as 7 am further increasing their value proposition.

b) Rise of third-party food delivery apps and services improves consumer choice and
threatens QSR’s take-away and delivery sales

Figure 31 Source: JBS Research

The increased emphasis that the time-pressed consumers have placed on convenience has resulted
in a surge in third-party food delivery apps operating in Colombo over the last few years. Such services
significantly expand the choice available to consumers, thus revolutionizing the off-premise dining
experience. This trend may potentially threaten the take-away and delivery sales of QSR chains in the
medium term. The short-term impact, however, is limited due to the prevalence of eat-in trends still
observed by the QSR chains. Furthermore, third party delivery apps are available in limited areas of
Colombo and hinge on the availability of smartphones.

In the recent past, food delivery in urban areas was largely confined to international QSR chains such
as Pizza Hut and Domino’s, limiting consumer options for convenient food delivery for home
consumption. The choice expanded significantly with food-delivery apps. In mid-September 2018,
international food delivery app Uber Eats entered the market, joining local players such as Quickee
and PickMe Food. With Uber Eats, a variety of over 150 restaurants, cafes and smaller street kiosks

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are available in just one app, thus empowering the consumer with significant choice relating to price
ranges, cuisines and even healthy options.

These apps however require a smartphone, whereas the QSR chains’ delivery systems have a hotline
that can be reached via any mobile or landline connection. At present smartphone penetration is
estimated to be around 60%-65%17. However, active use of smartphone penetration18 is lower as
depicted below. Such apps are therefore more likely to be used by SEC A and to a lesser extent, SEC B
households.

Digitalization of Sri Lanka, January 2018

Figure 32 Source: We Are Social, JBS Research

Increasing proportion of consumers are becoming health-conscious

Meals served by QSR chains, often defined as fast food, have come under intense scrutiny at the global
level for their unhealthy nature and plethora of health-related problems they cause. Fast food is
deemed to be one of the causal factors for the obesity epidemic in North America. However, at
present, the health concerns of fast food in the local QSR industry are benign. This is primarily due to
fast food being perceived as an indulgence and therefore consumed less frequently. Furthermore, this
trend is currently limited to SEC A households.

The premise of fast food is an emphasis on affordability and convenience. Therefore, they tend to be
highly processed and contain high amounts of preservatives, sodium, and unhealthy fats (saturated
and trans fats). The American Heart Association recommends a maximum of 2,300 milligrams (mg) of
sodium per day. Table 10 indicates that some menu items exceed half the daily recommended intake.
Excessive sodium intake is linked to obesity, high blood pressure, heart problems and increased risk
of stroke amongst other health concerns. Furthermore, fast food chains often promote carbonated
beverages alongside their meals, which are high in sugar and increase the risk of diabetes.

17
Dialog Axiata PLC management
18
Active mobile social media users are a reasonable proxy for gauging smartphone penetration, as social
media often tend to be amongst the first apps consciously downloaded

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Total Fat Sodium Sugars Protein

Calories
(in g) (in mg) (in g) (in g)
McDonald's Beef Big Mac 540 28 940 9 25
McDonald’s Fried Chicken Burger 630 29 1,030 11 28
McDonald’s Filet-O-Fish 390 19 560 5 17
KFC 2 pieces of Spicy Crispy Chicken 480 28 1,520 0 39
KFC 2 pieces of Grilled Chicken 290 11 930 0 49
Burger King Beef Whopper 660 40 980 11 28
Burger King Spicy Crispy Chicken Burger 670 42 1,080 8 25
Pizza Hut 2 slices of Hawaiian Chicken 720 32 1,500 6 34
Pizza Hut 2 slices of Cheese Pizza 760 38 1,400 2 32
Subway 6-inch Spicy Italian 470 24 1,550 6 19
Subway 6-inch Chicken Teriyaki 370 4.5 770 16 25
Subway 6-inch Oven Roasted Chicken 320 5 620 8 23
Table 10 Source: Company websites, Nutritionix, JBS Research

4.1.3. Demographic shifts are unfavorable for QSR chains

QSR meals are largely targeted towards children, teenagers, and middle-aged adults. An approximate
target age cohort for the QSR industry is between ages 6 and 60. Consumers aged above 60 are
strongly advised against fast food, as senior citizens are more prone to health problems. Many senior
citizens also experience a gradual, natural aversion to such meals.

The country is expected to see a rapid growth in the proportion of the population above 60 (which
was elaborated earlier in section 3.1.3). However, we do not expect the projected demographic shifts
to have a detrimental impact on the QSR industry, largely due to QSR meals still being an occasional
indulgence. QSR chains continue to observe sales from senior customers.

Fast food menu items are high in sodium, saturated fats and trans fats which are even more
detrimental to senior citizens. For example, seniors are recommended a sodium intake of no more
than 1,500 milligrams per day by the American Heart Association. However, in some fast food menus,
a single main menu item alone contains more than 1,500 mg of sodium (Table 10).

4.2. Competitive Analysis

4.2.1. KFC is the market leader in terms of total sales per annum
Kentucky Fried Chicken (operated by Cargills) is the current market leader of the local QSR in terms
of revenues per annum. In the financial year ended 31 March 2018, KFC generated revenues of LKR
3.6bn (an average of LKR 116mn per outlet). This market leadership position is attributable to the
popularity of its menu items and its better value for money proposition, both of which will be
discussed in subsequent sections.

However, McDonald’s leads the industry in terms of revenue per outlet, given their much smaller
outlet footprint and selective locations.

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4.2.2. Pizza Hut has a wider reach courtesy of its higher outlet count and an emphasis on
delivery
Year of Entry Local Outlet Count Global Outlet Count
KFC 1995 35 20,404
McDonald's 1998 11 37,200
Burger King 2014 20 16,859
Pizza Hut 1993 58 16,859
Subway 2014 4 42,998
Domino’s 2000 20 15,000
Taco Bell 2017 2 7,000
Table 11 Source: JBS Research

QSR footprint in Colombo

Figure 33 Source: Google maps, JBS Research

Pizza Hut dominates the local QSR industry in terms of outlet count, followed by KFC, Burger King and
Domino’s. This is in stark contrast to the global QSR industry, in which health-focused Subway
dominates the outlet count, followed by McDonald’s. Pizza Hut is the first large international QSR
chain to enter the country thus allowing it to benefit from first-mover advantage by garnering stronger
brand recognition and loyalty.

Despite McDonald’s relatively early entry, its outlet footprint of 11 is relatively low, due to much
higher capital expenditure requirements per store. Instead, McDonald’s leverages on its global brand
value as the world’s most iconic fast food chain, thus yielding the highest revenue per store amongst
its competitors.

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QSR chains are also beginning to enter untapped markets including large urban cities such as Kandy
and Galle. KFC recently launched its outlet in the eastern city, Batticaloa, which was well-received,
due to lack of out-of-home meal choices in such areas.

4.2.3. QSR chains serve a broad array of international menu items adopted to local tastes
Kentucky Fried Chicken (KFC) – KFC’s signature menu item is their pressure fried chicken pieces
seasoned with 11 herbs and spices that are a prominent trade secret. Although majority of their menu
items are fried, they do include grilled chicken which is a relatively healthier option. Apart from fried
chicken, they also serve ‘Zinger’ burgers (which include a vegetarian option), wraps and various rice
dishes that feature their signature fried chicken. Accompaniments to the meal include French fries,
chicken popcorn (mini pieces of boneless chicken), KFC Krushers (dairy-based drinks similar to
milkshakes), and ice cream. KFC’s menu only features one type of meat; chicken, which is the most
widely consumed meat type in the country.

McDonald’s – Specializes in fast food hamburgers. Its signature product is the beef Big Mac, which
consists of two beef patties and American cheese, but they also sell a chicken variant. Other main
menu items include beef burgers, cheese burgers, fish burgers, and a vegetarian burger. Menu items
that are a result of localization are the McSpicy Chicken Burger (best seller) and McDonald’s version
of rice and curry. They also serve fried chicken pieces that rival KFC’s fried chicken. Some of the
accompaniments to their mains are French fries, chicken nuggets, fried chicken wings, ice creams and
apple pie. McDonald’s also hosts a breakfast menu which includes hash browns, egg burgers and
pancakes as well as coffee.

Burger King – Specializes in fast food hamburgers. Its signature menu item is the flame grilled Beef
Whopper (and its chicken counterpart, Chicken Whopper). Other menu items are parallel to those of
McDonald’s including cheese burger, crispy chicken burger, fish burger, vegetarian burger, crispy
chicken pieces, rice and French fries. They also host a breakfast menu that comprises breakfast
burgers and coffees and begins serving at 6.45 am.

Pizza Hut – Specializes in pan pizzas. They serve a wide selection of toppings of different meats and
vegetables, many of them suited to local tastes (e.g. devilled chicken, tandoori chicken, butter chicken
Masala etc.). In Sri Lanka, Pizza Hut’s pepperoni pizza uses beef pepperoni due to its Halal
accreditation instead of traditional pepperoni which is made of a mixture of pork and beef. Although
their main offerings are pan pizzas which have thick, doughy bases, they offer a range of thin crust
pizzas and an “Italiano” range which attempts to mimic authentic Italian pizza. Other innovations
include crusts stuffed with either cheese or sausage. Apart from pizzas, Pizza Hut also serves a small
selection of pastas, calzones, quesadillas and rice dishes as well as appetizers such as garlic bread and
chicken wings, and desserts such as lava cake.

Domino’s – Specializes in pizza. They too offer a wide range of toppings with a variety of meats and
vegetables that are similar to those of Pizza Hut although their range is slightly narrower.
Furthermore, they also offer a limited range of pastas, calzones and rice dishes, along with sides such
as chicken wings, and garlic bread.

Taco Bell – Is a fast food chain that specializes in Mexican foods. The Mexican cuisine has a depth of
flavor and spice tolerance akin to the Sri Lankan cuisine allowing the chain to garner popularity
amongst the locals. Their signature items are tacos with a limited variety of chicken, fish and beef
fillings. Other main menu items that are popular in the Mexican cuisine are burritos, quesadillas and
chalupas with similar filings. Sides include Mexican fries, nachos and crispy chicken strips along with
some limited desserts and beverages.

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Subway – Specializes in serving submarine sandwiches. Subway identifies themselves as a fast-food

chain that promotes freshness and healthy eating (See Table 10). This is done through healthier
options such as freshly baked whole wheat breads, proteins and fresh vegetables. The menu allows
for consumer customization by choosing the type of bread, type of proteins, type of vegetables and
type of sauces to be used in the sandwich, although there are a number of pre-determined sandwich
options as well for convenience. Subway also includes a breakfast menu with breakfast-themed
sandwiches. Accompaniments to their main sandwiches are a range of cookies and packaged Lays
chips rather than French fries.

Figure 34 Source: JBS Research

4.2.4. KFC offers a greater value proposition than its competitors

McDonald Burger Pizza Taco
KFC 's
Domino's Subway
King Hut Bell

< LKR 149 11.9% 4.1% - - - - -

LKR 150 - LKR 299 11.9% 21.9% 18.8% 1.5% 8.9% 3.1% 1.1%
LKR 300 - LKR 499 28.6% 19.2% 26.6% 8.8% 13.0% 15.4% 25.8%
LKR 500 - LKR 749 11.9% 24.7% 25.0% 24.1% 11.4% 50.8% 31.5%
LKR 750 - LKR 999 14.3% 24.7% 21.9% 8.0% 10.6% 27.7% 33.7%
LKR 1,000 - LKR 1,499 7.1% 1.4% 4.7% 16.1% 20.3% - 7.9%
LKR 1,500 - LKR 1,999 7.1% - 1.6% 29.2% 21.1% - -
> LKR 2,000 7.1% 4.1% 1.6% 12.4% 14.6% - -
Total menu items 42 73 64 137 123 65 89
Table 12 Source: JBS Research

Pricing is important in the QSR industry due to the price sensitivity of its target customers, particularly
SEC B and C households who place a greater weighting on price relative to taste in purchase decisions.
The above table analyzes the affordability of menu items (including meals and sides but excluding
beverages) by depicting the proportion of menu items within each price range. Excluding the pizza-
based franchises, KFC’s menu is observed to have high affordability with 27% of its menu items priced
between LKR 300 – 500. KFC, McDonald’s and Burger King have 52%, 45% and 45% of their menu
items priced below LKR 500 respectively, thus emphasizing value for money.

On the other hand, Taco Bell is deemed to be relatively less affordable. Taco Bell Sri Lanka consciously
targets more upmarket consumers. This contrasts with Taco Bell in the United States, which is
considered to be cheap and unauthentic Mexican food targeted at the lower income households.

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KFC sources poultry, its main ingredient, locally, whilst herbs and spices, which form a small
proportion of ingredients, are imported. This enables KFC to achieve relative affordability as their
exposure to exchange rate volatility and import duties are low. McDonald’s import approximately 50%
of its ingredients (including all its beef and some of its poultry requirements.

Price of Average Meal

for a Family 19
KFC 2,405
McDonald’s 2,315
Burger King 2,560
Pizza Hut 2,470
Domino’s 2,484
Taco Bell 3,536
Subway 2,620
Table 13 Source: JBS Research

However, when considering the average family (of four members), all QSR chains except for Taco Bell,
have average family meal prices ranging from LKR 2,300 to LKR 2,600. Taco bell averages around LKR
3,500, with many combinations sitting above the LKR 3,000 mark.

QSR chains also conduct aggressive discounts and promotions (including many ‘buy one get one free’
offers) that do not necessarily center around festive periods. KFC sees its volumes rise as much as 60%
on promotion days. Such practices are short-term tactics and unsustainable in the medium to long
term.

4.2.5. Pizza-based QSR chains are more popular in Sri Lanka as opposed to the global brand
leader, McDonald’s

Facebook Likes Sri Lanka Facebook Likes Global

424,605
390,754 78,681,514

290,805
52,458,209
31,626,921
177,320
141,858 24,945,428
20,065,960
70,404 62,837 10,509,414
8,244,733

Figure 35 Source: JBS Research

There is a noticeable difference in popularity trends of various international QSR chains between the
Sri Lankan community and the global community. We observe that the pizza-based franchises, Pizza

19
Prices of an average meal was calculated for a family of four, including two adults and two children. Prices of
various combinations of menu items to form a meal for four were calculated, which included four drinks and
sides. An average of these various combination of meals were thus obtained.

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Hut and Domino’s Pizza are more popular (in terms of Facebook likes), despite pricing being similar to
other franchises. McDonald’s has built itself to be the most valuable restaurant chain globally, ranking
11th place on Forbes’ list of the world’s most valuable brands (with a brand value of USD 41.4bn).

We gauged the popularity of each chain based on the number of Facebook likes on each brand’s page
given that Facebook has the highest number of monthly active users amongst all social media sites.

5. Processed Meats
5.1. Industry Analysis
5.1.1. Improvement in affordability of processed meats is expected
Continued rises in household income will boost processed meats volumes
Household incomes have faced steady growth over the past eight years across all socio-economic
sectors (Figure 3). Consequently, this has increased their purchasing power for income-elastic
consumer discretionary goods (such as processed meats). In the medium run, we expect household
incomes to continue increasing, which will have a favorable impact on the processed meats market.

Penetration of processed meats amongst SEC A households is already high, therefore further growth
in their incomes will translate to less than proportionate growths in volumes. Such households will
instead demand more premium processed meats which carry higher margins.

SEC B and C households’ grocery baskets comprise largely consumer staples and therefore
penetration of processed meats is low in this segment. Increases in their household incomes will allow
them to begin indulging in discretionary items. Subsequently the volumes for processed meats will
grow as more consumers are able to afford them.

120
Sri Lanka's meat consumption amongst the lowest
100
Kilograms per capita

80
60
40
20 6.3
0

Figure 36 Source: FAO, OECD Data, JBS Research

According to the FAO, Sri Lanka’s meat consumption per capita is amongst the lowest in the world,
underscoring great potential for improvement in the country’s meat industry. This positive outlook is
also buoyed by the observation of rising meat consumption per capita depicted in the graph below.

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Meat consumption per capita rising rapidly

10
Per capita consumption (in kg)

8
Pork Mutton

6
Beef

2 Chicken

0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Figure 37 Source: Department of Animal Production and Health, JBS Research

High prices of meat have resulted in meat being an unaffordable necessity

1,900 Poultry prices are relatively volatile

1,700

1,500
Price per kg (in LKR)

1,300

1,100

900 Beef Chicken Pork Mutton

700

500

300

Figure 38 Source: Department of Census and Statistics, JBS Research

The country’s poor meat consumption per capita is partly explained by the high meat and poultry
prices faced by households. Consequently, this necessary source of protein remains out of reach for
a majority of the households, particularly in the rural areas.

High feed prices have contributed to the high meat prices. Prices of imported ingredients that are
used in animal feed have been artificially propped up by regulations to protect domestic producers.

Processed meats are priced higher than fresh meats due to value addition
Processed meats are priced higher relative to fresh meats due to value-adding procedures such as
curing, smoking, salting or addition of chemical preservatives. These are undertaken to either extend
the shelf life or modify the taste, which results in their price premium. This makes processed meats
more income elastic and out of reach to households at the lower end of the income spectrum.

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5.1.2. Faith-based abstinence place restrictions on consumption of certain types of meat

Another significant causal factor for the low meat consumption are the religious restrictions on a large
proportion of the country’s population. Buddhism is the largest segment, comprising 70% of the
population, followed by Hinduism (13%), Islam (10%) and Christianity/Catholicism (7%)20.

Various religions have rules prohibiting and discouraging the consumption of different types of meats.
This shrinks the target market for those specific meats. The impact of these religious taboos is more
profound in Sri Lanka due to its multi-religious demographic, resulting in low per capita consumption
for certain types of meat. However, urbanization will ease some of the pressures faced by the meat
industry due to more relaxed religious practices.

In Buddhism, restrictions and taboos on meat consumption are less pronounced. A proportion of Sri
Lankan Buddhists practice vegetarianism, some consume fish and other seafood but not meats, whilst
some consume all meats except beef. In Islam, the consumption of pork is strictly forbidden.
Furthermore, they cannot consume other types of meats that have not been prepared in a halaal
manner (slaughtered according to the prescribed method as per the Islamic Law). Hinduism’s respect
for cows has resulted in majority of the practitioners abstaining from consuming meat that is sourced
from cows such as beef and veal, although some denominations permit beef consumption. The
majority of the Hindus also practice vegetarianism or lacto-vegetarianism (includes dairy products but
excludes eggs) as they are encouraged to practice non-violence against all forms of life.

Based on our current demographics, this implies that 93% of the population face some sort of
restriction or discouragement for at least one type of meat. As chicken faces the least faith-based
restrictions, our demographics have resulted in poultry being the most popular type of meat as was
demonstrated in Figure 37.

5.1.3. Changing consumer lifestyles are influencing meat consumption

Urbanization and consumer sophistication will shift dietary habits
Observing the household expenditure habits on food and drink (detailed graph provided on page 59),
the majority of the households consume, rice, vegetables and fish (dried fish) as part of their main
meals. Meat consumption is low. Households instead source their proteins from fish and lentils. This
dietary habit is more prevalent amongst rural consumers. Meat is a more frequent component of the
urban consumer’s meal.

On further inspection of dietary habits, we note that currently, meat is mainly consumed in the form
of fresh meat cooked as spicy curries as opposed to processed meat products. This trend of consuming
meat in curry form is less prevalent among urban consumers, as they are more exposed to
international cuisines where processed meats are more prevalent. As a result, penetration of
processed meats is higher amongst urban consumers.

20
Department of Census and Statistics

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Positive growth in the value added meats market

16,000
14,000
12,000
Production (in MT)

10,000
8,000
6,000
4,000
2,000
0
2013 2014 2015 2016
Chicken Sausages Chicken Meatballs Other Processed Chicken Pork Beef

Figure 39 Source: Department of Animal Production and Health, JBS Research

The value-added meats market has seen moderate growth in the past and has been dominated by
chicken sausages followed by other processed poultry products.

Currently, the commercial capital, Colombo, is the most urbanized city (Figure 10), however there has
been a growing number of cities that have exhibited urban characteristics. This indicates increased
potentially new geographical areas for increased processed meat penetration.

Busier lifestyles have increased emphasis on convenience foods

As analyzed earlier (page 44), we have demonstrated that the population is getting progressively
busier and thus values convenience. This is a favorable trend for processed meats volumes given their
convenience in preparation.

Processed meats offer a range of conveniences to customers, which enhances their value over fresh
meats and enables them to carry a price premium.

Processed meats are available in either ready-to-eat form (pre-cooked sausages, ham, salami, canned
meatballs) which may require some heat to bring the product to an acceptable temperature level for
consumption, or ready-to-cook form (fresh sausages, bacon, formed meats, frozen meatballs) which
require sufficiently high temperatures to kill harmful bacteria and ensure safe consumption. Both
classifications tend to have less preparation and cooking time relative to fresh meats.

Due to addition of preservations, processed meats have a longer shelf life relative to fresh meats.
Chilled processed meats can be stored up to 7 days, whilst frozen processed meats can be stored up
to 2 years. This attribute enables customers to cut down on the number of shopping trips required.

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5.1.4. Meats provide required nutrition for healthy living, but processed meats are
carcinogenic and thus relatively unhealthy

Meat and poultry are relatively rich in proteins

Meat & Poultry
30
25
Protein per 100g

20
15
10
5
0

Figure 40 Source: Today's Dietician, JBS Research

Meats are rich in proteins which are required by humans to ensure a healthy lifestyle. Theoretically,
this implies that the meat industry should face relatively inelastic demand due to the essential
component they play in basic meals.

According to required protein intake based on age and gender, and the demographics of the
population, the required poultry consumption per capita to meet the daily protein intake (assuming
all protein is sourced from poultry) would approximate to 55kg21. There is thus a gross under
consumption of meats in the population vs. the actual per capita consumption of 6.3 kg (Figure 36).

Although processed meats provide the consumer with protein too, they are considered to be more
harmful than fresh meats. The procedure of transforming fresh meats into processed meats involves
adding nitrates or nitrites. According to a report published in October 2015, World Health
Organization (WHO) classified processed meats as a group 1 carcinogen due to the formation of
carcinogenic chemicals. This states that processed meats have the potential to cause cancer, which
resulted in negative publicity for the processed meats market. Furthermore, red meats were classified
as “probably” carcinogenic as they contain heme iron which can facilitate the production of
carcinogenic chemicals. This implies that the least harmful meat is fresh white meat, which includes
fresh poultry.

21
JBS Research

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 CARGILLS CEYLON PLC

5.1.5. Improvement in white goods penetration rates will boost processed meats volumes

White goods penetration is improving

100%

80%
% of households

2016
60%

40%

20%

2015
0%
Electricity Gas Cooker Refrigerator Microwave

Figure 41 Source: Lanka Market Research Bureau, JBS Research

Currently the household penetration of gas cookers is low at 68% (60% in rural areas and 81% in urban
areas). The statistic is even lower for refrigerators at 58% (52% in rural areas and 67% in urban areas).
This implies that the proportion of the target market that is able to store and prepare processed meats
is relatively smaller and the market is being underserved.

We expect this low penetration of white goods to increase primarily due to rising household
disposable incomes, as well as the availability of affordable financing schemes such as hire purchase.
Consequently, the rise in percentage of households that own the necessary white good will increase
the potential demand for processed meats.

5.2. Competitive Analysis

5.2.1. Cargills follows behind market leader, Keells Food Products, in a fragmented market
The local processed meats market is fragmented; including numerous players of various sizes. Keells
Food Products (KFP) has maintained its position as the market leader. We attribute the leadership
position of KFP to its history and thus accumulated experience, strong brand recognition power and
extensive portfolio.

In this industry, the barriers to entry are relatively low thus explaining the number of players in the
industry. Furthermore, there is a high threat of forward integration posed by players in the fresh
meats industry. For such players, a byproduct of their main line of operations is off-cut meats which
is a key ingredient in processed meats such as sausages. The cheap availability of these raw materials
puts them in a favorable cost position within the industry. Examples of players that have entered into
the local processed meats industry through forward integration include Prima, Bairaha and Pussalla.

5.2.2. Cargills has a wide product portfolio, catering to a large area of the target market
Cargills operates four brands in the processed meats industry; Goldi, their flagship brand, Sam’s which
is targeted towards children and Cargills Finest, the premium brand. More recently, Cargills launched
a new brand, Island’s Finest, that focuses on processed seafood (products include fish sausages,
prawn balls, crab balls etc.) At present, Island’s Finest has very limited availability. Keells Food
Products operates two brands that rival Cargills; Krest its mass-market brand that also includes a
ranged of crumb formed meat, and Elephant House, its premium brand.

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 CARGILLS CEYLON PLC

All players in the processed meats industry include chicken products in their portfolio as it is the most
widely consumed meat type. However, KFP’s ‘Elephant House’ brand is the only prominent brand to
sell pork sausages, a meat type that is avoided by 10% of the population. On the other hand, the Krest
brand has recently obtained Halal certification to ensure that their products can reach the Muslim
population, who tend to have relatively higher per capita consumption of processed meats.

A concern that has plagued the processed meats industry is the negative impact of the product on the
consumer’s health. Both Cargills and KFP have taken steps to address this problem by using lower
than standard levels of nitrite and nitrates in their products. This can be evidenced by the relatively
pale color of their sausages (higher levels of nitrites and nitrates lends sausages their pinkish hue).
KFP’s products have no added monosodium glutamate (MSG) and use natural coloring.

5.2.3. Keells Food Products commands a price premium over others

Price (in LKR)

Chicken Sausages 500g
Elephant House Chicken Sausages 742
Cargills Finest Chicken Sausages 700
Krest Chicken Sausages 550
Goldi Supreme Chicken Sausages 540
Prima Chicken Sausages 525

Chicken Meatballs 200g

Crescent Chicken Meat Balls 199
Krest Chicken Meat Balls 199
Goldi Chicken Meat Balls 199
Bairaha Chicken Meat Balls 190
Figure 42 Source: JBS Research

Observing the segment for chicken sausages which is the largest constituent of the value-added meats
market, Elephant House dominates all other brands including its Cargills counterpart, Cargills Finest.
Krest, Keells Food Products’ mass-market brand dominates Cargill’s mass market brand, Goldi as well.

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 CARGILLS CEYLON PLC

Detailed analysis of typical household expenditure

Total 54,999

Total 19,114

Total 19,114
Figure 43 Source: Household Income & Expenditure Survey, JBS Research

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 CARGILLS CEYLON PLC

Valuation
We initiate coverage of Cargills Ceylon PLC with a HOLD rating and a 12-month target price of LKR
211, which represents an upside of 5.3% from the current market price of LKR 200 as at 6 February
2019.

The 12-month target price was obtained using a combination of sum-of-the-parts discounted cash
flow model and relative valuation. The SOTP DCF model gave a target price of LKR 211.45 which was
allocated a weightage of 2/3 in the final target price. The relative valuation model yielded a target
price of LKR 209.07 and was allocated a 1/3 weighting;
2 1
𝐿𝐾𝑅 210.66 = × 𝐿𝐾𝑅 211.45 + × 𝐿𝐾𝑅 209.07
3 3

Sum of the Parts Discounted Cashflow

Using the discounted cashflow approach we obtained an intrinsic 12-month target price of LKR 211.45.
The group was broken out into its main operating segments; Retail, Dairy (Kotmale PLC), Other
FMCG22 and Restaurants. We incorporated a scenario analysis with a 0.2 weighting attached to both
the bear and bull case whilst the base case received a weighting of 0.6.

350
Sum-of-the-parts Summary

300 13.2
21.9
23.2
250 78.6
211.4
Price in LKR

200 -74.6
25.3
150 123.3

100

50

-
Retail Dairy Other FMCG Restaurant Associate Financial Debt and Target Price
Investment Investments Debt
Equivalents
Figure 44 Source: JBS Research

FMCG exc.
Assumptions Retail Kotmale Restaurant
Kotmale
Risk-free Rate 11.1%
Equity Risk Premium 7.0%
After-tax Cost of Debt 9.1%
Leveraged Beta 0.88 0.88 0.88 1.21
WACC 14.8% 14.8% 14.8% 16.5%
Table 14 Source: Bloomberg, Damodaran Online, JBS Research

22
Other FMCG constitutes frozen confectionery, processed meats, agri-foods, confectioneries and their
distribution operations.

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 CARGILLS CEYLON PLC

Key analyses and events incorporated

Bear Base Bull
Probability 0.2 0.6 0.2
Launches 32 outlets in Launches 32 outlets in Launches 32 outlets in
FY19 and 30 outlets in FY19 and 35 outlets in FY19, 50 outlets in FY20
FY20 and 20 outlets FY20 and 30 thereafter. and thereafter 40
Retail outlet thereafter. A shortfall A shortfall in target outlets, thus achieving
expansion in target outlet outlet additions due to their targets.
additions due to difficulty in obtaining
difficulty in obtaining suitable locations.
suitable locations.
Consumer confidence Continued consumer Recovery in consumer
deteriorates. ABV pessimism with confidence which
growth remains flat or uncertain year ahead inflates average basket
experience negligible due to upcoming values (ABV) and
Consumer confidence growth. This also leads elections. Slight pickup improvement in
to depressed growth in in ABV due a de-growth modern trade footfall.
FMCG volumes. in the previous year. Slight acceleration in
Recovery in FMCG FMCG volumes.
volumes.
GP margin remains Group GP margin Improvement in GP
stable at FY18 levels of improves to 12% due margin to 12% faster
Gross profit margin 11.6% to an increase in FMCG than assumed in the
sectors contribution to base case.
total revenue.
The USD 15mn (LKR 2.7bn) investment in distribution warehouse in the
Investments retail segment is split between FY19 and FY20
We project a significant decline in profit for the year in FY19 due to an
extraordinary income recorded in FY18 that is unlikely to be replicated. (FY
Extraordinary items 2018 recorded a gain of LKR 1.01bn from the disposal of investment
property)

Investment in We have accounted for Cargills Bank, in which Cargills Ceylon holds 39.7%,
Associates at 1.0x its book value.

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 CARGILLS CEYLON PLC

Base Case
The 12-month target price obtained by implementing the base case assumptions is LKR 212.3. This
yields a forward PE of 23.4x.

FY 2017 FY 2018 FY 2019 E FY 2020 F FY 2021 F

Revenue 84,190,870 91,293,127 97,322,520 109,896,295 122,389,541
YoY Growth 18.6% 8.4% 6.6% 12.9% 11.4%

Gross Profit 10,048,612 10,574,324 10,705,477 12,967,763 14,441,966

Gross margin 11.9% 11.6% 11.0% 11.8% 11.8%

Profit for the Period 2,284,196 3,330,921 2,328,390 2,782,351 3,203,813

Profit margin 2.7% 3.6% 2.4% 2.5% 2.6%
Property, plant &
equipment 21,875,935 25,076,817 26,593,504 29,351,199 32,037,488
YoY Growth 7.9% 14.6% 6.0% 10.4% 9.2%

Bear Case
The 12-month target price obtained by implementing the bear case assumptions is LKR 189.7. This
yields a forward PE of 20.9x.

FY 2017 FY 2018 FY 2019 E FY 2020 F FY 2021 F

Revenue 84,190,870 91,293,127 97,322,520 107,754,294 116,835,604
YoY Growth 18.6% 8.4% 6.6% 10.7% 8.4%

Gross Profit 10,048,612 10,574,324 10,705,477 12,499,498 13,552,930

Gross margin 11.9% 11.6% 11.0% 11.6% 11.6%

Profit for the Period 2,284,196 3,330,921 2,328,390 2,619,488 2,945,207

Profit margin 2.7% 3.6% 2.4% 2.4% 2.5%
Property, plant &
equipment 21,875,935 25,076,817 26,593,504 29,130,781 31,372,270
YoY Growth 7.9% 14.6% 6.0% 9.5% 7.7%

Bull Case
The 12-month target price obtained by implementing the bull case assumptions is LKR 230.5. This
yields a forward PE of 25.3x.

FY 2017 FY 2018 FY 2019 E FY 2020 F FY 2021 F

Revenue 84,190,870 91,293,127 97,322,520 113,622,718 129,758,865
YoY Growth 18.6% 8.4% 6.6% 16.7% 14.2%

Gross Profit 10,048,612 10,574,324 10,705,477 13,622,718 15,311,546

Gross margin 11.9% 11.6% 11.0% 11.8% 11.8%

Profit for the Period 2,284,196 3,330,921 2,328,390 2,869,581 3,388,367

Profit margin 2.7% 3.6% 2.4% 2.5% 2.6%
Property, plant &
equipment 21,875,935 25,076,817 26,593,504 29,989,637 33,123,010
YoY Growth 7.9% 14.6% 6.0% 12.8% 10.5%

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 CARGILLS CEYLON PLC

Relative Valuation
Using a relative valuation approach to value Cargills, we arrived at a 12-month target price of LKR
209.07. This value contributes a one-third weighting to our final estimate of CARG’s 12-month target
price.

We broke out Cargills into its three main operating segments and valued them separately; retail,
FMCG and restaurants. The multiple used was the median 12-month blended forward price to
earnings ratio which incorporates Bloomberg’s forecasted earnings of peers. The earnings of CARG
used to arrive at the implied value of each segment was our own DCF base case estimates of each
segment’s FY 19 earnings.

Peers 23 Blended Forward PE Ratio

Segment No. of Implied
Region Sector Median
peers Value
Retail Food Retail 11 30.78 106.54
Emerging Asia Packaged
FMCG 124 17.30 82.10
Pacific Foods & Meat
Restaurants Restaurants 16 21.96 20.43
12 Month Target Price 209.07
Table 15 Source: Bloomberg, JBS Research

Sensitivity Analysis
We conduct a series of sensitivity analyses in order to test the robustness of our 12-month target price
given that the price is predicated on and highly sensitive to our own assumptions. Varying GP margins
and revenue growth rate were incorporated in our scenario analysis when arriving at the SOTP DCF
target price.

Sensitivity Analysis 1: Each segment yields a different WACC, due to differing betas, therefore we
conduct a sensitivity analysis by varying all the WACCs by specified percentage points. We also vary
terminal growth rates. The results show that our target price is highly sensitive to the discount rate
(WACC). A decrease in the discount rate by 50 bps will change our recommendation from a HOLD to
BUY. This scenario is highly likely, given the high levels of risk-free rate that was used (based on the
5-year government bond rate). The yields spiked towards the end of last year following the political
crisis and the US Fed Rate hikes.

23
Peers used: Bangladesh, Brunei, Cambodia, China, Cook Islands, Fiji, French Polynesia, India, Indonesia,
Kazakhstan, Kyrgyzstan, Laos, Macau, Malaysia, Marshall Islands, Mongolia, Myanmar, Nepal, Northern Mariana
Islands, Pakistan, Papua New Guinea, Philippines, Samoa, Sri Lanka, Tajikistan, Thailand, Turkmenistan,
Uzbekistan, Vietnam.

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 CARGILLS CEYLON PLC

WACC
-1.5% -1% -0.5% Current +0.5% +1% +1.5%
+1.5% 488.37 390.53 326.92 282.22 249.09 223.55 203.25
Terminal Growth

+1% 395.90 331.29 285.89 252.23 226.29 205.67 188.91

+0.5% 335.75 289.63 255.44 229.08 208.14 191.11 177.00
Current 293.44 258.71 231.93 210.66 193.36 179.02 166.94
-0.5% 262.04 234.83 213.22 195.65 181.08 168.81 158.34
-1% 237.80 215.84 197.98 183.18 170.72 160.68 150.90
-1.5% 218.51 200.36 185.32 172.66 161.85 152.53 144.40

Sensitivity Analysis 2: We test the robustness of our 12-month target price to the median PE multiples
for each segment, given that the price is hinged on the assumption that the median peer is an
appropriate comparable as well as forecasts of Bloomberg analysts.

Median Forecasted Peer PE

x0.85 x0.9 x0.95 Current x1.05 x1.1 x1.15
200.20 203.69 207.17 210.66 214.14 217.63 221.11

Stock Price Analysis

A large trade was 192,205 shares
purchased by Norges were purchased by
Bank and sold by First Cargills CEO at LKR
State Investments 205 per share

250 Price at 2-year average PE 2,000

1,800
200 1,600
Trading volumes in '000s
1,400
Share Price (in LKR)

150 1,200
1,000
100 800
600
50 400
200
0 0
Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Jul-18 Oct-18 Jan-19

Table 16 Source: Bloomberg, Company Data, JBS Research

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 CARGILLS CEYLON PLC

Corporate Governance and Management Analysis

CARG is a subsidiary of CT Holdings PLC, a listed entity, where the latter holds 70.2% of the former.
However, CARG is run independently by its own board of directors as a consequence of being listed
on the CSE. Mr. Louis Page is the chairman of both Cargills Ceylon PLC and CT Holdings PLC.

CARG’s board of directors comprises of 11 members following the retirement of Mr. Anthony Page at
the conclusion of the board meeting held in August 2018. Five of the 11 board members are
independent thus conforming with the SEC’s corporate governance code that two-thirds of non-
executive directors should be independent. Six out of 11 board members also sit on the board of
directors of CT Holdings PLC. It should be noted that according to Companies Act of 2007, directors
above the age 70 must be put up for re-election at every annual general meeting (AGM).

The board sub committees include the audit committee, human resources and compensation
committee, nominations committee and related party transaction review committee.

Year of Shares held in Present

Committees
Name Position Age Appoin Cargills on CTH
Board? present in
tment 2Q FY 19
Chairman, 42,011
Mr. Louis Page 69 Yes Nominations (C)
NINED24 (0.0%)
CEO, 17,335,169
Mr. Ranjit Page 60 Yes Nominations
NIED25 (6.8%)
520,000
Mr. Joseph Page NINED 62 Yes
(0.2%)
4,571
Mr. Imtiaz Wahid NIED 58 2010 Yes
(0.0%)
141,714
Mr. Sidath Kodikara NIED 59 No
(0.1%)
571
Mr. Prabhu Mathavan NINED 50 No
(0.0%)
Audit (C),
57,143 RPTRC27 (C),
Mr. Priya Edirisinghe INED26 73 Yes
(0.0%) Nominations,
Remuneration
22,857
Mr. Sanjeev Gardiner INED 49 1994 No
(0.0%)
Audit, RPTRC,
22,857
Mr. Sunil Mendis INED 74 Yes Nominations,
(0.0%)
Remuneration
11,429
Mr. Errol Perera INED 72 No Audit, RPTRC
(0.0%)
Audit, RPTRC,
Mr. Deva Rodrigo INED 73 2016 - No
Remuneration
Table 17 Source: Company data, Registrar of Companies, JBS Research

The CEO of Cargills, Ranjit Page, owns a sizeable interest in Cargills. He is the second largest
shareholder of the company, with a direct holding of 6.8% and an indirect holding of 4.5% (through

24
Non-Independent Non-Executive Director
25
Non-Independent Executive Director
26
Independent Non-Executive Director
27
Related Party Transactions Review Committee

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 CARGILLS CEYLON PLC

the parent company, CT Holdings PLC). On 13 September 2018, Ranjit Page, purchased 192,205 shares
at a consideration of LKR 205 per share (LKR 39.4 million).

It is recommended as a corporate governance best practice that the position of Chairman and the
company’s CEO are held by two separate directors, however it must be noted that the Chairman and
CEO are siblings. The board also lacks diversity, with no females. While there is no statutory
requirement for boards to include females, there has been a global push to include females as
directors for better representation.

In FY 2018, Cargills paid LKR 352mn to the directors across the group (including subsidiaries) as
emoluments. This is a 26.8% YoY growth from the LKR 278mn that was paid in FY 2017.

Employee Share Option Scheme (ESOS)

The Employee Share Option Scheme (ESOS) was approved on 29 June 2017. Under the terms of the
ESOS, 7,679,997 ordinary shares (3% of issued capital) could be issued. These share options are
divided into three tranches, each of which are subsequently divided into three sub tranches with
differing vesting periods and exercise prices. The exercise prices of the three tranches are LKR 184.98,
LKR 172.33, and LKR 211.43. The vesting periods range from 3 months to 3 years.

In FY 2018, 3,840,000 share options were granted at a weighted average of exercise price of LKR
184.98, of these, 1,280,000 shares were exercisable. LKR 145mn was expensed in the income
statement as equity settled share-based payment transaction.

Independent Directors Summary

Diploma in Commercial Arbitration, Member of Chartered Accountants of
Mr. Priya Edirisinghe
Sri Lanka.
Chairman and CEO of Gardiner Group of Companies, director of several
Mr. Sanjeev Gardiner other public and private companies, BBA Royal Melbourne Institute of
Technology, BBA Monash University.
Former chairman of Hayleys PLC, former governor of the Central Bank of
Mr. Sunil Mendis
Sri Lanka.
Mr. Errol Perera Director of the Insurance Board of Sri Lanka.
Former senior partner of PricewaterhouseCoopers Sri Lanka, former
Mr. Deva Rodrigo member of Monetary Board of Central Bank of Sri Lanka, former chairman
of the Ceylon Chamber of Commerce.
Table 18 Source: Company Data, JBS Research

The Board Comments

Do independent board members constitute a majority of Only 5 out of 11 board members
NO
the board? are independent.
Do the board members have qualifications that are
YES
relevant to the company's challenges?
Does the board and its committees have budgetary
authority to hire independent third-party consultants
YES
without having to receive approval from the
management?
Are the board members elected annually or has the
Staggered: One third of the
company adopted an election process that staggers board
directors are retired by rotation.
member elections

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 CARGILLS CEYLON PLC

Does the company engage in related party transactions

with management, board members or associated However, there is a related party
YES
individuals with management or board members for transaction review committee.
goods and services on behalf of the company?
Has the board established a committee of independent
board members to oversee the audit of the company's YES
financial reports?
Does the company have a committee of independent
board members charged with setting executive YES
remuneration/compensation?
Does the company have a nominations committee of
Two of the 4 members on this
independent board members that is responsible for NO
committee are non-independent
recruiting board members?
Does the company have other committees that are
Executive committee and
responsible for overseeing management's activities in YES
Investments committee.
select areas?
Table 19 Source: Company Data, JBS Research

Management Comments
Complies with the Code of Ethics
Has the company adopted a code of ethics and does the
issued by the institute of
company's actions indicate a commitment to an YES
Chartered Accountants of Sri
appropriate ethical framework?
Lanka
Can shareholders be satisfied that the company does not
permit the insiders and their family members to use YES
company assets for personal reasons?
Are the parameters of share-repurchase programs and The Group has not undertaken
YES
price-stabilization efforts appropriate? any share repurchase program.
While the annual reports discuss
the results of operating activities
Has the management adequately communicated its long-
NO clearly, we believe that long-
term strategic plans to investors and shareowners?
term strategies are not clearly
communicated.
Does the management adequately understand and
communicate how nonfinancial KPIs and the
YES
environmental, social and governance-related risk and
opportunities are being handled by the company?
Does the company adequately disclose management's
financial and nonfinancial performance in a consistent and YES
transparent manner?
Table 20 Source: Company Data, JBS Research

Shareowner Rights Comments

Has the company issued different classes of common
NO
shares?

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 CARGILLS CEYLON PLC

Does the company permit shareowners to vote their

Shareholders are permitted to
shares prior to scheduled meetings of shareowners
YES nominate proxies to attend and
regardless of whether the shareowners are able to attend
vote at meetings.
the meetings in person?
Are the shareholders able to cast confidential votes? YES
Are shareholders allowed to engage in cumulative voting? N/A
Do shareholders have the right to approve changes to
corporate structures and policies that may alter the YES
relationship between shareowners and the company?
Must the board receive shareowner approval for
important decisions? Is a simple majority or a super- YES
majority required?
Are shareowners allowed to elect directors according to a
YES
"majority voting" standard?
Do shareowners have either a binding or advisory "say on Shareholders do not have a
NO
pay" concerning management remuneration? binding or advisory “say on pay”.
Do shareowners enjoy preemption rights that guard
against dilutive instruments such as new share issuances YES
or convertible securities?
Are shareowners permitted to recommend director
nominees to the board or place their own nominees on YES
the proxy ballot? In what circumstances?
There are no specific provisions
Are shareowners permitted to submit proposals for
NO for shareholder proposals to be
consideration at the company's annual general meeting?
taken up at the AGM.
Are the board and management required to implement
YES
proposals that shareowners approve?

Are the shareowners permitted to take legal action or

seek regulatory action to protect and enforce their YES
ownership rights?
Table 21 Source: Company Data, JBS Research

The above analysis was conducted based on “The Corporate Governance of Listed Companies: A
Manual for investors, Second Edition” by the CFA Institute

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 CARGILLS CEYLON PLC

JB Securities Disclaimer
Rating Structure
JBS Research
In

JBS Investment Research Fair Value/Market

Explanation
Rating Value
Stock's price is at least 10% lower than
Buy >1.1
the JBS fair value
Stock's price falls between 10% interval of
Neutral 1.0 ± 10%
JBS estimates of fair value
Stock's price is at least 10% higher than
Sell <0.9
JBS fair value
vestment
Rating
Explanation
Analyst Certification
The views expressed in this research report accurately reflect the personal views of the analyst(s) about the subject security(ies) and
subject company(ies); and no part of the compensation of the research analyst(s) was, is, or will be, directly or indirectly, related to the
specific recommendations or views expressed in the report.

General Disclaimer
This research is for our clients only.

Other than disclosures relating to JB Securities, this research is based on current publicly available information that we consider reliable.
We perform analysis and create quantitative models and estimates derived from our own review of such publicly available data without
any assistance from any represented company. Our estimates and models reflect our own judgment only; they are neither all-inclusive
nor
can they be guaranteed. The analysis and models are subject to change based on various other factors. Valuations are based on internal
quantitative models and qualitative interpretation. No representation or warranty, express or implied, is made that such information or
analysis is accurate, complete or verified and it should not be relied upon as such.

We seek to update our research as appropriate.

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availability or completeness of the data or calculations in this document, nor for any special, indirect, incidental or consequential damages
which may be incurred or experienced because of the use of the data or calculations made available herein.
This report does not constitute a personal recommendation or take into account the particular investment objectives, financial situations,
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Disclosure
JB Securities does and seeks to do business with companies covered in its research reports. Investors should be aware that the firm may
have a conflict of interest that could affect the objective of this report. Investors would consider this report as only a single aid in making
their investment decision.

JB Securities, and all related parties do to not hold any position in Cargills Ceylon PLC as at February 6 2019.

All share prices are as at market close on 6 February 2019 unless otherwise stated.

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 Cargills Ceylon PLC

Other Important Disclosures

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therefore is not subject to the FINRA Rule 2241 and Incorporated NYSE Rule 472 restrictions on communications with a subject company,
public appearances and trading securities held by a research analyst.
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