This is my first attempt at making sense of the Sri Lankan milk industry with an eye to look for potential investment opportunity. It is clear Kotmale and Lanka Milk suffered from a significant decline in revenue in the 12 months ending 31 March 2014.

Reasons:

Lanka Milk Foods

Government price control

“The company was further impacted by the inability to raise the prices of its powdered milk product in line with global price hikes.”

“The decision by authorities to deny companies engaged in distribution and marketing of milk powder a price hike has become a pressing issue for the entire industry. Moreover, the increase in prices of fuel have further added to our costs, making it next to impossible to maintain a profitable cost structure.”

Kotmale Holdings

Capacity constraints & inter-company consolidation

“As reported previously, consequent to the consolidation of the dairy sector operations within the Cargills Group and capacity constraints, some of the Kotmale branded products are now manufactured at another facility, with a Royalty fee being paid to Kotmale Holdings for use of the brand. As a result, revenue saw a drop of 36 % for the year at Rs. 783 Mn.”

Gross Profit

Now, moving on to analysing profitability. Lucky Lanka Milk has a higher gross profit margin than Kotmale Holdings due to the simple fact that yogurt accounted for 70% share of Lucky Lanka Milk’s revenue in 2012-13. Kotmale is more diversified. It is the biggest producer of pastuerised and UHT milk as well as cheese in Sri Lanka. The prevalence of lower margin pasteurised and UHT milk explains  Kotmale’s lower margin compared to Lucky Lanka Milk.

Net profit

Lanka Milk Foods profit before tax is all over the place. I guess the key reason why net profit in 2013-14 fell drastically was because of the government price control, which also impacted Kotmale Holdings. Lanka Milk Foods is the maker of Lakspray full cream milk powder, which has “nourished many generations of Sri Lankans for more than 40 years.”

If you look at Lanka Milk Foods segment breakdown, you will see the company is trying hard to diversify from powdered milk to higher value liquid milk. Liquid milk’s share of contribution to operating profit reached 61% in 2013-14 but powdered milk still contributed the bulk of the profit.

Lucky Lanka Milk, which has just recently listed on the Colombo Stock Exchange, has a very low net profit margin compared with Kotmale. However, this is deceiving as Kotmale earns a lot from interest income (2013: 2.66% of revenue), which artificially boosted its net profit margin.

Operating profit

A better indicator is operating profit. Lucky Lanka Milk is the star performer when it comes to operating profit. Why Lucky Lanka Milk still suffers from very low net profit margin?

The reason is Lucky Lanka has to spend a lot (around 6-7% of revenue) to service its loans, which is equivalent to 26% of 2013-14 revenue. Hopefully, with the proceeds from the IPO, the company can pare down its debt and this will boost profitability.

Conclusion

Lucky Lanka Milk is a better investment candidate than Lanka Milk Foods and Kotmale Holdings due to the fact that Lucky Lanka focuses on yogurt, which does not come under the government price control. Its simple product structure makes its financial performance more predictable. With the proceeds from the IPO, the company will embark on revenue-generating ventures including:

– Lucky Milk Bar with plans to open 1,000 of them. These bars will serve Lucky own products, juices and milk.
– Expand the distribution channel to include three-wheelers for door-to-door selling, not Yakult lady for sure.
– Focus on school canteens by promoting high nutrition milk based products in these establishments.

The downside is Lucky Lanka Milk has a P/E of 35 based on 2013-14 results, making it quite expensive.