Foundation Research Equities

PAKISTAN

Engro Foods Ltd.

Excellent prospects, but priced in
Event
700mn 48mn 748mn 27mn

05 July 2011
Engro Foods Ltd.
Engro Corp ownership Private placement investors Total shares outstanding Current OFS by Engro Corp Book Value CY10 account 1QCY11 account *
* (including private placement)

Engro Corporation (ENGRO) is offering 27mn shares of its subsidiary Engro

Foods Limited (E Foods) to be listed at Karachi and Lahore Stock Exchange to the general public. The offer price is PKR25/share (inclusive of PKR15/share premium). The public subscription is from July 5 to July 7. E Foods currently has 748 shares outstanding of which Engro holds 700mn shares. Engros last equity investment in the company was in CY10 when it injected PKR1.57bn in E Foods at par value. The current OFS is fully underwritten.

7.3 8.6

E Foods has earlier raised PKR1,200mn (selling 48mn shares) through a

private placement initially earmarked for foreigners only. But, due to low investor response, lead mangers ended up owning a substantial chunk of the above. The proceeds from the private placement will be used to partially fund the capital expenditure requirements in CY11 of Dairy & Juice and Ice Cream segments, and its subsidiaries. As per the Listing Regulations of the KSE, there is a six months holding period for all the shares subscribed through private placement/pre-IPO. We have analyzed the companys projections and present our valuations and recommendation.

Current Product Range CATEGORY UHT Whole Milk Hi-Cal Low Fat (HCLF) Flavored Milk Cream Juices Ghee Skimmed Milk powder Liquid Tea Whitener Tea Whitening Powder Ice Cream BRAND OLPERS OLWELL OWSUM OLPERS Cream OLFRUTE TARRKA GLORIOUS TARANG TARANG POWDER OMORE

Analysis
The group: ENGRO, which currently owns 94% of E Foods, is a public
listed company and its shares are quoted on all the three Stock Exchanges of Pakistan ENGRO is a diversified conglomerate with interests in fertilizer, foods, PVC resin manufacturing, energy, petrochemicals and industrial automation. It has also setup joint ventures, which are engaged in chemical terminal, control and automation and energy businesses. At present, ENGRO has over 3,200 employees and is one of Pakistan's largest investor with USD 1.7 Billion invested in the last five years.

Source: Information Memorandum

Engro Foods IPO to result in gain for Engro Corp: Engro Corps offer of
27mn shares of Engro Foods at share price of PKR25/share is fully underwritten. OFS will result in cash inflow of PKR675mn for Engro Corp and gain of PKR405mn (EPS impact of PKR1.0/share). We have not incorporated the sale in our model for Engro yet. We have an Outperform stance on Engro Corporation.

Tax credit of 15% for enlistment: As per Finance Bill 2011, the rate of tax
credit for listing on the Stock Exchange has been enhanced from 5% to 15%. This bodes well for E Foods net profits and cash flows.

Sector background: Pakistan currently stands as the 5th largest Milk

producing country in the world, with annual production of 38bn litres per annum. It has a livestock sector contributing over 11% to the GDP, and a milk economy that in value terms is 27.7% of the total agriculture sector. The milk production is expected to grow at 2% annually, however the processed industry is only 7% of tradable milk. Ultra High Temperature (UHT) treated milk market has grown at a 2000-2010 CAGR of 14%.

Analyst
Taha Khan Javed 92 21 35612290-94 Ext 313

The ice cream industry in Pakistan is divided into branded ice cream and
unbranded ice cream sectors. The total ice cream market currently stands at around 92mn litres with the unbranded ice cream sector accounting for

Disclaimer: This report has been prepared by FSL. The information and opinions contained herein have been compiled or arrived at based upon information obtained from sources believed to be reliable and in good faith. Such information has not been independently verified and no guaranty, representation or warranty, express or implied is made as to its accuracy, completeness or correctness. All such information and opinions are subject to chang e without notice. This document is for information purposes only. Descriptions of any company or companies or their securities mentioned herein are not intended to be complete and this document is not, and should not be construed as, an offer, or solicitation of an offer, to buy or sell any securities or other financial instruments. FSL may, to the extent permissible by applicable law or regulation, use the above material, conclusions, research or analysis before such material is disseminated to its customers. Not all customers will receive the material at the same time. FSL, their respective directors, officers, representatives, employees, related persons may have a long or short position in any of the securities or other financial instruments mentioned or issuers described herein at any time and may make a purchase and/or sale, or offer to make a purchase and/or sale of any such securities or other financial instruments from time to time in the open market or otherwise, either as principal or agent. FSL may make markets in securities or other financial instruments described in this publication, in securities of issuers described herein or in securities underlying or related to such securities. FSL may have recently underwritten the securities of an issuer mentioned herein. This document may not be reproduced, distributed or published for any purposes.

Engro Foods Ltd.

July 05, 2011

approximately 22% of the total ice cream market, whereas the branded ice cream sector has 78% share. Despite the devastating floods, this sector continued to grow and registered a volumetric growth of 20% YoY in 2010.

Juices, Nectars and Still drinks (JNSD) market is of 507mn liters, translating into a total market value of PKR31bn.
Market is subdivided into Juice and Nectar (JN), Still Drinks (SD) and Value added Still Drinks (VASD). JN is defined as Juices (100% fruit content) and Nectars (25% - 99% fruit content), SD is defined as 0-24% fruit content and VASD is SD with value addition such as innovative packaging or addition of pulp etc. E Foods plans are to focus on JN and VASD segments which has a market size of 114mn Liters, translating into a total market value of PKR11.4bn.

The company: The Company started operations in CY06 and its principal activity is to manufacture, process and sell
dairy and other food products. E Foods has established Milk Processing plants at Sukkur and Sahiwal, for processing and selling branded UHT milk (with total filling capacity of 1.1mn LPD). It has a powder plant in Sukkur (24 tonnes per day), an ice cream manufacturing facility in Sahiwal, 1 juice plant, 1 rice plant, 1 farm and 700+ milk collection centre. It has attained clear market leadership in UHT Industry with a market share of 39% at the end of 2010 and has launched multiple new products including Ice Cream, Flavored Milk, Fruit Juices and Milk Powders, that show great potential for future. Further capacity expansion will be undertaken in the form of a new plant, location of whose is currently being decided. As part of a future growth strategy, the Company is looking forward to becoming a fully developed food company with a complete range of products in all food segments, from confectionary to culinary and from infant foods to ready to cook meals. E Foods intends to become the premier food company in Pakistan.

Fig 1: Key financial statement numbers and ratios

PKR mn Sales Revenue Contribution margin Marketing investment EBITDA Financial Charges Net income EPS at existing 748mn shares P/E at OFS price of PKR25 Sales growth Marketing investment as % of sales EBITDA margin Net Margin Equity Total Debt Assets Cash flow from Operations Cash flow from investing Cash flow from Financing 125.1% 8.6% -4.0% -6.8% 2,732 3,202 7,325 (711) (2,376) 3,363 79.4% 9.0% 1.7% -3.0% 3,370 3,747 9,004 438 (2,020) 1,704 CY08 A 8,173 1,467 705 (323) 294 (554) (0.74) CY09 A 14,665 3,290 1,315 246 461 (433) (0.58) CY10 A 21,050 5,150 1,388 1,656 580 178 0.24 105.2 43.5% 6.6% 7.9% 0.8% 5,544 6,053 14,030 396 (4,360) 4,290 CY11 F 30,280 8,401 1,504 3,770 1,183 727 0.97 25.7 43.8% 5.0% 12.5% 2.4% 7,621 8,976 19,488 1,853 (6,535) 3,731 CY12 F 40,779 11,780 1,643 6,163 1,468 1,710 2.29 10.9 31.9% 4.0% 15.1% 4.2% 10,013 15,388 28,971 3,993 (10,218) 6,976 CY13 F 53,257 15,927 2,000 9,116 1,983 2,675 3.58 7.0 28.2% 3.8% 17.1% 5.0% 12,767 18,087 35,781 6,132 (8,516) 2,882 CY14 F 69,546 21,446 2,689 12,970 2,345 4,452 5.95 4.2 27.8% 3.9% 18.6% 6.4% 17,257 20,494 43,890 7,619 (9,083) 2,713

Source: Company prospectus and management presentation

Operating performance: E Foods strategy from the very beginning was to make heavy investments in infrastructure
development and brand building in the initial years. The above resulted in heavy losses carried in the book. However, going forward the Company plans to deliver significant improvement in the bottom line as it benefits start accruing from the investments made in the initial years. Improvement in contribution margin and reduction in marketing expense will lead to improvement in profitability in future.

Foundation Securities (Pvt) Limited

Engro Foods Ltd.

July 05, 2011

Fig 2: Key segment sales and profit

PKR mn Dairy and Juices sales Ice cream sales Farm sales Dairy and Juices profit Ice cream profit Farm profit CY08 A 8,173 4 (552) (23) 21 CY09 A 13,933 732 67 111 (462) (83) CY10 A 19,670 1,579 237 702 (382) (99) CY11 F 26,494 2,772 363 1,161 (327) (83) CY12 F 35,434 3,915 502 1,665 9 (53) CY13 F 45,734 5,211 567 2,214 128 3 CY14 F 58,796 6,999 684 3,048 479 50

Source: Company prospectus and management presentation

Key segments
Dairy and Juices: E Foods has achieved unprecedented success in the UHT dairy industry by achieving market
leadership in a short span of time. Companys brands include Olpers Milk (Olpers), the flagship brand of E Foods, Olwell (Olwell), Tarang Liquid and Powdered Tea Creamer (Tarang), flavored milk by the brand name Owsum (Owsum), a range of juices and nectars by the brand name Olfrute (Olfrute) and others. The market share of E Foods UHT segment has grown from 7% in 2006 to 39% in 2010 and is expected to reach 51% by the end of 2015.

Ice cream: E Foods Ice cream segment is under the brand name Omore. Omore was launched in Lahore, Islamabad
and Rawalpindi in March 2009. In the first year of operations Omore achieved sales volume in excess of 6mn litres. On the back of its successful launch and strong consumer acceptance, Omore has expanded to other towns in Pakistan, and was launched in Karachi in January 2011. Omore has grown by 100% in FY10 with a volume of 12.2 million litres and a market share of 17% making it a strong Number Two player in the Branded Ice Cream industry behind Unilevers Walls. Post Karachi launch its market share has increased to 22%, while the company is targeting market share of 30% by 2015.

Dairy Farm: E Foods established its own dairy farm in 2008. The farm covers an area of 557 acres (220 acres
owned, 337 acres leased) which is sufficient to house 10,000 animals. It also includes cropping land for growing fodder. As part of its business strategy, E Foods imported cows for its dairy farm as opposed to using local breeds. E Foods dairy farm remains one of the largest farms housing 2591 animals (1,476 adult cows and 1,035 immature cows and 80 male calves and bulls). Currently E Foods dairy farm is producing more than 20,000 LPD. The Company undertook this strategy as milk yield of imported cows is higher (more than 20 Liters/ day) as opposed to the national average of 6 to 8 Liters per day from the local breed. At present, the dairy farm milk is sold to E Foods at market prices and is used in various ambient and powder dairy products.

Upcoming projects: More recently, E Foods has also ventured into rice processing through Engro Foods Supply
Chain Limited (EFSL), (E Foods has a 70% shareholding in EFSL). The rice plant is located at Muridke which will have a total rice processing capacity of 56k tonnes/annum by the end of 2011.

The Company has entered into international markets with the setting up of Global Business Unit in North America,
with ENGRO acquiring Al-Safa, (a halal meat business in North America). Al-Safa will be transferred to E Foods at cost once SBP regulatory requirements are met. E Foods plans to further expand its portfolio by introducing value added products like Growing up Milk Powder (GUMP), Infant Nutrition, Cereals, Yogurt drinks, etc. Fig 3: Aggressive capital expenditure plans going forward (PKR mn)
CY11 F Dairy -Existing Business Dairy -new Business Ice cream Farm Rice Total 3,337 1,091 406 2,263 7,097 CY12 F 4,147 2,500 1,025 126 2,420 10,218 CY13 F 769 5,000 751 136 1,860 8,516 CY14 F 1,995 2,823 808 147 3,310 9,083 CY15 F 1,545 807 159 3,715 6,226

Source: Company prospectus and management presentation

Foundation Securities (Pvt) Limited

Engro Foods Ltd.

July 05, 2011

Key Risk

Imposition of VAT/RGST: Any levy of VAT/RGST is likely to negatively impact both volumes and margins in the
processed milk segment of the business.

High inflation and interest rates: With inflation and interest rate continuing to remain in double digits, consumers
purchasing power may reduce resulting in decline in companys margins and possibly volumes. While high interest can also negatively impact profitability.

Earnings remain highly vulnerable to any change in margin: The Company operates at very low net margins
(1QCY11 net margins of 1.8%) which are expected to improve going forward as revenues increase, while fixed costs remain constant. Low margins however mean that even if the projected net margins decrease/increase by 1%, earnings will change significantly (see Fig 4). Fig 4: Earnings remain highly vulnerable to any change in margin (PKR mn)
Net Earnings 1% rise in net Revised net margin margins EPS Chg from base case Sales revenue Base Case Net Earnings Net margin EPS Net Earnings 1% declinee in Revised net margin net margins EPS Chg from base case CY11 F 1,030 3.4% 1.38 42% 30,280 727 2.4% 0.97 425 1.4% 0.57 -42% CY12 F 2,118 5.2% 2.83 24% 40,779 1,710 4.2% 2.29 1,302 3.2% 1.74 -24% CY13 F 3,208 6.0% 4.29 20% 53,257 2,675 5.0% 3.58 2,142 4.0% 2.86 -20% CY14 F 5,147 7.4% 6.88 16% 69,546 4,452 6.4% 5.95 3,757 5.4% 5.02 -16%

Source: FS Research and management presentation

Foundation Securities (Pvt) Limited

Engro Foods Ltd.

July 05, 2011

Valuation and recommendation

We have valued E Foods on relative valuation basis, comparing the company with 1) FMCG sector companies listed
on the KSE and 2) FSL universe. Given the aggressive capital expenditure plans disclosed by the company (see Fig 3), we believe that discounted cash flow methodology is not appropriate given the low free cash flow in the medium term, along with little visibility in terms of long term sustainable capital expenditure and margin assumptions.

Based on peer comparison our target price for E Foods comes to be PKR39.6/share, while based on comparison
with FSL universe the target price is PKR15/share (details below). Those who think that E Foods ought to trade at multiples similar to FMCG companies may opt to subscribe to the offer. However, those with a conservative stance, who believe that FMCGs are trading at extremely high multiples (irrational in some cases) may find the stock overvalued at the subscription price, especially given little prospects of any dividend from Engro Foods in the medium term (aggressive capex plans). Valuation based on comparison with FSL universe

E Foods 1QCY11 book value/share is 8.6 (after incorporating private placement proceeds) which means it is being
offered at 2.9x book value compared to FSL universe CY11 P/B of 1.6x. Even on P/E basis the companys offer price is extremely high since its P/E is 25.7x for CY11, which reduces to 10.9x in CY12. Taking CY12 earnings as the benchmark, our target price is PKR15/share. For conservative investors, comparison with the broader market is more appropriate since the heavy weights in FMCG sector (Nestle and Unilever) are trading at irrationally high levels and their free float is insignificant. We are aware that E Foods float will also be limited which means that it may also be cornered. In conclusion though we are impressed the companys progress, we feel it is not a good buy at the price of PKR25/share. Fig 5: Valuation based on peer comparison with FSL universe
CY11 F EPS at existing 748mn shares FSL Universe P/E Target price 0.97 7.2 7.0 CY12 F 2.29 6.6 15.0

Source: Company Data, FS Research, July 2011

Valuation based on peer comparison with FMCG sector

Rather than taking only Nestle and Unilever (closest competitor to E Foods) we have taken the whole FMCG sector
since both the aforesaid shares are trading at extremely high premium as well as being illiquid. We have determined the value based on average of peer valuation measures which include EV/EBITDA, P/E, P/Sales, EV/Sales and P/Book Value. The highest value of E Foods comes at PKR110.1/share based on P/Book comparison while the lowest value determined is PKR28.5/share based on P/E comparison.

Taking arithmetic average of all measures the value comes out to be PKR56.6/share (See Fig 6). We have applied
30% discount to arrive at our target price of PKR39.6/share. We feel that 30% discount is justified given that the company is still in its formative stage (compared too much established companies in the sector) and reported its first year of profit in CY10. We advise only those investors to participate in the offering who believe that E Foods will trade at similar multiple to those of FMCG sector.

Foundation Securities (Pvt) Limited

Engro Foods Ltd.

July 05, 2011

Fig 6: Valuation based on peer comparison with FMCG sector

PKRmn Unilever Pakistan Foods Gillette Treet Clover Unilever Pakistan Zulfeqar Industries Colgate-Palmolive Noon Pakistan National Foods Pakistan Tobacco Lakson Tobacco Nestle Pakistan Mitchell's Fruit Farms Goodluck Industries Shezan International Shield Corporation Ismail Industries Total EV/EBITDA based valuation Sector EV/EBITDA EFL CY10 EBITDA EV Debt Cash Equity Target price P/E based valuation Sector P/E EFL CY11 earnings Price Target price P/Sales based valuation Sector P/Sales EFL CY10 Sales Price Target price 2.1 21,050 43,768 58.5 29.3 727 21,319 28.5 17.9 1,656 29,596 6,053 368 23,911 32.0 Sales 4,041 797 3,691 1,241 44,672 1,290 11,529 2,436 4,490 20,928 34,274 51,487 1,388 488 3,528 661 6,534 193,475 Net profit 437 26 266 15 3,273 31 1,152 27 87 1,521 1,023 4,113 41 1,366 106 22 211 13,718 Equity 404 389 2,036 370 3,560 303 3,577 237 742 3,869 7,350 5,582 291 13 848 154 1,728 31,454 EV EBITDA 9,203 697 1,088 59 3,720 572 519 46 68,437 5,523 212 75 20,044 1,925 334 139 3,669 335 27,213 3,211 17,057 2,129 260,209 7,479 620 131 151 5 822 228 451 71 7,405 942 421,154 23,565 Mkt Cap 9,113 1,097 2,189 636 69,849 315 21,132 96 2,421 24,711 15,099 250,103 394 152 884 314 3,773 402,278 PE 20.8 42.4 8.2 42.4 21.3 10.1 18.3 3.5 28.0 16.2 14.8 60.8 9.5 0.1 8.3 14.2 17.9 29.3 PB 22.5 2.8 1.1 1.7 19.6 1.0 5.9 0.4 3.3 6.4 2.1 44.8 1.4 11.8 1.0 2.0 2.2 12.8 P/Sales EV/Sales 2.3 2.3 1.4 1.4 0.6 1.0 0.5 0.4 1.6 1.5 0.2 0.2 1.8 1.7 0.0 0.1 0.5 0.8 1.2 1.3 0.4 0.5 4.9 5.1 0.3 0.4 0.3 0.3 0.3 0.2 0.5 0.7 0.6 1.1 2.1 2.2 EV/EBITDA 13.2 18.4 6.5 11.4 12.4 2.8 10.4 2.4 11.0 8.5 8.0 34.8 4.7 33.5 3.6 6.4 7.9 17.9

EV/Sales based valuation Sector EV/Sales EFL CY10 Sales EV Debt Cash Equity Target price P/B based valuation Sector P/B Last book value Price Target price Average EV/EBITDA EV/Sales P/E P/B P/Sales Grand Average 30% discount Target Price 32.0 53.7 28.5 110.1 58.5 56.6 17.0 39.6 12.8 6,442 82,385 110.1 2.2 21,050 45,821 6,053 368 40,136 53.7

Source: Company Data, FS Research, July 2011

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