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Company Name: Salada Foods Jamaica Limited

Sector: Manufacturing – Food, Tobacco & Beverages

Location: Kingston

Country: Jamaica

Competitors:

JSE Ticker: SALF JSE Segment: Manufacturing & Retail Majority Stakeholder: Donovan Lewis

Date: Thursday, April 29, 2011

Salada Foods Jamaica Limited BUY

JSE: SALF Bloomberg: SALF Ja

52 Week Range $7.50 – 14.00

Market Price $9.00

Valuation $11.76

Key Metrics – September 2010

Gross Margin 38%

Operating Margin 16%

Net Margin 14%

Debt-to-Equity 0.00%

Current Ratio 12.73

ROE 15.00%

ROA 13.00%

Book Value $7.48

EPS (Last 4Q) $0.73

Trailing PE 12.31

PBV 1.44X

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Executive Summary

Salada Foods Jamaica Limited (SALF) is the largest supplier of instant coffee and non-blue coffee in Jamaica. For the first two years of local the recession the company appeared very resilient recording record operating profits and also benefitting from the prevailing high interest rate environment. Since then, they have faced the pressures of a reduction in consumer demand which has forced them to absorbing the additional production costs associated with the volatility in commodity prices. Below, we look to offer insights into the company and its future prospects by examining qualitative and quantitative factors and then arriving at our recommendation.

Company Overview

Salada Foods Jamaica Limited (SALF) was established in 1958 and is the largest of four coffee processing plants in Jamaica. The company has been listed on the Jamaica Stock Exchange (JSE) since 1969 and majority ownership of 74% is held by Donovan Lewis’ Ideal Group of Companies and Resource in Motion Ltd. The company’s main business lines are the processing of coffee, tea, a range of beverages, drink mixes and dessert products which are currently distributed locally and exported to North America, Europe, the Caribbean and recently China.

Management & Corporate Governance The board is comprised of 6 independent members with the exception of John Rose who is the Managing Director. John Bell is the Chairman of the board of directors. None of the directors have ownership in the company and this should ensure the reliability and independence in steering the company’s operations.

Salada Summarized Timeline

Top 10 Shareholders

Shareholder % Stake

Resource In Motion Limited 56%

Advantage General Insurance Limited 9%

Donwis Limited 7%

Stocks and Securities Limited (ALPHA) 3%

Ideal Betting Company Limited 3%

Ideal Group Corporation Limited 3%

Ideal Financial Corporation Limited 3%

Ideal Portfolio Services Company Limited 2%

Donovan A. Lewis 2%

Tekodoo Investments Ltd. 1%

Board of Directors

Industry Experience

Board Mem bers

Dir

ec

tor

ship

s*

Ma

nu

fac

turi

ng

Dis

trib

uti

on

Insu

ra

nc

e

Inv

Ba

nk

ing

Ba

nk

ing

Board Mem bers

John Rosen 1 √

Michael Bernard 2 √ √

Jeffrey Cobham 3 √ √ √ √ √

Oliv er Holmes 1 √ √ √

Keshia Nelson-Brown 2 √ √

Eric Stultz 1 √

John Bell 1 √

1958 Established

Listed on the JSE 1969

2007 Jamaican Recession

starts

2008 Stock Split

Record Profits in

2009

2010 Profits fall especially with JDX

John Bell Chairman

Michael Bernard

Jeffrey Cobham

Oliver Holmes

Keshia Nelson-Brown

John Rosen

Eric Stultz

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Economic Analysis

Local Economy The spillover effect of the global downturn has had a severe impact on the Jamaican economy especially due to structural deficiencies including: inefficiencies in the public sector, high energy costs, crime and politics. The Jamaican economic downturn has therefore been characterized by: weakened consumer demand, exchange rate devaluation (stabilized now), elevated inflation levels (moderating) and negative GDP growth. The Jamaican economy has continued its decline since 2007, with year-on-year real GDP dropping 0.9% for the quarter ended December 2010. A closer look at the economy, showed the manufacturing sector declined by 2.6% for the corresponding period. However, the subsector, Food, Beverages & Tobacco (which includes Salada) declined at a slower rate of 0.7% for the period. In nominal terms, this equates to a 1.6% decline in the subsector while the company was able to generate a 6.9% increase in revenues for the December quarter. Therefore, excluding Salada’s performance, the sector would have experienced a greater decline. Salada’s impressive growth (especially under the circumstances) suggests that either: 1) The company is a beneficiary of the economic downturn due to its lower priced products being substituted for premium lines or 2) The company’s increased promotional activities were successful in maintaining demand. We believe it is a combination of both. Notably, although the coffee sector as a whole declined, non-blue mountain coffee production trended higher over the last couple of years according to a PIOJ report. This is corroborated by a Coffee Industry Board (CIBOJ) report which based on their market share implies the increased volumes were attributed to Salada. Global Economy The global economy has been under significant pressure over the last 3 years. According to the International Monetary Fund (IMF), global output is expected to surface at 4.2% in 2011, mainly driven by emerging markets. The US is expected to grow about 2.3%, the UK by 2.0%, Canada

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Economy Manufacturing

Tobacco Food & Beverages

0%

5%

10%

15%

20%

25%

30%

35%

2002 2003 2004 2005 2006 2007 2008 2009 2010

Nom GDP - Food, Beverages & Tobacco SALF Revenues

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

Jan

-06

May

-06

Sep

-06

Jan

-07

May

-07

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-07

Jan

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-08

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-09

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May

-10

Sep

-10

PTP Inflation Monthly Inflation

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by 2.7% and China by 9.6%. The slower growth in Europe and North America would still be welcomed by Salada who exports to those regions. Additionally, the recent entry into China appears to be a very lucrative opportunity. Elasticity Based on our analysis we believe that for the company’s main product “Mountain Peak” coffee, the demand has the price elasticity of a normal good due it being the start of the day for many persons. Blue-Mountain coffee which Salada processes to order is more of a luxury good and therefore has a high income elasticity. Tea is also a good substitute for coffee and the cross elasticity between the two is moderate.

Industry Overview

Jamaica’s coffee Industry is separated into two major categories: 1) Premium coffee which is dominated by the “Blue Mountain” lines and 2) Non- Premium coffee which is mainly instant coffee, primarily high mountain and non-blue mountain coffee lines. Though SALF is a participant in both categories, there core is in the non-premium coffee lines which are in fact imported. In terms of market share, Salada is estimated to account for over 62% of the local coffee market, fending off competitors which include:

1. Nestlés' Nescafe, 2. Jablum 3. GraceKennedy 4. Country Traders.

On the premium coffee market, their main rivals are Mavis Bank Coffee Factory and Wallenford Coffee Company which mainly supply the export market but this is less significant and more cyclical side of Salada’s operations. Interestingly, though the Jamaican Blue Mountain coffee is recognized as one of the finest in the world, it high costs forces Salada to import Green Coffee beans from Mexico and Guatemala to satisfy the price point for the local demand.

Source:CIBOJ annual report

Elasticity

Pr

ice

In

co

me

Co

mp

le

me

nts

Su

bstit

ute

s

Blue Mountain Coffee Low High Medium Low

Non-Blue Mountain Coffee Medium Low Medium High

Tea Medium Low Medium High

Drinks Medium Low Medium High

Salada Mountain Peak, 54%

Salada Mountain

Peak-Decaf, 8%

Coffee Break, 8%

Nescafe, 15%

Grace, 8%

Other, 7% Instant Coffee

4,014 4,570 4,419

8,468

6,787

-

100,000

200,000

300,000

400,000

500,000

600,000

2004 2005 2006 2007 2008

Green Coffee Imports

Kg

Bags

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Dominant Oligopoly Being the largest, they enjoy economies of scale as well the “Mountain Peak” brand being a legacy among the Jamaican populace. In fact we believe this position gives Salada significant pricing power over its few competitors leading to the view that they closely resemble a dominant oligopolistic firm. Market Leader Salada is the leader in non blue mountain coffee and instant coffee. Though SALF sells both tea and cocoa, Jamaica Teas Limited (JAMT) is believed to be the leader in teas which is also a substitute for instant coffee. Strong competition among drink mixes and insufficient data leaves theorizing that there is no clear leader for this product line. JSE Manufacturing Industry Of the publicly listed manufacturing companies, Salada is the fourth smallest of the 13 with market capitalization of $935 million. In terms of PE ratio, the company has a PE ratio of 12.31X which is higher than the industry average of 10.44X. In terms of PBV, Salada has a PBV of 1.40X in line with the industry average of 1.41X.

Porter’s Model – Five Industry Forces

Competitive Force Ranking Rationale

Threat of New

Entrants Low

The Coffee Industry Board of Jamaica regulates all coffee production, importation and exportation. The high cost of local coffee due to its premium quality makes it unattractive for the local market. Importation of cheaper coffee requires special permission from the regulator

Bargaining Power of

Suppliers Low

There is no single supplier of raw materials locally.

Bargaining Power of

Buyers Low

There is no single buyer such as the government which is

able to influence the company’s accommodation or ability

to generate revenues

Availability of

Substitutes Moderate

Tea is a good substitute for coffee

Rivalry Among

Competitors

Moderate -

High

Moderate for coffee and Tea Products. High for drink

mixes

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Porter’s Model – Five Forces of Industry Competition

INDUSTRY COMPETITORS

Rivalry Among Grace

Country Traders Nescafe Jablum

SUBSTITUTES – MODERATE

Teas

Energy drinks

POTENTIAL ENTRANTS - LOW

CIBOJ regulates all coffee activity

Jamaican grown coffee is very expensive

SUPPLIERS – LOW

Mexico

Guatemala

India

Jamaica

BUYERS - LOW

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SWOT Analysis

STRENGTHS WEAKNESSES

Mountain Peak brand has a decades long legacy with the

Jamaican populace, although below Blue Mountain quality.

Relatively lower prices due to premium lines

Largest coffee processor in Jamaica

Concentration in a single type of product (coffee based)

Spraying-drying method not the most efficient

production process

OPPORTUNITIES THREATS

Expansion of product distribution internationally

Introduction of value added products

Fairly untapped export market

Weak economic backdrop locally and internationally

Impact of natural disasters (hurricanes) on coffee farms

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Financial Statement Analysis – December 2010 (See Appendix 1)

Growth & Profitability Revenues – grew at a compounded annual growth rate (CAGR) of 10% from 2005 to 2010, a commendable achievement considering the downturn in the local economy. The growth in revenue followed through to the first quarter ended December 2010, which recorded 6.9% growth in revenues to $110 million. Peak volumes were achieved in 2009 and the company is steadily approaching those levels again. Margins – Gross, Operating and Net Margins showed steady improvements from 2005 until 2009, but the protracted recession took a toll on consumer demand in 2010 and forced the company to absorb increased production costs while increasing promotional activities. The reduction is margins are likely to be short-lived as the company is expected to pass on increased production costs to consumers with an improving economic backdrop. Net Profit – Rapid growth in Net Profit slowed once the local recession started in late 2007 and then started a decline from the peak in 2009 due to the company absorbing additional costs. The company is now in a better position to pass on costs to consumers, with demand expected to be less price elastic as time elapses. DuPont Analysis (ROE Decomposition) Asset Turnover has steadily trended down over the period while Financial Leverage was flat. Thus, ROE was driven by the movement Net Profit Margin which rapidly improved from 2005 – 2009 but fell in 2010 due to higher production and marketing costs as well lower interest income post JDX.

ROE – Dupont Analysis

Asset Turnover 1.15 1.25 1.17 1.08 0.93 0.75 0.72

xFinancial Leverage

1.32 1.25 1.20 1.15 1.15 1.19 1.14

xNet Profit Margin

10% 12% 20% 19% 25% 19% 18%

=ROE 15% 19% 28% 24% 27% 17% 14%

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0%

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200.00

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400.00

450.00

2005 2006 2007 2008 2009 2010 Last 12M

Revenues Revenue Growth

0%

10%

20%

30%

40%

50%

2005 2006 2007 2008 2009 2010 Last 12 M

Gross Margin Operating Margin Net Margin

-40%

-20%

0%

20%

40%

60%

80%

100%

0

20

40

60

80

100

120

2005 2006 2007 2008 2009 2010 Last 12M

Net profit Net Profit Growth

10%

15%

20%

25%

30%

0.00

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0.40

0.60

0.80

1.00

1.20

1.40

2005 2006 2007 2008 2009 2010 Last 12 M

Net

Prf

ot

Mar

gin

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Ass

et T

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ove

r/Fi

nan

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era

sge

Asset Turnover Financial Leverage

ROE Net Profit Margin

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Solvency Long-Term-Debt to Equity – The Company utilizes minimal long term debt in its balance sheet and its debt-to-equity ratio has averaged less than 2% over the last 5 years. Financial Leverage – the company has utilized very little leverage to grow their operations. In 2005, leverage was 1.25X and has incrementally declined 1.15X Interest Coverage – has been excellent due to very little debt on the balance which allows operating profit to comfortably cover interest costs. Conclusion: SALF holds virtually zero long-term debt while having strong cash balances relative to the company’s size. These can be channeled to driving future growth such as in the company’s recent attempt to acquire the government controlled Mavis Bank Coffee Factory. The company’s capacity to expand operations at this time is very favorable. Liquidity Current Ratio – As mentioned in the solvency measures above, the company maintains significant cash balances and short term deposits which results in a very attractive current ratio of 12X as at December 2010 compared to 4.21 in 2005. Undoubtedly this is highest of the JSE companies and speaks to their financial strength as a small player. Conclusion: The company’s liquidity position is very favorable and puts them in a position to look for expansion by acquisition especially with the company is expected to earn significantly less interest income going forward due to the JDX which was implemented in February 2010. If the company does not invest in any new ventures, it is likely they will pay out dividends to investors.

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1.35

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2005 2006 2007 2008 2009 2010 Last 12M

Debt-to-Equity Financial Leverage

0

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700

2005 2006 2007 2008 2009 2010 Last 12 M

Total Assets Total Shareholders' Equity

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Total Current Assets Total Current Liabilities

Current Ratio

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Outlook

Salada Foods Jamaica Limited, the largest producers of coffee and coffee based products in Jamaica has

consistently recorded improved revenue and profitability over the past 10 years. Revenues grew at a

compounded annual growth rate (CAGR) of 10% while profits climbed by a CAGR of 28% in the same

period.

As the global recession unwound in 2008, Salada was proactive in reengineering its distribution and

marketing operations to increase productivity while limiting the exposure to volatility in raw material

costs. The company assigned Musson Jamaica limited as the exclusive distributor of coffee on the

domestic market and this allowed better focus there marketing and distribution, leading to revenue

growth.

In recent years, the company has improved its internal infrastructure and broadened the distribution of

its products particularly in the overseas markets. Recently, Salada commenced distribution in China,

while maintaining exports to other markets within the Caribbean, North America and Europe.

Nevertheless, Salada Foods maintains a strong reliance on the domestic market which is the primary

contributor to its revenue base and profits. According to the company’s management, the export market

accounts for about 12% of revenues and may be an avenue for growth in future periods. In fact, the

company attributes top line growth in its latest nine months results to June 2010 to increased

exportation.

The outlook on the instant coffee business remains fairly strong both locally and internationally. The

premium brands are likely to continue facing downward pressure due to the sensitivity to consumer

spending both locally and internationally. Salada demonstrated strong revenue growth amidst the

economic headwinds and we believe as conditions improve, the company will reap further benefits. In the

short to medium term, we expect Salada to continue growing its revenue base and profitability through:

continued penetration of the international markets, introduction of value added products and more

focused marketing. Net profit is expected to grow approximately 16% over the next 10 years, with Salada

being viewed as a company significant growth potential

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Projections & Valuations

Stock Market - Going forward, the stock market is expected to rebound with a lower interest rate environment and gradual improvements in the local economy. Our valuation of the index suggests it could grow to 95,000 points within 12 months. Cost of Equity is derived by using the CAPM model. Without any debt on the company’s balance sheet, we would be unable to tell the cost of debt using a method such as the weighted average cost of capital (wacc). The risk free rate is estimated based on the yield of a liquid 10 year GOJ bond (local). Beta had to be estimated at 1.0, due to the low correlation between the movement of the JSE index and Salada. The market risk premium (MRP) was computed using the relative volatility of the JSE versus the NYSE and multiplying it by the market risk premium of the NYSE, to obtain the JSE MRP. A liquidity premium of 1.5% used to account for the illiquidity of the company’s shares. FCFE Valuation – Utilizing a free cash flow to equity (FCFE) valuation, our price target for Salada is $11.76 compared to the current market price of $9. The model assumes an average bottom line growth rate of 16% over the next 10 years and a sustainable growth rate of 10% thereafter. These assumptions are our fair estimate of the company’s future growth prospects and are also less aggressive than the historical performance Relative PBV Valuation – The average PBV of manufacturing companies on the JSE is 1.40 whereas trades at 1.44X times. While SALF is now in line with the industry, they were previously 2nd highest PBV in the market. With the significant cash resources on the company’s balance sheet, this metric is very important to watch. Relative PE Valuation – The manufacturing industry PE is 10.44X and Salada’s trailing PE is 12.31X. We believe the relatively higher PE is justified due to stronger growth expectations than the manufacturing sector which company has achieved over the last 10 years. Additionally, the higher PE is due to lower 2010 earnings which should improve within the next 12 months.

FCFE Model – Two Stages

Cost of Equity 15.61%

First Phase Growth Rate 20.00%

First Phase Growth Period 10 Years

Final Phase growth rate 10.00%

Cost of Equity - CAPM

Risk Free Rate 11.5%

Market Risk Premium 3.61%

Beta* 1.00

Liquidity Premium 1.50%

Cost of Equity 15.61%

*estimated due to the low correlation of SALF stock and market indices

Method Price

Market Price $9.00

FCFE Model – Fair Value

$11.76

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Technical Analysis

Momentum Indicators

Based on the low trading activity of the stock, momentum

indicators could give misreading signals but are still used

as a guide.

Relative Strength Index (RSI) – The RSI is a

momentum indicator which suggests a buy reading when

below the 30 mark and sells above the 7o mark. At 41.73,

the indicator is in the hold zone.

Commodity Channel Index (CCI or CMCI) – Similar

to the RSI indicator, a buy rating is generated below -100

and a sell rating above 100. The signal is currently

between both ranges and suggests a hold.

RSI

CMCI

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Recommendation

Salada has had a challenging 2010, stifled by weak consumer demand, increased production

costs and lower investment income after the JDX. However following major factors are

considered in determining the recommendation

1. We expect the economy to resume growth within 12 months and the measures taken by

Salada should result in greater returns.

2. As a dominant player in the instant coffee business, we believe can continue to grow their

market and improving their margins by the introduction of value added products such as

the 3-in-1 instant coffee mix)

3. The company’s high cash balance and pronouncements from management suggests they

are looking for growth and expansion opportunities.

4. Our FCFE valuation model suggests the stock is valued 31% higher at $11.76.

5. PE and PBV relative valuations show that the stock is trading above the market (PE) and

in line with the market respectively (PBV). We believe both valuations are justified and we

also expect that Salada’s profit growth will outpace the industry.

6. High cash resources suggest there could be a dividend capital distribution in the future

unless the company finds new ventures to expand.

With most factors being favourable for Salada and fair value which suggests the stock is

underpriced at a market price of $9 and fair value of $11.76, we recommend Salada as a BUY.

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Appendix 1 – Financial Summary

J$ Millions 2005 2006 2007 2008 2009 2010 Last 12 M Q1 2010 Q1 2011 SEP 2011E SEP 2012E

Income Statement

Revenues 268.74 302.93 342.75 393.80 432.43 426.38 433.54 103.63 110.80 484.92 512.80

Cost of Revenue 185.30 192.53 201.11 230.98 234.78 260.15 266.80 62.51 69.16 303.07 320.50

Gross Profit 83.44 110.40 141.64 162.82 197.65 166.22 166.74 41.13 41.64 181.84 192.30

Other Operating Revenue 0.90 1.80 2.67 2.32 2.77 2.56 1.74 0.92 0.10 0.37 2.59

Selling, General & Admin Expense

69.49 63.68 55.88 72.27 75.18 77.38 80.53 20.71 23.86 78.94 81.39

Operating profit 14.84 48.52 88.44 92.87 125.24 91.40 87.96 21.33 17.89 103.28 113.50

Interest Expense 0.35 0.16 0.26 0.37 2.59 2.62 2.62 0.00 0.00

Interest Income 14.66 21.54 39.18 34.30 29.56 10.94 6.20 34.46 30.00

Pretax Income 5.57 56.09 102.83 114.03 161.84 123.09 114.90 32.27 24.09 137.73 143.50

Taxation 2.82 19.17 34.67 38.71 53.64 41.68 38.95 10.76 8.03 45.91 47.83

Net profit 27.45 36.93 68.17 75.33 108.20 81.41 75.95 21.52 16.06 91.82 95.66

Balance Sheet

Cash and Short Term Investments

68.279 96.405 162.833 163.827 275.675 303.411 291.207 273.117 291.207

Total Assets 228.016 255.788 327.661 401.082 526.89 604.953 595.414 523.099 595.414

Total Current Liabilities 37.486 34.11 41.458 42.538 57.676 68.519 42.561 63.527 42.561

Long Term Loans 22.412 17.266 12.262 7.211 1.311 0 0 0 0

Total Liabilities 54.752 50.339 54.046 52.139 69.752 97.551 71.955 75.603 71.955

Total Shareholders' Equity 173.264 205.449 273.615 348.943 457.138 507.402 523.459 447.496 523.459

Ratios

Gross Margin 31% 36% 41% 41% 46% 39% 38% 40% 38% 38% 38%

Operating Margin 6% 16% 26% 24% 29% 21% 20% 21% 16%

Net Margin 10% 12% 20% 19% 25% 19% 18% 21% 14%

ROA 12% 14% 21% 19% 21% 13% 13% 4% 3%

ROE 16% 20% 28% 24% 27% 17% 15% 5% 3%

Debt-to-Equity 13% 8% 4% 2% 0% 0% 0% 0% 0%

Interest Coverage 42.41 299.50 340.13 249.64 48.43 34.94 33.62

Financial Leverage 1.32 1.25 1.20 1.15 1.15 1.19 1.14 0.00 0.00

Current Ratio 4.21 5.61 6.44 7.93 8.04 7.62 12.03 7.23 12.03

Per Share Data

Book Value per Share 1.67 1.98 2.63 3.36 4.40 5.40 6.40 6.40 7.40 4.50

Revenue Per Share 2.59 2.92 3.30 3.79 4.16 4.10 4.17 1.00 1.07 1.03

Earnings Per Share 0.26 0.36 0.66 0.73 1.04 0.78 0.73 0.21 0.15 0.76 0.92

Free Cash Flow Per Share -0.15 0.21 0.51 -0.18 0.76 0.00 0.00 0.00 0.00 10.00

Price 22 26 67 92 10.75 11.75 9 12.75 9

Valuation Metrics

Price To Book Value 0.13 1.31 2.54 2.74 2.44 2.18 1.41 1.99 1.22 2.22

Price to Revenue Per Share

0.85 0.89 2.03 2.43 2.58 2.86 2.16 12.78 8.44

Price to Earnings per Share

8.33 7.31 10.21 12.69 10.32 14.99 12.31 61.56 14.56

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Bibliography

Author Website

Jamaica Stock Exchange www.jamstockex.com

International Monetary Fund (IMF) www.imf.org

Bank of Jamaica www.boj.org.jm

Planning Institute of Jamaica www.pioj.gov.jm

Statistical Institute of Jamaica www.statinja.com

Business Monitor International www.businessmonitor.com

Bloomberg (Terminal) www.bloomberg.com

Investopedia www.investopedia.com

Coffee Industry Board www.ciboj.org

Salada Foods Jamaica Limited www.saladafoods.com