SRI LANKA: ASI LEAPS A STEP FORWARD…

With the extended bull run witnessed during this week, we believe the market would consolidate at current levels whilst continuing to generate healthy turnover levels during the coming weeks. We further expect the market to be driven by local high net worth; retail and institutional participants where the primary interest would be on mid cap stocks in the short run.

Going forward, with the positive macro developments and anticipated increase in economic activity coupled with the gradual recovery of global economy trickling down to the corporate sector, we believe the corporate sector earnings would rise by circa 30% YoY from 2010 onwards . This would be further strengthened by the policy decisions of the Central Bank to ease off foreign exchange controls, maintaining low interest rates, development of North and East etc.

Whilst the recent gains on most of the counters have been based on company fundamentals, a few others have gained more on speculations and rumours. Thus we strongly recommend investors to focus on companies with sustainably high ROCEs and earnings growth potential.

The market currently trades on trailing 4 quarter earnings multiple of 20.4X. However, given our expectation of higher corporate earnings from 2010 onwards we believe further long term upside is inevitable with the micro and macro changes taking place in the environment.

Our favourites would be the banking, hotels and consumer sectors, whilst diversified and manufacturing sectors could become secondary market movers. We see pockets of strong growth in key sectors such as Banking (Hatton National Bank, Commercial Bank, National Development Bank, Sampath Bank, Seylan Bank), Hotels (Asian Hotels & Properties, Aitken Spence Hotel Holdings, Keells Hotels, Stafford Hotels, Serendib hotels), Consumer (Hemas Holdings, Distilleries, CW Mackie), Manufacturing sector (Lanka Tiles, Royal Ceramics, Chevron Lubricants) and Diversified Sector (John Keells Holdings, Aitken Spence, Colombo Fort Land).

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Sri Lanka Policy rates not lowered because banks won’t lend’

The Central Bank could have reduced policy rates further but were adamant that caution was best in keeping inflation low but an IMF official in Sri Lanka says another reason not to reduce rates could have been the reluctance of commercial banks to pass on the benefit in terms of lower borrowing rates.

"When the IMF assists a country, one of the first things we do is to look at inflation and the interest rate environment. In most cases, their monetary polices are either too loose or too tight and we have to tell countries to either tighten policy interest rates, or to relax them. But in Sri Lanka, things were different," Dr. Koshy Mathai, IMF Resident Representative in Sri Lanka, told a recent forum.

"We told the Central Bank that there was a little more room for policy rates to be loosened but the bank told us ‘No’. The Central Bank said they preferred to be cautious in what they did, not wanting to do anything that could have inflationary pressures.

"But another reason for not wanting to reduce policy rates further may have had to do with the fact that commercial banks were not prepared to reduce their lending rates. The Central Bank may have thought there was no point in doing things to benefit commercial banks if these benefits were not passed on to the public," Dr. Mathai said.

Sri Lanka was holding talks with the IMF when the country was on the brink of balance of payments crisis towards the end of 2008 and the first few months of 2009.

By the time the IMF finally approved the US$ 2.6 billion standby facility in July 2009, Sri Lanka’s economy was already showing signs of improving because of the end of the war in May, which saw an increase foreign investor sentiment.

Headline inflation, which peaked at 28.2 percent in June 2008, a year where global food and oil prices reached never-before-seen heights, declined throughout 2009 and the Central Bank began to reduce policy rates and also relax penal interest rates on commercial bank borrowings with the intention of stimulating economic activity in the post-war economy.

But the banks were slow to respond.

"When we first came to Sri Lanka, banks were telling us that investors were not demanding credit from the banking sector. But now, they tell us that investors are practically begging for credit to invest in new projects.

"Since these borrowings are not for consumption, but are big investments they are not inflationary," Dr. Mathai said.

Policy interest rates are set at 7.5 percent (repurchase rate) and 9.75 percent (reverse repurchase rate). A year ago these rates stood at 10.25 percent and 11.75 percent respectively.

The average weighted fixed deposit rate of commercial banks last week stood at 10.46 percent. A year ago it was 16.92. The average weighted prime lending rate of commercial banks was 10.80 percent last week; a year ago the rate was 19.18 percent.

Dealers told the Island Financial Review that private sector credit was beginning to pick up but most investors were still cautious, adopting to wait until general elections are over by April this year.

Inflation expectations are picking up some dealers said.

"Global commodity prices are expected to pick up later this year and so inflation is expected to increase like the Central Bank said it would, but headline inflation is expected to remain in single digit levels. But the problem is in the fiscal front.

"We already see short term Treasury bills inch upwards for past several weeks, an indication that the government is thirsty for cash. Without a proper budget until May or after, it is going to be difficult to see how fiscal policy is going to make it easy for the Central Bank to conduct its monetary policy," a dealer said.

The Central Bank said last week it would keep policy rates as they were so as to stimulate economic activity through credit growth. It said it would continue to monitor inflation closely.

By Devan Daniel

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Sri Lanka may miss 2010 IMF deficit goal

COLOMBO, Feb 23 - Sri Lanka's 2010 budget deficit target for 2010 set by the International Monetary Fund as a condition for a $2.6 billion loan will be challenging to meet due to high post-war government spending, the central bank chief said.

Sri Lanka, which ended a 25-year war in May last year, promised to cut its fiscal deficit to 6 percent of gross domestic product this year.

"It's challenging." Governor Ajith Nivard Cabraal told Reuters on Tuesday. "The commitment is there. At the same time there may be areas where have to recognise that there is huge expenditure because we are in a post-conflict era."

He said the extra spending will help to achieve political stability.

"Long-term political stability is essential for us and sometimes we may have to sacrifice short-term gain. So that's the trade off."

The central bank has already acknowledged that the $40 billion economy has likely missed last year's budget deficit goal of 7 percent set by the IMF.

Since the end of the war, Sri Lanka has attracted more than $1.6 billion in foreign investment into government securities and $500 million into a sovereign bond. However, foreign direct investment is down close to 2006 levels.

"Last year the FDIs were in the range of around $600 million. In the context of the global situation we shouldn't get discouraged by that," Cabraal said.

The central bank is not considering to increase the limit of foreign investments in government securities from 10 percent, but foreigners can invest in more than $400 million worth of development bonds, which are likely to be rolled over this year, he said.

http://news.alibaba.com/article/detail/markets/100251244-1-interview-sri-lanka-may-miss-2010.html

Source: Reuters

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CW Mackie PLC (CWM) - Good Times Ahead!

Salient features 

• Share is worth approximately Rs 65/= on the basis of varied valuations. 
• One of the largest Exporters of Natural Rubber and Desiccated Coconut in Sri Lanka. Company exports approximately 3,500MT of Crepe Rubber, 4,000MT of Tech.Sp.Rubber and 3,000MT of Desiccated Coconuts.  
• Strong Local Distribution Network for branded consumer products. 
• Valuable land base which include a Long Term Leasehold ownership of prime property in Colombo ideal for development. 
• State of the art bottling plant for Bottling of renowned “Sun Quick” range of products under franchise and “Scan” Drinking water. Company bottle and distribute approximately 2mn liters’ of “Sunquick” and 3mn liters’ of “Scan” bottled water per annum respectively. 
• Importer and wholesale distributor of approximately 15,000MT of Sugar.
• Import and resale of Industrial and Light Engineering products.
• Agent for “Hempel” marine paint and protective coatings.

Company Profile
The CW Mackie was founded in 1900 by the late Mr C.W.Mackie a Scotsman, who carried on the enterprise as Merchants and Commissions Agents under the name of ‘CW Mackie & Company’. In 1922, the business was incorporated as a private limited company. In 1946, a consortium of Ceylonese and Indian Businessman bought over the shares of the company and converted it to a public company.

The year 1971 marked a significant change when Ceylon Trading Company Limited, the Sri Lanka based subsidiary of Aarhus United A/S of Denmark, bought a part of the Indian shareholding and took over the management of the company. In late 1994, shares equivalent to 25% of the total shares in the company were issued to the public so as to broad-base the ownership of and give the Company greater access to the capital market of Sri Lanka to raise capital funds for the future diversifications and expansions.

The Group consist of CW Mackie PLC and three subsidiary companies engaged in a diversity of activities such as export of primary and manufactured products, ranging from all types of natural rubber and coconut products to rubber based products; import, manufacture and distribution of sugar; import and resale of branded marine paints and protective coatings, welding equipment and consumables, refrigeration and air-conditioning and light engineering products.

Market Prices
The price movement of CW Mackie shares during the period from 18th February to 19th February 2010 are depicted in the graph below.

The highest traded price (year to date)  - Rs. 43.25

The lowest traded price (year to date)  - Rs. 11.00
The current trading price (19/02/2010) - Rs. 41.75

The share price does not reflect the true value of the company as the liquidity of the share is less than 10%. Three largest shareholders namely Lankem Ceylon PLC, Kotagala Plantation PLC and high networth investor Dr Thirugnanasambandar Senthilverl owns approximately 90% of the issued share capital of the company.

Price Earnings (PE) Multiple Valuation
Net earnings of the current year ending 31st December 2009, are estimated considering the earnings made by the Company up to 30th June 2009 and assuming the past trend of earnings to continue for the balance period while accounting for recent market conditions.

The current Market PER of the Colombo Stock Exchange is around 18 times. However, for the purpose of valuation we have assumed a realistic PER of 15.0 times. Accordingly the FY 2009 PER based valuation of the Company is approximately Rs. 62 per share.

Dividend Yield Based Valuation
Dividends based valuation is determined on the basis of 15% annual rate of Dividend growth and Terminal value derived through an exit price calculated linked to the current market dividend yield. Average dividend growth rate of 15% assumed as a against the Company’s forecast dividend growth rate of 33%. Also Cost of Capital/Discount Rate of 20% is assumed for the purpose of discounting future dividends and exit proceeds. No Dividend tax is considered.

Net Asset Value / Price to Book Value
The Net Asset Value is estimated based on the Balance Sheet of the Company as at 30th June 2009. Net Asset Value considers the market value of the assets after deducting the total liabilities divided by the number of ordinary shares in issue.

Considering the Net Asset Value per share computed above, we have estimated below the value per share based on the Price to Book Value (P/BV) ratios of the market as well as the Trading Sector Stocks of the Colombo Stock Exchange. Accordingly the FY 2009 PBV based valuation of the Company is approximately Rs. 76 per share.

* above valuation include adjustment of Rs 800mn assuming that the 253 perch property of CW Mackie PLC located at # 34, 36 DR Wijewardena Mawatha which is leased from the Urban Development Authority (UDA) is extended for a further period. Adjustment assumes the market value of the freehold property .


Why CW Mackie PLC is a strategic fit for Lankem Group?

• Lankem owns Rubber Plantation Companies such as Kotagala and Agarapatana and ownership of CW Mackie being one of the largest exporters of rubber will enhance the value chain of the group in a typical forward integration.
• EB Creasy and Darley Butler and Company would benefit through the integration of Distribution arm of CW Mackie and the "Scan" and "Sun Quick" product range. This will allow better market penetration and lower cost of distribution.
• CW Mackie leasehold ownership of property located at DR Wijewardena Mw, is considered to be valued over Rs1bn. This property is facing the road frontage from one side and Beira Lake Frontage from the other. This is an ideal location for mixed development or a recreation facility under a selected theme.
• Lankem group is a net importer whereas CW Mackie is a net exporter, which is expected to provide an ideal scenario for hedge against the foreign currency risk of the group.

Estimated Value per Share
In terms of the valuations carried out with regard to the earnings potential, dividend yield and the asset base of the Company and with due consideration of the current market price, liquidity of the stock and the potential of the trading sector in the country and other concerns with regard to the industry, country and global market as a whole, it is estimated that the value of Ordinary Shares of C W Mackie Co. PLC would be in the range of Rs. 65 per share.

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Distilleries Company of Sri Lanka (DIST) - Outlook remains positive

Originally set-up as a pioneering distillery, Distilleries Company of Sri Lanka (DIST) has pursued a policy of planned growth which has resulted in its transformation from a cash rich beverage play to a diversified company with exposure to key sectors of the economy. However, the company's primary focus remains on liquor products.

DIST has secondary interests spanning into diverse industries such as Telecom, Plantation, Textiles and through an associate stake in Aitken Spence in fields ranging from leisure to power.

The loss of Sri Lanka Insurance to the state subsequent to the Supreme Court ruling, coupled with the reduced earnings from Lanka Bell has curtailed DIST's 3QFY10 net  earnings. DIST's core hard liquor business has contributed 88.5% of the group's PBT during the quarter however the sectoral PBT dipped 14.2%YoY to LKR1,086.8 mn, whilst Lanka Bell recorded a loss of LKR132.6 mn (vs a loss of LKR112.0 mn). The plantation earnings improved significantly with the sector posting a PBT growth of 224.8% to LKR80.6 mn.

Quarterly performance at a glance
Net turnover dipped by 48.9%YoY in 3QFY10. Consolidated 3QFY10 net revenue has dipped by 48.9%YoY to LKR5,088.1 mn. This is mainly on the back of the lost earnings from SLIC and Lanka Hospitals (previously known as Appollo Hospital). However, net revenue has been spearheaded by the growth in the core distilling operation (up 9.0% YoY to LKR8,200.9 mn) amidst stringent laws passed to reduce liquor consumption.

However the contribution from Lanka Bell (down 20.4% YoY to LKR1,207.9 mn) and diversified sector (down 53.1%YoY to LKR314.6 mn) have dipped during the quarter under review mainly the on back of slow down in incremental subscriber growth in the fixed line segment coupled with the price war amongst the operators and the lost dividend income from SLIC received by the companies under diversified sector.
Gross profit down 28.8% YoY in 3QFY10. DIST's cost of sales has dipped by 60.2%YoY to LKR 2,528.3 mn in 3QFY10 due to reduced level of activity (on the back of losing SLIC and Lanka Hospitals). Whilst cost of sales of DIST's core liquor operation too has dipped by 2.5%YoY to LKR1,559.7 mn. DIST posted a gross profit of LKR2,559.8 mn, down 28.8%YoY in 3QFY10 whilst gross margins have improved to 50.3% in 3QFY10 (vs. 36.1% in 3QFY09).

Operating profit has dipped by 32.7%YoY to LKR1,160.7 mn in 3QFY10. Income from investments has fallen by a sharp 95.5%YoY to LKR80.1 mn in 3QFY10 largely due to the lost interest income earned by SLIC. Administrative expenses have dipped by a sharp 45.7%YoY to LKR764.5 mn whilst distribution cost has increased by 9.4%YoY to LKR714.8 mn in 3QFY10. The consolidated 3QFY10 operating profit has dipped by 32.7%YoY to LKR1,160.7 mn whilst the operating margin has improved to 22.8% in
3QFY10 (vs. 17.3% in 3QFY09).

Consolidated 3QFY10 pre tax profit dipped 27.0% YoY to LKR1,227.4 mn. DIST's finance cost has dipped by 22.6%YoY to LKR147.9 mn in 3QFY10 where the borrowing have halved to LKR4,282.6 mn on the back of losing SLIC. Further, the share of profit from associates has grown by 43.5%YoY to LKR214.6 mn largely on the back of improved performance from conglomerate Aiken Spence (SPEN, LKR1,230) despite DIST's current reduced stake in it. Consequently, DIST has posted a pre tax profit of LKR1,227.4 mn, down by 27.0%YoY in 3QFY10.

Consolidated 3QFY10 net profit records LKR841.4 mn (down 37.4% YoY). Income Tax expense has dipped 11.7% YoY to LKR338.2 mn due to reduced earnings. Consequently, DIST has posted a net profit of LKR841.4 mn, down by 37.4%YoY in 3QFY10.

The net profit margin has improved to 16.5% in 3QFY10 (vs. 13.5% in 3QFY09). Forecast FY10E net profit to reach LKR2,802.9 mn (down 17.2% YoY). The loss of SLIC coupled with the anticipated slowdown in returns from Lanka Bell and affected earnings of plantations due to the drought prevailed during the first half of the year drags down the anticipated profit for FY10E to LKR2,802.9 mn (down 17.2% YoY). On the back of the anticipated strong performance from the core distilling operation with the previously war affected North and East opening up and reduced losses from Lanka Bell, we expect DIST to post LKR3,349.1 mn (up 19.5% YoY) in FY11E.

Fundamental outlook remains healthy. Despite the temporary setback caused by the Supreme Court ruling on SLIC we believe future prospects for DIST are promising in the medium run, given the sustained growth in the beverage sector and with the purchase consideration being paid provides the company the opportunity to capitalize on future lucrative investment opportunities (however the nature of the bonds is still not known).


If the company would hold the bonds till maturity then the interest payment (circa LKR635 mn, assumed @10.5% coupon rate) would cushion the lost earnings from SLIC (On average SLIC has been contributing a near LKR600 mn to the bottom line).

Further, DIST has ventured into the Insurance business with the Insurance Board of Sri Lanka approving the registration of "Continental Insurance Lanka Ltd" as a fully owned subsidiary of DIST. DIST has planned an initial investment of LKR500 mn and if necessary the provision will be increased to LKR1.0 bn. We believe the Insurance Company is planned to start up as a Greenfield project and is deemed to have exclusively the
General Insurance business.

Given its proven ability to sustain robust earnings through new acquisitions, coupled with the favourable macro environment and cash rich liquor business, the share is attractive at present trading on 10.4X forecast FY11E net earnings and 1.3X PBV. Maintain - BUY.

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Sri Lanka: Plantation Sector Report

Investment Summary

Sri Lankan tea prices at record high levels: Sri Lankan tea prices marked a strong recovery from 2QFY10 onwards where it touched the highest ever prices in mid September which was recorded at LKR456 per kg (up 70% YTD). The upswing was mainly attributable to the global supply shortage created by the production deficit in Kenya, India and Sri Lanka due to unfavourable weather conditions. Furthermore, strong demand from the Middle East for Sri Lankan low grown teas and rising demand lead by slowly reviving global economy also strengthened the price increase. Going forward we expect the tea prices to stabilise at current levels and ease by mid 2010 with the production recovering globally. We forecast the prices to remain at LKR360 in 2009 and to reach LKR 389 (up by 8%) in 2010E.

Natural rubber prices on the rise: Local rubber sector suffered severely since FY08 owing to the global economic downturn where synthetic rubber was preferred by the buyers due to lower cost. Natural rubber prices have now started picking up on the back of rising fuel prices which will make synthetic rubber more expensive. Sri Lankan rubber prices which were at the lowest in December 2008 (LKR120 per kg) have now reached LKR350 per kg. We believe the upward price trend would sustain with the rising crude oil prices (now closer to USD80 per barrel) which would further strengthen the demand for natural rubber. Therefore we forecast the rubber prices to be at LKR211 per kg for 2009 and grow by a sharp 30% YoY to LKR274 per kg in 2010E.

Sector profitability to recover: The sector was poised to mark strong earnings in FY10E owing to high commodity prices. But the growth was hindered by the estate labour wage hike which increased the cost of production by a near 20% with effect from April 2009. However we believe the +70% rise in tea and three-fold rise in rubber prices would be able to wither the negative effects of the cost of production to a certain

extent. With tea prices stabilising at current levels and rising rubber prices which would be sustainable in the long run, we forecast the sector to record a strong earnings during the coming quarters.

Our key recommendations would be Malwatta (MAL), Kegalle (KGAL), Kotagala (KOTA) and Namunukula (NAMU) mainly on the back of strong earnings potential (where most of the companies have recorded results above expectations) coupled with strategies to strengthen the bottom line through aggressive cost management policies.

Tea Sector

Tea prices on a secular uptrend. Sri Lankan tea prices are at an all time high, despite the impact of the global financial crisis. The Net Sales Average (NSA) of tea at the Colombo Auction has risen by 74% YTD to LKR440 per kg, underpinned by continuing healthy demand from the key buying regions of the Middle East and Russia/Central Asian countries and also a shortfall in supply in the major growing regions of Asia and

Africa.

Prices of low grown teas, mostly consumed by markets in the Middle East have risen by 70% YTD to a record LKR456 per kg in September 2009 whilst those of high grown teas have soared by a similar percentage to LKR413 per kg.

Tea prices have been rising strongly over the past three years underpinned by increasing income levels in key markets in the Middle East, Russia/Central Asian republics, India and China. Prices at the Colombo Auction rose by 40% YoY to LKR 279 per kg in 2007 and surged further to a record high of LKR342 per kg in July 2008 before falling to LKR302 per kg at the end of the year following the impact of the global credit crisis.

Nevertheless, average tea prices were up 8% YoY in 2008 to LKR302 per kg.

Global tea prices in 2009 have been underpinned by a shortfall in output following drought conditions in the key growing regions. Nevertheless, strong underlying demand (despite the global economic slowdown) in the major consuming markets has also contributed to the positive price trend. We are of the opinion that tea prices are on a secular long term uptrend due to;

• a fundamental global shortfall in supply, as very little new planting has taken place,
• rising income levels in key consuming markets, and
• a switch in consumption from other beverages to tea as the health benefits of the product is recognized.

Consequently, we forecast the NSA of tea at the Colombo Auctions to rise by 20% YoY to LKR361 per kg in 2009, by a further conservative 8% YoY to LKR390 per kg in 2010 and by 10% YoY to LKR429 per kg in 2011.

Low grown tea prices to rise on demand from Middle East. The stronger flavored low grown teas are primarily consumed in the Middle Eastern and Russia/Central Asian markets and we expect demand from these regions to continue to improve as crude oil prices recover in the years ahead. Whilst new supplies of similar flavored and colored teas have come to the market from Vietnam, much of this output is being consumed by China. Consequently, we expect demand for Sri Lanka’s low grown teas to improve strongly.

High grown tea prices to increase on switch to tea from other beverages. The lighter colored and flavored high grown teas have been the bedrock of the tea industry. High grown teas are essentially demanded by the more discerning markets in Europe, which have traditionally preferred Coffee. However, with the increasing trend towards consumption of healthier beverages, we expect demand for high grown teas to improve.

Tea production to recover in 2010. Sri Lanka’s tea production rose by 4% YoY to 317.7 mn kg in 2008 following favorable weather conditions, uninterrupted factory operations and the cumulative impact of good agricultural practices.

In 2009, severe drought conditions have caused tea output to fall sharply in the first half of the year. Whilst tea production was down 41% YoY to 48.7 mn kgs in 1Q2009, 2Q2009 witnessed only a modest decline of 5.8% to 83.5 mn kgs as weather conditions improved. Further, wage related industrial action resulted in output being curtailed in 3Q2009, resulting in output falling by 8.2% YoY to 48.9 mn kgs in the first two

months of that quarter. The cumulative impact of the above was a 19.5% YoY decline in tea output to 181 mn kg in the first eight months of 2009. However, with improved weather and record high prices inducing higher leaf intake, total production for 2009 ended up with 289.8 mn kg which is down 9% Y0Y.

Looking ahead, assuming favourable weather conditions, continuing strong prices and the positive impact of replanting of higher yielding varieties, we believe that yields would revert to around the historical average of closer to 1,400 kgs per hectare. And given the fact that the area under cultivation is unlikely to change from the current 222,000 hectares, we are projecting tea output to rise by 4.2% YoY to 301.92 mn kgs in

2010 and further by 2.9% YoY to 310.8 mn kgs in 2011.

Increase in Cost of Production to be muted. Although non-wage costs (especially fertilizer and energy related expenses) rose by over 50% in 2008, the average Cost of Production (COP) of Sri Lankan tea increased by only a moderate 10.8% YoY to LKR262.60 per kg in the absence of a wage hike (wages account for around 55% of total cost of production of tea). This was also due to strong growth in output of over

4% YoY.

Sri Lankan plantation workers’ wages are reviewed every two years according to a collective agreement between the unions and the companies. The previous collective agreement, where the wage per worker per day was fixed at LKR290 expired in March 2009. However, following mounting pressure over rising cost of living, a fresh collective agreement was signed between the Plantation Companies and the Trade Unions

which fixed the daily wage of plantation workers at a maximum of LKR405 per day.

Whilst the hefty wage increase of around 40% has been implemented effective April 2009, an approximately 15% decline in non-wage costs (mainly on account of around a 30% decline in energy and fertilizer expenses) the COP in 2009 increased by a significant 17% YoY to LKR 307.6 per kg. However, with the full impact of the wage increase being accounted for in the year and the likely increase in non-wage costs on the back

of global inflationary pressures, we estimate COP to rise by another 5.7% YoY to LKR 334.8 per kg in 2010. We also project COP to rise by a further 12% YoY to LKR 385.8 per kg in 2011 on the back of an equivalent rise in wage and non-wage costs.

Gross margins in tea to remain positive. Despite increasing wages and other input costs, margins in tea have remained positive due to rising prices on the back of buoyant demand. In 2007 and 2008, gross profit of in tea reached LKR42.0 and LKR39.0 perkg respectively, converting to a gross margin of 15% and 13%.

Looking ahead, despite the impact of higher wages, we expect rising tea prices to enable tea plantations to

maintain healthy margins of 14.8% in 2009 (LKR53.58 per kg) and +15% in 2010 .

Rubber Sector

Rubber prices have bottomed out. Natural rubber prices (RSS1 -Ribbed Smoked Sheet) have risen strongly by 104% YTD to LKR318.60 per kg in December 2009 in line with recovery in crude oil prices. As natural and synthetic rubbers (the latter derived from crude oil) are substitutes, the price of natural rubber naturally tracks that of crude oil.

In addition, with Sri Lanka being a relatively small producer of natural rubber, much of the output is consumed by local industry (a near 60% being locally consumed), leaving little of the commodity for export, thus effectively soaring up prices.

In the two years prior to the global financial crisis, natural rubber prices at the Colombo Auctions rose sharply by 25% YoY to an average of LKR234.22 per kg in 2007 and a further 15% YoY to LKR 269.51 per kg in 2008 in tandem with the price of crude oil. In 2008, the price of RSS1 rose to a high of LKR 360 per kg in June, before collapsing to a low of LKR111.10 per kg in December following the global financial crisis.

However, some recovery was witnessed in December itself, with the price of RSS1 closing the year at LKR 150 per kg, enabling the price of the commodity to average LKR 269.51per kg in 2008, due to the severely affected last quarter.

In 2009, natural rubber prices have been buoyed by the recovery in crude oil prices, in addition to tight local supply on account of drought conditions. Further, with global recessionary conditions easing in 2H2009 and crude oil prices continuing to rise, further gains in natural rubber prices appear inevitable. With the price of RSS1 rising strongly by 104% YTD to December 2009, we expect the price of the commodity to average LKR 210.99 per kg in 2009, down 22% YoY on the back of volatile first nine months.

Approximately two thirds of global natural and synthetic rubber production is utilized in automobile manufacture and hence the demand for the commodity is inextricably linked to the fortunes of that industry, in addition to the price of crude oil. Consequently, with the likely recovery in global economic growth in 2010 and further gains in crude oil prices, we are projecting the price of RSS1 to rise strongly by 30% YoY to

an average of LKR274.29 per kg in 2010 and further by 20% YoY to LKR 329.14 per kg in 2011.

Rubber production to rise steadily. Underpinned by remunerative prices, natural rubber output in Sri Lanka has risen strongly over the past five years, from 92 mn kgs in 2003 to a record 129.2 mn kgs in 2008, a CAGR of 7%. With prices rising steadily over the years, replanting and new-planting of rubber land has also continued to increase with the cultivated area being tapped for rubber rising from 86,000 hectares in 2003

to 95,500 hectares in 2008, a CAGR of 2%. Higher prices have also resulted in improved agricultural practices (such as proper and timely application of fertilizer, use of rain-guards, improved tapping techniques etc.) enabling yields of rubber plantations to rise from 1,068 kgs per hectare in 2003 to 1350 kgs per hectare in 2008, a CAGR of 5%.

In 2009, national rubber output has increased to 113.8 mn kgs during the first nine months of the year which has increased by 3.6% from year ago. We believe the full production for 2009 to be around 140 mn Kgs recording a growth of 8% YoY.

With the BRIC economies demanding higher volumes of natural rubber coupled with the East Asian plantations switching from rubber to less labour intensive oil palm, the global natural rubber industry is experiencing a supply deficit which is expected to last beyond 2011. We believe this would further strengthen the demand for Sri Lankan rubber with the recovery of BRIC countries from the global economic downturn.

Looking ahead, we believe that Sri Lanka’s rubber plantations are well placed to reap the benefits of replanting and new-planting programmes and the good agricultural practices adopted over the past few years, enabling yields to rise strongly. Consequently, we are projecting rubber output (weather permitting) to rise by 10% YoY to153 mn kgs in 2010 and by a further 5% YoY to 161 mn kgs in 2011.

Cost of production of rubber is less onerous. The use of fertiliser and energy is much less in the manufacture of rubber relative to tea and therefore, despite the sharp increase in the costs of such inputs, the cost of production of the commodity rose by 9% YoY to LKR114 per kg in 2008. Further, the lower intensity of labour usage also contributed to containing the rise in COP of rubber as no wage increase was affected during the year.

However, following the hefty 40% wage increase in September 2009, COP of rubber is forecast to increase by a slower 4% YoY to LKR118.2per kg in 2009, with the approximate 30% decline in fertiliser and energy costs dampening the impact of higher labour costs. Nevertheless, with the full impact of the wage increase being accounted for in 2010 and the likely increase in non-wage costs on the back of global inflationary pres-

sures, we estimate COP to rise by a further 4% YoY to LKR123.02 per kg in the year. We also project COP to rise by a further 13% YoY to LKR138.8 per kg in 2011 on the back of an equivalent rise in wage and non-wage costs.

Hefty margins in rubber. Given the relatively lower COP of rubber, the gross margin of the commodity has been significantly positive over the past few years. In 2007 and 2008, gross profit of in rubber reached LKR129.4 and LKR155.5 per kg respectively, resulting in gross margins of 55% and 58%. With the recovery in rubber prices, despite the impact of higher wages, we expect rubber plantations to maintain margins of 45% in 2009 (LKR94.9 per kg), 57% in 2010 (LKR155.30 per kg) and 58% in 2011 (LKR181.4 per kg).

Oil Palm Sector

Oil palm to generate healthy margins. Cultivation of Oil Palm is carried out in Sri Lanka only on a very small scale, with just 4 of the 22 regional plantation companies operating a few small estates totalling 2876 hectares. The Crude Palm Oil (CPO) production of these estates is purchased by AEN (Private) Limited, a palm oil processing centre which manufactures Refined Palm Oil (RPO). AEN is a joint venture between Namunukula Plantations, Agalawatte Plantations and Elpitiya Plantations. However, palm oil manufacture is an important revenue and profit source for these companies as the commodity yields significant and stable gross margins/profits. Total output of CPO in 2008 increased by 32% YoY to 29.4 mn kgs.

In 2007, the price of CPO averaged LKR20 per kg whilst cost of production was at LKR8.30 per kg, yielding a gross profit of Rs. 11.6 per kg. This converted to a hefty gross margin of 58%, a remuneratively high level by any industry standard. But the prices fell to LKR16 per Kg in mid 2008 which continued for nearly a year (till August 2009) on the back of decline in global demand created by recessionary pressures.

However by the end of 2009, the companies were able to get back to normalcy with prices ranging between LKR19 – 20 per Kg. With a lower cost of production of LKR6 –8 per Kg, oil palm has given a gross margin of a near 50% for the planters and we believe the margins would further improve in the coming years with increasing prices and declining cost of production.

Opportunities in the green

Apart from the strong earnings potential (backed by the sustainable rubber prices coupled with high tea prices), the sector with its massive land mass has many more opportunities which are mostly untapped.

Tourism would be an ideal opportunity, where the greenery full of magnificent sceneries and soothing climate would be an unmatched competitive advantage over the competitors in the leisure business.

Forestry management is another lucrative business the sector could look into. At present this is restricted by stringent regulations and the sector collectively has proposed ways of sustainable forestry management to the regulatory bodies.

Furthermore, power generation using hydro, dendro and wind power to source its own electricity requirement would be another opportunity the sector could look into. This would result savings on the electricity expenditure (where 1 unit of electricity is consumed to produce 1kg of made tea) which would lead to reduce the cost of production significantly.

Investment Recommendation

Having recorded fluctuating profits during the past two years, prices of tea have picked up sharply since mid 2009 resulting better profit margins despite the wage hike pressure. In addition, rubber which experienced the lowest ever prices in December 2008 recovered during the last quarter of 2009 which is now enjoying LKR350 per kg on the back of rising global activity levels.

Island wide gross margin for tea in 2008 stood at 13% (2% dip from 2007) where as it is now at 15%. The margin was somewhat limited by the near 20% hike in COP resulted by the wage hike with effect from April 2009. However we believe the margins would be sustainable in the coming quarters giving a healthy margin of +15% for 2010E.

Rubber which used to generate the highest margins, faced the worst ever times ever on the back of global economic downturn which made the synthetic rubber (a by product of oil) cheaper and reducing the demand for natural rubber. This made the +50% margins enjoyed over the past years (since 2006) erode to 40% levels. Even though the prices picked up in the later part of 2009, backed by the slow recovery of

global activity we believe the year round margin to stabilize at 40% and to increase to 56% in 2010E.

The sector, which comprises of 18 listed companies, has posted LKR682.7 mn of net earnings during the last four quarters. It is currently trading at 28.3X on trailing 4 quarter earnings whilst trading at 1.2X PBV. The sector as a whole has marked a significant improvement from a week ago where the four quarter trailing PE was at 41.7X.This is directly attributable to the strong earnings released by a few counters during the week.

Looking at the above chart it is evident that sector has traded between 0.9X - 18.9X during the past four years. Going forward, we believe the sector may reach a target PE of 18X in the near future, making the sector more attractive.

When considering individual companies, our key buys would be Malwatta (MAL), Kegalle (KGAL), Kotagala (KOTA) and Namunukula (NAMU) mainly on the back of strong earnings potential (where most of the companies have released results above expectations) coupled with strategies to strengthen the bottom line through aggressive cost management policies. In addition we would also rate Banalangoda (BALA), Horana

(HOPL) as secondary buys considering their earnings which is below the earnings of the key buys but far above the rest of its peers.

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Colombo Fort Land & Building Company PLC (CFLB) the fully diversified conglomerate

COMPANY PROFILE
The Colombo Fort Land & Building Company PLC is a public limited liability company incorporated and domiciled in Sri Lanka and listed on the Colombo Stock Exchange.

The Company was incorporated on 30th April, 1895 for the purpose of acquiring the premises known as Leyden Bastian located in Fort of Colombo then, occupied by the Wharf & Warehousing Company Limited, and to develop this site to meet burgeoning demand for high quality office accommodation in the city.

Over the years, the Company has expanded by organic growth as well as strategic acquisitions and has evolved from a passive property owning company into a dynamic conglomerate with diverse interest in real estates, chemicals and paints, consumer products, distribution, manufacturing, construction, leisure management, plantations and investments.

GROUP HOLDINGS STRUCTURE

LATEST RESULTS - 31st December 2009

ASSET VALUE

REAL ESTATE AND PROPERTY MANAGEMENT
The freehold land and building located at the Sir Baron Jayathilaka Mawatha is owned by the Colombo Fort Land & Building Company PLC and the Company has rented out the building to tenants at market rates.

York Arcade Holdings PLC, a subsidiary owns a building equipped with modern office facilities and has rented out the premises to tenants at market rates.

CHEMICALS
Lankem Ceylon PLC, a Group subsidiary started its agrochemical business in in 1973. hey represent companies such as Syngenta, Dupont, Kumiai, Nissan, Sumitomo, Mitsui and Algea.

The Company manufactures markets and distributes agricultural products, namely Weedicides, Insecticides,
Fungicides and Foliar Fertilizers.

Lankem Ceylon PLC holds a strong position in the chemical sector solvent market. The Company imports all its raw materials from reputed companies such as Exxon Mobil, Sasol, CKG Chemicals.

The Company is an island-wide distributor for Ceylon Petroleum Corporation and continues to be the largest private sector distributor making the entire range of bituminous products to the road constructions industry.

PAINTS
Lankem Paints has been in operation from 1984 and is the pioneer coatings manufacturer in the country. The Company currently owns the international brand name Robbialac and markets all the coatings under the same brand.

CONSUMER PRODUCTS
The Consumer Products Division of the Group subsidiary Lankem Ceylon PLC specialises in manufacturing and marketing of domestic detergents, household insecticides and general purpose cleaners. The Company also imports washing powder.

PLANTATION
Kotagala Plantations PLC and Agarapatna Plantations are owned and managed by the Group.

LEISURE MANAGEMENT
The Group owns and manages three resort hotels. Hotel Club Palm Bay in Marawila is owned by Marawila
Resorts PLC and The Palms at Beruwala is owned by Beruwala Resorts Limited. Sigiriya Village Hotel, which is located in an ancient city is owned by Sigriya Village Hotels PLC.

CONSTRUCTION
The Group’s construction subsidiary, Lankem Developments PLC continues to focus on its core operating activities, namely water proofing and road construction.

DISTRIBUTION
E.B. Creasy & Company PLC, a subsidiary of the Group has an island-wide dealer network, which distributes hardware and automotive accessories, imported from well-known foreign principals as well as locally manufactured items. Darley Butler & Co. Limited has one of the most extensive distribution system in Sri Lanka has one of the largest team of professional Sales Representatives backed by a modern feet of vehicles and long establish network of financially sound goods.

Muller & Phipps (Ceylon) PLC and its subsidiary company Pettah Pharmacy Limited both are serving as agent representatives in Sri Lanka for foreign pharmaceutical companies and are engaged in importing, wholesaling and distribution of pharmaceuticals.

MANUFACTURING
Laxapana Batteries PLC quoted on the Colombo Stock Exchange is the pioneer manufacturer of dry cell batteries in Sri Lanka. The Company manufactures two types of dry cell batteries under the Laxapana brand name.

Creasy Foods Limited is the manufacturer of a range of medicated confectionery under licence from Cadbury Schwepps PLC of UK. The Company has diversified its activities and now produces falaovured sweets as well under the brand name of Candyman.

IMPORT AND MARKETING OF MOTOR VEHICLES & SPARE PARTS
Colonial Motors PLC is engaged in import and marketing of motor vehicles, spare parts and providing maintenance services. The business is highly competitive and continues to face severe competition.Carplan Limited, a subsidiary of Colonial Motors Limited, which holds the Agency rights for KIA Motors in Sri Lanka is engaged in import and marketing of motor vehicles and servicing of vehicles.

INVESTMENTS
Colombo Fort Investments PLC, Colombo Investment Trust PLC and Capital Investments Limited are associate companies in the Group engaged in holding and managing investment portfolios.

KEY SHAREHOLDERS

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Sri Lanka: AHUN records 20% top-line growth despite the off season in tourism

Aitken Spence Hotel Holdings' (AHUN) has recorded a net profit of LKR210.5 mn in 3QFY10 from a loss of LKR105.8 mn in 1HFY10, which is directly attributable to the reviving domestic tourism with higher occupancies and earnings from Maldivian hotels.

AHUN, a 71.7% owned subsidiary of local conglomerate Aitken Spence PLC (SPEN, LKR1379.00) currently operates 9 hotels in Sri Lanka, 7 in Maldives, 5 in Oman and another 5 in India. Company operates its resort portfolio under three brands; namely "Heritance", the premier brand with 5 star luxury properties, "Adaaran", the Maldivian resorts and "Aitken Spence Hotels", comprising of all managed properties. As a part of their asset light strategy, the company is continuously searching avenues to expand its presence regionally and globally using its expertise in hotel management with minimal capital participation .

Gross revenue up 20% YoY to LKR1,985.5 mn in 3QFY10. AHUN's top line has grown by a sharp 20% YoY in 3QFY10 and the result for cumulative 1-3QFY10 is also up by 8.8% YoY despite 6 months of the year falling into the off season of the tourism industry. The Sri Lankan sector recorded an improvement of 10.2% YoY whilst the South Asian sector has grown by a sharp 21.7% YoY during the quarter in concern,
mainly on the back of reviving domestic tourism and Maldivian contributions which were above expectations.

Operating costs have increased by 16.1%YoY in 3QFY10. The company's operating costs have increased by 16.1% YoY to LKR1,541.6 mn in 3QFY10 where as the cumulative growth for 1-3QFY10 was a slower 8.3% YoY. Staff costs and direct operating costs have risen by 7% and 33% YoY respectively during the quarter, on the back of increased activity in hotels whilst depreciation and amortization costs increased by 35% YoY owing to the increased asset base. Other indirect expenses has increased by a marginal 5% YoY in 3QFY10 resulting a dip of 0.8% YoY for the first nine months of the year as a result of the successful cost rationalization exercises implemented in its hotels .


Operating profit of LKR385 mn in 3QFY10. AHUN has converted its marginal profit of LKR69.8 mn in 1HFY10 into a profit of LKR385 mn just in three months due to the reviving local tourism which has shown signs of turnaround in the near future. This was further supported by the Maldivian sector earnings where the occupancy of AHUN's properties has gone up to 70% - 80% except a few resorts catering to niche up market segments.

Pre-tax losses year ago, converted into a profit in 3QFY10. AHUN's Sri Lankan resorts and hotels has posted a pre tax profit of LKR5.32 mn in 3QFY10 from a loss of LKR44.34 mn year ago, reducing the cumulative 9 months loss to LKR154.5 mn (vs a loss of LKR243.3 mn last year, down 36.5% YoY) mainly driven by the growing domestic tourism.

Furthermore, AHUN's associate earnings (Hotel Hill top and Browns Beach hotel) have also grown by stunning 106.5% YoY during the quarter in concern. However, the South Asian sector which comprises of Maldivian properties recorded a 39.3% YoY dip in its pre tax profits on the back of a slower recovery of the global economy (where the occupancy is still at 80%) and the downward pressure on the rates.

With the recovery of the global economy coupled with the company's world class hotel chain, we believe the sector will rebound and get back to its lucrative ways in the near future.

AHUN recorded a net profit of LKR210.5mn for 3QFY10. Backed by the local and Maldivian tourism which have already created signals of turnaround, AHUN has recorded a net profit of LKR210.5 mn (against the loss of LKR105.8 mn in 1HFY10) despite 6 months out of 9 months falling into the tourism off season.

However when comparing the bottom line with the same period in the previous year, AHUN has posted a significant dip of 41%. (Profit of LKR210.5 mn in 3QFY10 Vs profit of LKR357.8 mn in 3QFY09). It should be noted that the previous years net earnings includes the profit of LKR219 mn (included in Other operating income) which was gained from the disposal of Bathala Island Resort in FY09. Therefore, looking at the numbers excluding the capital gain, AHUN has posted a bottom line growth of a staggering 52% YoY for 3QFY10.

Future outlook
With the complete end to the 3 decade long terrorist conflict coupled with the positive macro economic outlook, tourism sector would be one of the first sectors to rebound. AHUN is positive on strong growth in local tourism, and as a part of their expansion strategy the company is planning to build one or more hotels in Trincomalee (where they have 100 acres) whilst seeking prospects in Jaffna and Kalpitiya. Also they are looking in to fill in its long lasting need for a City hotel in Colombo through acquisition or development of a new property.

Furthermore AHUN is refurbishing Neptune Hotel, one of its beach properties down south to be rebranded under its premier brand “Heritance”. Once refurbished, it will be a wellness resort and a spa specialising in ayurvedic treatments which will be opened in winter 2010.

According to their regional expansion strategies, plans have been finalised to add more properties in India (Under Heritance Brand) which would be operational in the coming years.

Forecast FY10 earnings revised down to LKR350 mn. Backed by the slower recovery of the South Asian sector which accounts to a plus 80% of the top line, we revised down our forecast net profit to LKR423.5 mn (down by 28.5% YOY) in FY10E and LKR851.8 mn (up by 101% YoY) in FY11E.

Share is fairly valued on 37.7X forecast FY10E earnings. The share has gained three fold (246%) since the end of war on 18th May 2009 whilst we believe further upside possible with growing earnings materialising in the coming quarters. Furthermore AHUN would be one of the prime beneficiaries of the revival of local tourism (with the complete end to the 3 decade long terrorist conflict and opening of the eastern coast which is rich of tourist hotspots such as Arugam bay, Nilaveli beach etc) which has 09 properties in all strategic locations in the island which are upgraded and ready for the boom (It would need 2-3 years to develop a new hotel).

AHUN is fairly valued on 37.7X forecast FY10E net profit and 18.7X projected FY11E earnings whilst it is trading on a PBV of 3.2X, we maintain – BUY

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