Sri Lanka: Budget 2011 - The Challenge ahead

A Challenge Ahead…

• President in his budget speech underscored that production drive in this decade should aim at expanding exports and replacing imports.
• The reallocation of the wealth of nation via altering the tax system seems pro investor as well as pro consumer, which is in line with our previous forecasts.
• The newly introduced tax measures will wet the investor appetite for further investments and increase future cash flows of the corporate.
• Given the inward nature of Sri Lanka’s capital formation, demand for luxury imports such as motor cars (therefore crude oil) will also scrape the skies, compelling the government to remain cautious on the BOP situation.

Synopsis

The 2011 budget proposal of the Government of Sri Lanka was unfolded before the general public yesterday. The overall outlook of the fiscal plan suggests that latter’s main aim is to achieve rapid economic development through import substitution and export expansion while attaining GDP growth and simultaneously curbing the deficit position of the government. President in his budget speech underscored that production drive in this decade should aim at expanding exports and replacing imports. The international trade strategy must aim at phasing out the trade deficit, improved marketing strategies coupled up with improvement in productivity and efficiency of labour and increasing the competitiveness of country’s export and imports.

Performing an active role as the facilitator of free economic activity the government imposed major changes in taxation and transfers as a measure to assist the private sector in achieving above mentioned macroeconomic challenges. The reallocation of the wealth of nation via altering the tax system seems pro investor as well as pro consumer, which is in line with our previous forecasts.

The major tax reforms and subsidies include the exemption of PAYE tax for annual incomes less than LKR 600,000, decreasing the corporate tax from 35% to 28%, reduction of income tax on Venture Capital corporations up to 12%, exemption of Economic Service Charge for investment trusts, reduction of Value Added Tax (VAT) from 20% to 12% for financial services, providing a subsidy of LKR 50,000 to small holder tea growers cultivating in excess of one hectare of land, removal of the Social Responsibility Levy, imposing CESS on primary goods and raw material exports.

The newly introduced tax measures will wet the investor appetite for further investments and increase future cash flows of the corporates. Consequently, it bears the propensity to enforce downward pressure on interest rates as the credit dependency of the corporates will shrink when non-debt based cash flows ooze in to the businesses with newly imposed tax cuts. The deposit base of the banking sector could also expand as a result, increasing the liquidity in the market. The downward pressure on interest rates as well as the tendency for the deposit base to grow could create upward pressure on urban land & property prices (drumming up the demand for construction material as well as home appliances and furniture) and gold prices with the high net worth investors preferring land and gold as a hedge against inflation. Also, given the inward nature of Sri Lanka’s capital formation, demand for luxury imports such as motor cars and all other passenger transport vehicles which benefited via the dip in vehicle tax (therefore crude oil) will also scrape the skies, compelling the government to remain cautious on the BOP situation.

Meanwhile, domestic and foreign investments would further flow into sectors supplying luxury and semi-luxury goods and services such as leisure and processed food, exploiting the newly created potential in the home market. Exemption of PAYE taxes for middle income earners and 5% pay hike for state employees (non pensionablewill also feed the effective demand in the system and further increase profitability of the corporate sector. In addition, an Employees’ Pension Fund to provide post retirement pension benefits to employees in the private and corporate sectors was proposed and 2% contribution from employees and a 2% contribution from employers to this fund were commissioned. Also it was proposed to set up an Overseas Employees’ Pension Fund (OEPF). Each employee is required to contribute at least Rs. 12,000 per annum to this fund. Hence, these funds would invariably creat a low cost funding tool for the government.

Further, the government targets the fiscal deficit to be LKR 433.7 billion, amounting to 6.8% of the 2011 GDP which is currently hovering at 8%. The revenue is expected to grow by LKR 157.8 billion which is 2.8% of 2010 revised GDP. The major portion of the increase in government revenue is expected to be derived from taxes on goods and services (up by LKR 66 bn ) and taxes on external trade (up by LKR 56.3 bn) which is expected to account for LKR 122.3 bn out of the LKR 157.8 billion revenue growth. The rest will be generated through income taxes and non tax revenue. Therefore, it is clear that government is expecting to increase its indirect tax incomes via shrinking its hold on the income taxes.

Furthermore, the figures revealed by the government demonstrate that total foreign financing of the fiscal deficit is expected to contract from LKR 205.5 bn to LKR 94.5 bn recording a staggering 54% YoY fall. In connection, the domestic financing is expected to increase by LKR 98 bn to LKR 339.2 bn from LKR 241.2 bn, marking a 40.6% YoY rise. This would have a positive impact on the banking sector loan book growth creating risk free lending avenue for the commercial banks and activate the excess liquidity of circa LKR 143 bn which is currently lying idle in the system. We forecast the interest rates to remain unaffected albeit the increase of credit demand by the government since the supply of credit remains unexhausted.

The Revenue at 15.2% of GDP

Tax Revenue

The government expects to achieve an increase in tax revenue from LKR 720bn in 2010 to LKR 862.1bn.for 2011

Direct tax revenue

Historically income tax together with the VAT has been the key contributor of government’s tax income. However, the 2011 budgetary proposals suggest a drastic reduction of tax rates in both these components. Tax rates on personal income has reduced from 5%-35% to 4%-24% while the tax free income threshold has increased from Rs.300, 000 to Rs.500,000 .The employee earnings of SLR 600,000 per year would also be exempted from the PAYE tax. However, the budget aims to generate further revenue by subjecting the public sector incomes to the PAYE tax system.

The reduction in tax rates will in turn create an increase in disposable income. This would contribute to an increase in consumption resulting in expansion of the consumer tax income. In this regard, the tax reforms are aligned with the government’s objective of increasing tax revenue by broadening the tax base while reducing the tax rates.

The increase of tax base together with the measures of incorporating tax evaders to the system would further enhance governments revenue generation thereby increasing the possibility of expected tax revenue increase by LKR142.1bn

The income generated by means of Grants has been estimated to increase from LKR16.2bn to LKR22.6bn further facilitating the Revenue generation.

The Cost at 22.4% of GDP

The expected salaries and wages bill for 2011 is forecasted to reach LKR 344.0 bn from LKR 295.3 bn recorded in 2010, stamping an increase of16.5% YoY. The increase in salaries and wages is most welcome as it will ease off the cost of living pressure of the fixed income earners.

The interest expenses have also demonstrated a negligible increase from LKR 350.3 bn to LKR 352.9 bn explicating the positive impact of reduced deficit targets for 2011. In addition, the sharp reduction in interest rates on Government securities from September 2009 coupled with initiatives taken by the government to restructure debt profile to longer maturities help to reduce the growth in interest cost.

The total payments on subsidies for 2011 have recorded an increase of LKR 10.1 bn from LKR 197.2 bn to LKR 207.3 bn marking a growth of 5.1% YoY. The challenge of resettlement of IDPs and demining activities in the North and East and development of basic infrastructure facilities in those areas become the prime objectives of the transfer payments for 2011. Government has allocated budgetary resources further 80,000 houses. Initiatives such as ‘Gama Naguma’ will target building 80,000 housing units for low income rural households each year.

Education and public health allocation for 2011 has increased from LKR 29.4 bn to LKR 54.0 bn marking a YoY growth of 83.7%. The government expects to increase efficiency and productivity of the work force through vocational training and providing technological knowledge. In this regard government expects to train and provide technological knowhow to 300,000 youth with a cost of LKR 16 bn over the course of next three years. Also 500 secondary schools will be constructed as a measure to increase the rural education levels of the country. In addition, further LKR 750 mn will be allocated to establish English as a life skill.

The allocated Defence expenditure for 2011 has witnessed a marginal increase up to LKR 214 bn LKR although the reasons behind the increase are not clearly stated.

Capital expenditure

Infrastructure development has received an increase from LKR 359.0 bn to LKR 413.7 bn marking a YoY growth of LKR 30.1 bn (+ 9.1%). For public investments in roads, electricity, water, irrigation, ports and aviation activities, capital investment in power generation and distribution is likely to exceed LKR 64 bn over the two years. There is also further allocation of LKR 20 bn in support of the provisional road development initiative.

Funding Mix

Furthermore, the figures revealed by the government demonstrates that total foreign financing of the fiscal deficit is expected to contract from LKR 205.5 bn to LKR 94.5 bn recording a staggering 54% YoY fall. The lower dependency on external debt as a measure of financing the fiscal deficit is most welcomed as it will reduce the outflow of foreign exchange from the economy.

In connection, the domestic financing is expected to increase by LKR 98 bn to LKR 339.2 bn from LKR 241.2 bn, marking a 40.6% YoY rise. This would have a positive impact on the banking sector loan book growth creating risk free lending avenue for the commercial banks and activate the excess liquidity of circa LKR 143 bn which is currently lying idle in the system. We forecast the interest rates to remain unaffected albeit the increase of credit demand by the government since the supply of credit remains unexhausted.

Impact on CSE

The first comprehensive budget to be released after the 3 decade war is expected to induce corporate profits via the reduction of several tax revisions. The commercial entities are bound to benefit with the overall reduction in corporate taxation by 7%, to 28%, support lent for SMEs and tax holiday for fresh investments (for investments less than USD5,000 but not more than USD10 mn).

With the current market capitalization capped at LKR2.2 trillion, the government focuses to increase the entities listed on the CSE via Initial Public Offers (IPO). Thus, 1% of the value of IPO has been allowed as a deductible expense for tax purposes. Furthermore, the snap shot below shows the overall cost changes proposed on transactions on CSE:

We view the effective increase in the overall cost of transactions to 1.12% from 1.02% will not majorly restrict investor participation as the capital gains tax still is pegged at 0%. With the YTD foreign interest being an outflow of LKR28.3 bn, we can expect foreigners to revert their attention to Sri Lankan investment market with the relaxation of exchange control restrictions for foreign entities investing in unit trusts coupled with the favorable exchange control facilitation to promote and develop local equity market .

Affected Counters

With the abolition of bank debit tax, reduction in VAT on financial services from 20% to 12%, removal of VAT on leasing assets and the reduction in overall income taxation to 28%; banks and the financial sector stands out as a clear beneficiary of the tax revision.

Tourism, viewed to be a billion dollar business, the government is making moves in charging better rates whilst also reducing taxation by 3% to 12%. We expect the hotel & travels portion of CSE listed entities to post better earnings in the periods to come, as sufficient accommodation to cater the targeted tourists is taken. Thus we believe, the hotel sector counters will have a further run despite being currently expensive.

Most of the counters in the manufacturing sector operate in construction related fields. Thus, counters such as the tile sector (Lanka Tiles, Lanka Walltile, Parquet Ceylon and Royal Ceramics), cable industry (ACL Cables, Kelani Cables and Sierra Cables) and the cement manufactures (Tokyo Cement and Lanka Cement) are all expected to be direct/indirect beneficiaries of the planned rehabilitation and construction programs strongly shouldered by the support lent by international organizations and neighboring countries.

The spirits industry was already hit by the recent upward revision in excise duties, and now with the increase in taxation on profits to 40% from 35%, counters such as Ceylon Tobacco, Lion Brewery and Distilleries, will find their Net Profit margins thinning.

The tax structure of the telecommunication has been simplified favouring local consumption than international calls and tax exemption on imported high tech equipment, the telco sector is bound to face the changes with a general levy of 20% in lieu of the existing levies which are narrowed.

After a general cut on motor vehicle taxes in June 2011, a further reduction of 25% has been proposed on passenger vehicles. However, the annual revenue license fee for motor vehicle is moved up by 10%. Motor sector counters such as Diesel & Motor Engineering, Sathosa Motors, United Motors and Ashok Leyland in specific is expected to benefit.

Export oriented counters such as Haycarb, Richard Exports, Hayleys Exports, Kuruwita Textiles, Dankotuwan Porcelain and printcare are all expected to benefit from the export friendly move in reducing income tax of such entities to 12% from 15% for businesses carrying value additions in the country and holding patent rights in Sri Lanka whilst also benefiting from the moves to mitigate the loss of GSP Plus concessionary scheme.

The overall Plantation sector will be highly affected by the proposed CESS on both bulk tea and rubber exports, which amounts to LKR10 and LKR8 per kg respectively, which is proposed by the government with the intention of enhancing the value added export segment in the industry.

The proposed expansion of Laksathosa and Co-op city outlets signals competition for Cargills Ceylon, though the outcome still cannot be quantified.

Entities such as Lanka Milk Foods and Kotmale Holdings investing heavily in capitalizing on the transformation from powdered to liquid milk; are further supported by the government encouraging the import of high yielding diary animals.

Effects on the Banking Finance & Insurance

The most discussed area throughout the budget was, empowering the village & facilitating the rural areas to contribute to economic prosperity. This has opened up avenues for banking finance & insurance sector to expand. The emphasis on micro finance was a key element throughout the post war era in the banking finance and insurance sector which the 2011 budget has taken initiative.

The favorable contributions to the sector from the 2011 budget were basically via abolishing the bank Debit Tax, reducing VAT on financial services from 20% to 12%, reduce tax on profits of banking & finance institutions from 35% to 28%( the reduction of tax on profits is applicable to all offshore & domestic banks, finance companies, leasing, insurance & other specialized banking & financial companies)

Even though the government has brought down the tax rates the banks would not get much benefited in terms of profitability & returns available for fund providers. This is due to the necessity of creating a separate investment fund account with the Central Bank, where all the tax savings to be transferred in to it.

The Central Bank & the Department of Inland Revenue will issue specific regulations requiring banks to adopt low interest rates & longer term maturity for lending.

The higher per capita income, stabilized inflation (6%), reduced poverty, reduced unemployment levels, lower personnel income taxes, reduction of PAYE tax would lead people to save more & there is potential for banks to expand their deposit base, and this will enhance the lending capabilities of banks.

Referring to the government statistics the commercial bank advances to the private sector in June 2010 are as follows- agriculture & fishing 14%, industry 38%, services 21%. Since the agricultural, industrial, & service sectors are to expand with the new budget, the growth potential in the advances to these sectors would also be high.

Leasing companies are to be majorly benefited from the 2011 budget. VAT on leasing of three wheelers, Lorries, trucks, & private busses being removed.

With the aid of the proposed Presidential Commission on Banking & Financial service the government is focusing on transforming Sir Lanka as a regional financial hub.

The budget 2011 is supportive to mobilize savings on unit trust with the exemption of the economic services charge. Further the exchange control restrictions on foreigners & foreign funds investing in Units Trusts are also exempted to promote more funds flowing to the economy.

Fueling Travel & Tourism

Budget adding value

The 2011 Budget has identified Tourism as a “Billion Dollar Business”, as the country has immense potential over achieving such an outcome. Despite the steep growth in arrivals, the income from this segment has been moderate. In order to overcome such a situation a levy of US$20 (App: LKR2,220) is imposed on a per bed basis on all 5 star hotels offering less than US$ 125 per guest nigh from January 2011.Invariably targeting the high caliber tourist by 2016 targeting 2.5mn.

The industry should be enriched with the addition of star class hotels chains, to accommodate such an inflow. Sri Lanka currently has a total room capacity of 14,461 of which the 5 star accounts only a mere 3080. From a hotel income point of view, it has been proposed to reduce tax on income earnings from tourism and related business from 15% to 12%.

It has also being proposed by the government to upgrade and refurbish all the rest-houses and all government circuit bungalows in order to spur the tourism segment locally. 

In addition the budget further emphasizes on benefiting other industries related to the tourism sector such as :

• Local agriculture and industries
• Motor vehicle sector with the reduction in taxes on passenger transportation vehicles by 25%: exempt importation of electric and hybrid vehicles from Excise tax and VAT.
• Reduction of Custom duties and VAT on various machinery and equipment not available locally, this will facilitate the expansion and refurbishment process.
• Reduce excessive taxes on branded consumer durables which will popularize local and tourist shopping.

Meanwhile from a financial perspective lifting up exchange control restrictions on foreigners and foreign funds investing in unit trust etc, will not only attract the leisure crowd but encourage the business oriented to visit Sri Lanka.

Construction Sector

The construction sector contributes approximately 6 percent of the country’s Gross Domestic Production (GDP).In accordance to Central Bank of Sri Lanka this sector grew at an average rate of 7.5 percent during the 3 years ended 2010.

Further the 2011 Fiscal Budget has identified the importance of providing tax benefits to the construction sector; to invariably elevate construction in the economy. Below mentioned are the tax/fiscal benefits the 2011 budget address.

• Reduction of income taxes on construction.
• Reduction in custom duties in selected goods and raw materials.
• Capital allowances granted at a rate of 33 1/3 percent on the cost of acquisition of plant and machinery and a rate of 10 percent on the cost of construction on new buildings.

The above mentioned tax and fiscal benefits are expected to favorably facilitate;

• Reconstruction of electricity and irrigation facilities.
• Construction of road and bridges.
• Reconstruction of schools, health facilities and other public places. (Especially in the north and east areas)

Furthermore, with the tourist arrivals to the country accelerating, the room capacity of hotels needs to be tripled from a current level of around 15,000 rooms. Therefore, we believe that this would also have favorable impact on the construction sector.

Land & Property

Overall Land & Property segment seems to foresee a growth a in value as a result of the recent developments taking place in the construction sector together with favorable macro economic factors (Low interest rates and inflation).

A large scale construction is taking place within Colombo city limits and other parts of the country with the growth in the construction sector. This would accelerate demand for land. In addition the low interest rates would further strengthen demand for land.

Manufacturing Sector Overview

Budget 2011 has focused heavily to elevate Sri Lanka’s manufacturing sector to a highly diversified and value adding segment. In pursuing this strategy government has taken a major strategic initiative of imposing a CESS on all exports of raw & semi processed form, where all exports of finished goods will be free from such CESS. This would encourage manufacturing organizations to focus more on value added exports whilst the counters already focusing more on value added exports will be highly benefited. This would also lead the domestic manufacturing entities to put more emphasis on building their own brands rather than exporting in bulks.

According to government estimates, the export potential of value added, branded exports exceed US$ 5 bn over the medium term. Subsequently, government has made a provision to reduce Income tax from 15% to 10% for all export companies encouraging export oriented production in general. At the same time government has taken an initiative to reduce the income tax from 15% to 10% for industries with domestic value addition in excess of 65%, and Sri Lankan brand names with patent rights reserved in Sri Lanka. This will encourage the manufacturing entities to base their production facilities mainly within the country itself whilst the counters which are already having a high domestic value addition would benefit immediately.

Budget also includes a provision for reducing duties and taxes on machinery, equipment and raw materials, making modern technology more affordable to manufacturing entities. Furthermore, it will encourage expansion and modernization which will in turn improve the profitability of the counters in the long run. The Government also has decided to reduce the corporate tax from 35% to 28% which will invariably benefit the domestic manufacturers as a whole.

Furthermore the 5 year tax holiday proposed on any company which is undertaking new projects with a minimum investment of US$ 5000 (but not more than US$ 10 mn), would definitely encourage new investments in manufacturing industry particularly with many manufacturing companies looking to take advantage of the construction sector boom.

Powering through tariff empowerment

The pro investor budget seems to have a major emphasis on the infrastructural development in the island in lieu of a total investment target of circa 32%-35% of GDP over the next 6 years. The said budget has allocated LKR413bn for public investments in roads, electricity, water, irrigation ports and aviation activities. A sum exceeding LKR64 bn over the next two years is said to be assign towards capital investments in the expansions of power generation and distribution in the country with a target of electrifying the country 100% by 2015.

Over the years access to electricity in the rural sector has increased from 78.5% in 2006 to 83.2% in 2009 while it has risen from 62.3% to 84% in the estate sector. Further with the development in the power sector the government has been able energize the country with no blackouts since 2006.

Together with the capital improvement in the power and energy segment an 8% increase in tariff was imposed on the consumption excluding small businesses and SME. This would have an impact on the corporate and household sector in the island whilst driving the expenditure high. The manufacturing organizations with high emphasis on power would witness a surge in cost of sales with the above price movement. Further the CCPI index would be negatively affected as clothing electricity and gas sub index reflects 18.3% of the major the index.

Towards a leading information era

With a percept towards a digital future and technologically savvy nation, the government has implemented various projects to usher in the information era to Sri Lanka. Whilst the island is ranked 7th among the 50 best emerging global cities that attract outsourcing, IT and BPO services are ranked as the 5th largest export segment in the country.

With regard to ICT literacy, the government targets to achieve a rate of 75% (literacy) by 2016 in lieu of making the island an emerging IT hub (with USD2 bn exports by 2016).

The telecommunication sector also showed an above average growth comparative to other regional countries (witnessed an YoY incline of 25% in 1st half of 2010) together with a high telephone density (telephone per 100 persons) of 94 in 2010.

A VAT exemption on the high tech equipment and machinery which the telecommunication segment is highly dependent on would attract capital investments further strengthening the industry. Technological growth in telecommunication sector is pivotal to elevating the ICT in an economy.

Thus, the fiscal benefits granted to telecommunication sector would shoulder the growth in the ICT industry as well. Further, a telecommunication levy of 20% together with a 2% license fee on the gross revenue would simplify the previous complex tax structure.

The increased taxation on the industry would be offset by the developments in the technological arena together with the increased literacy rate in ICT. Further the 25% decrease in local call charges would induce the number of local units whilst generating a higher rate of economic activity in the island.

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Hatton National Bank (HNB) net profit up 23% YoY in 2Q2010

Hatton National Bank's (HNB) net profit has grown 23% YoY to LKR1,220.3 mn in 2Q2010 mainly on the back of a 7% YoY increase in net interest income, 25% YoY increase in non interest income and a 94% YoY reduction in provisioning cost which enabled 1H2010 net profit to grow by 10% YoY to LKR1,888.5 mn. With the economy expected to grow by circa 6%-7% during the next few years and contributions from the previously war affected North and East to the main stream economy the banking sector outlook remains positive with loan growth (grew 2.2% YoY in May) expected to gather momentum from 2H2010 with the low interest rate environment. HNB's net interest margins are expected to be intact at around 5%, whilst continuing to benefit from the wider reach facilitated by 189 branches (20 branches in the North and East) and higher retail focus.

However, we maintain our forecast 2010E net profit at LKR4,101.0 mn (down 9% YoY)with slower credit growth in 1Q2010 than anticipated coupled with high operating costs and projected 2011E net earnings at LKR4,547.8 mn (up 11% YoY).

The voting share is fairly valued at 17.0x forecasted 2010E profit and 15.3x on forecast 2011E whilst trading 2.4x PBV. The non voting share remains attractive on 11.0x forecast 2010E net profit and 10.0x projected 2011E net earnings whilst 1.5x PBV. Maintain BUY.

Interest income has dipped 16% YoY to LKR7,576.7 mn in 2Q2010. HNB’s interest income has dipped 15.6% YoY to LKR7,576.7 mn in 2Q2010, mainly due to a 19.4% YoY dip in interest income from loans and advances to LKR5,827.8 mn. The dip in interest income from loans and advances was on the back of low rates despite performing loans growing by 4.4% during the quarter to LKR164.2 bn. However interest income from fixed income securities remained flat at LKR1,748.8 mn even though treasury bill and bond portfolio (held to maturity) grew by 9.5% to LKR61.6 bn during the quarter which is approx. 21% of the banks’ total asset base.

Interest expenses dipped 31% YoY to LKR3,714.1 mn in 2Q2010. Group’s interest expenses have dipped 30.9% YoY to LKR3,714.1 mn in 2Q2010, on the back of 30.5% YoY drop in interest cost on deposits to LKR3,295.5 mn. The drop in deposit cost is largely attributable to low deposit rates and the shift in the deposit mix from high cost time deposits to low cost CASA products (CASA mix improved to circa 50% of total deposit base from 48% in 1Q2010). Further deposit base also recorded a marginal 1% growth to LKR216.4 bn during the quarter. Interest expenses on other interest bearing liabilities also dipped by 34.3% YoY to LKR418.7 mn.

Net interest income grew 7% YoY to LKR3,862.6 mn. The dip in interest income was off set by a faster decline in interest cost enabling net interest income to grow by 7.1% YoY to LKR3,862.6 during 2Q2010. Interest margins also improved to 5.3% (up 1.3% QoQ) in 2Q2010.

Non interest income grew 25% YoY to LKR2,000.6 mn in 2Q2010. Non interest income has grown by 24.8% YoY to LKR2,000.6 mn in 2Q2010 due to 31.6% YoY increase in other income to LKR1,764.1 mn. Other income growth was supported by the capital gains made by selling off shares it held in Commercial bank and Distilleries.

Foreign exchange income fell by 9.7% YoY to LKR236.5 mn, due to stagnant exchange rates.

Operating cost has increased by 13% YoY in 2Q2010 to LKR3,400.2 mn. Operating costs have risen by 12.6% YoY to LKR3,400.2 mn, mainly due to a 17.7% YoY increase in personnel costs to LKR1,283.4 mn. Increase in personnel cost was a result of salary revision undertaken across all staff grades of the bank during 2009. Consequently the operating cost per branch stands at LKR18.0 mn per quarter and the cost to income ratio is at circa 58%.

Provisioning cost has dipped 94% YoY to LKR 10.0 mn in 2Q2010. Total provisions have dipped 94.0% YoY to LKR10.0 mn, mainly due to a 160.0% YoY improvement in recoveries and 50.8% reduction in specific provisions. Gross NPL ratio for HNB is at 6.5% (compared to 7.4% in 1Q2010) and net NPL ratio stands at 3.3%. HNB’s non performing loans reduced by 8.0% to LKR13.4 bn during the quarter and the provision cover stood at 42%. (compared to 39% in 1Q2010).

Total tax bill has risen 13% YoY to LKR1,217.9 mn in 2Q2010. Value added tax (VAT) has increased by 19.5% YoY to LKR630.4 mn and corporate tax increased 7.1% to LKR587.5 mn pushing up the total tax bill (VAT and Corporate tax) by 13.2% YoY to LKR1,217.9 mn in 2Q2010. Thus the effective tax rate of the bank is near 50% in 2Q2010.

Net profit up 23% YoY to LKR1,233.1 mn in 2Q2010. Consequent to a 7% YoY increase in net interest income, 25% YoY increase in non interest income and a 94% YoY reduction in provisioning cost helped HNB’s profitability in 2Q2010. Cumulative 1H2010 profits also rose 10% YoY to LKR1,870.1 mn.

Forecast 2010E net profit maintained at LKR4,101.0 mn (Down 9% YoY). With the economy expected to grow by circa 6%-7% during the next few years and contributions from the previously war affected North and East to the main stream economy, the banking sector outlook remains positive where loan growth expected to gather momentum from 2H2010 onwards with the low interest rate environment. HNB’s net interest margins are expected to be intact at around 5%, whilst continuing to benefit from the wider reach facilitated by 189 branches (20 branches in the North and East) and higher retail focus (Retail mix is circa 60%).

However, we maintain our forecast 2010 net profit at LKR4,101.0 mn (down 9% YoY) with slower credit growth in 1Q2010 than anticipated (private sector credit growth in January 2010 was 0.6% MoM and 1.6% MoM in February 2010) coupled with high operating costs. However we expect 2011E net earnings to grow by 11% YoY to LKR4,547.8 mn on the back of loan book expansion (where the private sector credit is expected to grow from 2H2010 onwards) and cost rationalisation strategies expected to be adopted by the bank.

The voting share is fairly valued on 17.0x forecast 2010E net profit. The voting share is trading at 17.0x forecasted 2010E profit and 15.3x on forecasted 2011E whilst trading 2.4x PBV.

The non voting share remains attractive on 11.0x forecast 2010E net profit and 10.0x projected 2011E net earnings whilst 1.5x PBV. Given the stable macro economic outlook and expected credit growth HNB, is in a better position to reap the benefits out of it with its island wide coverage (has the largest presence in North and East). Further HNB’s new branches (specially in North and East) breaking even in the coming years will contribute positively to banks bottom line. Bank also has a divesified product portfolio where they aggressively look at growing areas such as foreign worker remittences, credit card business and pawning. Further we believe HNB would adopt necessary measures to curtail its costs with its newly adopted core banking system in the future. Thus we Maintain BUY.

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Ceylon Tobacco (CTC) net earnings up by a sharp 45.1% YoY in 2Q2010

Ceylon Tobacco's (CTC) is the monopoly market operator for manufacturing, marketing and importing cigarettes in Sri Lanka. The company segregates the market based on income levels and markets Dunhill and Bensons for high income category along with Gold leaf for the middle income category, followed by Four Aces, Three Roses and Capstan for the low income category and Pall Mall as a value for money product. The company's net profit has increased by a strong 45.1% YoY to LKR1,116 mn in 2Q2010 on the back of high margin brand mix and stabilizing volume levels resulting from improved economic conditions in the country coupled with aggressive cost management initiatives.

Net revenue has increased 16.8% YoY to LKR3,418 mn in 2Q2010. CTC’s gross revenue has increased by a moderate 11.3% YoY to LKR16,300 mn in 2Q2010, resulting in a cumulative figure of LKR30,772 mn for the first half of 2010. Further the top line has risen by 12.6% QoQ owing to the excised price revision which took place in May 2010 where prices of all CTC brands went up by LKR1.00 per stick.

Further the company’s continuous focus on improved sales mix coupled with the grabbing of market share from illegal distributors and improved economic conditions has limited the impact from declining volumes resulting from the ban on smoking in public areas coupled with change in smoking habits amongst the general public.

However, the government’s continuous efforts in curbing the presence of smuggled and counterfeit cigarettes provide some optimism for volume growth in future.

Government levies continued to be nearly 80% of gross revenue, which grew by 10% YoY to LKR12,882 mn during the quarter in concern. Consequently, net revenue has grown by a healthy 16.8% YoY to LKR3,418 mn in 2Q2010 and LKR6,499 mn for 1H2010 (up 15.8% YoY).

Total operating costs have dipped 11.9% YoY to LKR1,572 mn. CTC’s total operating costs have dipped 11.9% YoY to LKR1,572 mn in the quarter in concern whilst recording a dip of 5.3% YoY in 1H2010. This could be directly attributable to the sharp fall of 27.3% YoY in raw material costs and 4.2% YoY dip in operating costs during the quarter in concern. Fall in raw material costs is resulted by lower sourcing costs of tobacco leaves when compared with the corresponding period last year where the company had to import tobacco due to the production shortage in the country.

The company’s productivity improvements have resulted 4.2% YoY dip in operating costs in 2Q2010 and 12% YoY saving for the first half of the year.

Net profit has risen by a strong 45.1% YoY to LKR1,116 mn. Net interest income has fallen by 52.0% YoY to LKR61 mn in the quarter in concern owing to falling interest rates. Nevertheless backed by the strong performance coupled with cost rationalization techniques, the company has recorded a net profit of LKR1,116 mn for 2Q2010, up by a sharp 45.1% YoY and LKR1,754 mn for the first six months of 2010 (up 39% YoY).

Forecast 2010E net profit to reach LKR4,487 mn. We forecast CTC to post a conservative net profit of LKR4,487 mn in 2010E (up by 9.1% YoY) whilst projecting 2010E net profit up by 7.5% to LKR4,823 mn on the back of the company’s continued focus on improving its brand mix coupled with successful cost rationalization exercises.

Fairly valued on 13.2X forecast 2010E net profit. The share is fairly valued on 13.2X forecast 2010E net profit and 12.3X projected 2011E net earnings. Further given the historical dividend payout ratio of nearly 100% and LKR9.7 per share being already declared, we believe the share would continue to be a dividend play - Maintain BUY

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John Keells Hotels (KHL) Repositioning hits the bottom line.....

John Keells Hotels (KHL), an 82% owned subsidiary of local conglomerate John Keells Holdings (JKH) currently operates 7 hotels in Sri Lanka and 4 in Maldives. Company operates its resort portfolio under three brands; namely the premier brand Cinnamon (2 hotels under this brand), the resort hotel brand Chaya (6 hotels) and John Keells Hotels (3 hotels).

Keells hotels are positioned in all key tourist hot spots in the country and experienced a strong spurt of growth in earnings with the revival of the industry. Further KHL is the hotel chain with highest number of beach hotels located in beaches which are among the top ten in the Asian Continent. Further the company is placing more emphasis on these beach hotels and would complete the repositioning of them in the next couple of years. Nonetheless the company is keen on strengthening their presence in the same area where they are planning to add three more beach hotels to their portfolio by FY13 (In Ahungalla, Beruwala and Trinco).

Financial Performance
KHL's top line has dipped 5% YoY in 1QFY11 mainly on the back of closure of three hotels during the quarter for renovation and repositioning and of the off-peak seasonality effect. Further 60% of the quarterly revenue has been generated by the Tour Operators and Travel Agents according to the rates agreed upon an year before. Hence the real increase in ARRs are not fully reflected in 1QFY11 performance. Closure of Chaya Lagoon Hakuraa in Maldives was the major hit on revenue which has eroded the consolidated revenue by circa 13% YoY in 1QFY11.

However the Sri Lankan resorts have exhibited a sharp increase of 50% YoY to LKR272.6 mn in 1QFY11 on the back of the sharp increase in occupancy rates during the year, despite the closure of Cinnamon Lodge Habarana and Corral Gardens Hikkaduwa.

The dip in revenue has been out paced by the dip in Cost of Sales (down 15% YoY in 1QFY11) leading the company to improve the Gross Profit marginally to LKR758.6 mn in 1QFY11. Subsequently the gross margin has increased 3% YoY to 67% in 1QFY11.

The EBITDA has dipped 28% YoY to LKR64.4 mn on the back of the 12% YoY increase in Operating expenses. However the increase in operating costs have been somewhat weathered by the two fold increase in other income. Other income constitutes the interest received from banking the proceeds from the rights issue during the quarter (The company raised LKR3.6 bn via the rights issue of one ordinary share for every three shares held in order to support the expansion process).

Following the 28% YoY dip in EBITDA and the sharp increase in the tax bill the net profit for the period has dipped 12% YoY to LKR167.1 mn in 1QFY11. Further it is noteworthy that the interest expenses have seen a 21% YoY dip following the tailing off of circa LKR217 mn of debt during the quarter and the slide in interest rates.

The Sri Lankan segment has reduced its losses by 83% YoY supported by the increased arrivals, occupancies and ARRs despite the closure of two hotels for renovation and repositioning. Although the Maldivian segment has seen 128% YoY increase in their losses to LKR153.4 mn mainly due to the closure of Chaya Lagoon Hakuraa in 1QFY11.

Recommendation
KHL passed the break even occupancy level during 4QFY10 and has managed to maintain the occupancies at reasonable levels up to date. During FY10 KHL achieved an overall occupancy of 55% as opposed to 31% in FY09, thus we expect it to reach +65% in FY11. Further with growing occupancy levels KHL is expected to increase their ARRs above the industry expectations. With improvements in ARRs and Occupancies with KHL’s brand image and positioning we saw a complete turnaround in 4QFY10, where the company posted a profit of LKR477.5 mn up 35% YoY. Further the company recorded a 197% YoY increase in cumulative earnings during FY10.

Maldivian segment which hedged the negative earnings of the Sri Lankan segment all throughout, faced severe problems due to the recessionary pressure on the Maldivian tourism industry following the world economic and financial crisis.

However we saw record high arrivals of +200 k per month (up circa 20% YoY) and occupancy levels of 60-70% during 4QFY10 indicating the end of the tourism lull in Maldives. With the revival of the industry in 4QFY10 the Maldivian segment of KHL saw a 10% YoY increase in the bottom line to LKR1.6 bn. Going forward we believe the increase in occupancy coupled with the increase in ARRs would further uplift the contribution from theMaldivian sector.

Therefore we expect KHL to defy industry trends and report a strong earnings growth of 223% YoY to LKR661.8 mn in FY11E and 96% YoY to LKR1,294.2 mn in FY12E. Profit growth is driven by higher occupancy and ARRs, savings on Finance costs and accommodation capacity expansions. Further refurbishment projects carried out in most of the hotels has paid off during 4QFY10 itself and KHL is placing more emphasis on Chaya Blu, Coral Gardens and Benthota Beach Hotel as they are located in beaches which are among the top ten in the Asian Continent. Further they will be constructing three more hotels in the same coastal belt to strengthen their presence.

KHL is fairly valued at 45.3X forecast FY11E net profit and 23.2X projected FY12E earnings whilst it is trading on a PBV of 2.5X FY11E and 2.3X FY12E. Nonetheless the counter is trading at a 8% discount to the EVPS. Further the share has outperformed the market by circa 21% since the end of war on 18th May 2009 albeit has underperformed the sector index by 68%. KHL the second largest hotel chain will expand its portfolio in the coming three years to account for 8% of the total room availability in Sri Lanka. With the said high earnings potential with the expected revival in the tourism industry and increase in occupancy coupled with expected increase in ARRs and the planned expansion of accommodation capacity, KHL would sustain an impressive earnings growth during the next couple of years. Therefore in-view of strong performance, we believe further upside is possible and we maintain – BUY

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Nations Trust Bank (NTB) net profit up 86% YoY to LKR280.1 mn in 2Q2010

Nations Trust Bank's (NTB) net profit has grown by 86% YoY to LKR280.1 mn in 2Q2010, enabling 1H2010 cumulative net profit to grow by 49% to LKR494.2. Net profit in 2Q2010 grew mainly on the back of 32% YoY increase in net interest income and 55% YoY reduction in provisioning cost. With low interest rates and expected economic boom, banking sector outlook remains positive with loan growth (grew by 2.2% in May) expected to gather momentum from 2H2010 on-wards. Despite slower private sector credit growth NTB recoded circa 15% growth in performing loans from December 2009 where other banks recorded an average growth rate of 8-9%. NTB's net interest margin has improved to near 5.5% whilst the young and dynamic bank is set to grow in the coming years. We are maintaining our forecast 2010E net profit at LKR969.7 mn (up 41% YoY) and projected 2011E net earnings at LKR1,296.9 mn (up 34% YoY). Thus the share offers good value on 14.8x forecast 2010E net profit, 11.0x projected 2011E net earnings, 2.0x PBV. Maintain BUY.

Interest income has dipped 22% YoY to LKR2,541.2 in 2Q2010. NTB’s interest income has dipped 21.9% YoY to LKR2,541.2 mn in 2Q2010, caused by a 19.8% YoY dip in interest income on loans and advances to LKR1,581.1 mn and a 25.2% YoY dip in Interest income on other interest earning assets to LKR960.1 mn. The interest income on loans and advances have dipped despite the 6.4% YoY increase in performing loans during the quarter mainly on the back of low interest rates. Though the government securities portfolio (held to maturity) has remained flat the reduction in Treasury bill rates has impacted the income from fixed income securities negatively.

Interest Expenses has dipped 42% YoY to LKR1,389.0 mn in 2Q2010. Interest expenses has dipped 41.7% YoY to LKR1,389.0 mn mainly on the back of a 48.3% YoY dip in interest expense on other interest bearing liabilities as well as a drop of 33.4% YoY in interest expense on deposit. The interest cost was reduced with low deposit rates and shift in the deposit mix towards low cost
CASA products (CASA contribution improved to 29% from 27%). NTB’s deposit base also grew 4.1% during the quarter to LKR45.9 bn.

Net interest income has increased by 32% YoY to LKR1,152.2 mn in 2Q2010. Despite interest income having dipped by 22% YoY interest cost has dipped at a faster pace by 42% YoY enabling the net interest income to grow by 32% YoY to LKR1,152.2 mn.

Non interest income grew 6% YoY in 2Q2010. Non interest income has grown by 5.7% YoY to LKR477.0 mn in 2Q2010 due to gains made in forex earnings compared to losses suffered in the 2Q2009. However other operating income dipped 66.7% to LKR416.4 mn during 2Q2010.

Operating costs have increased 21% YoY in 2Q2010. Operating costs have increased 20.8% YoY to LKR892.4 mn, which was resulted by 85% YoY increase in personal costs to LKR408.0 mn which could be attributable to the increase in the number of employees. However premises, equipment and
establishment expenses have reduced by 10.1% YoY to LKR188.8 mn. However NTB’s cost to income ratio has improved to 55% from 57% as at 31st March.

Provision for bad and doubtful debts and loans has decreased by 55% YoY in 2Q2010. Provision for bad and doubtful debts and loans has decreased by 55.2% YoY to LKR90.6 mn, which was resulted by the 63.7% YoY decrease in specific-provision to LKR79.1 mn. Further NTB’s gross NPL ratio improved to 6.1% (7.0% in 1Q2010) and net NPL ratio to 3.2% (3.8% in 1Q2010).We believe NTB would be able to improve its NPL’s in the coming quarters with the improvement seen in recoveries.

Total tax bill has increased 57% YoY to LKR366.1 mn in 2Q2010. Value Added Taxation on banking income has increased by 72.6% YoY to LKR139.2 mn whilst tax on consolidated profit has also increased by 49.1% YoY to LKR226.9 mn which increased the total tax bill by 57% YoY to LKR366.1 mn in 2Q2010. Thus the effective tax rate in 2Q2010 is near 57%.

Net profit up 86% YoY to LKR280.1 mn in 2Q2010. Consequently a 32% YoY increase in net interest income and 55% YoY reduction in provisioning cost has pushed up NTB’s net profit by 86% YoY to LKR280.1 mn in 2Q2010.

Forecast 2010 net profit maintained at LKR969.7 mn (up 41% YoY). With the expected growth in the economy and low interest rate environment the banking sector outlook remains positive with loan growth (grew 2.2% in May) expected to gather momentum 2H2010 onwards. Despite slower private sector credit growth NTB recoded circa 15% growth in performing loans from December 2009 where other banks recorded an average growth rate of 8-9%. NTB’s net interest margins is expected to be intact at around 5%, whilst the young and dynamic bank is set to grow in the coming years. Therefore, we are maintaining our forecast 2010E net profit at LKR969.7 mn (up 41% YoY) and projected 2011E net earnings at LKR1,296.9 mn (up 34% YoY).

Share offers good value on 14.8x forecast 2010E net profit. The share offers good value on 14.8x forecast 2010E net profit, 11.0x projected 2011E net earnings, 2.0x PBV. Maintain BUY.

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Odel PLC (ODEL): Net Profit has surged two folds in 1QFY11..

Odel PLC (ODEL), one of the nation's largest fashion, apparel and cosmetics retailers has exhibited strong performance in 1QFY11, upon being listed in the Colombo bourse during the same quarter. ODEL stores offer a broad selection of merchandise and feature products from both local and exclusive international brand sources. The Company operates 12 stores where the flagship store being located in the heart of Colombo and the rest spanning within the three districts of the Western Province and plans to open three more stores during the year 2010 (possibly in Wattala, Battaramulla and Kandy).

ODEL's revenue has grown by an impressive 62% YoY to LKR691.9 mn in 1QFY11. The expansion of branch net work, increase in tourist arrivals and better macro economic situation have served as the catalysts in driving up the revenue. However the Revenue per Sq. Ft has reduced by circa 5% to LKR5.4 K per Sq.Ft on the back of incremental revenue per Sq.Ft has been relatively lower at LKR5 K per Sq.Ft.

The overall COS per Sq.Ft has reduced 10% YoY to LKR3.4 K in 1QFY11 owing to the lower COS per Sq. Ft in new outlets which stands at LKR2.8 K per Sq.Ft. Subsequently the Gross profit has surged 77% YoY to LKR264.1 mn in 1QFY11 on the back of the faster dip in COS Sq. Ft vs. the Revenue per Sq.Ft. Further the gross profit margin has improved from 35% in 1QFY10 to 38% in 1QFY11.

Subsequent to the 77%YoY increase in Gross Profit the EBITDA has increased by 85% YoY in 1QFY11 due to the relatively slower increase in operating costs, which has recorded an increase of circa 61% YoY in 1QFY11. The increases in operating costs are attributable to the expansion of the branch network and increase in operations. With the expansion move the employee and rental costs have increased by circa 15% YoY and the Sales commissions and advertising costs have increased by circa 10% YoY.

Following the impressive 95% YoY increase in EBIT and the 17% YoY dip in finance costs the Profit before tax has soared 272% YoY to LKR60.2 mn in 1QFY11. However the fivefold YoY increase in the tax bill has diluted the profits of the company resulting in a 199% YoY increase in Net profit of LKR37 mn.

The increased tourist influx following the three decade old war would have a positive impact on ODEL as the company is renowned as favourite Shopping Mall of tourists in Sri Lanka”. Recovery in the economy brought about higher consumer sentiment driven by confidence in the market along with the reduction in unemployment. Thus with the disposable income on the rise local consumers tend to have a higher demand towards premium quality products.

ODEL’s market positioning as a premium department store is a competitive advantage with a lower substitutability and a few number of competitors. With the expansions which are currently carried out, ODEL expands its reach and would have access to a bigger market without dilution. The company’s own brand which yields a higher margin is mainly sold via the outlets in the Colombo suburbs. With the store expansion taking place the contribution from the own brands (at present the contribution is circa 20-30% of the top line) is expected to increase.

Against the backdrop and the 1QFY11 results being in line with our forecasts we maintain our FY11E earnings at LKR189.6 mn (UP 34% YoY) and FY12E earnings at LKR235.5 mn(up 24% YoY).

In terms of earnings based valuations the share is fairly valued on 21.4X forecast FY11E net profit and 17.2X forecast FY12E earnings. The share saw +100% increase in the share price on the first day of trading itself and currently trades at circa 85% premium to the issue price. Going forward we expect the counter to perform on par with the broad market and the downside risk is fairly limited, thus we rate ODEL a HOLD

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Tokyo Cement (TKYO): Outlook positive on the back of changing macro dynamics

Tokyo Cement's (TKYO) recorded a net profit of LKR240.5 mn in 1QFY11 (vs a loss of LKR (55.9) mn in1QFY10). TKYO posted strong net earnings on the back of 7.2% YoY growth in the top line, improved gross profit margin and 46.8% YoY dip in finance cost.

The resolution to the national conflict would shape up developments in the North & East and thus TKYO would be able to fulfill the demand with its excess capacity. A marked reduction in the cost base is expected through the synergies of the bio mass plant (LKR200 mn savings) and relatively low interest cost. Against this backdrop we expect TKYO to record LKR839.3 mn in FY11E (up 188%YoY). Further, we believe Tokyo cement is poised for demand driven growth especially in FY12E and we expect a conservative 33% YoY increase in net earnings to post LKR1,112.9 mn.

TKYO (voting) currently trades on 11.9X forecast FY11E net profit, 9.0X projected FY12E net profit and 1.2XPBV. TKYO non-voting currently trades on 8.9X forecast FY11E net profit and 6.7X projected FY12E net profit. We believe the share has strong upside given the positive earnings outlook, on the back of rising demand based on North & East developments, reduction in interest cost and favorable effects of Bio Mass plant. However, due to the fluctuating nature of the earnings exhibited in the past and lack of transparency associates a risk factor with the counter.

Despite the risk of fluctuating earnings exhibited, we continue to place more weightage on the catalysts for growth (greater home building demand, larger construction projects, location advantage and strong brand equity) and as a proxy to the reconstruction drive we believe the counter holds significant upside. Hence we maintain BUY.

Revenue has grown by 7.2% YoY to LKR3,426.0 mn in 1QFY11. TKYO's top line has grown by 7.2% YoY to LKR3,426.0 mn in 1QFY11 which is mainly due to a near 15% YoY growth in sales volume whilst with marginal variances, the price was maintained at circa LKR730/bag (maximum retail price is circa LKR785/50kg bag).

Operating at a near 65% production capacity (total capacity of 1.8 mn metric tons)complemented by an additional 600,000 MT bagging plant, TKYO is positioned to strengthen its revenue base in the future given the increase in demand.

Gross profit increased by 81.6% YoY to LKR825.8 mn in 1QFY11. Despite the increase in the top line the cost of sales has dipped by 5.1% YoY mainly on the back of relatively lower price of clinker, hence the gross profit has grown by 81.6% YoY during the quarter to post LKR825.8 mn. TKYO’s gross margins have strengthened significantly from 14.2% in 1QFY10 to 24.1% in 1QFY11 backed by strong growth in the top line and the dip in cost of sales.

EBITDA has increased by 43.5% YoY to LKR620.3 mn in 1QFY11. The operating expenses have risen sharply during the quarter (LKR620.3 mn in 1QFY11 vs LKR432.3 mn in 1QFY10) mainly on the back of the Nation Building Tax (3% of Turnover) being charged under the expenses.

PBT has increased by three fold YoY to LKR240.4 mn in 1QFY11. The finance cost during the quarter has dipped 46.8% YoY to LKR146.3 mn on the back of reduced borrowings (23% YoY dip to LKR1,663.0 mn) and lower interest rates (to a near 8.8% from 12.7% an year ago). Further, during 1QFY11 the depreciation cost dipped by 7.6%YoY to LKR233.6 mn. Subsequently, the PBT grew by near three fold to LKR240.4 mn during 1QFY11.

Net profit has grown to LKR240.5 mn in 1QFY11 vs. LKR (55.9) mn in 1QFY11. During the quarter under review TKYO has posted an impressive LKR240.5 mn in net earnings vs. a loss of LKR55.9 mn in 1QFY10.

Expected Growth and developments in the North & East. Following the entirely resolved terrorist conflict, demand is expected to grow (where the growth potential is signaled in this quarter under review) with the new infrastructure and highway developments in the North and developments could be expected to shape up in the rural areas particularly in the North & East. With 1.8 mn MT capacity and at the present 65% utilization levels, TKYO is positioned to exploit the business opportunities in the North & East as it arises.

Due to location advantage and the involvement with the Japanese owners (Nippon Coke Engineering Co, Japan and St Anthony’s Consolidated Ltd owns 27.5% each) bulk of the development projects in the Eastern province could be awarded to TKYO cement. However, the benefits would kick in based on the speed of infrastructure developments whilst we believe that the present excess capacity of the Trincomalee plant will be utilized to cater for the demand created through the East development contracts thereby contributing towards strong earnings growth in the future.

Power generated through the bio mass plant. The new bio mass plant of TKYO currently generates 10MW where as the power requirement to facilitate their internal requirement is circa 7.5MW whilst the company supplies the surplus to the national grid. This facility is expected to generate cost savings of around LKR200 mn from FY11 onwards. Further, the company incorporated a wholly owned subsidiary “Tokyo Cement Power (Lanka) Ltd” during early this year for setting up and operating of power generation, giving an indication that the company would look for more power projects in the future.

FY11E net profit to reach LKR839.3 mn, up 188% YoY. The resolution to the national conflict would shape up developments in the North & East and thus TKYO would be able to fulfill the demand with its excess capacity. A marked reduction in the cost base is expected through the synergies of the bio mass plant (LKR200 mn savings) and relatively low interest cost. Against this backdrop we expect TKYO to record LKR839.3 mn in FY11E (up 188%YoY). Further, we believe Tokyo cement is poised for demand driven growth especially in FY12E and we expect a conservative 33% YoY increase in net earnings to post LKR1,112.9 mn.

Share offers significant value. TKYO (voting) currently trades on 11.9X forecast FY11E net profit, 9.0X projected FY12E net profit and 1.2XPBV. TKYO non-voting currently trades on 8.9X forecast FY11E net profit and 6.7X projected FY12E net profit. We believe the share has strong upside given the positive earnings outlook, on the back of rising demand based on North & East developments, reduction in interest cost and favorable effects of Bio Mass plant.

However, due to the fluctuating nature of the earnings exhibited in the past and lack of transparency associates a risk factor with the counter. Despite the risk of fluctuating earnings exhibited, we continue to place more weightage on the catalysts for growth (greater home building demand, larger construction projects, location advantage and strong brand equity) and as a proxy to the reconstruction drive we believe the counter holds significant upside. Hence we maintain BUY.

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