Budget Overview - 2010

• High current expenditure of LKR879.6bn together with poor revenue collection lead to an overall budget deficit of 476.4bn (9.9% of GDP) in 2009.
• Projected revenue growth for 2010 is somewhat ambitious 15.8% to LKR841.0 bn, with expenses projected to increase by a slower 6.5% largely due to slower escalation in recurrent expenditure.
• With the improvement in projected revenue growth and manageable level of recurrent expenditure government expects the budget deficit as a percentage of GDP to be maintained at 8% (downby 2% YoY). Further deficit is expected to be financed using 28% foreign financing and 72% using domestic borrowings.
• The budget deficit during the first four months of 2010 curtailed at 3.1% as a percentage of GDP.
• The “mini” budget presented did not have any revised revenue proposals and the 2011 budget that will be presented in November 2010 is expected to propose more detailed policy initiatives.

Deficit target of 8.0% of GDP in 2010, ambitious yet achievable
The United Peoples Freedom Alliance (UPFA) government presented its sixth consecutive fiscal budget in parliament on 29th June 2010 for the remaining six months of the year. Further this would be the fifth budget paper presented under the “Mahinda Chinthanaya” programme, following the current President taking up office in 2005.

The 2010 “mini” budget was presented with the wake of IMF’s third tranche of USD407.8 mn being disbursed, which considerably strengthened the government’s coffers. Despite the circa LKR1 bn reduction on expenditure for defense and public security and LKR17 bn reduction on other goods and services mainly due to the drop in such expenditure on national security, the Recurrent Expenses are expected to increase
by 5.5% to LKR928.3 bn mainly due to expected increases in salaries and wages, interest expenditure and subsidies and transfers. The total expenditure is expected to grow by 6.5% to LKR1,279.8 bn whilst total Revenue (excluding grants) is expected to grow at a faster 16.9% to LKR817.8 bn (including grants 15.9% growth to LKR840.9 bn), capping the target deficit at 8.0% of projected GDP. However a 15% plus growth
in revenue could be an uphill task given the current tax regime nevertheless a 24.6% growth seen in the first five months of the year is an assuring factor. Further, Jan-April 2010 has recorded a budget deficit of 3.1% vs 4.1% recorded in the same period in 2009.

The “mini” budget presented did not have any revised revenue proposals and the 2011 budget that will be presented in November 2010 is expected to propose more detailed policy initiatives.

Poor revenue collection and increased spending Divert Deficit target in 2009
IMF deal extended in view of better fiscal management. International Monetary Fund has released funds worth USD407.8mn today which was discontinued following the last year's budget diversion from the expected deficit of 6.5% of GDP to 9.9% due to increased spending and poor revenue collection over the period. The amount was released on the assurance of a more responsible fiscal management for the coming
year. Even though the capital expenditure was 10.9% lower than projected amount , the high current expenditure of LKR879.6bn together with the 10.2% lower revenue lead to an overall budget deficit of 476.4bn (9.9% of GDP) whilst the growth in revenue was circa 5.7%YoY

Revenue targets fell short by 10.2% in 2009. The government has fallen behind its original revenue target of LKR855.0 bn largely owing to slow down in collection of tax revenue which was attributable to the decline in international trade related taxes and reduced domestic economic activities coupled with global economic recession. The high inflationary scenario has had a negative impact on consumption growth, leading to a VAT collection of LKR185.7 bn (lower than the original estimate of LKR221.9 bn). Further the revised value of LKR149.7 bn in 2009 has fallen behind the projected income tax collections of LKR166.7 bn (up 11.4 % YoY).

Recurrent expenditure has overshot target by 6.8% in 2009. The revised recurrent expenses for 2009 was LKR879.6 bn vs the budgeted figure of LKR823.5 bn (up 6.8%) YoY. Increase in salaries & wages, pension payments, interest payments, counter terrorism activities, provision of humanitarian facilities for IDPs and resettlement activities in conflict affected areas drove the recurrent expenses higher than budgeted. Further revised recurrent expenditure as a percentage of GDP stood at 18.2% vs 15.8% which was budgeted in 2009.

Capital expenditure continues to be the scapegoat. Capital spending has been curtailed at LKR330.5 bn (still up 30.9 % YoY), 10.9% lower than the original estimate in 2009. Despite the government's emphasis on infrastructure development, spending on highways and ports following the war have been lower than expected.

Both Domestic and Foreign borrowings to bridged the deficit. Domestic financing contributed 82.2% whilst Foreign financing contributed 17.6% to finance the overall budget deficit of LKR476.4bn. Foreign financing soared to LKR 83.9bn (plus 45% YoY higher than the estimate) whilst the domestic financing dipped by 24.9% YoY to LKR 392.5.6bn (yet 114.3% higher than the forecasted).

Fiscal position to improve in 2010
Revenue projected to grow by 15.9% YoY in 2010. The target of 15.9% YoY growth in revenue to LKR840.9 bn is somewhat ambitious where the total revenue collected for the period Jan-May’10 the has been LKR298.2 bn. The “mini” budget has not proposed any new revenue proposals where the more detailed policy initiatives would be proposed in the 2011 budget Nov 2010. The total revenue is estimated to be generated from LKR729 bn tax revenue and LKR88.8 bn non-tax revenue. Whilst the government
estimates the taxes from external trade to rise 14.0% YoY to LKR145.2 bn, mainly on the back of increase in imports, the Jan-May’10 figures show a 14.2% YoY dip on the back of the Government scaling down certain duties.

Further, the recently proposed tax reforms on imported vehicles, raw materials, electronic goods and etc could also hinder the revenue stream despite the expected increase in the number of items imported. The government expects to meet the revenue target mainly through 14.9% YoY growth in income tax, 20.3% YoY growth in taxes on Goods and services and 14.0% YoY growth in taxes on external trade. Further, the improved domestic economic activities and increase in imports are expected to shoulder the revenue growth.

Total government expenditure for 2010 is estimated at LKR1,279.8 bn. Total government expenditure for 2010 will comprise of LKR928.3 bn (up 5.5% YoY) recurrent expenses and LKR352.5 bn capital expenditure. However the overall government spending for the first four months of 2010 stood at LKR410.9 bn which leaves the government with LKR868.9 bn for the remaining period of 2010.

Recurrent expenditure expected to rise by only 5.5% YoY in 2010. Government expects recurrent expenditure to rise only by 5.5% YoY to LKR928.3 bn in 2010 largely on account of falling inflation levels. However interest cost (which constitutes 36% of recurrent expenditure) is expected to be the main driver of expenditure growth rising 8.9% YoY to LKR337.2 bn in 2010.

Further salaries and wages which accounts for circa 32% of total recurrent expenditure will be increased 9.4% YoY to LKR296.7 bn in the budget 2010. From salaries and wages 47% will be paid to national security and 36% is for education & health.

Subsidies and transfers which account for 22% of recurrent expenditure will be increased 6.7% YoY to LKR202.9 bn whilst pension to public servants would account for nearly 46% of the total subsidy payments.


The total defence and public security expenditure is projected to be at LKR186.3 bn compared to LKR187.2 bn (reduction of mere 0.5%). However we see a considerable reduction in other goods and services estimates from LKR108.5 bn in 2009 to LKR91.5 bn (down 18.6% YoY) largely due to reductions in expenditure on national security.

Further it should be noted that the government has utilized LKR327.0 bn as recurrent expenditure during the first four months of 2010 from the budgeted figure of LKR928.3 bn for 2010.

Capital expenditure is projected to rise by 12.1% YoY in 2010. Government expects a 12.1% YoY rise in capital spending to LKR 361.5bn in 2010 where the main focus is on road development which constitutes 23% of total capital expenditure. Further 10% of non recurrent expenses will be directed towards water & irrigation infrastructure whilst 11% is for the improvement in education & health system in the country. During the period Jan-April 2010 government has only spent LKR89.1 bn from the total budgeted
amount leaving another which leaves them with LKR272.4 bn for development activities for the 2H2010.

Foreign financing to rise in 2010. The government would rely on both foreign and domestic financing to service the planned fiscal deficit of LKR438.8 bn. The government plans to increase its total foreign borrowings by 47.2% YoY to LKR123.5 bn which are largely committed funds. The bulk of the deficit would be financed by domestic borrowing of LKR315.3 bn which would be at a dip of 24.5% YoY. As the proposed budget outturn indicates a reduction in domestic financing by LKR77.1 bn, the government
expects pressure on interest rate to ease which would facilitate credit expansion for private sector development

General benefits of budget 2010

Infrastructure:
Road network: The government has allocated LKR83.4 bn, which is 23% of the total capital expenditure budget for the development of highways. 530 km of rehabilitated national roads, 300 km of rehabilitated provincial roads and 34 new bridges would be added to the road network in 2010. Further, 181 km of express ways, 104 bridges and 1,500 km national roads would be upgraded during the next 3 years.

Port and Aviation: A total of LKR30 bn has been provided for the development of port and aviation facilities where the main projects would be Colombo port expansion, Hambanthota Port development and the construction of the new airport in Maththala.

Irrigation and Water management: It has been proposed to invest LKR37 bn in irrigation and water management systems which include construction of Moragakanda dam and irrigation system, Uma Oya diversion project, Deduru Oya etc. These projects are expected to bring additional area of land under irrigation and convert many lagging districts into economically prosperous areas during next six years.

Terrorist conflict affected areas: A comprehensive medium to long term reconstruction strategy has been planned to transform conflict affected areas into decent living conditions. Funding arrangements are already in place to implement transport, electricity, water, schools, healthcare and all essential facilities in the areas.

Public services:
Health and Education: A total of LKR40.8 bn has been allocated to ensure a quality healthcare system and an education system in the country. Out of that LKR13,300 mn is to be spent on supplying drugs and pharmaceuticals to government health care centers in assuring free healthcare to the nation. Further, a national policy on nursing services will be introduced to improve quality of service whilst indigenous medicine would be popularized as a supplementary health service.

The government proposes to build partnerships with private sector to facilitate students who do not get placement in local universities due to limited openings. This would open more opportunities to the students whilst saving foreign exchange spent on education abroad.

Transport: LKR6,650 mn has been set aside to meet expenditure on subsidized railway and road transportation in 2010.

Water & Electricity: 100,000 new water connections and 250,000 new electricity connections are planned for 2010. This would be augmented to 150,000 water connections and 300,000 electricity connections per year 2011 onwards.

Welfare and social safety: Proposed assistance to the poorer segments of the society, displaced persons, nutritional intervention programs and enhancement of school education exceeds LKR164,000 mn for 2010.

Recent Tax Reforms
There has not been any tax revisions in the mini budget proposed. Following are some recent tax reforms :

• Vehicles : A general 50% reduction of duties on imported vehicles. The tax revision on motor vehicles with effect from 1st June 2010 is as follows :

• Also, an overall removal of 15% surcharge on custom duty, resulting in a four band custom duty structure of 0%, 5%, 15% and 30% was seen with the tariff revision.

• Imported raw materials/ machines and electronic items : A 3% reduction in duty on imported raw materials/ machines to 8% from 11%. Electronic items such as cameras and watches are now prone to a deduction below 10% of overall taxes and are only liable to Port tax levy and Nation Building Tax and not Cess or VAT.

• Wheat Flour : Consequent to the withdrawal of tax concessions on wheat flour, the price of wheat flour increased by LKR10.5 per kg from 22nd June 2010 onwards.

• Sugar, Liquor & Tobacco : Taxation on imported sugar increased by LKR5.0 per kg. Taxes on cigarettes also moved up by LKR1.0 per stick whilst taxes levied on a proof litre of spirits hiked by LKR50.0. These tax impositions came into force from 24th June 2010 onwards.

• Value Added Tax

• Port and Airport Development Levy

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Odel Unlimited (ODEL) Initial Public Offering

Odel Unlimited (ODEL), one of the nation's largest fashion, apparel and cosmetics retailers announced its IPO of 16.7 mn shares at LKR15.00 per share, expecting to raise LKR250.5 mn in total. The proceeds of the issue is planned to be partly utilized to support the expansion of branch net work (LKR150.5 mn) of the company and the rest (LKR100 mn) would be employed to settle part of outstanding loans.

The Company focuses on delivering maximum fashion and value to its shoppers by offering compelling selections. Odel stores offer a broad selection of merchandise and feature products from both local and exclusive international brand sources. The Company operates 12 stores 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 flagship store boasts of an average footfall of plus 1,500 per day (3,000 per day in the weekend) and a conversion rate of +90% whilst other branch stores also demonstrate above average footfalls and conversion rates though relatively lower than that of the flagship store.

Nonetheless Odel's cautious branch expansion efforts have made them to break even at the first month of operations itself. Given the uptrend in revenue stream and the company's emphasis on retiring debt capital we project net profit to grow by a three year CAGR of circa 27% during 2011E- 2014E.

In terms of earnings based valuations the share is attractive valued on 11.5X forecast FY11 net profit (based on the issue price of LKR15.00 per share) which is at a plus 20% discount to the forward market earnings multiple.

Further on a free cash flow to the firm (FCFF) valuation, intrinsic value per share is circa LKR18.00 (given a cost of capital rate of 18%) and remains attractive at the issue price of LKR15.00.

Based on both valuations the share generates good value at the issue price of LKR15.00. Further Odel IPO would be an opportune window for adventurers to capitalize on short term gains and to benefit in the medium term with the aggressive expansion driven organic growth of the company. Therefore strong upside for the share could be expected with steady income streams and Odel’s brand image coupled with strong investor appetite for IPOs, thus we recommend SUBSCRIBE

Industry Overview and Future Outlook
As a department store, Odel offers a wide range of product categories and operates across major segments of the Sri Lankan premium non-food retail industry. Except for the flagship outlet, the other stores generally focus on the premium clothing and footwear retail industry.

The country’s clothing and footwear industry is highly competitive as Sri Lanka being a major garment manufacturing nation. Low and middle level markets are spearheaded by clothing store chains such as “No Limit”, “House of Fashion” and “Fashion Bug” with stores Island wide. A high number of counter freight clothing items of premium brands are also visible in the country at a low price.

Odel has demonstrated strong performance where its top line grew at a four year CAGR of circa 11%. ODEL has reported a revenue of LKR2,416.8 mn in FY10, up circa 24% YoY. The growth in revenue is attributable to the aggressive expansion programme, improvement in per capita consumption and the increase in influx of tourists with the end of the three decade old war.

Revenue Trend
Subsequent to the strong spurt of growth in revenue the Operating profit has grown by circa 34% YoY to LKR208.2 mn in FY10. Further the EBITDA has been growing at an impressive four year CAGR of circa 26% with overheads being kept intact over the last five years.

In particular in FY10 EBITDA has surged by 68% YoY to LKR336.9 mn. Further the EBITDA margin has improved to 14% in FY10 from 10% in FY09 on the back of the capital gain of circa LKR75.6 mn made in FY10.

EBITDA vs EBITDA Margin Revenue: Cost Structure NPAT has grown by a tremendous three folds in FY10 on the back of the improvement in EBITDA and the reduction in finance costs. Even if the capital gain is removed the NPAT has marked a growth of 100% YoY in FY10.

Comparatively the Sri Lankan premium clothing and footwear industry is dominated by few players in the market of which Odel enjoys a sizable market share. Dilly’s Distinct and Cotton Collection cater to the same market segment as Odel although the product spread is rather limited as they focus mainly on premium clothing retail.

As a multi category retailer Odel contends with a broad range of competitors, not only limiting to the premium clothing retailers. Sri Lankan malls such as Crescat, menswear outlets such as Hameedias and sports outlets such as Reebok and Nike too competes with Odel in the respective fields.

The increased tourist influx following the three decade old war would have a positive impact on Odel as the company is renowned as “the tourist shopping destination 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 dilusion.

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.

Valuations
Revenue is expected to increase at three year CAGR of circa 13% from FY11E to FY14E mainly on the back of improvement in consumption, growth in tourist arrivals to the country and better market reach via expansion of the branch network.

We expect the operating costs would grow at a three year CAGR of circa 13% from FY11E to FY14E slightly above the historical growth momentum. However we expect the OPEX to income ratio to reduce to circa 90% over the next four years from its current +95% levels due to revenue growth outpacing the OPEX growth.

As at 31st March 2010 the company has a debt of approximately LKR550 mn (Short and Long Term borrowings) with an interest cost of plus LKR70 mn. Odel is planning to retire part of its debt during FY11E using part of the funds (circa LKR100 mn) raised by the IPO. This would give rise to savings on interest costs from FY11 onwards without disturbing the cash position of the company. However we believe the company would resort to working capital loans and overdrafts to fund the short term funding requirements. Further it should be noted that the company would make its gearing position healthier by reducing the debt to equity ratio to less than 5% from its current 47%.

Given the uptrend in revenue stream and the company’s emphasis on retiring debt capital we project net profit to grow by a 3 year CAGR of 20% during 2011E – 2014E.

In terms of earnings based valuations the share is attractive valued on 11.5X forecast FY11 net profit (based on the issue price of LKR15.00 per share) which is at a plus 20% discount to the forward market earnings multiple.

Further on a free cash flow to the firm (FCFF) valuation, intrinsic value per share is circa LKR18.00 (given a cost of capital rate of 18%) and remains attractive at the issue price of LKR15.00. Based on both valuations the share generates good value at the issue price of LKR15.00. Further Odel IPO would be an opportune window for adventurers to capitalize on short term gains and to benefit in the medium term with the aggressive expansion driven organic growth of the company. Therefore strong upside for the share could be expected with steady income streams and Odel’s brand image coupled with strong investor appetite for IPOs thus we recommend SUBSCRIBE.

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Sri Lanka Corporate Earnings - Analysis FY 2010

Market earnings have grown by an overwhelming 190% YoY in 4QFY10 and a sharp 44% YoY in FY10.
The conducive business environment subsequent to the end of the three decade old conflicts coupled with political stability and positive economic outlook has raised the business sentiments and the corporate earnings during 2HFY10 has been exceptional despite the slow global economic recovery.

The Corporate Earnings have gained in line with the market till 2007 and during the heightened war the corporate earnings have outstripped the prices. However with the complete end of the three decade long war and positive economic outlook the share prices have exceeded the growth in earnings.

SECTORAL CONTRIBUTION
Banks, Finance and Insurance sector has emerged as the major contributor to the corporate earnings contributing for circa 37% of the total corporate earnings in FY10. Diversified Sector has contributed for circa 24% whilst Food, Beverage and Tobacco sector has contributed to circa 17% of the corporate earnings in FY10.

TELECOMMUNICATIONS

Telecommunication sector has made a turnaround from the staid period by posing a +twofold YoY increase in profits to circa LKR1,309.1 mn in 4QFY10. However the FY10 saw a cumulative loss of circa

LKR9,223.6 mn mainly on the back of the massive asset impairments of Dialog Telekom which took place during the year. Further relatively high number of operators triggered stiff competition on tariffs which
reduced the profitability of the industry as a whole. Thereby the industry experienced a more turbulent period from 2008 to 2010 being a deflator to cumulative market earnings.

BANKS, FINANCE & INSURANCE

Banking and finance sector recoded a growth of 65% YoY during 1Q2010 which was driven by favourable macro economic conditions and political stability in the country. We witnessed banks such as Sampath Bank, Commercial Bank, DFCC Bank and Nations Trust Bank recoding impressive results during 1QFY10, which was backed by improved net interest incomes and reduction in provisions. Lanka Orix Leasing, LB Finance were in the forefront of the earnings drive of finance companies whilst HNB Assurance and Ceylinco Insurance spear headed the insurance sector earnings during the quarter. Further in terms of 4Q cumulative earnings the sector recoded a 50% YoY growth which was supported by banking sector counters such as HNB, SAMP, DFCC and NTB, finance companies such as LOLC, LFIN, First Capital Holdings and Asia Capital.

FOOD, BEVERAGE & TOBACCO

Food and Beverage sector earnings grew by a moderate 12% YoY in 4QFY10 whilst it improved by a decent 30% YoY in FY10. The growth was spearheaded by improved earnings in Ceylon Tobacco, Nestle
Lanka and Ceylon Tea Services, whilst poultry sub-sector counters together with Lanka Milk Foods & Lion Brewery ably shouldered the sector earnings growth.

CHEMICALS

The Chemicals and Pharmaceuticals sector grew by a impressive 370% during 4QFY10 whilst it grew by 55% YoY in FY10. The outstanding results of Haycarb that propelled the growth in the sector was at-
tributable to the organic growth and capital gains which incurred during the period. The exceptional growth of 930% YoY 4QFY10 achieved by chemical industries aided in spearheading the sectoral growth. Further the 200% YoY 4QFY10 improvement of Lankem Ceylon enhanced the sector growth even though Chemnex was holding the market down.

CONSTRUCTION & ENGINEERING

Earnings of the construction and engineering sector has increased by 5% YoY in FY10 to LKR1907.86 mn mainly on the back of the 10% YoY increase in earnings of Colombo Dockyard. DOCK contributed for
almost 99% of the sectoral earnings whilst Lankem Developments has made a turnaround by improving their earnings two folds YoY to LKR3.29 mn in FY10. Construction & Engineering sector has achieved a 5 year earnings CAGR of 57% which is recorded as the highest sectoral earnings growth in the Colombo Bourse.

DIVERSIFIED

The diversified sector earnings grew by an impressive 88% YoY during 4QFY10 whilst it grew by 54% YoY in FY10. This growth was spearheaded by outstanding results posted by Hayleys owing to the capital gains made from divesting a few hotels under Carbotels and increased contribution Hayleys MGT. Further, Carsons Cumberbatch reported an exceptional growth mainly due to better palm oil returns and profits from the beverage business. Colombo Fort Land reported impressive growth on all sectors especially in plantations
whilst the diversified segmental profit was further supported by John Keells Holdings where the hotel arm performed above expectation. Richard Pieris turned around strongly (276% YoY) during the year and shouldered the sectoral growth.

HOTELS & TRAVELS

The Hotel sector earnings grew by an impressive 319% YoY during 4QFY10 whilst it grew by 643% YoY in FY10. Hotels and Leisure sector is the prime beneficiary of the complete end of the three decade long war, whereby the sector propelled the earnings of the broad market in 2HFY10. 4QFY10 was a turnaround period for almost all the hotels and exhibited tremendous improvement in earnings on the back of circa 54% YoY increase in tourist arrivals during the quarter and improved ARRs and occupancy rates.

INVESTMENT TRUST

The investment trust sector earnings grew by 152% YoY during 4QFY10 whilst the FY10 earnings grew by 143% YoY in FY10. The growth was lead by growth in Ceylon Guardian, Touchwood, Sunshine holdings
and Ceylon investments. Apart from Renuka holdings and Watapota investments which saw sharp dip in earnings during FY10 all other companies in the sector have witnessed significant turnaround.

LAND & PROPERTY

A 172% YoY growth in 4QFY10 and a 42% YoY increment for FY10 was lead by the sector heavyweight Overseas Realty. Overseas Realty contributed over 75% of the total quarterly earnings of the sector whilst
showing an increase of 72% YoY for 4QFY10. Property Development shouldered the earnings during the year whilst East West turned around strongly (up 1791% YoY).

MANUFACTURING

The manufacturing sector earnings witnessed a 67% YoY growth during 4QFY10 whilst it saw 91% YoY growth during FY10. The growth was driven by Chevron Lubricants (up 97% YoY) on the back of bet-
ter margins whilst Royal Ceramic also lent support (up 86% YoY in FY10). Lanka Ceramic, Lanka Wall tiles and Grain Elevators saw im pressive growth in their bottom line mainly driven by increased consumer spending. However, Pelwatta Sugar weathered a challenging period (down 569% YoY in FY10) where it has been a drag on the sectoral performance whilst ACL cables too have negatively impacted the growth (down 101% YoY in FY10).

PLANTATIONS

The sector has grown two-fold in 2010/FY10 to LKR1,937.8 mn owing to high tea and rubber prices which prevailed since mid 2009 despite low output levels. During 1Q2010/4QFY10, the sector saw net earnings of LKR1,313.7 mn versus a loss of LKR391 mn in the corresponding period previous year which could be mainly attributable to the escalated rubber prices where companies with exposure to rubber benefited immensely.

OIL PALMS
The sector has recorded an impressive two fold growth in net earnings for 1Q2010/FY2010 which could be mainly attributable to the remarkable performance in Bukit Darah; the holding company of 4 oil palm companies which operate plantations in Malaysia along with holdings in the Carsons Cumberbatch group. Rising oil palm prices (which were at a drop in 2008 due to global recession) strengthen the performance in the four oil palm companies. Further, for the year FY2010 sector has recorded LKR3.2 bn from the LKR894 mn posted last year.

SERVICES
A fivefold increase was seen in services sector during 4QFY10 and +400% YoY increase in earnings for FY10 whilst Health care sector recorded 201% YoY increase during 4QFY10 and 148% YoY increase during FY10. Services sector growth was spearheaded by the impressive improvements in earnings of Asiri Group Hospitals and Nawaloka Hospitals

STORES & SUPPLIES
The stores & supply sector witnessed an over whelming 233% YoY growth during 4QFY10 whilst FY10 earnings grew by 245% YoY mainly on the back of strong growth seen in E B Creasy (up 579% YoY in FY10).

TRADING
The trading sector earnings grew by 32% YoY during 4QFY10 whilst it grew by an impressive 272% YoY in FY10. This growth was spearheaded by exceptional results posted by Browns where the FY10 earnings have grown by 113% YoY, however there was a downward trend in quarterly performance. With the latest tax and tariff reforms implemented in June 2010 there seem to be a favorable prospect for the trading sector in the near future.

MOTORS
Motor sector recoded an impressive +300% YoY increase during 4QFY10 and FY10. Sector growth was driven by Diesel and Motor Engineering Company, United Motors and Colonial Motors. Further the recent 50% import duty reduction on motor vehicles will also have a positive impact on its top line growth in the future.

FOOTWEAR & TEXTILES
The Footwear and Textile sector trended downwards 31% YoY during 4QFY10 whilst it grew by an impressive 97% YoY in FY10. Hayleys MGT spearheaded the entire sector with outstanding results whilst contributing over 100% of the total sectoral earnings in 4QFY10.Ceylon Leather is on the path of recovering from a loss making run whilst presenting profits for 4QFY10 as well as FY10. On the other hand Kuruwita Textiles added pressure on the Footwear and textile sector with a 177% YoY dip in 4QFY10 dragging
the earnings of the company into negative figures.

POWER
The sector has marked a turnaround in 1Q2010/4QFY10 recording a net profit of LKR744.8 mn whilst resulting a cumulative 4 quarter profit of LKR356.8 mn. This is mainly attributable to the improved performance in Lanka IOC, which contributed negatively to sector performance in 2008/FY2009. The three other companies which are mainly into hydro power generation have shown improved earnings from the corresponding period previous year. With the market re-rating to a new and higher valuation plane with the positive macro environment the market is currently trading on 4 quarter trading multiple of 19.8x. Given our expectation of near 30-35% YoY growth in corporate earnings in FY11 the market PER would fall to circa 15.0x.

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Distilleries Company (DIST) - Earnings dampened

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, Power, Insurance, Textiles and through an associate stake in Aitken Spence in fields ranging from leisure to logistics.

The purchase consideration of Sri Lanka Insurance (SLIC) is to be repaid to DIST in the form of treasury bills with a maturity period of five years. This is an outstanding launching pad for DIST for future business acquisitions. Deeming it illegal, the Supreme Court reversed the privatisation of SLIC in June 2009 and ordered the Treasury to refund the money paid for the deal, LKR 6.05 bn (Further, the company is entitled to keep the profits it earned during the time it ran the insurer).

The losses made from the Telecom subsidiary has dragged down the FY10 performance whilst the reduced earnings from the diversified sector too have negatively impacted the bottom line during the year. DIST's core hard liquor business has shouldered the group's PBT during the year whilst the sectoral PBT has marginally grown to LKR4,262.0 mn, whilst Lanka Bell recorded a loss of LKR556.7 mn (vs a profit of LKR76.5 mn in FY09). The plantation earnings improved marginally where the sector posted a PBT growth of 5% to LKR98.6 mn whilst the diversified segment posted a loss of LKR39.6 mn vs a profit of LKR281.4 mn in FY09.

However, the FY09 net profit includes the profit attributable to SLIC group of LKR730.5 mn and excluding this the FY10 net earnings has dipped only by 11.2%YoY.

FY10 performance at a glance
Gross turnover remained flat whilst net revenue dipped by 7.2%YoY in FY10. Consolidated FY10 gross revenue remained flat during FY10 whilst net revenue has dipped by 7.2%YoY toLKR20,287.0 mn. The dip in net revenue is mainly on the back of the declined contribution from Lanka Bell and the diversified segment. However, the core distilling operation grew marginally (Gross profit up 6.0% YoY to LKR mn) amidst stringent laws passed to reduce liquor consumption whilst the plantation sector too reported 16.2% YoY growth in Gross profit. However the contribution from Lanka Bell (down 21.1% YoY to LKR5,160.0 mn) and diversified sector (down 38.7%YoY to LKR1,016.5 mn) have dipped during the year 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 9.9% YoY in FY10. DIST’s cost of sales has dipped by 9.9%YoY to LKR 8,735.8 mn in FY10. Whilst cost of sales of DIST’s core liquor operation too has dipped by 6.1%YoY to LKR6,832.908 mn. DIST posted a gross profit of LKR8,735.8 mn, down 9.9%YoY in FY10 whilst gross margins have marginally dipped to 43% in FY10 (vs. 44.3% in FY09).

Operating profit has dipped by 15.3%YoY to LKR4,058.8 mn in FY10. Income from investments has fallen by 16.2%YoY to LKR575.3 mn in FY10 largely due to the relatively low interest rates. Administrative expenses have dipped by 4.6%YoY to LKR2,880.3 mn whilst distribution cost also has dipped by 7.7%YoY to LKR2,372.0 mn in FY10. The consolidated FY10 operating profit has declined by 15.3%YoY to LKR4,058.8 mn whilst the operating margin has dipped to 20% in FY10 (vs. 21.9% in FY09).

FY10 pre tax profit dipped 13.1% YoY to LKR3,808.6 mn. DIST’s finance cost has dipped by 25.2%YoY to LKR559.7 mn in FY10 due to reduced borrowing (21% YoY reduction to LKR4,113.9 mn) and low interest rates. Further, the share of profit from associates has dipped by 8.0%YoY to LKR309.6 mn largely on the back of reduced holdings in conglomerate Aiken Spence (SPEN, LKR1,555). Consequently, DIST has posted a pre tax profit of LKR3,808.6 mn, down by 13.1%YoY in FY10.

FY10 net profit records LKR2,367.3 mn (down 30.1% YoY). Income Tax expense have dipped 15.7% YoY to LKR1,418.7 mn due to reduced earnings. Consequently, DIST has posted a net profit of LKR2,367.3 mn, down by 30.1%YoY in FY10. However, the FY09 net profit includes the profit attributable to SLIC group of LKR730.5 mn and excluding this the FY10 net earnings has dipped only by 11.2%YoY.

Forecast FY11E net profit to reach LKR2,959.1 mn (up 25% YoY). With the anticipated recovery of Lanka Bell (the industry wide efforts to reduce the price war and the regulator’s move to charge interconnect charges and introduce floor rates) and growth in the key liquor business (expected rise in tourism, more sales in the previously war affected North and East and anticipated increase in disposable income), we expect DIST to post LKR2,959.1 mn (up 25% YoY) in FY11E. We expect the core businesses to post 31.5%YoY growth in net earnings to reach LKR3,891.3 mn in FY12E. All the forecasts exclude the impact from the purchase consideration of LKR6.05 bn treasury bonds receivable.

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. The Insurance Company is started up as a Greenfield project and has exclusively the General Insurance business.

DIST also made an investment of LKR750 mn on a 4MW power plant in an estate in Bogawanthalawa which is owned by Madulsima plantations PLC, an associate of DIST. This project which has already entered into a “Standardised Power Purchase Agreement” is estimated to have a payback period of circa 3 years.

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 9.6X forecast FY12E net earnings and 1.2X PBV.

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John Keells Holdings (JKH): FY10 records 10% YoY growth in net earnings

John Keells Holdings (JKH) the largest listed conglomerate on Colombo bourse with a market capitalization of LKR113.2 bn (USD994.6 mn) marks it’s strong presence in Leisure, Transportation, Food & Beverage, Property Development, IT and Financial Services Sectors. Conglomerate John Keells Holdings (JKH) has reported net profit of LKR5,201.5 mn in FY10, up by 9.9% YoY, slightly above our original expectation of LKR4.7 bn.

JKH's FY10 earnings have been spearheaded by strong growth in the core Transportation sector (Net Profit up 38.9%YoY) and the much anticipated revival in the Leisure sector (NP up six folds YoY). Further, the financial services sector (NP up 43.5%YoY) also performed strongly. However, the other core sectors such as Property (NP down 28.8%YoY), Consumer foods & Retail (NP down 45.2%YoY) and Information Technology (NP up 110.5%YoY) have under performed due to lower activity levels, squeezed margins and costs associated with capacity building.

Quarterly performance at a glance
JKH’s FY10 Consolidated revenue has increased 17% YoY to LKR47,980.0 mn whilst that of 4QFY10 has grown by an impressive 40.7%YoY to LKR13,924.6 mn. This is mainly due to the consolidation impact of Union assurance (which is now a subsidiary) and during the year the top line contribution from the Leisure, Consumer food & retail and Financial services sectors have grown strongly whilst Property sector has shown improvement in revenue. Though revenue from Transportation sector dipped 17%YoY during FY10 it has shown impressive performance during 2HFY10.

Cost of Sales have also increased (+18% YoY to LKR36,914.0 mn) in line with the rise in turnover levels whilst Gross profit has grown 12.8% YoY to LKR11,066.0 mn during FY10.

Meanwhile JKH's total operating expenses have increased by a sharp 19.5% YoY to LKR10,778.8 mn in FY10 mainly due to the consolidation impact of Union Assurance, Capacity building (at Keells super markets) and increased marketing and distribution costs in John Keells foods India and in local Consumer Food business. Further, escalating costs in the Transportation sector subsequent to the altered operating model in the bunkering unit and increased costs in the hotel sector also have contributed to the increase in costs.

Further, JKH's other operating income in FY10 has shot up by 34.4% YoY to LKR5,020.7 mn, attributable mainly to the finance income of Union assurance (which is now a subsidiary) and the circa LKR751.0 mn capital gain on disposal of KHL rights (JKH divested 150 mn of its rights in KHL in Mar'10 and subscribed for the entirety of its remaining rights and an additional rights of 7 mn shares. Subsequently, JKH currently holds 82.9% of KHL where it previously held 92.7%). These have supported to weather the impact from reduced interest income earned on the investment portfolio mainly due to dip in interest rates. Subsequently, operating profit rose by 16.9%YoY to LKR5,351.8 mn during the year.

JKH's share of profit from associates have increased by 9.2% YoY to LKR2,555.9 mn in FY10 mainly due to the improved performance of Transportation sector associate South Asia Gateway Terminals and financial services associate Nations Trust Bank (NTB: LKR 37.5) having performed well. Further, the IT segment has witnessed a turnaround to make LKR17.6mn Vs a loss of LKR167.2 mn. Subsequently, EBIT grew by 14.3% YoY to LKR7,907.7 mn during the year.

Finance cost has dipped by 19.2% YoY to LKR1,370.2 mn on the back of low interest rates and reduced borrowings. The Profit before Tax has increased by 3.9% YoY to LKR6,537.6 mn during FY10 despite the capital gain on AMW (LKR1,025 mn) in the previous year.

Tax expenses during FY10 dipped 25.7%YoY (due to last year's one-off tax expenses of LMS) and subsequently JKH's Net Profit has grown 9.9% YoY to LKR5,201.5 mn.

Sectoral Snapshot


Transportation sector net profit up 38.9% YoY to LKR2,258.8 mn in FY10 
JKH’s key Transportation sector which is mainly represented by the fully owned subsidiary Lanka Marine Services [LMS] and 42.2% owned associate South Asia Gateway Terminals (SAGT) reported a 38.9%YoY increase in bottom line to LKR2,258.8 mn whilst the top line declined by 17%YoY to LKR9,494.7 mn. The top line dipped mainly due to the reduced contribution from LMS on the back of low oil prices and high competition. Despite this setback LMS retains the market leadership and has managed to post positive earnings (4QFY10 EBIT of LKR60 mn Vs LKR64 mn in the previous period though FY10 EBIT fell by 40%YoY to LKR175 mn).

Performance of Port operator SAGT has improved significantly during FY10 with container throughput increasing by circa 12% YoY to 1,882,220 TEUs (Apr’09 – Mar’10). The volumes have risen steadily from April’09 despite the sharp dip witnessed in the first four months of 2009. The increase in throughput volumes is mainly on the back of increased activity in low margin transshipment (circa 77% of the total volumes is from transshipment). The increase in total volume could be attributable to recovery in regional trade, competitive rates, efficiency and persuading existing shipping line customers to move containers through the Colombo port than direct calls at Indian ports. The sectoral share of associate company income (consisting of SAGT and Maersk Lanka) has increased by 10.7% YoY to LKR2,158.4 mn.

The transportation sector posted 38.9%YoY growth to reach LKR2,258.8 mn spearheaded by the impressive performance by SAGT however in absence of the one-off charges (circa LKR630 mn) of LMF in FY09.

Leisure sector net profit up by six folds to LKR893.0 mn in FY10
The Leisure sector has recorded a remarkable six fold increase during FY10 to reach LKR893.0 mn, mainly on account of the improved performance of the Sri Lankan City and resort hotels. Both city and resort hotels showed impressive performance during the 2HFY10 on the back of increased tourist influx into the country. All four Maldivian resorts are currently operational including the completion of the breakwater construction
at Cinnamon Island Alhidoo and according to the company despite the dip in tourist arrivals to Maldives all four resorts have performed satisfactorily especially in the 3rd and 4th quarters. The Sri Lankan resort hotels have shown improvement in occupancy, with occupancy levels averaging around 60% during the 2HFY10 whilst the city hotel occupancy rate has picked up to circa +90% where it was previously at a near 50%.

Consumer Foods & Retail sector net profit down 45.8% YoY to LKR45.8 mn in FY10
The Consumer Foods & Retail sector that includes listed subsidiaries Ceylon Cold Stores [CCS: LKR205.0] and Keells Food Products [KFP: LKR66.75] has recorded a profit of LKR45.8 mn in FY10 (Vs a profit of LKR83.6 mn in FY09). However, the top line grew by 12.1% YoY to LKR15,843.5 mn mainly due to growth in the retail sector (circa 18%YoY up) and a near 6%YoY increase in consumer food revenue driven by CCS. However, the net earnings were dragged down mainly by poor performance by the processed meat business in India and hampered convenience food segment in Sri Lanka. JKH is continuing its aggressive expansion drive with regard to the supermarket chain totaling 45 outlets, whilst the company plans to increase the total number of supermarkets to +50 by end FY11.

Property Development sector net profit down 28.8% YoY to LKR292.1 mn in FY10
The Property sector has recorded a dip in earnings to LKR292.1 mn in FY10 (down 28.8% YoY), on account of revenue recognition from the completion on "Monarch" in the corresponding previous period. With the third apartment tower 'The Emperor's" (163 apartments) construction underway, we believe recognition of earnings (a near 82% sold and circa 20% is already recognized) from this project would be: recognition
of 20% over FY10 and the rest to be spread through out FY11 and FY12.

Financial Services sector net profit up 43.5% YoY to LKR477.6 mn in FY10
The Financial Services sector has recorded 43.5% YoY growth in earnings to LKR477.6 mn inFY10 where the turnover has grown phenomenally to LKR5,262.3 mn (vs LKR499.3 mn) on account of the consolidation of subsidiary Union Assurance [UAL: LKR112.0] coupled with healthy performance of the stock broking arm on the back of increased trading in the stock market and better contribution from associate Nations Trust Bank [NTB:LKR38.75].

Information Technology sector net profit up 110.5% YoY to LKR 17.6 mn
The Information Technology sector has recorded a net profit of LKR17.6 mn in during FY10 (vs a net loss of LKR167.0 mn in FY09) driven by improved performance of the Indian BPO operations that has operated on a break even level. The Other businesses of JKH including Plantation Services, Strategic Investments and
the Corporate Centre recorded a net profit of LKR1,216.5 mn in FY10 (vs LKR2,323.5 mn in FY09). The impact of the capital gain from the disposal of AMW in FY09 was partially set off by the treatment of UAL and gains made on KHL rights.

Future Outlook
Looking ahead, we expect JKH’s key Transportation sector to record improved earnings mainly on the back of better performance by SAGT despite the reduced LMS market share. Further, with recovery in the regional trade, competitive rates and persuading existing shipping line customers to move containers through the Colombo port than direct calls at Indian ports, volumes at SAGT is expected to grow by a near 8%-10% YoY during FY11.

With the signs of recovery witnessed during 2HFY10 we expect the profitability of SAGT to improve not only due to the increase in transshipment volume but also on the back of the expected change in mix between domestic container volumes (which gives three times the revenue of the transshipment containers) and the transshipment containers (the current mix between domestic volumes to transshipment is 77% to 23%). This change in mix is expected to materialize with increased activity in the local economy and construction sector reviving coupled with increase in the regional trade. However, the transportation sector remains vulnerable to sudden changes in the global economic climate.

With changing macro environment in Sri Lanka the local tourism industry is poised for strong growth and we expect significant improvement in both the local city and resort hotels. The number of arrivals to the country is already up 50% YoY during Jan-Apr’ 10. However, the Maldivian segment is expected to weather a challenging period on account of depressed international tourism on the back of the slow recovery from
global recession. The Sri Lankan sector would revive strongly given increased economic and business activity subsequent to the ending of war and infrastructure developments in the previously war torn areas. JKH with its portfolio of 2,000 rooms comprising of 860 city rooms and 775 resort rooms is well positioned to reap the
benefits. Further, JKH is currently investing heavily in upgrading the existing hotel properties and in new hotel ventures where it re-launched the 80 room Clun Oceanic in Trincomalee as “Chaaya Blue” in May 2010 at a cost of LKR450 mn. Further, JKH acquired 4.6 acres of land which give them a contiguous block of 10 acres on the prime Beruwela beach front on which the group has planned to build a 190 room hotel at an investment of LKR2 bn. In addition, the 254 rooms in the South wing of Cinnamon Grand hotel is currently being re-furbished at a cost of LKR300 mn. The key plans in the leisure arm includes refurbishment of Cinnamon Lodge Habarana (LKR300 mn), Coral Gardens Hikkaduwa (LKR1.1 bn), Chaaya Laoon Hakuraa Huraa (USD2.6 mn) and Bentotal beach hotel (LKR200 mn). In view of the substantial plans for expansion John Keells Hotels went for a rights issue of 1:3 to raise approximately LKR3.6 bn.

Going forward, we believe a significant proportion of the earnings arising from the property development (164 apartments Emperor) would be recognized in FY11 and FY12 and there by contributing to sectoral growth. With a real estate portfolio of more than 33 acres of land in Colombo (where contiguous large blocks of land are available) and 133 acres outside Colombo the sector is primed to benefit. Further, we believe the sector would benefit significantly from the declining interest rates and the anticipated demand from expatriate Sri Lankans.

The Financial services sector is expected to record consistent performance on the back of improved performance of associate NTB and continued growth of UAL (the 4th largest insurer by asset). However, on account of the local Banking Act, JKH will have to reduce its stake in NTB to 15% by 2012.

Despite the start up costs, the Information Technology sector would benefit from the BPO venture and post moderate earnings growth, albeit off a low base.

The Consumer Food & Retail sector is expected to rebound from FY11 onwards on the back of increase in demand from the North and East whilst we believe the sector has potential to post attractive earnings through cost rationalization and further consolidation of its renowned brands.

Trading on 13.6X forecast FY12E earnings. We continue to maintain our forecast net profit of LKR6,553.5 mn (up 26% YoY) in FY11E and project net earnings to rise by a further 26.8% YoY to LKR8,312.5 mn in FY12E. The main attraction of the stock is the fast EPS growth, a CAGR of 20.3% over 2005/2012E. JKH is currently trading on 17.3X forecast FY11E earnings, 13.6X projected FY12E earnings and 2.1X PBV (2011) where the counter has always been trading on premium to market. However, the premium may be justified with investments already in place in the domestic leisure sector and its large real estate portfolio, the company is primed to reap strong benefits from the macro upside. Further, JKH continues to be cash rich, subsequent to the rights issue in 2007 coupled with the drawing of USD75 mn loan facility from the International Finance Corporation (IFC) and in a strong position to launch fresh acquisitions/investments (Further, JKH is capable of raising substantial capital both in debt and equity market if needed). Healthy balance sheet along with investments in place we believe the share has marked upside, whilst being a proxy to the macro upside - Maintain BUY

JKH Annual Report http://www.keells.com/pdf/annual_reports/jkh_ar_2009_10/john_keells_annual_report_2009_10.pdf

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John Keells Hotels (KHL) recorded a net profit of LKR205.0 mn for FY10 up 197% YoY

John Keells Hotels (KHL), a 82% owned subsidiary of local conglomerate John Keells Holdings (JKH: LKR188.00) 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).

The share has out-performed the market by circa 21% since the end of war on 18th May 2009 albeit has underperformed the sector index by 68%, therefore we believe further upside is possible with growing earnings materialising in the coming quarters. Furthermore KHL would be one of the prime beneficiaries of the revival of local tourism industry, opening up of the previously war torn Northern and Eastern coasts, having 07 properties in strategic locations in the island which are upgraded and ready to cater the surge in demand. Further KHL will be adding another three hotel properties to their portfolio during the coming three years.

Financial Performance
Net revenue up 18% YoY to LKR6,038.1 mn in FY10. KHL’s top line has grown by 18% YoY in FY10 mainly on the back of revived Sri Lankan operations coupled with the improved performance in the Maldivian operations. The company’s Sri Lankan resort and hotel operations has posted a sharp increase of 32% YoY in its revenue whilst the Maldivian segment has grown by a 15% YoY despite the recessionary pressure on the Maldivian Tourism Industry during the first half of the year.

Operating costs have increased by 7%YoY in FY10. The company’s operating costs have increased by 7% YoY to LKR3,623.9 mn in FY10 whilst the final quarter recorded a relatively faster growth of 15% YoY due to high activity levels in the hotels since it is the best quarter in terms of operations. However depreciation and amortization costs dipped by 2% YoY despite the increased asset base.

EBITDA has increased 62% YoY to LKR1,284.2 mn in FY10. KHL has recorded an EBITDA of LKR1,284.2 mn in FY10 (up 62% YoY) whilst recording a slower rise of 15% YoY in 4QFY10. The company’s healthy results in the last quarter is mainly attributable to the revived local tourism which generated better margins coupled with the Maldives earnings which were above expectations.

Pre-tax profits grew two folds YoY in FY10. The company has recorded a pre-tax profit of LKR208.2 mn (up 194% YoY) in FY10, whilst its 4QFY10 earnings also increased 33% YoY to LKR479.7 mn. KHL’s Sri Lankan resorts and hotels have reduced its pre-tax losses by 91% YoY to LKR19.7 mn in FY10. Further the Maldivian segment which comprises of four properties recorded a tremendous improvement in pre-tax profits to LKR227.8 mn (vs. a loss of LKR11.9 mn)on the back of all four hotels being operational following the completion of the breakwater construction at Cinnamon Island Alhidoo.

KHL recorded a net profit of LKR205.0 mn for FY10. Backed by the booming local leisure industry and recovering Maldivian tourism, KHL has recorded a net profit of LKR205 mn in FY10 up 197% YoY despite the first half of the year falling into tourism off season. Further KHL’s earnings improved by circa 36% YoY to LKR480.5 mn in 4QFY10 supported by improved ARRs and occupancy levels.

4QFY10 Geographical Segmental Performance at a Glance
4QFY10 which is the best quarter for KHL has recorded a sharp increase in revenue supported by the 52% YoY increase in the Sri Lankan contribution to LKR463.8 mn and 10% YoY increase in the Maldivian contribution to LKR1,611.9 mn. Subsequently the Direct costs and other operating costs of SL resort operations have increased by a slower 22% YoY compared to the revenue growth, improving the operating profits by an impressive ten folds to LKR104.9 mn in 4QFY10. Further the pre-tax profit has increased eight fold YoY to LKR90.9 mn in 4QFY10 and the profit for the year has surged by a whopping pace to LKR91.7 mn during the same period.

Maldivian operations have been lagging during the quarter on the backdrop of the recessionary pressure on the tourism industry in Maldives. However the profits at all levels have grown in line with the growth in revenue.

Ready to reap the benefits
KHL the second largest hotel chain in Sri Lanka invests heavily to refurbish and reposition the existing hotels and put up new hotel facilities to cater the growing demand with the revival of the local tourism industry. According to the plans KHL would reposition 133 roomed Benthota Beach Hotel and rebrand it with its premier brand "Cinnamon" with an investment of circa LKR800 mn. The repositioning process would uplift the grading of the hotel to 4+ star whilst reducing the accommodation capacity to 115 rooms. Further KHL plans to invest another LKR800 mn in repositioning and refurbishing the Coral Gardens Hotel in the South Coast. The KHL presence in the southern coastal belt would be further strengthened by the addition of two hotels, one in Ahungalla and the other in Beruwala. The new construction at Ahungalla would be a 5 star hotel with an investment of LKR1.6 bn which is to be completed by the end 2013. KHL plans investing LKR1.7 bn in constructing a 190 roomed 3 star hotel in Beruwala which would be operational by the end of 2011.

KHL rebranded Club Oceanic Hotel as Chaya Blue in May '10 after an intensive refurbishing exercise. A near LKR400 mn was spent on rebranding the hotel and increasing the accommodation capacity to 80 rooms. Further a 120 roomed 3+ star hotel is to be built in Nilaveli at a total consideration of LKR1.3 bn where the construction would be completed by end 2012.

With the completion of the proposed hotel developments and expansions by 2014 KHL would account for 12% of the room capacity in the Southern Coast and +40% in the Eastern Coast expanding the country portfolio to 8% of total room capacity of the country from 5% in 2010.

Since the FY10 earnings are broadly in line with our forecasts, we maintain our FY10E forecast earnings at LKR687.6 mn and FY11E forecast earnings at LKR930.6 mn. KHL would be one of the prime beneficiaries of the revival of local tourism, opening up of the previously war torn Northern and Eastern coasts, having 07 properties in all strategic locations in the island which are upgraded and ready to cater the surge in demand. Further KHL plans to add three new hotel properties to their portfolio during the coming three years. The improved ARRs and occupancy rates coupled with the organizational synergies have boosted KHL’s FY10 earnings which are broadly in line with our forecasts. Therefore we maintain our FY10E forecast earnings at LKR687.6 mn and FY11E forecast earnings at LKR930.6 mn (up 35% YoY).

KHL is fairly valued at 41.3X forecast FY11E net profit and 30.5X projected FY12E earnings whilst it is trading on a PBV of 3.5X FY11E and 3.2X FY12E. Nonetheless the counter is trading at a 20% discount to the EVPS and a discount of 53% to our estimates. Further the share has out-performed 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, KHL would sustain an earnings growth of 15-20% in the forth coming period. Therefore in-view of the brighter future, we believe further upside is possible and we maintain - BUY

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DFCC Bank (DFCC) net profit up 70% YoY in 4QFY10

DFCC Bank's (DFCC) net profit has grown 70% YoY to LKR710.6 mn in 4QFY10 enabling FY10 earnings to grow by 26% YoY to LKR2,580.0 mn. 4QFY10 earnings grew mainly on the back of 20% YoY increase in net interest income, 73.4% YoY increase in non interest income and 44.0% YoY reduction in provisioning cost. 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. DFCC's interest margins are healthy around 6.1% levels and we believe going forward they would be able to maintain an ave. interest margin of circa 5%. However it should be noted that DFCC's NPL ratios stand above the industry average.

Interest income dropped 16% YoY in to LKR2,670.5 in 4QFY10. DFCC’s interest income has fallen 16.2% YoY to LKR2,670.5mn in 4QFY10, due to a 27.4% YoY dip in interest income from loans and advances to LKR1,897.2 mn. This is mainly on the back of fall in interest rates and a 9.7% YoY dip in performing loans to LKR47.0 bn . However interest income from fixed income securities grew 34.7% YoY to LKR773.3 mn which was driven by a 131.5% YoY growth in the Treasury Bill and Bond portfolio (held to maturity) to LKR22.0 bn which is approx. 24% of the banks’ total asset base.

Interest expenses dipped 38% YoY to LKR1,225.5 mn in 4QFY10. Group’s interest expenses have dipped 38.2% YoY to LKR1,225.5 mn in 4QFY10, on the back of 29.4% YoY drop in interest cost on deposits to LKR593.7 mn and a 44.7% YoY drop in interest expenses on other interest bearing liabilities to LKR631.8 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. However DFCC’s deposit base has grown by 8.2% YoY to LKR25.5 bn during FY10 and it is also noteworthy that the bank has been able to grow its low cost savings deposits by 94% YoY to LKR4.6 bn during the year amidst stiff competition.

Net interest income grew 20% YoY to LKR3,661.0 mn. The dip in interest income was off set by a faster decline in interest cost enabling net interest income to grow by 20.1% YoY to LKR1,445.0 mn during 4QFY10. Further net interest income during FY10 grew by 22.7% YoY to LKR5,197.6 mainly supported by a 15% YoY reduction in interest cost.

Non interest income grew 73% YoY in 4QFY10. Non interest income has grew 73.4% YoY to LKR374.3 mn largely due to a 122.6% YoY growth in other income such as dividend income, commission income, fee based income and capital gains in 4QFY10. However DFCC has recorded a foreign exchange loss of LKR33.7 mn during 4QFY10.

Operating cost has increased by 32% YoY in 4QFY10 to LKR835.5 mn. Operating costs have risen by 31.7% YoY to LKR835.5 mn, mainly due to a 17.0% YoY increase in personnel costs to LKR451.1 mn and 134.0% YoY increase in other overheads to LKR215.8 mn. Increase in operating costs can be attributable to the two new branches opened during the quarter. The operating cost per branch presently stands at LKR9.0 mn per quarter.

Provisioning cost has dipped 44% YoY to LKR105.8 mn in 4QFY10. The specific provisioning cost has reduced by 11.0% YoY to LKR275.5 mn whilst total recoveries have increased 11.9% YoY to LKR181.7 mn in 4QFY10 leading to an overall 44.0% YoY dip in total provisions to LKR105.8 mn. Further non performing loans have increased 15.3% YoY to LKR7.8 bn where the gross NPL ratio stands at 10.2% and net NPL exposure is at 5.1% which is above the industry average.

Associate company profit has risen 14% YoY to LKR325.0 mn in 4QFY10. DFCC’s associate company, Commercial Bank (COMB) has brought in a post tax profit of LKR325.0 mn (up 13.7% YoY) during the quarter. DFCC holds 28.63% of COMB which is presently reflected on the balance sheet valued at LKR7,819.0 mn vs. the current market value of LKR16,274 mn gives rise to an unrealised gain of circa LKR8,455 mn. However the banking regulator has presently introduced a 10% cap (which could go up to a maximum of 15% with special approval) on ownership, and thus requires DFCC to scale down its ownership in COMB by 2012.

Total tax bill has grown by 10% YoY to LKR471.2 mn in 4QFY10. Value Added Taxation on banking income has increased 35.3% YoY to LKR231.5 mn whilst tax on consolidated profit has fallen 7.0% YoY at LKR239.7 mn.

Net profit up 70% YoY to LKR711 mn in 4QFY10. Consequently with a 20.1% YoY growth in net interest income and 44% YoY dip in provision costs DFCC’s, 4QFY10 net profit has grown by 70.0% YoY to LKR710.6 mn. Further with this sharp net profit growth in the 4th quarter, the bank’s FY10 net profit also has risen 26.2% YoY to LKR2,580.0 mn.

Forecast FY2011 net profit maintained at LKR2,651.0 mn (up 3% 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 is expected to gather momentum (we believe private sector credit would grow by 10-12% in 2010E and 2011E) with the low interest rate environment. DFCC’s interest margins are healthy around 6.1% levels and we believe going forward they would be able to maintain an ave. interest margin of circa 5%. However it should be noted that DFCC’s NPL ratios stand above the industry average (Industry ave. NPL ratio is near 7% where DFCC’s NPL rato is at near 10%). Thus we are maintaining FY11E profit forecast at LKR2,651.0 mn (up 3% YoY) and FY12E profit forecast at LKR2,741 mn (up 3% YoY).

Share offers good value at 10.5x forecasted FY11E net profit and 1.2x PBV. Despite the marginal increase in bottom line expected in FY11E, share continues to offer good value trading on 10.5x (circa 25% discount to the sector) expected FY11E and 10.1x forecast FY12E earnings whilst trading 1.2x PBV.

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