sri lanka - leading from the front

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Sri Lanka Country Report 06 April 2011

2

Sri Lanka – Key economic indicators

INDICATORS 2007 2008 2009 2010E 2011F 2012F

GDPNominal GDP (US$ bn) 32.3 39.6 42.2 47.6 54.5 62.7

Real GDP by production (LKR bn)

GDP 2233 2366 2449 2645 2866 3125

Agriculture 266 286 295 315 331 349

Industry 635 673 701 760 825 902

Services 1332 1407 1453 1570 1710 1874

Real GDP growth (%) 6.8 6.0 3.5 8.0 8.3 9.1

Real GDP by production (% YoY)

Agriculture 3.4 7.5 3.1 7 5.0 5.4

Industry 7.6 5.9 4.2 8.4 8.5 9.4

Services 7.1 5.6 3.3 8 8.9 9.6Real GDP (demand side) (%YoY)

Private final expenditure 20.9 28.4 0.6 18.2 19.0 20.0

Government final expenditure 21.1 30.6 19.3 26.5 18.0 19.0

Gross capital formation (ex valuables) 21.7 21.5 (2.6) 18.0 18.0 20.0

Aggregate ratios (% of real GDP)

Consumption/GDP 82.4 86.1 82.0 86.1 88.3 90.7

Private consumption/GDP 67.2 70.0 64.3 65.7 69.8 71.8

Government consumption/ GDP 15.3 16.2 17.6 25.9 18.5 18.9

Investments/GDP 28.0 27.6 24.5 24.5 26.0 26.7

Fiscal aggregates (%GDP)

Govt budget deficit 6.9 7 9.9 8 6.8 6

External sector

Exports (US$ bn) 7.7 8.1 7.1 8.3 9.4 11.1

% YoY 11.4 6.1 (12.9) 17.2 13.3 18.1

Imports (US$ bn) 11.2 14.0 10.2 13.5 16.1 18.2

% YoY 8.9 25.4 (27.1) 32.3 19.3 13.0

Trade deficit (US$ bn) (3.5) (5.9) (3.1) (5.2) (6.7) (7.1)

Services (US$ bn) 0.2 0.4 0.4 0.4 0.6 1.0

Current transfers (US$ bn) 2.3 2.7 3.0 4.1 4.5 4.5

Current account deficit (US$ bn) (1.3) (3.8) (0.2) (0.7) (1.6) (1.6)

% to GDP (4.1) (9.5) (0.5) (2.3) (3.4) (3.2)

Inflation

CPI (Avg) 15.8 22.6 3.4 5.9 7.0 7.0

Interest and exchange rates (EOP)

Reverse repo rate 12 12 9.75 8.75 9 9.25

Repo rate 10.5 10.5 7.5 7.25 7.75 8.25

Cash reserve ratio 10 7.75 7 7 8 9

LKR/USD 108.7 113.0 114.4 110.9 109.0 108.0

Source: CBSL, RCML Research




3

Dear Investors,

Every nation experiences epochs of transition that define the trajectory of its veryexistence for long periods of time. Sri Lanka is at one such crossroad today, engaged in a

sweeping transition following the end of 26 years of ethnic conflict. The economy

exhibits mixed features such that it cannot be strictly defined in terms of stage of

economic development. While it compares well with industrialised economies on some

social indicators and development goals, on most other counts, it resembles a typical

low-income economy.

Yet the island nation of Sri Lanka is undoubtedly the rising star of the Asian economy.

Situated at the very heart of global shipping routes, it plays a vital role in international

trade—linking East and West. The Sri Lankan stock market (CSE) rebounded smartly from

the global financial crisis to emerge as the world’s best performing market in 2010. The

economy too is expected to move to a higher growth trajectory, beyond the inertia

provided by ‘peace-dividends’. Indeed, Sri Lanka is now classified as a frontier market—in

other words, a country that has immense untapped potential for growth, thanks to

newfound economic and political stability. The key challenge going forward would be to

bring ethnic minorities into the mainstream political and economic development process.

In this report, we capture the macroeconomic trends and growth potential of the

Sri Lankan economy along with the primary challenges ahead. We have highlighted five

key sectors—agriculture, tourism, telecom, financial services and consumer goods—that

have the highest potential from an investment point of view. We also initiate coverage

on four of the nation’s top five listed companies. And for a fuller flavour of this beautiful

island nation, we include some vignettes from our trip and a selection of views from

prominent stakeholders in the economy.

Regards,

Jay Shankar

Chief Economist, Religare Capital Markets

Jay Shankar Vallabh Kulkarni, FRM Rumit Dugar Ishank Kumar Gaurang Kakkad

(91-22) 6766 3442 (91-22) 6766 3438 (91-22) 6766 3444 (91-22) 6766 3467 (91-22) 6766 3470

[email protected] [email protected] [email protected] [email protected] [email protected]




4

Sri Lanka: Expert Speak

Our objective is to transform Sri Lanka into the economic centre of the world. Using

our strategic geographical location, we will develop the country as a Naval, Aviation,

Commercial and Knowledge Hub, serving as a key link between the East and the West.

Dr Saj Mendis

Director GeneralMinistry of Economic Development

“

”

The whole world has recognised our future in knowledge-based industries. Our aggressive plans to implement state-of-the-art information infrastructure will be the

key driver in the country’s growth over the next decade.

V P K Anusha Palpita

Director General of TelecommunicationsTelecommunications Regulatory Commission of Sri Lanka

“

”

We expect strong domestic consumption and a revival in exports, as global demand

picks up, to keep up the economic momentum.

KrishanBalendra

President, Head of Corporate Finance & StrategyJohn Keells Holdings PLC

“”

Sri Lanka’s financial sector is geared up to provide the necessary support for an

accelerated pace of economic growth with financial inclusion.

Russell de Mel

Chief Executive OfficerNational Development Bank PLC

“”

We are very positive on the Sri Lankan economy. As a well diversified business group,

our growth prospects, consequent to the country’s economic performance, remains

very bright.

Pravir D Samarasinghe

Director/Chief Operating OfficerRichard Pieris and Company PLC

“

”




5

The telecom sector is set to witness a period of high growth in both data and voice

services. As a leading telecom player, our initiatives will be focused on developing a

smarter telecommunication network in remote areas of the country.

Supun Weerasinghe

Group – Chief Operating OfficerDialog Axiata Plc

“

”

We see a continuation of strong domestic demand, complemented by export

demand, that is likely to spur industrialisation in the economy. This will relax to some

extent the constraints which manufacturers face because of smaller domestic size.

Malinga Arsakularatne

Chief Financial OfficerHemasHoldings PLC

“

”

The government remains committed to provide a level playing field to private banks.

We see strong economic growth and credit demand supporting our margins.

RanjithSamaranayake

Executive Director/Group Chief Financial OfficerSampath Bank PLC

“”

As banking penetration improves, specially in rural and northern parts of the country,

people are likely to gain from financial inclusion.

Rajendra Theagarajah

Managing DirectorHatton National Bank PLC

“”

As we rebuild our country, there will be a huge requirement of capital for

infrastructure development.

A N Fonseka

General Manager/Director & Chief ExecutiveDFCC Bank

“”




6

Contents

Chapter Page No.

Sri Lanka Economics – Leading from the front 1

Advantage Lanka: Demographic dividends to drive growth this decade 2

GDP: Broad-based 8%+ growth over the next decade 8

Inflation: Not a threat to growth 11

Money and Banking: Navigating structural economic shifts 12

External sector: Strong recovery 14

Foreign trade: Promising exports despite challenges 17

Capital markets: On a roll 19

Agriculture & Tourism

Agriculture & Fisheries 23

Tourism 25

Sri Lanka Economics – A snapshot 27

Sri Lanka – Key economic forecasts 31

Telecom

Sector Report: Maturing voice market 33

Dialog Axiata: Growth moderating; turning more defensive – HOLD 35

Banking

Sector Report: Good times ahead 46

Commercial Bank of Ceylon: Poised for take-off 55

Hatton National Bank: Strong earnings profile to drive valuations 62

Diversified

John Keells Holdings: Diversification remains the key 70

References 82

Sri Lanka Diary 83




7

Economy



Sri Lanka Economic Outlook 06 April 2011

1

Jay Shankar Vallabh Kulkarni

(91-22) 6766 3442 (91-22) 6766 3438

[email protected] [email protected]

GDP growth forecast

0

2

4

6

8

10

12

0

2

4

6

8

10

12

2007 2008 2009 2010E 2011E 2012E

Services IndustryAgriculture GDP

(% YoY) (% YoY)(% YoY) (% YoY)

Source: Govt., RCML Research

MILANKA 30-share index

Source: Bloomberg, RCML Research

USD/LKR exchange rate

0

20

4060

80

100

120

M a r - 9 1

M a r - 9 2

M a r - 9 3

M a r - 9 4

M a r - 9 5

M a r - 9 6

M a r - 9 7

M a r - 9 8

M a r - 9 9

M a r - 0 0

M a r - 0 1

M a r - 0 2

M a r - 0 3

M a r - 0 4

M a r - 0 5

M a r - 0 6

M a r - 0 7

M a r - 0 8

M a r - 0 9

M a r - 1 0

M a r - 1 1

USDLKR


Sri Lanka Economics

Leading from the front

Sri Lanka―s economy is referred to as a ‘frontier market―. The term coined by theInternational Finance Corporation (IFC) about a decade ago refers to a countrythat is less developed but has immense untapped potential for growth, thanks tonewfound economic and political stability, and is typically characterised by alarge-enough population. The other important pull factor for investors, besidesthe opportunity to get in early on the rapid growth phase, is that these marketsare supposed to have a low correlation with the rest of the world—thus givinginvestors a ‘hedging― window.

We visited Sri Lanka to better gauge the growth dynamics and challenges ahead.During the course of our visit, we met stakeholders from the private sector,farmers, the common man as well as policymakers. This report aims at providing

a macro view of the economy, with a discussion on key sectors driving growth.We also initiate coverage on four of the top five listed companies by market cap.

The new ‘Asian Miracle―: It may not be perfect, but Sri Lanka surely capturedworld attention in 2010, with an indigenous growth model that has deliveredremarkable results. The new ‘Asian Miracle― has been among the best marketperformers across the globe.

Reaping the dividends of peace: The Sri Lankan economy posted robust GDPgrowth of close to 8% in 2010. The higher growth trajectory has been madepossible by a cluster of factors that may, in general, be referred to as the ‘peacedividend―. Year 2010 saw a pick-up in rebuilding efforts, after the restoration of peace. There is clearly a much improved business confidence, accompanied by a

far stronger macroeconomic environment. The gradual global economic recoverytoo has aided growth significantly.

Easy monetary policy paves way for growth: A significant decline in inflation andsubsequent improvement in inflation outlook have enabled the Central Bank of SriLanka to adopt an accommodative monetary policy environment, leading to adecline in interest rates in the economy. Expansion in domestic economic activityalong with a remarkable improvement in Sri Lanka―s international trade has led tosignificant revenue buoyancy and an improvement in the fiscal situation.

Boom town?: We note that the island nation has more than its fair share of positives—booming tourism (600,000+ arrivals in 2010), a strong financial sector(stable banking system and doubling of the stock market in two consecutive years

with 60+ companies now planning to list), speedy execution on developmentgoals (poverty at 7.6%, literacy at 97% in age group 15–24 and unemployment at5.3%), booming private corporate profits (268% growth for listed players), aforward looking Budget with growth and equity both in focus, and one of the moststable political systems in the region.

Stable governance holds the key: The peace dividend that has enabled thissignificant improvement in investment climate also brings with it seriouschallenges—that of ensuring both equitable distribution of the benefits of growthamongst the people and of promoting balanced growth across regions. The currentgovernment of Mahinda Rajapaksa has successfully demonstrated its resolve toachieve these goals. We are confident that this proactive and stable governmentcan lead the economy on a sustainable path of high growth—doubling the GDP in

six years—with robust human development indicators, despite limited resourcesand frequent natural calamities. ‘Mahinda Chintana―, the government―s vision document, if implemented in earnest can ensure sustainability of growth.




2

Advantage Lanka

Demographic dividends to drive growth this decade

HDI ahead of most South Asian economiesAt 0.656, Sri Lanka is the only country in South Asia to feature in the top 100 HumanDevelopment Index (HDI) rankings (91st position). The HDI evaluates the four basiccriteria for human development, namely life expectancy, literacy rate, communityparticipation and standard of living. With the return of peace post the civil war,Sri Lanka is expected to rise further in the HDI rankings.

Fig 1 - Human Development Index

0.4

0.5

0.60.7

0.8

0.9

1.0

B a n g l a d e s h

I n d i a

I n d o n e s i a

T h a i l a n d

S r i L a n k a

C h i n a

U S

Source: WDI, RCML Research

Fig 2 - Unemployment rate

0.93.6 3.7 4.3 4.7 5.1 5.8

7.8 7.9 8.1 8.1 8.4 8.7 9.310.7

18.0

23.9

0

7

14

21

28

T h a i l a n d

S K o r e a

M a l a y s i a

C h i n a

U K

J a p a n

S r i L a n k a

I t a l y

I n d o n e s i a

G e r m a n y

B r a z i l

R u s s i a

A r g e n t i n a

U S

I n d i a

S p a i n

S A f r i c a

(%)

Source: IMF, RCML Research *2009 data

Rich demographic dividends

The term demographic dividend indicates an opportunity very rarely experienced by acountry and is characterised by an increase in the proportion of working age population.At 29 years, Sri Lanka―s median age is one of the lowest amongst the developingeconomies. This augurs well for sustaining high economic growth in the long term.Sri Lanka―s demographic dividends (dependency ratio below 60) which began in 2000will continue to support growth at least until 2020.

Fig 3 - Dependency ratio

45

55

65

75

85

95

105

1 9 5 0

1 9 5 5

1 9 6 0

1 9 6 5

1 9 7 0

1 9 7 5

1 9 8 0

1 9 8 5

1 9 9 0

1 9 9 5

2 0 0 0

2 0 0 5

2 0 1 0

2 0 1 5

2 0 2 0

2 0 2 5

2 0 3 0

2 0 3 5

2 0 4 0

Sri Lanka India Indonesia World Africa Asia

Source: World Bank, RCML Research

Sri Lanka the only country in South Asia

to feature in the top 100 HDI rankings

Favourable demographics to supportgrowth until 2020




3

These demographic trends imply that the country is poised to have a productive labourforce in a decade, precisely at the time when China―s working population would peak.With improving education and healthcare facilities, Sri Lanka―s large labour pool canprovide a low-cost, much-needed workforce to the world and may mean substantialemployment creation in the continent in the coming decades.

Fig 4 - Median age

15

20

25

30

35

40

45

50

1 9 5 0

1 9 5 5

1 9 6 0

1 9 6 5

1 9 7 0

1 9 7 5

1 9 8 0

1 9 8 5

1 9 9 0

1 9 9 5

2 0 0 0

2 0 0 5

2 0 1 0

2 0 1 5

2 0 2 0

2 0 2 5

2 0 3 0

2 0 3 5

2 0 4 0

2 0 4 5

2 0 5 0

Sri Lanka China India Brazil(Years)

Source: World Bank, RCML Research

Stable political environment

After a three-decade civil war that ended in 2009, Sri Lanka has entered a period of peace and political stability. The political environment appears to have solidified furtherfollowing the ruling United People―s Freedom Alliance―s (UPFA) landslide victory in therecent nationwide local authority elections. President Mahinda Rajapaksa―s attempts tocombine economic progress with equity, and human and social development, along

with efforts to address minorities― underlying grievances would go a long way towardsbolstering longer-term stability–in turn needed to bolster the investment climate.

Strategic geographic locationSri Lanka is located on an important sea route connecting Europe and the Middle Eastwith the rest of Asia. It is well connected to Southeast Asia, Europe, Australia and Africa.The government plans to develop the coastal town of Hambantota as an internationaltransport hub, with a world class port and a cargo airport.

Fig 5 - Time required to start a business

0

20

40

60

80

100

120

140

160

180

2003 2004 2005 2006 2007 2008

Sri Lanka India China Indonesia(Days)

Source: IMF, RCML Research

Median age of 29yrs among the lowest

in developing economies

Stable political environment to bolster

investment climate




4

Abundant natural resources

Sri Lanka―s geography presents a rich mosaic of forests, wetlands, agricultural land, andminerals. The country has an abundance of industrial mineral resources that includeapatite, calcite, clay, dolomite, feldspar, graphite, limonite, kaolin, mica, quartz, rutile,silica sand and zircon. Graphite and mineral sands are mainly exported.

Business confidence on the riseThe country is in an early phase of social and economic growth, with the vast rebuildingexercise following the civil war increasing the potential business opportunities. Thegovernment―s foreign investment–friendly economic policy should encourage significantFDI and FII flows in the next five years. Along with the domestic consumption potential,the country can be seen as a potential export hub for the manufacturing and serviceindustries. Amongst neighbouring countries, the time required to start a business is theshortest in Sri Lanka.

Opportunities across sectors

ElectricityThe current plan for development of the electricity sector has been designed to providethe entire populace with high quality, uninterrupted power supply by 2012. Thecountry―s electricity generation capacity is estimated to increase to 4,732MW by 2016from the current 2,891MW. This translates into a significant opportunity for privateplayers in the electricity generation and transmission space.

IrrigationThe irrigation sector is expected to become a key driving force in agriculturaldevelopment over the next decade. The focus will be on water resource developmentand the improvement and modernisation of irrigation facilities. Investment in irrigation is

expected to grow multifold over the next five years to LKR 6.4bn in 2015 from LKR2.5bn currently. By 2020, the share of private investment in irrigation facilities is likelyto be at 25% from a lower single-digit share in 2011.

Fig 6 - Investment in electricity sector

0

50,000

100,000150,000

200,000

250,000

300,000

350,000

400,000

2011 2012-13 2014-20

Foreign Domestic(LKR mn)

Source: Sri Lanka Govt., RCML Research

Fig 7 - Investment in irrigation facilities

0

1000

2000

3000

4000

5000

6000

7000

2011 2013 2015 2017 2020

Public Private(LKR mn)


Telecommunications

Sri Lanka―s telecom sector has grown significantly at 40–60% over the past few years.The government plans to take necessary steps to introduce the telecom tower sharingsystem to prevent excessive proliferation of towers. The Business Process Outsourcing(BPO) and Knowledge Process Outsourcing (KPO) industries will be encouraged, in

order to ensure efficient service delivery and to create employment opportunities.

Rebuilding exercise following the civil

war offers large business opportunities

Significant opportunity for private

players in the power sector

Telecom sector has grown at 40–60%

over the past few years




5

Fig 8 - Investment in telecom

0

5,000

10,000

15,000

20,000

25,000

30,000

35,00040,000

45,000

2011-13 2014-16 2017-20

(LKR mn)


Fig 9 - Telecom sector targets

Segment 2010 2015 2020

Fixed access services (mn) 3.5 6 10

Cellular mobile subscribers (mn) 16 18 20

Public pay phones (‘000) 7 12 15

Internet and e-mail (mn) 0.4 5 10

Telephone density (%)(Mobile and fixed) 93 95 98


Transportation

Roads are the main mode of transport in the country. About 90% of passengers and 98%of freight are carried by road. Key port development projects in progress includeColombo South Harbour Project (CSHP), Hambantota Port Development Project, OluvilPort Development Project and Galle Tourist Port Development Project. The completionof these projects will increase cargo handling capacity by 4.5mtpa.

Fig 10 - Investment in roads sector

0

100,000

200,000

300,000

400,000

500,000

600,000

700,000800,000

2011-14 2015-17 2018-20



Fig 11 - Investment in aviation sector

0

50,000

100,000

150,000

200,000

250,000

300,000

2011-13 2014-16 2017-20



Healthcare

Sri Lanka has made good progress in providing universal healthcare facilities over thelast few years. Key health indicators such as life expectancy and mortality rates remainbetter than the averages for countries at comparable levels of income and are even closeto rates seen in some developed countries.

EducationHeavy investment in the education sector over the past few years has placed Sri Lankaahead of many South Asian countries in terms of educational development. The GlobalCompetitive Report (2008) positioned the country at 44 in terms of quality of the

education system out of the 131 countries surveyed.

Several key port development projects

in progress




6

Fig 12 - Investment in education

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

2011 2012 2013 2014 2015



Fig 13 - Investment in healthcare sector

0

5,000

10,000

15,000

20,000

25,00030,000

35,000

2011 2012 2013 2014



We believe that a combination of favourable demographics, urbanisation, a burgeoningmiddle class, and democratically-driven trade and resources policies will continue todrive growth in the marketplace, even after the dividends of peace wane. ‘MahindaChintana―, the government― vision document, if implemented in earnest can furtherensure sustainability of growth.




7

Mahinda Chintana Vision 2011–16

The Socio Economic Development Strategy for the next decade based on the MahindaChintana – Vision for the Future, the President Mahinda Rajapaksa, envisages a SriLanka that:

Has an economy with a green environment and rapid development

Aspires to be a stable society with a high quality of life for all of its people havingaccess to decent living, electricity, water, schooling and health facilities

Maintains the best of Sri Lankan culture, traditions and long standing globalidentity

Aims to consolidate as an emerging market economy; integrated into the globaleconomy and is competitive internationally

Intends to have the characteristics of a middle income economy with aknowledge-based society

This vision is articulated identifying specific targets aiming at achieving the MillenniumDevelopment Goals (MDGs) ahead of time. Among the Mahinda Chintana Goals(MCGs) for 2016 are the following;

Eradication of hunger and hard-core poverty

Universalization of secondary education for all

Reducing malnutrition rate of children from a third to 12-15 percent

Increasing life expectancy from 76 to 80 years

Increasing access to clean water in urban areas from 65 to 90 percent

Raising forest coverage from 28 to 43 percent

These are to be attained through rapid economic growth and a change in the structureof the economy to a modern, environmentally friendly and well connected rural-urbaneconomy that can create better-remunerated employment opportunities:

Almost doubling of per capita GDP by 2016 to above US$ 4,470 to be attainedthrough an economic growth of over 8 percent per annum

Investment to be increased to 33-35 percent of GD P with sustained commitmentof public investment of 6-7 percent of GD P to support private investment

Exports to grow at twice the rate of real GDP

High spending tourism to grow in order to generate fourfold expansion in touristearnings and remittances inflows, based on skills, to be doubled

The share of rural employment to decline from about two-thirds to half; and

The share of urban population to increase from a quarter to a third

Source: Mahinda Chintana Vision 2011-16, Govt. of Sri Lanka




8

Sri Lanka GDP

Broad-based 8%+ growth over the next decade

Peace after three decades of civil war has given a tremendous fillip to economic activityin Sri Lanka. Besides the robust 8% growth in the economy in 2010, what is important isthe broadening base of the growth process. While it―s true that there are serious regionalimbalances in growth, this is largely a product of the prolonged civil war. In fact,massive efforts are underway to rebuild the economy in the north and northeast regionsthat saw widespread destruction during the conflict. We believe the Sri Lankan economyis capable of delivering growth in excess of 8% for the next five years (8.4% in 2011E) provided the government is proactive in directing the growth process.

Rebuilding the economyThere are various options before the government to advance growth in hitherto war-tornregions including the set up of special economic zones (SEZ), export oriented zones andindustrial estates, promotion of micro, small and medium enterprises (MSME), and

provision of fiscal incentives for setting up industries. Our interaction with policymakersconvinced us that the government is actively taking these initiatives, along with buildingbasic physical infrastructure on a war-footing—roads, power plants, telecom and smallerairports, among others.

Fig 14 - GDP by production

0

2

4

6

8

10

12

0

2

4

6

8

10

12

2003 2004 2005 2006 2007 2008 2009 2010E 2011E 2012E

Services Industry Agriculture GDP(% YoY) (% YoY)(% YoY) (% YoY)


Fig 15 - Sector contribution to GDP

Agriculture12%

Industry29%

Services59%


Fig 16 - Employment by sector

Services43%

Industry24%

Agriculture33%


Broadening base of growth led by

massive rebuilding efforts in war-hit

north and northeast regions




9

There is also a concerted effort to push for greater integration with the Indian andPakistani markets by expanding on the current free trade agreements (FTA) anddeveloping on the proposed CEPA agreement. Understandably, a small population of 20 million is a big deterrent to setting up large-scale manufacturing plants that can reapeconomies of scale. The way out is to explore export opportunities and build robust

trade ties, especially with neighbouring economies.

Trade and tourism to witness highest growth in the post-civil war eraThe service sector is the largest component of GDP at ~60%, providing employment to43% of the population. In 2009, growth in the sector slowed to 3.3% YoY, but it pickedup in 2010 to 8.0% YoY. Telecom, transport, trading and financial services are the maincontributors to growth. Public administration and defence expenditures were dominanttill 2008–09 due to domestic hostilities and the expansion of public sector employment.

Fig 17 - Disaggregation of services sector (2002)

Banking,insuranceand realestate14%

Governmentservices

15%

Transportand

communication

19%

Wholesaleand retail

trade41%

Other11%


Fig 18 - Disaggregation of services sector (2010)

Banking,insuranceand realestate15%

Governmentservices

13%

Transportand

communication

23%

Wholesaleand retail

trade39%

Other10%


There is also a growing IT sector, especially for training and software development. Thetourism sector was hit by the volatile security situation, but is expected to revive whenthe scenic northeastern region becomes safer for visitors (600,000+ tourists in 2010).Trade and transport activity are also expected to receive a major boost whenconstruction of the biggest port on land is completed at Hambantota. The port, withrecord capacity of 20mn teus per year, will service ships travelling along one of theworld―s busiest shipping lines—the east-west shipping route.

Fig 19 - Disaggregation of industrial sector (2002)

Mining andquarrying

4%

Manufacturing

66%

Construction22%Electricity,

gas andwater8%


Fig 20 - Disaggregation of industrial sector (2010)

Mining andquarrying

8%

Manufacturing

60%

Construction24%Electricity,

gas andwater8%


Services the largest component of GDP

at ~60%, employing 43% of the

population




10

Fig 21 - Disaggregation of manufacturing sector (2002)

Cottageindustry

6%

Factoryindustry

89%

Tea, rubberand coconutprocessing

5%


Fig 22 - Disaggregation of manufacturing sector (2010)

Cottageindustry

6%

Factoryindustry

91%

Tea, rubberand coconutprocessing

3%


Government incentives to boost industrial activity in the next five yearsThe industrial sector contributes 29% to GDP while employing 24% of the population.Manufacturing is the largest industrial sub-sector, accounting for 18% of GDP.Construction constitutes 7%, mining and quarrying 1.5%, and electricity, gas, and water2% of GDP. Within the manufacturing sector, food, beverage and tobacco is the largestsub-sector in terms of value addition, accounting for a 44% share. Textiles, apparel, andleather is the second-largest sector with 20% of the value addition. The third largest ischemicals, petroleum, rubber, and plastic products.

Fig 23 - Disaggregation of agricultural sector (2002)

Tea11%Paddy

14%

Coconut11%

Other foodcrops

31%

Fishing11%

Other22%

Source: Office Sri Lanka Govt., RCML Research

Fig 24 - Disaggregation of agricultural sector (2010)

Tea9%Paddy

16%

Coconut9%

Other foodcrops

32%

Fishing10%

Other24%


Cash crop–driven agriculture losing its sheenThe agriculture sector has become relatively less important to the Sri Lankan economyin recent decades. It employs 33% of the working population, but accounted for only12% of GDP in 2010; down from ~17% in 2002. Farmers cultivate cash crops like tea,rubber and coconuts from plantation agriculture, and food crops from subsistenceagriculture. Rice, the principal food crop, is cultivated extensively and is the mainsource of livelihood for over 70% of Sri Lanka―s rural population. Domestic agriculturesuch as rice and other food crop cultivation is expected to improve significantly with thereturn of peace to the eastern and northern provinces. In recent years, the contributionof the paddy industry to GDP has increased, while that of other cash cropshas contracted.

Industrial sector contributes 29% to

GDP and employ 24% of the population

Share of agriculture in GDP down from

17% in 2002 to 12% in 2010




11

Inflation

Not a threat to growth

The evolving consumption trends in urban as well as rural parts of the country haveresulted in a higher cost of living. After touching 40% in mid-2008, food inflation hasremained stubbornly high over the past few years. Nonetheless, we believe the countryshould be able to achieve high growth even at elevated levels of inflation. Governmentpolicies to control inflation while balancing real growth have been successful until now.But any further increase in interest rates might pose downside risks to our 2011 GDPgrowth target of 8.4%. We expect inflation to reach 8% by the end of this year and 7%on average.

Food prices remain high but core inflation decliningInflation, as measured by the Colombo Consumers― Price Index (CCPI), computed by theDepartment of Census and Statistics, increased to 7.8% YoY in February ―11 from 6.8%in January, mainly due to the increase in prices of most varieties of vegetable, coconut,

coconut oil, red onions and rice. This was primarily owing to both crop destruction andtransport dislocations that occurred due to the flood situation that prevailed in majorfood-producing areas in 2011.

Core inflation, which measures the price movement of non-food and non-energy itemsin the basket, decelerated further to 2.9% YoY and 5.5% on an annual average basis inFebruary ―11 from 3.6% and 6% respectively in January ―10.

As far as the fuel basket is concerned, higher crude prices have prompted downstreamcompanies to increase petrol prices by LKR 5. In January, the government reduced theimport duty on petrol from LKR 15 to LKR 5. The increase in fuel price would certainlyelevate the cost of living, but so would the duty reduction; while the former woulddirectly contribute to the rise in cost of living, the latter would cause a cost surge

indirectly through reduction in tax revenue. In short, inflation is here to stay!

Low risk of demand/supply side inflationWe see no immediate signs of demand-side inflation as capacity utilisation rates remaincomfortable. The country―s risk of supply-side inflation is also not that significant—thegovernment might need to intervene with a support mechanism such as tariff reductionson imports to offset supply-side inflation if any.

Fig 25 - Inflation trends in Sri Lanka

(5)05

101520253035

404550

M a y - 0 5

A u g - 0 5

N o v - 0 5

F e b - 0 6

M a y - 0 6

A u g - 0 6

N o v - 0 6

F e b - 0 7

M a y - 0 7

A u g - 0 7

N o v - 0 7

F e b - 0 8

M a y - 0 8

A u g - 0 8

N o v - 0 8

F e b - 0 9

M a y - 0 9

A u g - 0 9

N o v - 0 9

F e b - 1 0

M a y - 1 0

A u g - 1 0

N o v - 1 0

F e b - 1 1

Consumer Price Index Food Inflation(% YoY)


We expect inflation to reach 8% by theyear-end

Comfortable utilisation rates lower risk

of demand-side inflation




12

Money and Banking

Navigating structural economic shifts

Central Bank of Sri Lanka (CBSL) is responsible for planning and execution of monetarypolicy in the country. The vast structural changes now taking place in the economycould result in significant fluctuations in financial flows and changes in financial habitsof people as well as shifts in the velocity of money and money multiplier. In our view,CBSL monetary policy action going forward will be aimed at curbing recent appreciationin the Sri Lankan rupee (LKR), containing demand-side pressures and taming inflation.

Policy rate hikes expected

In its January policy meet, CBSL cut the repo and reverse repo rates by 25bps and 50bpsrespectively, while maintaining the status quo during its February meet. Inflationaccelerated at the end of last year even as the economic upswing is set to stay strong.Despite this backdrop, CBSL anticipates that food price pressures will ease in comingmonths. However, with the MENA unrest, crude remaining above US$ 110/bbl and the

Japanese calamity, we believe inflation is unlikely to fall significantly in 2011.Accordingly, we expect the repo rate to eventually move up by 50bps in 2011.

Pick up in credit growthCBSL has enforced an interest rate ceiling of 14% on home loans and 24% p.a. on creditcard advances. The banks reduced lending rates by an average of 2% during 2010 inaddition to a 2.7% cut in 2009. This led to a late pickup in credit to ~20% in Q42010.We expect credit to the private sector to expand at ~16% in 2011, while the broadmoney and reserve money grows at ~15%.

CBSL monetary policy outlookIn our view, CBSL monetary policy action will be aimed at the following:

Curbing recent appreciation in the rupee: Sri Lanka still runs large external deficitsand, in contrast to the rest of Asia, is liberalising the capital account side of itsbalance of payments to attract more inflows.

Containing demand-side pressures: CBSL remains keen to foster rapid growth andbelieves that productivity improvements and increased investment in infrastructureprojects will, for some time to come, allay capacity constraints and contain anydemand-side pressures.

Taming inflation: Consumer price inflation has accelerated to 6.9% at the end of 2010. Food inflation has been a major cause of concern and the reduced importduties may help subdue inflation in the medium term.

Fig 26 - Monetary policy rates

6

7

8

9

10

11

12

A

u g - 0 3

F e b - 0 4

A

u g - 0 4

F e b - 0 5

A

u g - 0 5

J a n - 0 6

J u l - 0 6

J a n - 0 7

J u l - 0 7

J a n - 0 8

J u l - 0 8

J a n - 0 9

J u l - 0 9

J a n - 1 0

J u l - 1 0

J a n - 1 1

Statutory reserve ratio Repo Reverse repo(%)


Repo rate to eventually move up by

50bps in 2011

CBSL looking to curb recent rupee

appreciation and tame inflation




13

Fig 27 - Call rate

0

5

10

15

20

25

30

35

40

45

J u l - 0 3

D e c - 0 3

J u n - 0 4

D e c - 0 4

J u n - 0 5

D e c - 0 5

J u n - 0 6

D e c - 0 6

J u n - 0 7

D e c - 0 7

J u n - 0 8

D e c - 0 8

J u n - 0 9

D e c - 0 9

J u n - 1 0

D e c - 1 0

(%)


Fig 28 - Interest rates on government securities

(%) Dec-08 Dec-09 Dec-10 Jan-11 Feb-11

1 Month T-bill 17.1 7.8 7.3 7.1 6.9

3 Month T-bill 17.9 7.9 7.3 7.1 7.1

6 Month T-bill 18.6 8.7 7.4 7.2 7.1

1 Year Bond 19.4 9.4 7.5 7.4 7.3

5 Year Bond 19.2 11.5 9.2 8.9 8.9

10 Year Bond 16.6 11.3 9.7 9.3 9.3


Improved investor confidence, high

liquidity and low inflation expectations

led to downward shift in yield curve




14

External sector

Strong recovery

The island economy has a large diaspora living across the world—most of them left thecountry during the civil war. This explains the high remittances that the economyreceives. In 2009, remittances accounted for ~27% of all foreign exchange earnings,followed by textiles and garments at 26% and tea at 10%. To encourage remittances, thepayment of a bonus on interest earned on NRFC and RFC deposits was introduced lastyear. Further, the Parliament approved an amendment to the Inland Revenue Act toprovide tax concessions on foreign income and profits earned through providingservices to non-residents. We expect remittances to increase further from the currentlevel of 8% of GDP in the coming years.

Fig 29 - Net foreign investment in Sri Lanka

(0.4)

0.0

0.4

0.8

1.2

1.6

2.0

2.4

2.8

(0.2)

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.41.6

2003 2004 2005 2006 2007 2008 2009

Direct investment Long term investmentPortfolio Investment Private investmentFinacial account balance (R)

(US$bn) (US$bn)


Exchange rate largely stable

The exchange rate of the Lankan Rupee (LKR) is determined by the market on a free-floatbasis. Over the last few months, the LKR has remained largely stable because of subdued FII (portfolio investment) activity. CBSL is determined to maintain internationalreserves at a comfortable level of ~5–6 months of imports. We expect the exchange rateto remain largely stable with a tendency to gently appreciate in the next few months.

Fig 30 - USD/LKR exchange rate

0

20

40

60

80

100

120

M a r - 9 1

M a r - 9 2

M a r - 9 3

M a r - 9 4

M a r - 9 5

M a r - 9 6

M a r - 9 7

M a r - 9 8

M a r - 9 9

M a r - 0 0

M a r - 0 1

M a r - 0 2

M a r - 0 3

M a r - 0 4

M a r - 0 5

M a r - 0 6

M a r - 0 7

M a r - 0 8

M a r - 0 9

M a r - 1 0

M a r - 1 1

USDLKR


Fig 31 - Foreign investment in stock markets

(10)

(5)

0

5

10

O c t - 0 6

M a r - 0 7

A u g - 0 7

J a n - 0 8

J u n - 0 8

N o v - 0 8

A p r - 0 9

S e p - 0 9

F e b - 1 0

J u l - 1 0

D e c - 1 0

(LKRbn)


Exodus during civil war now a source of

high remittances

Subdued FII activity has kept exchange

rate largely stable




16

Fig 35 - Sector-wise foreign exchange earnings

Sector2008

(LKR mn)% share Sector

2009(LKR mn)

% share

Textiles & Garments 376,024 26.5 Private Foreign Remittances 382,818 26.6

Private Foreign Remittances 316,091 22.3 Textiles & Garments 376,146 26.2

Tea 137,600 9.7 Tea 136,171 9.5

Transportation services 108,430 7.6 Transportation Services 99,391 6.9

Rubber based products 58,671 4.1 Rubber based product 44,163 3.1

Tourism 37,094 2.6 Tourism 37,506 2.6

Minor Agriculture products 31,069 2.2 Computer & IT services 28,161 2

Petroleum products 27,551 1.9 Minor Agriculture Products 27,616 1.9

Computer & IT services 24,917 1.8 Petroleum Products 15,484 1.1

Others 302,118 21.3 Others 289,122 20.1

TOTAL 1,419,565 100 1,436,578 100

Source: Central Bank of Sri Lanka

Fig 36 - Debt as a percentage of GDP (%)

0

40

80

120

160

200

R u s s i a

C h i n a

S K o r e a

I n d o n e s i a

S A f r i c a

T h a i l a n d

A r g e n t i n a

M a l a y s i a

I n d i a U

S

B r a z i l

S p a i n

G e r m a n y

U K

S r i L a n k a

I t a l y

J a p a n





17

Foreign trade

Promising exports despite challenges

Sri Lanka qualified for the GSP facility (general preferential scheme for sustainabledevelopment) for the period 2006–10, on account of compliance with internationalobligations on human rights, labour rights, good governance and environmental policy asper the GSP Regulation. The scheme provided access to 7,200 Sri Lankan products atzero duty into the European Union. Even though economic recovery in most developedmarkets like the US and EU has been sluggish, leading to lower consumption demand, SriLanka―s exports have increased over the last few months. Benevolent macroeconomicpolicies and progressive industry initiatives have aided growth. However, we believepolicymakers must encourage exports towards higher-growth regions/economies. Further,Sri Lanka must diversify its exports beyond garments and tea.

Diversification of export destinations key to growthPolicymakers in Sri Lanka must encourage and improve trade ties with economies that

are expected to exhibit faster growth on a sustainable basis. Currently, 59% of SriLankan exports have the US and Europe as destinations. Just 1% goes to China which islikely to remain the fastest growing economy in the next decade. Similarly, only 4% of total exports reach India, which is growing at 8–9%, and is likely to be among the topthree fastest growing large economies. Indeed, compared to other Asian countries whichdirect 35–40% of total exports to fellow Asian countries, Sri Lanka exports less than10%, even though Asia is likely to be the growth engine of the decade.

Fig 37 - Sri Lanka―s foreign trade

0

2

4

6

8

10

12

14

16

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9

2 0 1 0

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9

2 0 1 0

Exports Imports

(US$ bn)


Exports up a record 34% YoY in Dec ―10; imports up 31%Both exports and imports recorded their highest ever values in December ―10. Earningsfrom exports increased by 34% YoY to US$ 968mn. This is the highest monthly increasesince October ―04, reflecting substantial growth in some of the relatively newercategories of exports, such as boats, bicycles, electrical equipment, rubber products,petroleum products, food, beverages and tobacco.

Imports have been strong over the last couple of years in this consumption-ledeconomy. Demand for investment goods has been high, reflecting a rapid recovery of the economy post-war as well as extensive future expansion prospects. Tax/dutyreductions have supported increased demand for consumer goods. In December ―10,imports rose by 31% to US$ 1.43bn mainly due to higher imports of intermediate goods,

led by higher expenditure incurred on petroleum products. As a result, the trade deficitexpanded to US$ 5.2bn in 2010 compared to US$ 3.1bn in 2009.

Strong exports despite withdrawal of the GSP scheme and sluggish global

recovery

Less than 10% of Sri Lanka―s exports are

to Asia despite the region―s rapid

growth

Exports and imports hit peak levels in

December ―10




19

Capital markets

On a roll

The Sri Lankan markets rebounded in 2010 on peace dividends, outpacing the rest of the world to grow at a record ~80%. The Colombo Stock Exchange (CSE), the country―sprimary bourse, is one of the most modern exchanges in South Asia, providing a fullyautomated trading platform. The CSE has 235 listed companies with a combined marketcapitalisation of US$ 22.5bn. The Colombo All Share Index (ASI) and Milanka PriceIndex (MPI) are the two principal stock indices of the CSE.

Fig 41 - MILANKA Index performance over the years


The MPI is composed of a select group of 25 stocks, a list which is reviewed eachquarter, as opposed to the API, which includes all of the ~235 stocks on the exchange.The consumer staples sector leads the pack with a weightage of ~30% in the index,followed by industrials (26%) and financials (25%). Over the last one year, consumerstaples and materials have been the outperformers with returns of 127% and 146%respectively; followed by financials in the ~90% range.

Fig 42 - MPI sector-wise performance

(% change) 1M 3M 6M 1YR

Consumer Staples (4) 18 22 127

Consumer Discretionary (6) (8) (7) (22)

Financials 1 (3) (8) 88

Energy 0 (2) (4) (3)

Materials 6 11 20 146

Industrials 2 2 (6) 62

Telecom (6) (10) (18) 51

Utilities 3 0 (20) 75

Total (1) 4 (0) 74


CSE the primary bourse with 235 listed

companies and market cap of

US$ 22.5bn

Stock markets up 80% in 2010 with

outperformance from consumer staples

and materials




20

Fig 43 - MPI sector weightings

Consumer Staples30%

ConsumerDiscretionary

3%

Financials25%

Energy3%

Materials3%

Industrials26%

Telecom9%

Utilities1%


Foreign investment freely permittedForeign investment in the stock market is freely permitted except in the case of a fewcompanies where certain restrictions are imposed. Investment in shares in Sri Lanka andrepatriation of proceeds take place through Share Investment External Rupee Accounts(SIERA) opened with licenced commercial banks. Income from investments such asinterest, dividends and profit realised from such investments are not subject to exchangecontrol regulations by the Sri Lankan government.

Fig 44 - Foreign investment in stock markets

(10)

(5)

0

5

10

O c t - 0 6

D e c - 0 6

F e b - 0 7

A p r - 0 7

J u n - 0 7

A u g - 0 7

O c t - 0 7

D e c - 0 7

F e b - 0 8

A p r - 0 8

J u n - 0 8

A u g - 0 8

O c t - 0 8

D e c - 0 8

F e b - 0 9

A p r - 0 9

J u n - 0 9

A u g - 0 9

O c t - 0 9

D e c - 0 9

F e b - 1 0

A p r - 1 0

J u n - 1 0

A u g - 1 0

O c t - 1 0

D e c - 1 0

(LKR bn)


Fig 45 - MILANKA index – Price to earnings ratio

0

10

20

30

40

50

60

M a

y - 0 6

J u l - 0 6

S e

p - 0 6

N o

v - 0 6

J a

n - 0 7

M a

r - 0 7

M a

y - 0 7

J u l - 0 7

S e

p - 0 7

N o

v - 0 7

J a

n - 0 8

M a

r - 0 8

M a

y - 0 8

J u l - 0 8

S e

p - 0 8

N o

v - 0 8

J a

n - 0 9

M a

r - 0 9

M a

y - 0 9

J u l - 0 9

S e

p - 0 9

N o

v - 0 9

J a

n - 1 0

M a

r - 1 0

M a

y - 1 0

J u l - 1 0

S e

p - 1 0

N o

v - 1 0

J a

n - 1 1

M a

r - 1 1


Foreign investment in the stock market

largely unrestricted




21

Fig 46 - Market performance of MPI constituents

CompanyBloombergticker

SectorMarket cap

(LKR mn)Index

wt.Trailing

P/EReturn %

3M avg.turnover

(LKR mn)

John Keells Holdings JKH SL Equity Industrials 186,468 17.5 31.8 4.0 (0.4) 59.8 95.8

Hatton National Bank HNB SL Equity Financials 124,173 11.7 15.2 (2.3) (4.5) 100.8 37.3

Bukit Darah BUKI SL Equity Consumer Staples 122,329 11.5 42.3 (10.2) 42.8 282.3 26.3

Commercial Bank of Ceylon COMB SL Equity Financials 95,651 9.0 17.8 2.4 0.0 84.9 2.1

Dialog Axiata DIAL SL Equity Telecom 86,324 8.1 17.7 (6.2) (10.2) 51.4 15.8

Ceylon Tobacco Co CTC SL Equity Consumer Staples 67,680 6.4 13.2 0.3 (1.0) 44.7 2.1

Distilleries Co of Sri Lanka DIST SL Equity Consumer Staples 56,970 5.4 25.6 3.8 8.3 60.9 41.5

Cargills Ceylon CARG SL Equity Consumer Staples 50,445 4.7 69.2 (4.1) 14.8 212.8 12.3

DFCC Bank DFCC SL Equity Financials 48,315 4.5 17.7 1.2 (9.3) 98.8 9.8

Hayleys HAYL SL Equity Industrials 29,250 2.7 16.2 0.2 14.5 68.6 36.3

Richard Pieris & Co RICH SL Equity Industrials 26,540 2.5 43.1 (2.8) 12.3 258.6 68.2

Environmental Resources Investment GREG SL Equity Cons. Discretionary 24,285 2.3 27.9 (6.7) (5.3) (33.1) 34.9

Chevron Lubricants Lanka LLUB SL Equity Energy 19,644 1.8 12.8 (0.3) (2.0) (5.6) 6.4

Colombo Dockyards DOCK SL Equity Industrials 17,931 1.7 8.2 (3.0) (6.4) (5.5) 11.4

Nations Trust Bank NTB SL Equity Financials 17,711 1.7 14.5 (2.9) (11.8) 124.2 10.6

Ceylinco Insurance Co CINS SL Equity Financials 14,600 1.4 28.1 26.3 78.0 216.0 52.6

Tokyo Cement Co Lanka TKYO SL Equity Materials 13,345 1.3 48.4 14.6 12.5 160.2 9.7

Overseas Realty Ceylon OSEA SL Equity Financials 12,568 1.2 17.4 (2.6) (9.1) (1.2) 2.7

CIC Holdings CIC SL Equity Materials 11,657 1.1 25.2 (3.0) 9.4 131.7 20.6

Seylan Bank SEYB SL Equity Financials 9,880 0.9 15.4 (2.9) (21.2) 60.8 9.3

Lanka IOC LIOC SL Equity Energy 9,745 0.9 N/A 1.7 (0.5) 3.1 2.1

Vallibel Power Erathna VPEL SL Equity Utilities 7,172 0.7 16.4 3.2 0.0 74.5 4.9

Ceylon Hotels Corp CHOT SL Equity Cons. Discretionary 5,498 0.5 N/A (7.5) (14.9) 20.8 1.1

Kelani Tyres TYRE SL Equity Cons. Discretionary 4,317 0.4 20 3.3 (10.5) 66.5 26.3

Touchwood Investments TWOD SL Equity Consumer Staples 1,753 0.2 3.6 0.8 (15.2) 27.8 7.2

Source: Bloomberg, RCML Research * Arranged in decreasing order of index weight




22

Agriculture & Tourism




23

Agriculture & Fisheries

Strong government support

The agriculture sector in Sri Lanka plays a vital role in the country―s economicdevelopment. At present, agriculture contributes ~13% to the country―s GDP andemploys ~33% of its workforce. Of the total cultivable land (2.9mn ha), paddy occupies40% while coconut, tea and rubber together account for 39%. Other crops include fieldcrops, horticulture and export crops. The government has recently formulated a newdevelopment vision highlighting the importance of agriculture to overall growth.

Fig 47 - Distribution of cultivated land used for agriculture

Tea12%

Rubber7%

Coconut20%

Paddy40%

Others21%

Source: Mahinda Chintana, RCML Research

Agri policy aims to relieve bottlenecks and raise output

At present, the agricultural sector faces a number of constraints including lowproductivity, slow technological innovation, inadequate credit flows, poor access tointernational markets and inadequate use of quality seeds and planting material. Toaddress these issues, the government―s agricultural policy aims at realising multiple goalsincluding:

Achieving food security

Ensuring higher and sustainable income for farmers

Ensuring remunerative prices for agricultural produce

Providing uninterrupted access to competitive markets both in Sri Lanka and abroad

Encouraging farm mechanisation

Expanding cultivation acreage

Reducing wastage in transit

Ensuring environmental conservation

Introducing efficient farm management techniques, and

Using high yielding seeds and improved water management.

Paddy cultivation the main source of

livelihood for 70% of Sri Lanka―s rural

population

Government―s agricultural policy aims

at easing productivity, technology and

credit constraints




24

These measures are aimed at raising agricultural output significantly during the nextdecade, while maintaining its contribution to GDP at a satisfactory level. Accordingly,government support is expected in all major steps in the production cycle; fromcultivation to marketing in both domestic and international markets. We expect theagriculture sector to grow at an average of 7% over the next decade.

Fig 48 - Target investment in agricultural sector

0

10,000

20,000

30,000

40,000

50,000

60,000

2011 2013 2015 2017 2020



Fig 49 - Target investment in fisheries sector

0

10,000

20,000

30,000

40,000

50,000

60,000

2011 2013 2015 2017 2020



Large potential in fisheries industry

Sri Lanka―s strategic location (coastline stretching across 1,340km) offers large untappedpotential in the fisheries sector. This sector contributes ~1.2% to GDP and employs over650,000 people directly and indirectly. The fisheries sector has delivered a mutedperformance over the past few decades owing to low levels of modern technology, post-harvest losses and the unavailability of real time weather data. Now, however, thegovernment―s Fisheries Development Policy 2007–16 aims at exploiting the country―sfisheries and aquatic resources in a sustainable manner and encourages private sectorinvestment, while conserving the coastal environment. The government envisagesinvestment of ~LKR 50bn in the fisheries sector by 2020. We expect the sector to growat 10% YoY over the next decade.

Agri sector expected to grow at an

average of 7% over the next decade

Government envisages investment of

~LKR 50bn in the fisheries sector by

2020




25

Tourism

Flourishing post-war

The last couple of years witnessed a dramatic transformation in Sri Lanka―s tourismindustry, a direct consequence of the return of peace to the island nation. In 2010, keytourism source countries such as the US, Japan, UK and other European countriesrelaxed their advisories for tourism travel to Sri Lanka. The US$ 300mn industry is nowforecast to grow at ~20% CAGR to US$ 1bn by 2015.

Fig 50 - Monthly tourist arrivals

0

10,000

20,000

30,000

40,00050,000

60,000

70,000

80,000

90,000

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

2009 2010 2011

Source: Dept of tourism, RCML Research

Fig 51 - Tourist arrivals by country of residence

0

5000

10000

15000

20000

25000

30000

35000

North

America

Western

Europe

Eastern

Europe

Middle East East Asia South Asia Australasia

2010 2011


Government thrust on tourismThe government is targeting US$ 1bn in annual tourism receipts by 2015. In order toachieve this, it has launched a series of marketing promotions over the past 12 monthsaimed at attracting foreign tourists. Steps are also being taken to improve tourisminfrastructure. A Malaysian company is to develop a US$ 100mn high-speed railwaytrack from Colombo―s Kollupitiya to the Bandaranaike International Airport.

Sharp rebound in Sri Lanka―s tourism industry post-war

Government targeting US$ 1bn in

annual tourism receipts by 2015




26

Further, many hotel chains have announced expansion or renovation plans. InSeptember ―10, the Taj Hotels & Resorts announced its plan to expand operations in SriLanka. The Hong Kong-based Shangri-La chain of hotels is also looking to enter themarket. With peace taking root in the country, we believe the stage is set for severalyears of strong growth in tourism arrivals and revenues. We expect tourist arrivals to

grow at ~25% annually to 2mn by 2015.

Fig 52 - Tourist receipts

0

50

100

150

200

250

300

350

400

450

2001 2002 2003 2004 2005 2006 2007 2008 2009

Tourist receipts(US$ mn)


Fig 53 - Employment in tourism sector

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

Managerial Scientific &Professional

Technical Clerical Alliedand Supervisory

Manual & Operative

2007 2008 2009 2010





27

Sri Lanka Economics: A snapshot

Fig 54 - Current account balance

(12)

(10)

(8)

(6)

(4)

(2)

0

2004 2005 2006 2007 2008 2009

(% of GDP)

Source: WEO, RCML Research

Fig 55 - Current account balance

(5)

0

5

10

15

20

Indonesia Malaysia India UnitedStates

Argentina Sri Lanka

(% of GDP)


Fig 56 - Foreign direct investment, net

0.0

0.5

1.0

1.5

2.0

2004 2005 2006 2007 2008 2009

(% of GDP)


Fig 57 - Foreign direct investment, net

0.0

0.5

1.0

1.5

2.0

2.5

3.0


Argentina Sri Lanka

(% of GDP)


Fig 58 - GDP per capita (current US$)

0

500

1,000

1,500

2,000

2,500

2004 2005 2006 2007 2008 2009

(US$)


Fig 59 - GDP per capita (current US$)

0

10,000

20,000

30,000

40,000

50,000

IndonesiaMalaysia India UnitedStates

ArgentinaSri Lanka

(US$)





28

Fig 60 - Gross domestic savings

02468

101214

161820

2004 2005 2006 2007 2008 2009

(% of GDP)


Fig 61 - Gross domestic savings

0

5

10

15

20

2530

35

40


Argentina Sri Lanka

(% of GDP)


Fig 62 - Highest marginal corporate tax rate

31

32

33

34

35

36

2004 2005 2006 2007 2008 2009

(%)


Fig 63 - Highest marginal corporate tax rate

05

1015202530354045

Indonesia Malaysia India UnitedStates Argentina Sri Lanka

(%)


Fig 64 - Market capitalisation

0

5

10

15

20

25

30

2004 2005 2006 2007 2008 2009

(% of GDP)


Fig 65 - Market capitalisation

0

20

40

60

80

100

120

140

160

Indonesia Ma laysia India UnitedStates

Argentina Sri Lanka

(% of GDP)





29

Fig 66 - Military expenditure

0

1

2

3

4

2004 2005 2006 2007 2008 2009

(% of GDP)


Fig 67 - Military expenditure

0

1

2

3

4

5


Argentina Sri Lanka

(% of GDP)


Fig 68 - Mobile cellular subscriptions

0

20

40

60

80

100

2004 2005 2006 2007 2008 2009

(per 100 people)


Fig 69 - Mobile cellular subscriptions

0

20

40

60

80

100

120

140

Indonesia Ma laysia India UnitedStates Argentina Sri Lanka

(per 100 people)


Fig 70 - Remittances

6

7

8

9

2004 2005 2006 2007 2008 2009

(% of GDP)


Fig 71 - Remittances

0

2

4

6

8

10


Argentina Sri Lanka

(% of GDP)





30

Fig 72 - Life expectancy at birth

50

55

60

65

70

75

80


Argentina Sri Lanka

(years)


Fig 73 - Birth rate

0

5

10

15

20

25


Argentina Sri Lanka

(per 1000)


Fig 74 - Age dependency ratio

40

45

50

55

60


(%)


Fig 75 - Rural population

0102030405060708090


(% oftotalpopulation)


Fig 76 - Ease of doing business index

0

20

40

60

80100

120

140

160


Argentina Sri Lanka

(1= mostbusiness friendly)


Fig 77 - Total reserves in months of imports

0

2

4

6

8

10

12


Argentina Sri Lanka

( in months)





31

Sri Lanka – Key economic indicators

INDICATORS 2007 2008 2009 2010E 2011F 2012F

GDPNominal GDP (US$ bn) 32.3 39.6 42.2 47.6 54.5 62.7

Real GDP by production (LKR bn)

GDP 2233 2366 2449 2645 2866 3125

Agriculture 266 286 295 315 331 349

Industry 635 673 701 760 825 902

Services 1332 1407 1453 1570 1710 1874

Real GDP growth (%) 6.8 6.0 3.5 8.0 8.3 9.1

Real GDP by production (% YoY)

Agriculture 3.4 7.5 3.1 7 5.0 5.4

Industry 7.6 5.9 4.2 8.4 8.5 9.4

Services 7.1 5.6 3.3 8 8.9 9.6

Real GDP (demand side) (%YoY)

Private final expenditure 20.9 28.4 0.6 18.2 19.0 20.0

Government final expenditure 21.1 30.6 19.3 26.5 18.0 19.0

Gross capital formation (ex valuables) 21.7 21.5 -2.6 18.0 18.0 20.0

Aggregate ratios (% of real GDP)

Consumption/GDP 82.4 86.1 82.0 86.1 88.3 90.7

Private consumption/GDP 67.2 70.0 64.3 65.7 69.8 71.8

Government consumption/ GDP 15.3 16.2 17.6 25.9 18.5 18.9

Investments/GDP 28.0 27.6 24.5 24.5 26.0 26.7

Fiscal aggregates (%GDP)

Govt budget deficit 6.9 7 9.9 8 6.8 6

External sector

Exports (US$ bn) 7.7 8.1 7.1 8.3 9.4 11.1

%YoY 11.4 6.1 (12.9) 17.2 13.3 18.1

Imports (US$ bn) 11.2 14.0 10.2 13.5 16.1 18.2

%YoY 8.9 25.4 (27.1) 32.3 19.3 13.0

Trade deficit (US$ bn) (3.5) (5.9) (3.1) (5.2) (6.7) (7.1)

Services (US$ bn) 0.2 0.4 0.4 0.4 0.6 1.0

Current transfers (US$ bn) 2.3 2.7 3.0 4.1 4.5 4.5

Current account deficit (US$ bn) (1.3) (3.8) (0.2) (0.7) (1.6) (1.6)

% to GDP (4.1) (9.5) (0.5) (2.3) (3.4) (3.2)

Inflation

CPI (Avg) 15.8 22.6 3.4 5.9 7.0 7.0

Interest and exchange rates (EOP)

Reverse repo rate 12 12 9.75 8.75 9 9.25

Repo rate 10.5 10.5 7.5 7.25 7.75 8.25

Cash reserve ratio 10 7.75 7 7 8 9

LKR/USD 108.7 113.0 114.4 110.9 109.0 108.0





32

Telecom



Telecom Sector Report 06 April 2011

33

Rumit Dugar Udit Garg

(91-22) 6766 3444 (91-22) 6766 3445


Rapid growth in telecom services in recent years,

leading to 80% market penetration

Incremental growth to come from data services as

voice segment reaches saturation point

Telecom

Maturing voice market

The telecom sector in Sri Lanka has seen rapid growth over the past few years,leading to 80% market penetration. The overall Sri Lankan wireless revenuesare at 2% of GDP. The telecom space is a 5-player market with an addressablepopulation of 22mn. Dialog Axiata is the incumbent market leader with ~41%subscriber market share and 55% revenue share.

Regulatory regime supportive: Following Bharti Airtel―s entry into Sri Lanka, thecompetitive intensity in the country―s telecom sector increased, triggering a fiercetariff war. The regulatory body then intervened and brought in tariff floors in orderto protect the existing players. We believe the telecom industry in Sri Lanka willincrementally start to enjoy a favourable regulatory regime with the telecomauthority positively disposed towards industry health.

Data services to lead the way: With the wireless market largely penetrated,subscriber growth has started to wane and, as such, growth in voice services willstart to weaken. In our view, data services will be the growth driver goingforward as broadband penetration remains low. The government has given out3G spectrum to three players, viz. Dialog, Mobitel and more recently to Bharti.This apart, with rising PC penetration, broadband usage will also rise and drivedata consumption further. In all, we see revenue growth moderating for thesector given a maturing voice segment. Incremental growth should largely bedriven by (1) some elasticity induced by lower effective tariffs, and (2) growthfrom higher data consumption due to 3G.

Fig 1 - Key telecom metrics in Sri Lanka

Total Population (mn) 22

Wireless revenues as % of GDP 2%

Fixed Line

Total number of Fixed Phones 3,548,921

Teledensity (Fixed Phones per 100 inhabitants) 17

Teledensity (Fixed) in Colombo District 39

Wireless

Number of Cellular Mobile Subscribers 16,305,417

Mobile Subscription per 100 people 79

Internet and Broadband

Internet & Email Subscribers (Fixed) – June 2010 260,000*

Mobile Internet Broadband Subscribers – June 2010 120,000*

Source: Telecommunications regulatory commission of Sri Lanka * Provisional

Fig 2 - Sri Lanka: Wireless spectrum allocation

(MHz) 2G spectrum (Paired bands) 3G spectrum

900MHz 1800MHz Paired Unpaired

Dialog 7.5 15 10 5

Mobitel 7.5 7.5 10 5

Tigo (Etisalat) 7.5 6 0 0

Hutch 7.5 7.5 0 0

Airtel 5 7.5 10 0

Source: Telecommunications regulatory commission of Sri Lanka



Telecom Sector Update 06 April 2011

34

Fig 78 - Sri Lanka: Wireless market snapshot (as of Q4CY10)

Source: Company,* Net adds and subscribe numbers are as of Q3CY10

387 640 850 612 754

6,716

3,8403,100

1,641 1,317

Net adds'000

Subscribers '000

6%

20%

38%

60% 134%

Dialog Mobitel Tigo Airtel Hutch

Ownership Axiata–83.3%

Others–16.7%

Sri Lanka Telecom

100.0%

Etisalat

100.0%

Bharti Airtel

100.0%

Hutchison

Telecommunications

100.0%

Market position #1 #2 #3 #4 #5

Sim Market share (%) 41 23 19 9 8

Revenue share (%) 55 31 13 n.a 1



Dialog Axiata Plc Initiating Coverage 06 April 2011

38

Fig 86 - Direct cost changes with effect from July 2010

Current Previous Comments

Telecom Dev charge(US$/min)

0.015 0.038All operators have to pay a TDC levy to thegovernment for international minutes terminated;Cost is shown under Levies (direct costs)

Incoming access

local charge(US$/min)

0.055 0.052

Incoming Local Access Charge (ILAC), which is

paid to the operator on whose network theinternational call is terminated, was increased

Internationalinterconnect fee(US$/min)

0.500* 0.016International interconnect fee was reduced fromUS$ 0.0155 to LKR 0.50 per minute

Source: Telecommunications regulatory commission of Sri Lanka,* Amount in LKR

Fig 87 - Changes to Indirect tax structure proposed in the budget

Old structure New structure Comments

Telecom Levy 20.0%The government introduced atelecommunications levy of 20%, removingmost of the old taxes

Current Cess 0.03% The current cess and investment cess (1%) was

replaced by a flat 2% licence fee which will becharged on gross revenue, which the operatorsdecided to pass onto customers.

License fee 2.0%

VAT 12.0%The telecom sector is now exempt from payingVAT

Other Indirect taxes 15.0%

Effective 31.3% 22.4%

IDD levy LKR 2.0A new levy of LKR 2/min has been imposed onoutgoing IDD calls

Source: Company, Sri Lanka budget

Peaking capex intensity and higher CFO leading to FCF generation

We estimate that Dialog will generate ~LKR 9bn–10bn of FCF in 2011 and 2012 as itbenefits from higher cash from operations, largely due to EBITDA margin improvementsover the past two years and a lower capital intensity of 15 –20% of sales compared to25%+ over the past few years. The high FCF generation should help improve leverageratios and enable the company to pay dividends going forward.

Fig 88 - Dialog free cash flows

(LKR mn) 2009 2010 2011E 2012E

CFO 6,956 14,717 16,768 18,087

Capex 6,443 6,790 8,000 8,000

FCF 513.0 513.0 7,927.8 8,767.9

Capex / Sales 18% 16% 18% 17%

Debt 31,964 25,505 22,721 19,009

Net Debt/Equity 0.7 0.5 0.4 0.2

Net Debt/EBITDA 3.2 1.3 0.9 0.6

Source: Company, RCML Research. Note: Calculations above are derived from the reported balance sheet.

High FCF should help improve leverage

ratios and allow for dividend payouts




39

Valuation

Initiate with HOLDWe initiate coverage on Dialog with a HOLD rating and a DCF-derived December ―11price target of LKR 12.5, offering an upside of 18% from current levels. Our target priceimplies a 2011E/2012E EV/EBITDA of 6.8x/6.0x and P/E of 15x/13x. With Dialog likely

to start generating stable FCF going forward, we believe DCF is an appropriate valuationmethodology for the company.

As Dialog begins to produce significant cash flows amid a moderating growthenvironment, we believe the stock will turn increasingly defensive in nature andinvestors would increasingly look at dividend yields going forward. The companyannounced a dividend of LKR0.20 for 2010, implying a payout of 34% post preferreddividend payout. According to our discussions with the management, dividends arederived based on free cash flows for the year and deleveraging for the year. We modelfor a 40% payout from FCF which implies a dividend yield of 4% for 2011 based on ourcurrent target price.

Fig 89 - Dialog DCF valuation

Key assumptions WACC assumptions

10 year Revenue CAGR (FY10-20E) 7% Cost of equity = 15.8%

10 year EBITDA CAGR (FY10-20E) 13% Risk free rate = 9.8%

10 year NOPAT CAGR (FY10-20E) 13% Beta = 1.00

EBITDA margin (FY10; FY20) 37% , 39% Equity risk premium = 6.0%

NOPAT margin (FY10; FY20) 13% , 26% Cost of debt = 10.0%

ROIC (FY10; FY20) 10% , 16% Tax = 28.0%

Terminal assumptions Debt/capital = 20.0%

Terminal Revenue growth Rate % 3% Equity/capital = 80.0%

Terminal EBITDA Margin 39% WACC = 14.1%

Terminal NOPAT Margin 26% DCF output (LKR mn)

Terminal ROIC 50% Current EV 115,602

Long Term Capex / Sales 10% Net debt 20,072

Terminal value as % of EV 37% Current Equity value 95,531

Implied 2021E exit FCF multiple (x) 9.0 Current equity value/share 11.7

Implied 2021E exit EBITDA multiple (x) 6.2 Dec -11 equity value/share 12.5

Source: Company

Our DCF target price of LKR 12.5

implies a 2011E/2012E EV/EBITDA of

6.8x/6.0x




40

Fig 90 - Asia valuations

Asian Valuation Comps Bloomberg Ticker Currency Price Market cap EV/EBITDA P/E2yr

EBITDA

In LC (US$ mn) 2011 2012 2011 2012 CAGR

Developed Wireless

Hong Kong

SmarTone Telecom Holding Ltd 315 HK Equity HKD 12.58 $1,660 6.6 x 5.4 x 22.7 x 18.6 x 7%

Korea

LG Uplus Corp 032640 KS Equity KRW 6240 $2,961 2.1 x 1.9 x 9.5 x 7.6 x -5%

SK Telecom Co Ltd 017670 KS Equity KRW 165000 $12,282 3.4 x 3.3 x 7.9 x 7.1 x 6%

Singapore

StarHub Ltd STH SP Equity SGD 2.77 $3,769 8.0 x 7.5 x 15.4 x 14.4 x 8%

Taiwan

Far EasTone Telecomm Co Ltd 4904 TT Equity TWD 44 $4,904 6.5 x 6.3 x 15.8 x 14.7 x 2%

Taiwan Mobile Co Ltd 3045 TT Equity TWD 70 $9,122 10.3 x 10.1 x 14.7 x 14.0 x 2%

Developed Wireless Average $5,783 6.2 x 5.8 x 14.3 x 12.7 x

Asia Emerging Wireless

China

China Unicom Hong Kong Ltd 762 HK Equity HKD 14 $41,467 5.1 x 4.4 x 40.4 x 23.3 x 11%

China Mobile Ltd 941 HK Equity HKD 74 $191,028 4.0 x 3.9 x 10.2 x 10.0 x 4%

India

Bharti Airtel Ltd BHARTI IB Equity INR 362 $31,065 9.9 x 7.3 x 21.7 x 16.4 x 26%

Idea Cellular Ltd IDEA IB Equity INR 70 $5,214 9.3 x 6.8 x 26.8 x 24.6 x 22%

Indonesia

Indosat Tbk PT ISAT IJ Equity IDR 5200 $3,267 4.8 x 4.4 x 20.7 x 14.5 x 10%

XL Axiata Tbk PT EXCL IJ Equity IDR 5800 $5,705 5.8 x 5.3 x 12.7 x 10.8 x 13%

MalaysiaDiGi.Com Bhd DIGI MK Equity MYR 29 $7,402 8.9 x 8.4 x 17.5 x 16.4 x 5%

Philippines

Globe Telecom Inc GLO PM Equity PHP 837 $2,564 4.6 x 4.5 x 12.0 x 11.8 x 1%

Thailand

Advanced Info Service PCL ADVANC TB Equity THB 87 $8,525 5.3 x 5.2 x 11.8 x 11.1 x 2%

Total Access Communication PCL DTAC TB Equity THB 48 $3,760 4.4 x 4.6 x 11.6 x 12.4 x -2%

Sri Lanka

Dialog Axiata PLC DIAL SL Equity LKR 10.6 $782 5.9 x 5.2 x 12.9 x 10.7 x 11%

Asia Emerging Wireless average $18,026 6.4 x 5.5 x 15.7 x 13.4 x


Key risks

Tariff floors being continuously revised downwards

In our view, margins could come under pressure if tariff floors are steadily reviseddownwards as high competition in the sector means that operators will immediatelymove to the lowest tariff permissible, thus impacting growth. As such, with growth in thesector beginning to wane, any operating leverage would be difficult to achieve andmargin improvements would have to be supported by network upgrades and tighteroperational efficiencies.

Lower tariff floors would result in

further price wars




41

Regulatory risksThe regulator in Sri Lanka controls the industry structure and tariffs and hence can alterthe sector―s competitive landscape. Besides this, the sector faces significant costs in theform of taxes and levies imposed by the government. Although the government issupportive of the industry and it enjoys various tax benefits, including lower effectivecorporate tax rates, lower indirect taxes on telecom services and tax exemptions on

telecom equipment, any unfavourable changes in tax structure could have some impacton the sector.

Company profile

Dialog was incorporated in 1993 and went public in May ―05. The company―s shares arelisted on the Colombo stock exchange. Dialog offers a wide range of telecommunicationservices including cellular telephony, fixed landline, broadband, and television services,amongst others. It is the largest mobile phone service provider in Sri Lanka with ~55%market share by revenue.

Fig 91 - Revenue split by divisions

CellularOperations, 6

8%Global, 23%

FixedTelephony, 4

%

Transmissionand Infra, 1%

Entertainmentand

Media, 4%

Source: Company , *As per Q4CY10

Fig 92 - Segmental profit split

85% 80% 71% 67%

67% 57% 56% 59%

-51% -36% -26% -26%

-100%

-50%

0%

50%

100%

150%

200%

1QCY10 2QCY10 3QCY10 4QCY10

Others Global Cellu lar Operat ions

Source: Company

Fig 93 - Shareholding pattern

Axiata Group

BHD

83%

Dialog Telecom

Emp. ESOS

2%

Others

15%

Source: Bloomberg




42

Board of directors, auditor and key managementThe company has a small board of six directors, including three independent members.The three non-independent members are representatives from the Axiata group. Theauditors are PricewaterhouseCoopers.

Fig 94 - Composition of board of directors

Director Type Designation Profile

Mr. Datuk AzzatKamaluddin

Non-independent Chairman

Mr. Kamaluddin is an Independent Non-Executive Director of Axiata Group Bhd.He is a lawyer by profession and graduated from the University of Cambridge, UK,with degrees in Law and International Law. At present, he is director of severalpublic listed and private limited companies.

Dr. Shridhir SariputtaHansa Wijayasuriya

Non-independent Group CEO

Dr. Wijayasuriya joined the company in 1994 as a member of the foundingmanagement team, and has functioned in the capacity of Chief Executive of DialogAxiata since 1997. He is also the Group Chief Operating Officer of Axiata GroupBhd. Dr. Wijayasuriya holds a degree in Electrical and Electronic Engineering fromthe University of Cambridge, UK; a PhD in Digital Mobile Communications fromthe University of Bristol, UK; and an MBA from the University of Warwick, UK.

Mr. Azwan KhanOsman Khan

Non-independentGroup CSO

(Axiata group

Bhd.)

Mr. Khan is the Group Chief Strategy Officer of Axiata Group Bhd. He is anengineering graduate (First-Class Honours) from the Imperial College, University of London, with a broad mix of telecommunications and non-telecommunications

experience across a range of companies. Mr. Khan is also an active board memberin several companies.

Mr. Moksevi RasinghPrelis

IndependentMr. Prelis has 27 years of experience in the banking sector, of which 21 years werein the capacity of CEO/Director of the DFCC Bank and the Nations Trust Bank.

Mr. Mohamed VazirMuhsin

Independent

Mr. Muhsin―s experience includes working as a Strategic Management Consultantand Director on international corporate and foundation boards. Prior to hisretirement as the Vice President & Chief Information Officer at the World Bank,Mr. Muhsin was responsible for aligning information technology with theorganisation―s business strategy.

Mr. JayanthaDhanapala

Independent

Mr. Dhanapala was a career diplomat in the Sri Lanka Foreign Service and theUnited Nations. He was Ambassador of Sri Lanka and Permanent Representative tothe UN in Geneva (1984–87), Ambassador of Sri Lanka to the US (1995–97) andUN Under-Secretary-General (1998–2003).

Source: Company

Fig 95 - Key management

Name Designation Profile

Dr. Shridhir SariputtaHansa Wijayasuriya

Director / Group Chief Executive

Dr. Wijayasuriya joined the company in 1994 as a member of the foundingmanagement team, and has functioned in the capacity of Chief Executive of DialogAxiata since 1997. He is also the Group Chief Operating Officer of Axiata GroupBhd. Dr. Wijayasuriya holds a degree in Electrical and Electronic Engineering fromthe University of Cambridge, UK; a PhD in Digital Mobile Communications fromthe University of Bristol, UK; and an MBA from the University of Warwick, UK.

Mr. Upali GajanaikeChief Executive Officer – DialogTele-Infrastructures

Mr. Gajanaike is the CEO of Dialog Tele-infrastructures. He has over 15 years of experience in telecommunications and has been with the company since itsinception. Mr. Gajanaike holds a degree in Electronic and TelecommunicationsEngineering from University of Moratuwa and an MBA from the University of Colombo.

Mr. Supun Weerasinghe Group Chief Operating Officer

Mr. Weerasinghe holds a Bachelor of Science degree in Accountancy and FinancialManagement from the University of Sri Jayewardenepura, Sri Lanka and an MBA(Distinction) from the University of Western Sydney, Australia. He is an AssociateMember of the Chartered Institute of Management Accountants, UK.

Ms. Sandra De Zoysa Group Chief Customer OfficerMs. De Zoysa is the Group―s Chief Customer Officer; she has over 20 years of experience in customer service management and is a certified analyst, auditor andcustomer service manager of the Asia Pacific consumer service consortium.

Mr. Nushad Perera Group Chief Marketing Officer

Mr. Perera has over 10 years of work experience with Dialog and more than 25years of marketing and sales experience in the ICT and marketing communicationindustry. He holds an MBA (Marketing) from the University of Leicester, as well as aDiploma in Marketing Communication from Charted Institute Of Marketing (CIM).

Mr. Pradeep De Almeida Group Chief Technology Officer

Mr. De Almeida graduated with a BSc. in Electronic and TelecommunicationEngineering and is a member of the Institution of Engineers, Sri Lanka. He has over

10 years of experience and has also gained international exposure at overseassubsidiaries and business ventures of Telekom Malaysia in India and Africa.

Source: Company




43

Consolidated financials

Profit and Loss statement Balance sheet

Y/E Dec (LKR mn) CY09 CY10 CY11E CY12ERevenues 36,250 41,423 45,171 48,068

Growth (%) - 14.3 9.0 6.4

EBITDA 8,319 15,085 17,260 18,746

Growth (%) - 81.3 14.4 8.6

Depreciation & amortisation 18,351 9,754 9,930 10,056

EBIT (10,032) 5,331 7,331 8,690

Growth (%) - (153.1) 37.5 18.5

Interest (1,747) 125 47 175

Other income - - - -

EBT (11,779) 5,455 7,378 8,865

Income taxes 428 490 664 798

Effective tax rate (%) (3.6) 9.0 9.0 9.0

Extraordinary items - - - -

Min into / inc from associates - - - -

Reported net income (12,207) 4,965 6,714 8,067

Adjustments - - - -

Adjusted net income (12,207) 4,965 6,714 8,067

Growth (%) NA 35.2 20.2

Shares outstanding (mn) 8,143.8 8,143.8 8,143.8 8,143.8

FDEPS (LKR) (adj) (1.5) 0.61 0.82 0.99

Growth (%) - NA 35.2 20.2

DPS (LKR) - 0.2 0.4 0.5

Y/E Dec (LKR mn) CY09 CY10 CY11E CY12ECash and cash eq 5,295 5,434 6,464 7,583

Accounts receivable 9,646 9,629 10,382 10,991

Inventories 211 271 292 310

Other current assets 0 0 0 0

Investments 29 31 31 31

Gross fixed assets 0 0 0 0

Net fixed assets 55,979 53,014 51,085 49,029

CWIP 0 0 0 0

Intangible assets 3,847 3,757 3,757 3,757

Deferred tax assets, net - - - -

Other assets - - - -

Total assets 75,007 72,136 72,011 71,700

Accounts payable - - - -

Other current liabilities 12,668 12,094 13,041 13,805

Provisions 2 14 14 14

Debt funds 31,964 25,505 22,721 19,009

Other liabilities 2,264 2,909 2,909 2,909

Equity capital 31,806 30,556 29,306 28,056

Reserves & surplus (3,697) 1,057 4,020 7,907

Shareholder's funds 28,109 31,613 33,326 35,963

Total liabilities 75,007 72,136 72,011 71,700

BVPS (LKR) 3.5 3.9 4.1 4.4

Cash flow statement Financial ratios Y/E Dec (LKR mn) CY09 CY10 CY11E CY12E

Net income + Depreciation 6,148 15,292 17,308 18,921

Non-cash adjustments 659 42 (711) (972)

Changes in working capital 149 (617) 172 139

Cash flow from operations 6,956 14,717 16,768 18,087

Capital expenditure (6,443) (6,790) (8,000) (8,000)

Change in investments 65 88 0 0

Other investing cash flow (948) 125 47 175

Cash flow from investing (7,326) (6,577) (7,953) (7,825)

Issue of equity (1,071) 461 (1,250) (1,250)

Issue/repay debt (8,630) (6,459) (2,784) (3,713)

Dividends paid 0 (2,004) (3,751) (4,180)

Other financing cash flow 0 0 0 0

Change in cash & cash eq (10,071) 139 1,030 1,120

Closing cash & cash eq (4,776) 5,434 6,464 7,583

Y/E Dec CY09 CY10 CY11E CY12E

Profitability & Return ratios (%)

EBITDA margin 22.9 36.4 38.2 39.0

EBIT margin (27.7) 12.9 16.2 18.1

Net profit margin (33.7) 12.0 14.9 16.8

ROE (43.4) 16.6 20.7 23.3

ROCE (18.9) 8.9 12.5 15.1

Working Capital & Liquidity ratios

Receivables (days) 97 85 84 83

Inventory (days) 2 2 2 2

Payables (days) 128 107 105 105

Current ratio (x) 1.2 1.3 1.3 1.4

Quick ratio (x) 1.2 1.2 1.3 1.3

Turnover & Leverage ratios (x)

Gross asset turnover

Total asset turnover 0.6 0.6 0.7

Interest coverage ratio

Adjusted debt/equity 1.1 0.8 0.7 0.5

Valuation ratios (x)

EV/Sales 3.1 2.7 2.5 2.4

EV/EBITDA 13.6 7.1 5.9 5.2

P/E - 17.4 12.9 10.7P/BV 3.1 2.7 2.6 2.4




44

DuPont analysis

(%) CY09 CY10E CY11E CY12E

Tax burden (Net income/PBT) 103.6 91.0 91.0 91.0

Interest burden (PBT/EBIT) 117.4 102.3 100.6 102.0

EBIT margin (EBIT/Revenues) (27.7) 12.9 16.2 18.1

Asset turnover (Revenues/Avg TA) 0.0 0.6 0.6 0.7

Leverage (Avg TA/Avg equtiy) 2.6 2.5 2.2 2.1

Return on equity (43.4) 16.6 20.7 23.3

Company profile

Dialog offers a wide range of telecommunication services including

cellular telephony, fixed landline, broadband, and television

services, amongst others. It is the largest mobile phone service

provider in Sri Lanka with ~55% market share by revenue.

Stock performance

3

6

9

12

15

Jan-09 Jun-09 Nov-09 May-10 Oct-10 Apr-11

Recommendation history

Date Event Reco price Tgt price Reco

6-Apr-11 Initiating Coverage 10.6 12.5 Hold

l Hold




45

Banking



Banking Sector Report 06 April 2011

46

Ishank Kumar Siddharth Teli Nikhil Rungta

(91-22) 6766 3467 (91-22) 6766 3463 (91-22) 6766 3451

[email protected] [email protected] [email protected]

Robust GDP growth to support 20%+ CAGR in loan

growth over 2010–12

Improving macro fundamentals and strong earnings

growth support our positive outlook

Banking

Good times ahead

We believe Sri Lanka―s financial sector is well positioned to leverage on growthopportunities emerging after an end to the country―s long-running civil war. Inour view, Sri Lanka has a sound financial system with a diversified loan portfolio,robust interest margins, a strong liability profile and comfortable capital positions.While asset quality did deteriorate sharply in 2008 and 2009 due to escalation of the war and the global financial crisis, we note that NPAs have declinedsignificantly in 2010 as economic growth gathered steam. Credit offtake is also setto improve with robust GDP growth and higher operating leverage, while thegovernment―s proposal to slash taxes would bolster earnings and ROE.

We initiate coverage on two large private banks—Commercial Bank of Ceylon(COMB) and Hatton National Bank (HNB)—with BUY recommendations. WhileCOMB and HNB have re-rated sharply in the last two years, we are positive onthese banks as we believe that strong earnings growth and improving macrofundamentals would drive stock performance.

Loan offtake to remain strong fuelled by robust GDP growth: Sri Lanka―s financial services industry is largely dominated by the banking sector, with totalassets of banks (both licenced commercial and specialised banks) constituting~62% of the assets of financial institutions. Moreover, the top 6 banks accountfor ~70% of cumulative banking assets. While loan growth was muted in 2009, ithas picked up strongly in 2010 and we expect a 20%+ CAGR over 2010 –12,underpinned by robust investment demand, falling interest rates and risingpersonal incomes. We note that the bank credit-to-GDP ratio remains low at

~30% as against ~50% in India.

NIMs strong due to high CASA: The sector―s liability profile remains strong withCASA funds contributing ~50% of the total deposits for large banks. This coupledwith stronger yields resulted in high NIMs of ~4.5% for the banking system in2009. Margins have remained stable in 2010 supported by an improvement inloan-to-deposit ratio (LDR). However, with the cost of deposits bottoming out andLDRs already at ~80%, we believe margins could come under pressure (albeitfrom a high base). We also note that the government has asked banks to depositsavings arising from lower taxes in a low-yielding investment fund, which couldfurther strain NIMs.

Higher operating leverage, better asset quality to bolster earnings: We expect

the cost-to-income ratio for banks to decline in 2011–12 as operating leverageimproves. Asset quality deteriorated significantly in 2008 and 2009 with GNPAincreasing from ~5.2% in December ―07 to ~9% in 2009 due to the financialcrisis, escalation of war efforts and a spike in interest rates in 2008. However,with a revival in global and Sri Lankan economies, asset quality has started toimprove and GNPA has climbed down to ~6%. Lower incremental slippages andhigher recoveries have boosted earnings growth of banks in the last few quarters.

Valuations – not cheap but earnings uptick to buoy performance: The Banking& Financial Index (BFI) has risen by more than 400% since April ―09. As a result,valuations of banking stocks are no longer cheap. COMB/HNB are currentlytrading at 2.4x/2.7x BV (adjusted for revaluation reserve) and 11.3x/11.9x EPS on2012E. However, we believe that improving fundamentals of the Sri Lankan

economy and strong earnings growth would drive stock performance. We have aBUY rating on both banks with target prices of LKR 330/ LKR 300.




48

Assets book well diversified

Sri Lanka―s banking system comprises licensed commercial banks (LCB) and licensedspecialised banks (LSB), which number in at 22 and 9 respectively. Out of the 22 LCBs,two banks, namely Bank of Ceylon (BOC) and People―s Bank are state-owned andaccount for ~35% of total banking assets (2009). Apart from these state-owned players,

there are 9 private sector and 11 foreign banks. In the private space, 3 large banks(COMB, HNB and Sampath Bank) constitute ~25% of the country―s total banking assets.Among LSBs, National Savings Bank (NSB) is the largest in Sri Lanka and accounts for~71% of the total assets of LSBs and 12% of total banking assets (2009).

Fig 97 - Composition of banking sector (as on 30 September 2010)

Type of Bank # Banks# Main

branches

Total assets

LKR bn % Share

Licensed Commercial Banks 22 1,408 2,809 83.6

- State Banks 2 640 1,156 34.4

- Private domestic banks 9 722 1,248 37.1

- Foreign banks 11 46 405 12.0Licensed Specialised Banks 9 468 553 16.4

- State Banks 6 405 470 14.0

- Private Banks 3 63 83 2.5

Banking Industry 31 1,876 3,362 100.0


As per CBSL―s regulation, LCBs are required to maintain ~20% of their net time anddemand liabilities in the form of government securities. As on 31 December 2009, thetotal investment in government securities far exceeded the regulatory requirement due tomuted advances growth and surplus liquidity in the system (which banks parked ingovernment securities). However, with the pick-up in credit demand in 2010, the loan-to-deposit ratio (LDR) has improved across banks.

Fig 98 - Composition of assets – LCBs (As on 31 Dec 2009)

GovtSecurities

25%

Loans andadvances

55%

Foreignbalances

6%

Other assets14%

Source: CBSL

Fig 99 - Sources of funds – LCBs (As on 31 Dec 2009)

Capital andreserves

8%

Rupeedeposits

57%

Foreigncurrencydeposits

17%

Rupeeborrowings

9%

Foreignborrowings

4%

Otherliabilities

5%

Source: CBSL

The loan book of the banking system is also well diversified. Exposure to tradingactivities made up ~26% of total advances in 2009 followed by the consumption,housing, agricultural and industrial sectors. About 47% of total advances have amaturity period of more than one year; however, we note that the CASA proportion of large banks (except NSB) is robust at ~50%.

3 large private banks including COMB

and HNB constitute ~25% of total

banking assets

Overall loan book well dispersed across

sectors




50

Fig 103 - Credit demand vs real GDP growth

(5)

0

5

10

15

2025

30

35

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

9 M 0 9

9 M 1 0

Advances growth (%) GDP growth (%)

Source: CBSL

Fig 104 - Strong GDP growth to boost credit demand

0

2

4

6

8

10

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9

2 0 1 0

2 0 1 1 E

2 0 1 2 E

(%) Real GDP growth

Source: CBSL

...and declining interest ratesWe note that interest rates for the banking system have declined in the last 18 monthswhich would boost consumption and investment. To encourage investment in theeconomy, CBSL has reduced repo/reverse repo rates by 3.5% since October ―08 to7%/8.5%. The central bank has also lowered the statutory reserve ratio (proportion of net time and demand liability required to be parked with CBSL) by 3% to 7%. Thiscoupled with lower inflation has resulted in a significant decline in lending and depositrates. As per data released by CBSL, the weighted average prime lending rate of commercial banks has declined from 19.2% at the end of 2008 to 10% at the end of September ―10. The weighted average deposit rate has similarly declined from 11.6% to6.6% over this period.

Fig 105 - CBSL has reduced policy rates significantly

0

2

4

6

8

10

12

0

2

4

6

8

10

12

14

J u l - 0 3

J a n - 0 4

J u l - 0 4

J a n - 0 5

J u l - 0 5

J a n - 0 6

J u l - 0 6

J a n - 0 7

J u l - 0 7

J a n - 0 8

J u l - 0 8

J a n - 0 9

J u l - 0 9

J a n - 1 0

J u l - 1 0

J a n - 1 1

RepoReverse repoStatutory reserve ratio (R)

(%) (%)


Fig 106 - As a result, lending and deposit rates have declined

0

4

8

12

16

20

2005 2006 2007 2008 2009 2010 *

Average weighted PLR Average weighted deposit rate(%)

Source: CBSL * As on 30 September 2010

NIMs strong at 4–4.5% but could decline from high base of 2010Overall NIMs in Sri Lanka are robust at 4–4.5% due to high yields on advances and astrong liability franchise marked by a CASA ratio of ~50% (Fig 102). NIMs of thebanking system remained largely stable in 2010 as a sharp decline in yield on assets wasoffset by a lower cost of deposits (led by higher low-cost deposit mobilisation and adecline in term deposit rates) coupled with an improvement in C/D ratio.

PLR of commercial banks down

from 19.2% at end-2008 to 10% at

end-Sept ―10

Higher CASA and stronger yields aided

margins in 2010




51

Fig 107 - NIMs strong at 4.5% driven by high CASA ratio

3.0

3.4

3.8

4.2

4.6

1 9 9 8

1 9 9 9

2 0 0 0

2 0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

2 0 0 9

9 M 1 1

(%) NIMs


Going forward, we believe that NIMs could come under pressure as banks focus onraising high-cost deposits to fund incremental growth. From our discussions with themanagements of Sri Lankan banks, we infer that the cost of deposits has largelybottomed out whereas the yield on advances is likely to fall further due to re-pricing of assets and high competition. We also note that the government has asked banks todeposit savings arising from lower taxes in a low-yielding investment fund, which couldfurther strain NIMs.

Cost-to-income ratio to decline with higher operating leverage

The cost-to-income ratio of the overall banking system has declined from 68% in 2001to ~50% in 9M2009 due to higher operating leverage. Going forward, we expectoperating expenses to increase at under 15% for banks under our coverage, leading to a

further decline in cost-to-income ratio.

Fig 108 - Cost-to-income ratio likely to improve further

45

50

55

60

65

70

75

1 9 9 8

1 9 9 9

2 0 0 0

2 0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

9 M 0 9

(%)

Source: CBSL

Improvement in asset quality to lower credit costsOverall asset quality declined in 2008 and 2009 as slippages increased due to the globalfinancial crisis, escalation of war efforts and higher lending rates. However, with robusteconomic growth, a revival in external demand and surrender of the LTTE, incrementalslippages have come down significantly. Moreover, all large banks are witnessing strongrecoveries from earlier NPAs, boosting their non-interest income and profitability. As per

CBSL, gross NPA in the system has come down from ~9% in 2009 to ~6% and provisioncoverage has improved to ~56% from ~45% earlier. With strong economic growth

But margin headwinds ahead as deposit

cost has bottomed out and assets are

re-priced downward

Opex expected to increase at sub-15%




52

likely, we believe that asset quality could improve further and the GNPA ratio trenddown. Higher recoveries from earlier NPAs and lower incremental provisions are likelyto bolster profitability.

We note that CBSL guidelines require NPAs to be recognised when an account is

overdue for 90 days and over and these are classified under the Specific Mentionsaccount. However, NPA provisions start only when the account is six months overdue(or a sub-standard asset).

Fig 109 - Improvement in asset quality to reduce provisioning expenses

0

10

20

30

40

50

60

70

0

2

46

8

10

12

14

16

18

1 9 9 8

1 9 9 9

2 0 0 0

2 0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

9 M 0 9

N o v 1 0

GNPA NNPA Provision coverage ratio (R)(%) (%)

Source: CBSL

We also note that banks in Sri Lanka are carrying excess provisioning on the standardasset portfolio. To create a buffer, CBSL had earlier mandated that banks create astandard asset provision of 1%. However, with robust economic growth, CBSL nowplans to reduce this requirement to 0.5% by Dec ―11 (in phases as a 0.1% reductionevery quarter effective from Q410).

Banks adequately capitalised for growthSri Lankan banks have a total CAR/tier I ratio of 14.5%/12.3% at the end of September―09 (as against the regulatory requirement of 10%/5%). While current mandatory capitalrequirements are lower than Basel III norms (common equity/tier I/total CAR of 7%/8.5%/10.5%), we believe that the high CAR and strong ROE profile of Sri Lankanbanks would support growth in the medium term.

Large banks seeing strong recoveries

from older NPAs and lower incremental

defaults




53

Fig 110 - Tier I ratio of banks above 10% as against regulatory requirement of 5%

0

2

4

6

8

10

12

14

16

1 9 9 8

1 9 9 9

2 0 0 0

2 0 0 1

2 0 0 2

2 0 0 3

2 0 0 4

2 0 0 5

2 0 0 6

2 0 0 7

2 0 0 8

9 M 0 9

CAR Tier I(%)

Source: CBSL

Effective tax rate likely to declineSri Lankan banks are heavily taxed as they have to pay a value-added tax (financial VAT)of 20% apart from a corporate tax of 35%. However, the government recently proposedto reduce the corporate tax rate from 35% to 28% (from 1 April 2011) and financial VATfrom 20% to 12% (from 1 January 2011). As a result, we expect the effective tax rate forbanks to decline in 2011 and 2012, supporting higher profitability. However, thegovernment may require banks to pass on the benefits arising from the lower taxes,either partially or fully.

Valuations not cheap but strong earnings growth to provide support

The Sri Lankan stock market has run-up significantly since April ―09 in anticipation of strong GDP growth in the post-war period, rallying 114% in 2009 and 96% in 2010.

Banking and financial services stocks have outperformed the broader market with theBFI index rising by 125% in 2009 and 141% in 2010.

While valuations are no longer cheap, we believe that strong earnings growth andimproving macro fundamentals would support stock performance. We initiate coverageon COMB and HNB with BUY ratings and expect these companies to post an earningsCAGR of 27%/24% over 2010–12 backed by a strong credit CAGR of ~20%, healthymargins, higher operating leverage and lower taxes.

Fig 111 - Banks have outperformed broader market in the last two years

-

100

200

300

400

500

M a r - 0 6

J u n - 0 6

S e p - 0 6

D e c - 0 6

M a r - 0 7

J u n - 0 7

S e p - 0 7

D e c - 0 7

M a r - 0 8

J u n - 0 8

S e p - 0 8

D e c - 0 8

M a r - 0 9

J u n - 0 9

S e p - 0 9

D e c - 0 9

M a r - 1 0

J u n - 1 0

S e p - 1 0

D e c - 1 0

M a r - 1 1

ASPI BFI

Source: RCML Research

Sector CAR/tier I ratio of 14.5%/12.3%

at end-Sept ―09 versus regulatory

requirement of 10%/5%

Government proposes to slash

corporate taxes and financial VAT in

2011

Strong earnings growth and an

improving macro would support stock

performance




54

Fig 112 - Valuation summary – Sri Lankan vs Indian banks

CMP(Rs/LKR)#

Target(Rs/LKR)#

RecoMCAP

(Rs/LKR bn)#

P/BV (x) P/E (x)EPS

growthAverageRoE (%)

AverageRoA (%)

FY12E* FY13E* FY12E* FY13E* FY11-13E* FY11-13E* FY11-13E*

Indian banks

PSU Banks

SBI 2,823 3,500 BUY 1,793 2.1 1.8 12.0 9.9 25.6 18.0 1.1

SBI # 2,191 2,867 1,391 1.7 1.5 9.6 7.9 26.0 18.9 1.1

PNB 1,198 1,475 BUY 378 1.6 1.3 7.0 5.8 21.8 24.3 1.4

BoB 959 1,130 BUY 349 1.6 1.4 8.2 7.0 12.5 23.2 1.3

BoI 487 520 HOLD 255 1.4 1.2 7.4 6.1 22.9 20.6 1.0

Canara Bank 641 660 HOLD 284 1.3 1.1 6.5 5.9 6.0 23.9 1.2

Dena Bank 112 160 BUY 32 0.9 0.8 5.2 4.3 11.3 21.5 0.9

UBI 348 410 BUY 176 1.3 1.1 6.7 5.8 20.0 21.8 1.1

OBC 394 445 BUY 98 1.0 0.8 6.4 5.0 13.7 18.1 1.1

Corporation Bank 644 745 BUY 92 1.1 0.9 5.7 4.7 19.4 21.9 1.1

Private Banks

ICICI Bank 1,108 1,175 HOLD 1,276 2.1 1.9 19.0 15.2 26.1 11.4 1.4

ICICI Bank # 867 934 998 2.1 1.9 15.2 12.1 26.7 14.4 1.8

HDFC Bank 2,371 2,390 HOLD 1,103 3.8 3.2 21.8 17.3 27.5 18.6 1.7

Axis Bank 1,436 1,650 BUY 590 2.6 2.2 13.8 11.4 24.3 20.2 1.7

Yes Bank 315 380 BUY 109 2.4 2.0 12.5 9.7 27.2 21.4 1.4

Sri Lankan banks

COMB 268 330 BUY 96 2.8 2.4 13.7 11.3 27.2 20.8 1.8

HNB 253 300 BUY 83 3.2 2.7 14.7 11.9 24.4 23.2 1.7

Source: Company, RCML Research; # Units in LKR for Sri Lankan Banks; conversion rate - Rs 1 = LKR 2.49; *Numbers based on calendar years for Sri Lankan Banks



Commercial Bank of Ceylon Initiating Coverage 06 April 2011

55

Ishank Kumar Siddharth Teli Nikhil Rungta

(91-22) 6766 3467 (91-22) 6766 3463 (91-22) 6766 3451


Profitability and return ratios

(%) CY09 CY10 CY11E CY12E

Net interest margin 4.2 4.9 4.7 4.6

Non-int inc/Total inc 38.3 29.3 28.9 27.9

Cost/Inc Ratio 45.7 43.1 43.0 41.4

RONW 16.2 18.6 21.4 22.5

ROA 1.4 1.6 1.8 1.8

Net NPA 4.9 2.8 2.3 1.9

Financial highlights

(LKR mn) CY09 CY10 CY11E CY12E

NII 12,421 16,374 18,409 21,784

Growth (%) (3.7) 31.8 12.4 18.3

PPP 10,923 13,191 14,752 17,702

Growth (%) (7.2) 20.8 11.8 20.0

FDEPS (LKR) 11.2 14.6 19.5 23.6

Growth (%) 1.5 30.5 33.6 21.2

Commercial Bank of Ceylon

Poised for take-off

We initiate coverage on Commercial Bank of Ceylon (COMB) with a BUY ratingand a target price of LKR 330. COMB is the largest private sector bank inSri Lanka with a 12% market share by asset base. The bank also has a healthypresence in Bangladesh which constitutes ~10% of total advances (2009).While NIMs could decline from 2010 levels as the incremental C/D ratio trendslower in 2011, the bank―s robust liability franchise (CASA proportion of ~55%)would support strong margins of ~4.5%. We also expect asset quality toimprove with the ongoing revival in domestic and external demand. The stock istrading at 2.4x/11x BV/EPS on 2012E. We believe strong earnings growth(27%+ CAGR over 2010–12E) and an improving macro environment would bekey drivers for stock performance.

Strong GDP growth to drive 21% CAGR in advances: Overall credit demand inSri Lanka has picked up in H2CY10 after remaining muted in 2009 and H1CY10.We note that the overall credit-to-GDP ratio in the country remains low at~30%. A sharp decline in interest rates (~9ppt drop in weighted average PLR of Sri Lankan banks since December ―08 to ~10%) and robust GDP growthprospects (~8.5%+ over 2010–12) would fuel strong business growth for banks.COMB would also benefit from its presence in Bangladesh and its plan to expandinto retail. We are factoring in a 21% CAGR in advances over 2010–12.

NIMs to remain in 4–4.5% range: NIMs have improved from 4% in Q2CY09 to4.7% in Q4CY10 driven by higher CASA mobilisation and an improvement inLDRs. However, with LDRs already at ~82% at the end of December ―10 and thecost of deposits close to bottoming out, we expect NIMs to decline and are

factoring in a 25bps dip in 2011–12. Nonetheless, this still leaves COMB withstrong 4.5%+ margins.

Asset quality to improve further: The bank―s GNPA shot up from 4.8% inDecember ―07 to 8.9% in June ―09 due to the global financial crisis and theescalation of war efforts at home. However, with the revival in domestic andexternal demand, GNPA has fallen to 4.2% by the end of December ‘10 . Weexpect a further decline to sub-4% levels by December ―12.

Well placed to leverage strong emerging demand: Given its leadership position,we believe that COMB is well placed to capitalise on the strong credit demand inSri Lanka. We expect earnings to grow at a 27% CAGR over 2010–12 backed bystrong credit growth, lower credit costs, higher operating leverage and a lower

effective tax rate. ROE is likely to improve from 16% in 2009 to 22%+ by 2012.While valuations are not cheap at 2.4x 2012E BV (adjusted for revaluationreserve) and 11.3x 2012E EPS, we expect strong earnings growth and improvingfundamentals to buoy stock performance.

CMP TARGET RATING RISK

LKR 268 LKR 330 BUY MEDIUM

CSE BLOOMBERG

COMB.N COMB SL

Company data

Market cap (LKR mn / US$ mn) 95,650 / 867

Outstanding equity shares (mn) 357

Free float (%) 100

Dividend yield (%) 1.9

52-week high/low (LKR) 293 / 145

3-month average daily volume 318,016

Stock performance

Returns (%) CMP 1-mth 3-mth 6-mth

COMB 268 1.9 0.0 (3.6)CSE Index 7,022 (0.1) (1.0) (8.6)

Valuation matrix

(x) CY09 CY10 CY11E CY12E

P/BV @ CMP 3.7 3.2 2.8 2.4

P/BV @ Target 4.6 3.9 3.4 2.9

P/E @ CMP 24.0 18.4 13.7 11.3




56

Investment rationaleLargest private sector bank in Sri LankaCOMB is the largest private sector bank in Sri Lanka (fourth largest includinggovernment-owned banks) with assets worth LKR 370bn (US$ 3.3bn) at the end of December ―10, equivalent to ~12% of the country―s total banking assets. At the end of

2009, the bank had a strong distribution network of 144 branches in Sri Lanka. Apartfrom regular branches, the bank also has 24 outlets in supermarkets and a network of 355 ATMs.

Fig 113 - Key metrics of largest banks in Sri Lanka – 30 September 2010

OwnershipAssets Deposits CASA NIMs Tier I GNPA NNPA

(LKR mn) (LKR mn) (%) (%) (%) (%) (%)

Bank of Ceylon Government 635,539 456,020 49.0 3.3 10.6 5.0 2.6

People's Bank Government 570,569 452,685 50.5 5.4 7.8 5.9 1.4

Commercial Bank of Ceylon Private 364,614 252,562 54.2 4.6 10.8 5.0 3.4

Hatton National Bank Private 304,594 221,238 51.1 5.3 10.3 5.9 3.1

Sampath Bank Private 178,131 143,072 48.9 5.1 10.0 5.5 1.2

Source: Company, RCML Research

Loan book likely to grow at 21% CAGR through 2012COMB―s loan growth was subdued in 2008 and 2009 as credit demand slowed downsignificantly due to the global financial crisis and the heightened internal conflict.However, with a revival in macro conditions in Sri Lanka and other economies, creditgrowth has picked up. Over July–December ―10, COMB―s advances grew by 27% andconsequently YoY growth improved from 7% at the end of H1CY10 to 29.5% at the endof CY10. Considering GDP growth of ~8.5–9% over CY10-CY12, we believe that thebank―s loan book could grow at a 21% CAGR over this period.

Fig 114 - Loan book to grow at 21% CAGR over CY10-CY12

50

60

70

80

90

100

(10)

0

10

20

30

40

C

Y 0 4

C

Y 0 5

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Y 0 6

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C

Y 0 8

C

Y 0 9

C

Y 1 0

C Y

1 1 E

C Y

1 2 E

(%)(%) Credit growth Deposit growth

C/D ratio (R)


Fig 115 - Breakup of advances – 2009

Industrial16%Exports

10%Imports

12%

CommercialTrading

10%

Services13%

Housing &Construction

9%

Tourism &Allied

3%

Agriculture &Fishing

5%Consumption

5%

Others17%


International presence to support balance sheet growthApart from Sri Lanka, COMB has operations in Bangladesh and the Maldives whichaccounted for 9.8% and 2.8% of total advances respectively at the end of 2009. Thebank ventured into Bangladesh in 2003 with the acquisition of Credit Agricole Indosuezand had ~15 delivery points in the country at the end of 2009. It is currently focusing onthe corporate segment and has a market share of less than 1%. Going forward, it aims tofurther expand its operations and venture into the retail segment.

Asset base totals US$ 3.3bn or 12% of

the country―s banking assets

Revival in advances with 27% growth

over Jul-Dec ―10




57

Liability franchise strong; NIMs healthy at ~4.5%Reported NIMs have improved from 4.1% at the end of December ―09 to 4.7% at end-December ―10 due to strong CASA growth (27% YoY in 2010) and a better C/D ratio(82% vs. 70% in Dec ―09). The CASA ratio has improved from 48% in 2009 to 55% in2010 as the bank relied primarily on low-cost deposits to fund incrementalgrowth—term deposits declined by ~5% in 2010 as against 27% growth in CASA. With

C/D deposits already at 82%, COMB would have to raise high-cost deposits goingforward. This coupled with a bottoming of deposit rates could put pressure on NIMs. Weare factoring in a 25bps decline in NIMs through 2012 in our estimates.

Fig 116 - NIMs have remained above 4.5%...

3.4

3.6

3.8

4.0

4.2

4.4

4.6

4.8

0

20

40

60

80

100

Q 1 0 8

Q 2 0 8

Q 3 0 8

Q 4 0 8

Q 1 0 9

Q 2 0 9

Q 3 0 9

Q 4 0 9

Q 1 1 0

Q 2 1 0

Q 3 1 0

Q 4 1 0

(%)(%) CASA LDR NIMs (R)


Fig 117 - … driven by low cost deposits mobilisation

(10)

0

10

20

30

40

Q 1 0 9

Q 2 0 9

Q 3 0 9

Q 4 0 9

Q 1 1 0

Q 2 1 0

Q 3 1 0

Q 4 1 0

CASA deposits Term deposits

Total deposits

(YoY growth %)


Asset quality to improve furtherGNPA increased from 3.4% in March ―08 to 8.9% in June ―09 owing to unfavourablemacro conditions both at home and globally. However, asset health has improvedsignificantly in the last 18 months driven by a revival in exports and robust GDP growth

in Sri Lanka. GNPA/NNPA are down from 8.9%/6.7% in June ―09 to 4.2%/2.8% inDecember ―10. We expect a continued improvement in 2011 and 2012 as recoveriespick up and slippages remain low.

Credit costs are also likely to come down from 0.9% in 2009 to ~0.65% in 2011 and2012. We note that Central Bank of Sri Lanka plans to reduce the standard assetprovisioning requirement to 0.5% (from 1% currently) by December ―11 in a phasedmanner (0.1% reduction every quarter). Thus, the bank would not be required to makeany incremental provisions on standard assets in the next few quarters.

Fig 118 - Asset quality deteriorated in 2008 and 2009…

0

10

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30

40

50

60

70

012345678

C Y 0 5

C Y 0 6

C Y 0 7

C Y 0 8

C Y 0 9

C Y 1 0

C Y 1 1 E

C Y 1 2 E

(%)(%)Gross NPA

Net NPAProvision coverage ratio (R)


Fig 119 - …but is on the mend

0

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Q 1 0 8

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(%)(%) Gross NPA

Net NPAProvision coverage ratio (R)


CASA ratio up from 48% in 2009 to

55% in 2010

Recovery in export segments and robust

GDP growth to help contain NPAs




58

Return ratios set to expandWith strong business growth expected through 2011–12, we believe that higheroperating leverage would improve the profitability of Sri Lankan banks in general. In2010, COMB―s operating expense as a percentage of its asset base was rather high at~2.9%; we expect this to dip to 2.6–2.7% as operating expenses increase at a 12%CAGR over 2010–12 against a 14% increase in net revenues. NII is projected to grow at

a 15% CAGR over the same period; however, non-interest income growth could belower at a 11% CAGR due to the higher base of 2009/10 which saw a boost from higherNPA recoveries.

We expect total costs (operating expenses + credit costs + taxes) to decline from 5.1% in2010 to 4.4% in 2012 driven by higher operating leverage and a reduction in effectivetax rate. We note that the government of Sri Lanka has reduced the corporate tax ratefrom 35% to 28% (effective 1 April 2011) and financial VAT from 20% to 12% (effective1 January 2011). We thus expect the bank―s ROA/ROE to improve from 1.6%/18.6% in2010 to 1.8%/22.5% in 2012 (ROE based on net worth ex-revaluation reserve).

Fig 120 - ROA and ROE to improve going forward

(%) CY06 CY07 CY08 CY09 CY10E CY11E CY12E

Net interest income/Assets 3.8 4.7 4.7 4.1 4.7 4.5 4.5

Non-interest income /Assets 2.4 1.9 2.5 2.6 2.0 1.8 1.7

Net revenues/Assets 6.2 6.6 7.2 6.7 6.7 6.4 6.3

Operating expense/Assets 3.3 2.5 2.9 3.1 2.9 2.7 2.6

Provision/Assets 0.3 0.7 0.8 0.5 0.3 0.4 0.4

Taxes/Assets 1.6 1.7 2.0 1.7 1.9 1.4 1.4

ROA 1.0 1.7 1.5 1.4 1.6 1.8 1.8

Equity/Assets 7.3 7.7 8.7 8.6 8.6 8.5 8.2

ROAE 14.1 22.1 17.3 16.2 18.6 21.4 22.5


Capital position comfortableCOMB―s CAR/tier I ratio at the end of December ―10 stood at 12.3%/10.9% which ismuch higher than the regulatory requirement of 10%/5%. While we note that currentminimum capital requirements could go up in line with recommendations of theBasel III committee (mandating common equity/tier I/CAR of 7%/8.5%/10.5% for banks),we believe that COMB―s strong ROE profile would support balance sheet growth.

Fig 121 - Adequately capitalised for growth

0

2

4

6

8

10

12

14

16

18

CY04 CY05 CY06 CY07 CY08 CY09 CY10E CY11E CY12E

(%) CAR Tier I


Improvement in return ratios to be led

by operating leverage and lower taxes

CAR of 12.3% far above regulatory

requirement of 10%




59

Well placed to leverage emerging demand; initiate with BUYThe Sri Lankan stock market has appreciated significantly since May ―09 as the advent of peace in the country has boosted business confidence. The benchmark index of thebanking, finance and insurance sector (BFI Index) has risen by 125% in 2009 and 140%in 2010. At the CMP of LKR 268, COMB is trading at 2.4x 2012E BV (adjusted forrevaluation reserve) and 11.3x 2012E EPS. While valuations are not cheap (see fig 112

for a comparison with Indian banks), we are positive on the stock and believe that strongearnings growth amid an improving macro backdrop is likely to propel stockperformance.

We expect COMB―s earnings to grow at ~27%+ CAGR over 2010–12 driven by strongbusiness growth, higher operating leverage and a reduction in effective tax rate. ROE islikely to improve to 22%+ by 2012 from 19% in 2010 (calculated after excludingrevaluation reserve from net worth). Given the strong GDP and earnings growth alongwith improving ROEs, we believe the stock could trade at 14x 2012E EPS, implying a23% upside from current levels. We initiate coverage on COMB with a BUY rating.

Fig 122 - Price to 1-yr fwd BV vs ROE

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S e p - 0

9

M a r - 1 0

S e p - 1

0

M a r - 1 1

(%)(x) Price/ 1-yr fwd book 12 mth rolling RoE (R)

Source: Bloomberg, Company, RCML Research

Fig 123 - Price to 1-yr fwd EPS

02468

1012141618

J a n - 0 5

J u l - 0 5

J a n - 0 6

J u l - 0 6

J a n - 0 7

J u l - 0 7

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J a n - 1 0

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(x) Price/ 1-yr fwd EPS


30%+ earnings CAGR lends confidence

on stock performance




61

Quarterly trend

Particulars Q4CY09 Q1CY10 Q2CY10 Q3CY10 Q4CY10

Net interest income 3,587 3,574 3,819 4,312 4,668

YoY growth (%) 1.2 21.5 34.2 41.5 30.1

QoQ growth (%) 17.7 (0.4) 6.9 12.9 8.3

Non - interest income 1,365 1,256 1,339 1,469 1,626

Total income 4,952 4,830 5,158 5,781 6,295

Total operating expenses 2,507 2,349 2,288 2,365 2,977

- Employee expenses 1,473 1,356 1,294 1,338 1,642

Pre-provision profit 2,445 2,481 2,870 3,416 3,317

Provisions (272) (27) 104 196 (188)

PBT 2,719 2,509 2,767 3,225 3,508

Income taxes 1,512 1,401 1,561 1,804 1,734

PAT 1,207 1,108 1,206 1,422 1,774

YoY growth (%) 8.3 24.1 7.4 46.4 47.0QoQ growth (%) 24.2 (8.2) 8.9 17.9 24.8

Company profile

COMB is the largest private sector bank in Sri Lanka with a total

asset size of LKR 370bn (US$ 3.3bn) at the end of December 2010.

The bank has a strong distribution network and liability franchise

marked by a CASA ratio of ~55%. Apart from Sri Lanka, COMB has

operations in Bangladesh and the Maldives which accounted for

9.8% and 2.8% of total advances respectively at the end of 2009.

Stock performance

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6-Apr-11 Initiating Coverage 268 330 Buy

l Buy



Hatton National Bank Initiating Coverage 06 April 2011

62 Ishank Kumar Siddharth Teli Nikhil Rungta

(91-22) 6766 3467 (91-22) 6766 3463 (91-22) 6766 3451



(%) CY09 CY10 CY11E CY12E

Net interest margin 5.8 5.6 5.5 5.5

Non-int inc/Total inc 30.8 32.3 32.6 31.9

Cost/Inc Ratio 56.6 58.9 57.8 55.9

RONW 24.1 21.8 23.4 24.5

ROA 1.7 1.7 1.8 1.8

Net NPA 2.9 2.0 1.7 1.5


(LKR mn) CY09 CY10 CY11E CY12E

NII 14,555 15,787 17,902 21,286

Growth (%) 16.1 8.5 13.4 18.9

PPP 9,123 9,597 11,207 13,795

Growth (%) 18.6 5.2 16.8 23.1

FDEPS (LKR) 12.9 13.7 17.2 21.2

Growth (%) 57.6 6.3 25.5 23.3

Hatton National Bank

Strong earnings profile to drive valuations

We initiate coverage on Hatton National Bank (HNB) with a BUY rating and atarget price of LKR 300. HNB is the second largest private sector bank in SriLanka with a strong distribution network and market leadership in the retail andSME segments. A robust liability franchise (CASA proportion of ~52%) and highpricing power support best-in-class NIMs of 5%+. We also expect asset quality toimprove with the ongoing revival in domestic and external demand. While thestock has appreciated significantly since April ’09 (currently at 2.7/11.9 BV/EPSon 2012E) and valuations are no longer cheap, we believe strong earnings growth(24%+ CAGR) and an improving macro environment would bolster valuations.

Loan book to grow at 20% CAGR: HNB’s business growth was subdued in 2009and H1CY10; however, credit demand has picked up in H2CY10 driven bystrong GDP growth (~8% in 2010) and a revival in external demand. We notethat the overall credit-to-GDP ratio in Sri Lanka remains low at ~30%. Thiscoupled with a lower interest rate (9ppt drop in weighted average PLR of SriLankan banks to 10% over December ’08 to September ’10) and robust GDPgrowth prospects would fuel strong business growth for banks.

High pricing power and robust liability franchise to support NIMs: HNB’s loanbook is quite granular in nature with a strong emphasis on the retail and SMEsegments. As a result, pricing power on the asset side is higher. On the liabilityside, the bank has a solid retail depositor base and robust CASA levels of ~52%.We therefore expect NIMs to be maintained at 5%+ through FY12 despite strongcompetition and a sharp drop in interest rates.

Asset quality to improve further: Asset health deteriorated in 2008 and 2009 dueto the financial crisis and the escalation of war efforts, with GNPA increasingfrom 6.3% in December ’07 to 8.7% in June ’09. However, with the revival indomestic and external demand, asset quality has improved significantly, asevidenced by a drop in GNPA to 4.5% in December ’10. We expect a furtherdecline to sub-4% levels by December ’12 as slippages continues to trend downand recoveries pick up.

Strong earnings growth to drive valuations: We expect earnings to grow at a24% CAGR over 2010–12 backed by strong credit growth, higher operatingleverage and a lower effective tax rate. With strong earnings growth, we expectROE to increase from ~22% in 2010 to 24-25%+ in 2012 (ROE based on net

worth ex-revaluation reserve). The stock has appreciated by ~385% since April’09 and is currently trading at 2.7x BV and 11.9x EPS on 2012E. Given the strongGDP and earnings growth along with improving ROEs, we believe the stockcould trade at 3.2x 2012E BV and 14x 2012E EPS, implying a 19% upside. BUY.



CSE BLOOMBERG

HNB.N HNB SL

Company data

Market cap (LKR mn / US$ mn) 83,113 / 750

Outstanding equity shares (mn) 287

Free float (%) 100




Stock performance


HNB 253 (1.7) (4.5) (6.9)CSE Index 7,022 (0.1) (1.0) (8.6)

Valuation matrix

(x) CY09 CY10 CY11E CY12E

P/BV @ CMP 4.3 3.7 3.2 2.7

P/BV @ Target 5.2 4.4 3.8 3.2

P/E @ CMP 19.7 18.5 14.7 11.9




63

Investment rationaleRobust presence and brand nameHNB is the second largest private commercial bank in Sri Lanka with an extensivedistribution network of 187 branches. It has a strong presence in rural and semi-urbanareas driven by its emphasis on building a regional presence—this in turn results in a

robust client base and access to low-cost deposits (CASA ratio of ~52% at the end of December ―10). A strong regional footprint has also translated to a more granular assetcomposition and a leadership position in the SME and retail segments where interestspreads are higher. The company―s asset book is well diversified in terms of its exposureto industries and counterparties, as indicated in the charts below.

Fig 124 - Industry-wise exposure – 2009

Agricultureand fishing

10%Manufactruing

14%

Tourism7%

Construction17%Traders

12%

Financial andbusinessservices

6%

Pawning12%

Others22%


Fig 125 - Exposure by counterparties – 2009

Corporates >LKR 1bn

10%

CorporatesLKR 100mn -

1bn24%

CorporatesLKR 35mn -

100mn8%

SME LKR10mn -35mn

8%

Microfinance4%

Housing10%

Personal loans31%

Leasing5%


Loan book likely to grow at 20% CAGR through 2012

HNB―s loan growth was subdued over 2008–09 as the bank adopted a cautious lendingapproach against the backdrop of the global financial crisis, a ramp-up of home warefforts and a spike in interest rates. However, with the macro revival in Sri Lanka andother economies, the bank has once again trained its sights on business growth. After amuted performance in 2009 and a sequential decline in Q1CY10, HNB―s loan bookgrew by 4.4%/7%/12% QoQ in Q2/Q3/Q4CY10. Overall, loan book grew by 22% YoYin 2010. Considering GDP growth of ~8.5% over 2010–12, we believe that the bank―soverall loan book could grow at a 20% CAGR over this period. HNB is also likely tobenefit from a stronger government thrust on infrastructure and economic revival in thehitherto war-torn northern and eastern regions where it has a strong presence.

No. 2 private bank in Sri Lanka with

187 branches and strong regional

footprint

Economic revival post-war to supportstrong credit demand




64

Fig 126 - Credit growth has picked up from Q2CY10 onwards

68

70

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74

7678

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82

84

(5)

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Q 1 0 9

Q 2 0 9

Q 3 0 9

Q 4 0 9

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Q 3 1 0

(%)(%) Credit growth Deposit growthC/D ratio (R)


Fig 127 - Loan book could grow at 20% CAGR over 2010–12

70

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95

(5)

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(%)(%) Credit growth Deposit growth

C/D ratio (R)


Higher pricing power, robust liability franchise to support best-in-class NIMsDespite a sharp reduction in interest rates, HNB has reported robust NIMs of 5%+ due

to its strong liability franchise (CASA proportion at ~52%, up 28% YoY in CY10) and thedeployment of surplus liquidity. The LDR rose from ~76% in December ―09 to 83% inDecember ―10 as the bank trimmed its high-cost deposits and credit growth picked up.While LDR is likely to remain at this level going forward, we believe that higher pricingpower (driven by a strong presence in pawning, SME and other retail segments) wouldprotect NIMs.

Fig 128 - NIMs have remained above 5%...

4.0

4.4

4.8

5.2

5.6

6.0

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52

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Q 3 1 0

(%)(%)CASA NIMs (R)


Fig 129 - …and expected to remain stable

(10)

(5)

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Q 2 0 9

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CASA deposit Term deposit

Total deposits

(YoY growth %)


Asset quality to improve further

GNPA increased from 6.3% in December ―07 to 8.7% in June ―09 owing to theunfavourable macro conditions. However, with a revival in exports and robust GDPgrowth, asset quality has shown an improving trend. GNPA has already declined to4.5% at the end of December ―10 and we expect a further decline to sub-4% levels by2012 as recoveries pick up and slippages continue to trend down.

Credit costs have come down from 0.4% in 2009 to 0.2% in 2010. We are factoring in35bps credit costs in 2011 and 2012. We note that Central Bank of Sri Lanka (CBSL) isplanning to reduce the standard asset provisioning requirement to 0.5% (from 1%currently) by December ―11 in a phased manner (0.1% reduction every quarter). Thus,HNB would not be required to make any incremental provisions on standard assets inthe next few quarters.

Presence in pawning, SME and other

retail segments strengthen pricing

power

GNPA likely to fall below 4% by 2012




65

Fig 130 - Asset quality deteriorated in 2008 and 2009…

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80

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C Y 0 5

C Y 0 6

C Y 0 7

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(%)(%)Gross NPANet NPAProvision coverage ratio (R)


Fig 131 - …but improving now

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(%)(%) Gross NPANet NPAProvision coverage ratio (R)


Return ratios set to improve on operating leverage and lower taxesOperating expenses for HNB (and Sri Lankan banks in general) are higher at ~4.6% of

assets; however, we expect a reduction to 4.2–4.4% in 2011/12 driven by higheroperating leverage. We expect operating expenses to grow at a 13% CAGR over2010–12 as against a 16% increase in net revenues. ROA is likely to improve from 1.6%to 1.8% in 2012 due to a lower effective tax rate. We note that the government of SriLanka has reduced the corporate tax rate from 35% to 28% (effective 1 April 2011) andfinancial VAT from 20% to 12% (effective 1 January 2011).

Fig 132 - ROA and ROE to improve going forward

(%) CY08 CY09 CY10 CY11E CY12E

Net interest income/Assets 5.1 5.4 5.3 5.2 5.2

Non-interest income /Assets 2.4 2.4 2.5 2.5 2.4

Net revenues/Assets 7.4 7.8 7.8 7.7 7.6

Operating expense/Assets 4.3 4.4 4.6 4.4 4.2

Provision/Assets 0.6 0.3 0.1 0.2 0.2

Taxes/Assets 1.4 1.4 1.4 1.2 1.3

ROA 1.2 1.7 1.6 1.8 1.8

Equity/Assets 7.2 7.0 7.5 7.6 7.5

ROAE 16.3 24.1 21.8 23.4 24.5


Capital position comfortable

HNB―s CAR/tier I ratios at the end of December ―10 stood at 12.7%/11% which is muchhigher than the regulatory requirement of 10%/5%. While we note that current

minimum capital requirements could go up in line with recommendations of the BaselIII committee (common equity/tier I/CAR of 7%/8.5%/10.5%), we believe that a strongROE profile would support balance sheet growth. In the medium term, the managementaims to maintain a tier I ratio of 9%. As per our estimates, tier I capital would remainabove 10% by the end of 2012 despite ~20% CAGR in advances over 2010–12.

Opex to trend down to 4.2–4.3% of

assets

Tier I expected to remain above 10% by

end-2012 despite ~20% CAGR in

advances




66

Fig 133 - Adequately capitalised for growth

0

2

4

6

810

12

14

CY04 CY05 CY06 CY07 CY08 CY09 CY10E CY11E CY12E

(%) CAR Tier I


Strong earnings potential to support valuations; initiate with BUY

Sri Lankan banks (and the broader market) have appreciated significantly since May ―09as the return to peace in the country boosted business confidence. At the CMP of LKR253, HNB is trading at 2.7x 2012E BV (after excluding revaluation reserve from networth) and 11.9x 2012E EPS. While valuations are not cheap (for a comparison withIndian banks, please refer to fig 112), we believe that improving fundamentals andstrong earnings growth are likely to drive stock performance.

We expect HNB―s earnings to grow at ~24%+ CAGR over 2010–12 backed by strongbusiness growth, higher operating leverage and a reduction in effective tax rate. ROE islikely to improve to 24%+ by 2012 from 22% in 2010 (ROEs calculated on net worthex-revaluation reserve). Given strong GDP and earnings growth along with improvingROEs, we believe the stock could trade at 3.2x 2012 BV and 14x 2012E EPS, implying a19% upside from the current level. We initiate coverage on HNB with a BUY rating.

Fig 134 - Price to 1-yr fwd BV vs ROE

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M a r - 1

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1

(%)(x) Price/ 1-yr fwd book

12 mth rolling Core RoE (R)


Fig 135 - Price to 1-yr fwd EPS

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18

M a r - 0 5

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(x)Price/ 1-yr fwd EPS


Earnings projected to grow at ~30%+CAGR over 2010–12; BUY




67

Standalone financials

Profit and Loss statement Key ratios

Y/E March (LKR mn) CY09 CY10 CY11E CY12EInterest earned 34,836 30,564 35,882 42,875

Interest expended 20,281 14,777 17,980 21,589

Net interest income 14,555 15,787 17,902 21,286

Non-interest income 6,481 7,541 8,672 9,973

Operating expenses 11,913 13,731 15,367 17,464

Pre-provisioning profits 9,123 9,597 11,207 13,795

Provision & contingencies 710 344 772 927

PBT 8,361 9,112 10,435 12,868

Income tax & VAT 3,807 4,225 4,300 5,303

Net profit 4,553 4,887 6,135 7,566

Y/E March (LKR mn) CY09 CY10 CY11E CY12EValuation ratios (x)

P/E 19.7 18.5 14.7 11.9

P/BV 4.3 3.7 3.2 2.7

P/ABV 5.0 4.1 3.5 2.9

Return Ratios (%)

Spread analysis

Yield on advances 16.6 12.9 12.6 12.6

Yield on investments 12.2 9.6 9.8 9.9

Cost of funds 9.1 6.0 6.2 6.2

NIMs 5.8 5.6 5.5 5.5

Operating ratios

Operating cost to income 56.6 58.9 57.8 55.9

Operating expenses/Avg. assets 4.4 4.6 4.4 4.2

Proportion of CASA deposits 46.1 52.2 50.9 49.8

Non-int Inc/ Total income 30.8 32.3 32.6 31.9

Credit-Deposit ratio 79.3 84.5 84.6 84.7

Investment/Deposit 27.8 27.0 26.6 26.1

Asset quality & Capital

Gross NPA 6.2 4.5 4.0 3.6

Net NPA 2.9 2.0 1.7 1.5

Coverage ratio 52.8 56.6 57.7 58.3

CAR 13.2 12.6 12.2 11.9

Tier I 11.1 11.0 10.8 10.7

Growth ratios

Net interest income 16.1 8.5 13.4 18.9

Non-interest Income 10.2 16.4 15.0 15.0

Pre-provisioning profit 18.6 5.2 16.8 23.1

Net profit 57.8 7.3 25.5 23.3

Assets 9.3 12.7 18.6 18.6

Advances (3.6) 20.2 20.0 20.0

Deposits 12.7 12.9 19.9 19.8

Du pont analysis

Net interest income/assets 5.4 5.3 5.2 5.2

Non interest income/assets 2.4 2.5 2.5 2.4

Operating expense/Assets 4.4 4.6 4.4 4.2

Provisions/Assets 0.3 0.1 0.2 0.2Taxes/Assets 1.4 1.4 1.2 1.3

ROA 1.7 1.7 1.8 1.8

Equity/Assets 7.0 7.5 7.6 7.5

ROAE 24.1 21.8 23.4 24.5

Balance sheet Y/E March (LKR mn) CY09 CY10 CY11E CY12E

Cash in hand & bal with CBSL 16,165 18,373 21,449 25,380

Bal with banks, money at call 22,403 15,682 18,034 20,739

Investments 58,476 64,057 75,722 89,007

Advances 166,812 200,590 240,708 288,850

Fixed assets (net) 8,559 8,762 9,634 10,559

Other assets 9,322 10,020 11,022 12,125

Total assets 281,737 317,484 376,570 446,660

Equity capital 5,084 5,319 5,319 5,319

Reserves & surplus 15,516 18,886 22,978 28,024

Net worth 20,600 24,204 28,296 33,342

Deposits 210,363 237,404 284,665 340,925

CASA deposits 97,021 123,929 144,997 169,646

Term deposits 113,342 113,475 139,668 171,279

Borrowings (+sub-ord bonds) 20,651 27,024 31,078 35,739

Other liabilities & provisions 30,123 28,852 32,532 36,653


Per share data

Y/E March CY09 CY10 CY11E CY12E

Shares outstanding (mn) 354 357 357 357

FDEPS (LKR) 12.9 13.7 17.2 21.2

DPS (LKR) 4.3 4.7 5.7 7.0

Book value (LKR) 58 68 79 93

Adjusted book value (LKR) 50 62 73 86




68

Quarterly trend

Particulars Q4CY10 Q1CY10 Q2CY10 Q3CY11 Q4CY11

Net interest income 3,822 3,661 3,863 3,933 4,330

YoY growth (%) 11.1 6.9 7.1 6.2 13.3

QoQ growth (%) 3.2 (4.2) 5.5 1.8 10.1

Non - interest income 1,333 1,393 2,001 2,014 1,706

Total income 5,155 5,054 5,863 5,947 6,036

Total operating expenses 2,874 3,306 3,400 3,689 3,335

- Employee expenses 1,370 1,472 1,508 1,477 1,526

Pre-provision profit 2,281 1,748 2,463 2,257 2,701

Provisions (339) 46 8 37 (42)

PBT 2,618 1,697 2,451 2,230 2,739

Income taxes 732 1,035 1,218 1,172 799

PAT 1,887 662 1,233 1,058 1,940

YoY growth (%) 151.5 (7.5) 23.2 11.3 2.8QoQ growth (%) 98.5 (64.9) 86.4 (14.2) 83.5

Company profile

HNB is the second largest private sector bank in Sri Lanka with a

strong distribution network and market leadership in the retail and

SME segments. The bank has an extensive distribution network of

187 branches and has a strong presence in rural and semi-urban

areas driven by its emphasis on building a regional presence.

Stock performance

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l Buy




69

Diversified



John Keells Holdings Plc Initiating Coverage 06 April 2011

70

Gaurang Kakkad Varun Lohchab

(91-22) 6766 3470 (91-22) 6766 3458



(%) FY10 FY11E FY12E FY13E

EBITDA margin 5.4 5.2 8.6 12.2

EBIT margin 0.6 0.9 4.4 8.2

Adj PAT margin 8.4 10.3 12.0 13.8

ROE 8.5 11.7 14.9 17.9

ROCE 0.5 0.8 4.7 9.3


(LKR mn) FY10 FY11E FY12E FY13E

Revenue 47,980 58,381 70,397 83,727

Growth (%) 17.0 21.7 20.6 18.9

Adj net income 4,045 6,033 8,450 11,549

Growth (%) 39.2 49.2 40.1 36.7

FDEPS (LKR) 6.5 9.7 13.6 18.6

Growth (%) 41.2 49.2 40.1 36.7

John Keells Holdings Plc

Diversification remains the key

We initiate coverage on John Keells Holdings Plc (JKH) with a BUY rating and aMarch ―12 price target of 340, offering a 15% upside from current levels. JKH isthe largest company by market capitalisation in Sri Lanka and a dominantplayer in the leisure, consumer foods, retail, and transportation businesses. Thecompany will also be able to capitalise on the fast growing financial servicesbusiness through its presence in insurance, banking and capital marketoperations. Further, JKH has interests in property, information technology andplantation services in Sri Lanka. We believe the company is well placed tocapture the resurgence in growth across sectors in the post-war economy.

Strong growth in transportation with stable margins: Transportation remains JKH―slargest profit contributor, accounting for 20% of the group―s revenues but 41% of

profits. We expect the transportation segment to report revenue CAGR of 19% overthe next three years to LKR 16.1bn in FY13. EBIT margins for the segment are at25% and are likely to be maintained over our forecast period.

Strong rebound in leisure business post-war: JKH is amongst the top players inthe hotel industry with ~2,000 hotel rooms (including resorts in the Maldives).The leisure segment has the group―s single largest net asset exposure,encompassing two city hotels that offer more than 40% of the five-star roomcapacity in Colombo, seven resorts spread across prime tourism spots in SriLanka and four resorts in the Maldives. We expect the leisure business to report a25% revenue CAGR over FY10-FY13 as average room rates (ARR) andoccupancy levels improve across assets. EBIT margins for the business are

projected to nearly double from 13% in FY10 to 25% in FY13.Retail expansion to spur growth in consumers business: JKH is a market leaderin the soft drink and ice cream categories in Sri Lanka with its Elephant House brand. It is also a dominant player in the processed meats segment. This apart,the company operates in the retail segment through its Keells Super chain of supermarkets. We expect the foods and retail businesses to report a 10% and25% CAGR in revenues respectively over FY10-FY13.

Property biz to see stable margins; for Financials strong all-round growth: Weexpect a bulk of property business sales to come from the three towers comprising475 apartments at Colombo, while the financial services business is likely to reportstrong growth across insurance, banking and capital market operations.

Initiate with BUY: JKH is currently trading at a P/E of 21.7x and 15.9x its FY12Eand FY13E earnings respectively. We initiate coverage on the stock with a BUYrating and an SOTP-based price target of LKR 340.



CSE BLOOMBERG

JKH.N JKH SL

Company data

Market cap (LKR mn / US$ mn) 183,635/ 1,700

Outstanding equity shares (mn) 620.4

Free float (%) 100




Stock performance


JKH 297 2.5 (0.4) (12.2)

CSE Index 7,022 (0.1) (1.0) (8.6)

Valuation matrix(x) FY10E FY11E FY12E FY13E

P/E @ CMP 45.4 30.4 21.7 15.9

P/E @ Target 52.2 35.0 25.0 18.3

EV/EBITDA @ CMP 76.0 64.6 32.6 19.3

RCML vs consensus

ParameterFY12E FY13E

RCML Cons RCML Cons

Sales (LKR mn) 70,397 NA 83,727 NA

EPS (LKR) 13.6 NA 18.6 NA




71

Investment rationale

Conglomerate with well-diversified presence

JKH is a dominant player in Sri Lanka―s transportation, leisure, consumer foods and retailindustries. The company also has a presence in insurance, banking and capital market

operations, apart from interests in property, information technology and tea/rubberplantations. We believe JKH is in a strong position to capture the resurgence in growthacross sectors in post-war Sri Lanka.

Fig 136 - JKH segmental revenue breakup (FY10)

Consumer

Foods &

Retail

33.0%

Leisure

24.0%

Financial

Services

11.0%

Others

5.9%Property

3.4%

Information

Technology

3.0%

Transportation

19.8%


Fig 137 - JKH segmental EBIT breakup (FY10)

Transportati

on

30.2%

Others

29.8%

Leisure

18.8%

Financial

Services

10.7%

Consumer

Foods &

Retail

5.3%

Property

4.9%

Information

Technology

0.2%


Fig 138 - JKH segmental revenue breakup (FY13)

Consumer

Foods &

Retail

31.9%

Leisure

26.7%

Financial

Services

12.3%

Others4.5%

Property3.1%

Information

Technology

2.3%

Transportation

19.2%


Fig 139 - JKH segmental EBIT breakup (FY13)

Information

Technology

0.6%

Property4.0%

Others5.4%

Financial

Services

12.9%

Consumer

Foods &

Retail

16.7%

Leisure

35.1%

Transportation

25.2%


Strong growth visibility in transportation JKH―s mainstay is its transportation business which accounts for 20% of the group―srevenues but 41% of the profits (PAT of LKR 2.3bn in FY10, up 38% YoY). JKH holds a42% stake in South Asia Gateway Terminals (SAGT) which is the strongest growth driverfor the business. SAGT has a capacity of 2mn TEU and reported a throughput of 1.88mnTEU in FY10, a growth of 7%. The expected build-up in infrastructure projects and tradevolumes in Sri Lanka, with accelerated development in the formerly strife-torn northernand eastern regions, augurs well for growth in the transportation business.

JKH remains the largest cargo and

logistics service provider in Sri Lanka




72

Fig 140 - SAGT monthly TEU―s trend

0

20,00040,000

60,000

80,000100,000120,000

140,000

160,000180,000

200,000

J a n - 0 9

M a r - 0 9

M a y - 0 9

J u l - 0 9

S e p - 0 9

N o v - 0 9

J a n - 1 0

M a r - 1 0

M a y - 1 0

J u l - 1 0

(TEU's)

Source: Company

The company plans to bid for a new terminal at the Colombo South Harbor, which

could lead to a capex requirement of US$ 350mn over the next 4 –5 years, if successful. JKH also has joint ventures with Deutsche Post for DHL Air Express and A P Moller forMaersk Lanka. Other operations include freight forwarding, warehousing and supplychain management.

We expect the transportation segment to report a 19% CAGR in revenue over the nextthree years to LKR 16.1bn in FY13. Segmental EBIT margins are at 25% and will likelybe maintained over our forecast period.

Fig 141 - Transportation segment sales trend

02,0004,0006,0008,000

10,00012,00014,00016,000

18,000

F Y 0 3

F Y 0 4

F Y 0 5

F Y 0 6

F Y 0 7

F Y 0 8

F Y 0 9

F Y 1 0

F Y 1 1 E

F Y 1 2 E

F Y 1 3 E

(30)(20)(10)0102030405060

70

Sales Sales growth (R)(LKR mn) (%)


Fig 142 - Transportation segment EBIT trend

0500

1,0001,5002,0002,5003,0003,5004,0004,500

F Y 0 3

F Y 0 4

F Y 0 5

F Y 0 6

F Y 0 7

F Y 0 8

F Y 0 9

F Y 1 0

F Y 1 1 E

F Y 1 2 E

F Y 1 3 E

0%

500%

1000%

1500%

2000%

2500%

3000%

3500%

EBIT EBIT margin (R)(LKRmn)


Conflict resolution supporting strong recovery in leisure business JKH is amongst the top players in the Sri Lankan hotel industry with ~2,000 hotel rooms(including resorts in the Maldives). The company―s hotel business, which was makinglosses during the long-running civil war, is now likely to be a key beneficiary of thegrowing influx of tourists into the country as well as the government―s thrust on tourismas a key growth driver for the economy. Tourist arrivals into Sri Lanka rose 22% in FY10following the end of civil war in May ―09 (and subsequent removal of internationaltravel advisories).

Strong revival in tourist traffic with the

return to peace




73

Fig 143 - Monthly tourist arrivals

0

10,000

20,000

30,000

40,000

50,00060,000

70,000

80,000

90,000

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

2006 2007 2008 2009 2010

Source: Company

Fig 144 - Tourist arrivals to the region

0

5,000

10,000

15,000

20,000

25,000

India Indonesia Vietnam Sri Lanka

1990 2008('000)


Fig 145 - Tourist arrivals to Sri Lanka (1982 – 2010)

0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

1982 1986 1990 1994 1998 2002 2006 2010 Source: Company, RCML Research

JKH operates under two brands, Cinnamon Hotels and Resorts, and Chaaya Hotels and

Resorts. The leisure segment has the group―s single largest net asset exposure,encompassing two city hotels that offer more than 40% of the five-star room capacity inColombo, seven resorts spread across prime tourism spots in Sri Lanka, and four resortsin the Maldives.

Fig 146 - Cinnamon Grand operational performance

0

20

40

60

80

100

M a y - 0 9

J u n - 0 9

J u l - 0 9

A u g - 0 9

S e p - 0 9

O c t - 0 9

N o v - 0 9

D e c - 0 9

J a n - 1 0

F e b - 1 0

M a r - 1 0

0

20

40

60

80

100

Average room Rate Occupancy (R)(US$) (%)


Fig 147 - Cinnamon Lakeside operational performance

0

1020

3040

50

607080

S e p - 0 9

O c t - 0 9

N o v - 0 9

D e c - 0 9

J a n - 1 0

F e b - 1 0

M a r - 1 0

0

20

40

60

80

100

Average room Rate Occupancy (R)(US$) (%)


JKH operates 13 hotels and resorts in Sri

Lanka and the Maldives with ~2000

rooms




74

Fig 148 - JKH Hotels operational details

Colombo Hotels

Rooms (No) 850 850 850 850

Increase (%) 0.0% 0.0% 0.0%

Room Revenues LKR mn 1,885 2,356 3,141 3,770

Occupancy rate(%) 75.0% 75.0% 80.0% 80.0%

ARR (LKR) 8,100 10,125 12,656 15,188

Realisation Increase (%) 10.3% 25.0% 25.0% 20.0%

Other Revenues 1,335 1,602 1,923 2,307

Growth% 20% 20% 20%

Country side resorts

Rooms (No) 800 800 1,000 1,200

Increase (%) 0.0% 25.0% 20.0%

Room Revenues LKR mn 946 1,537 2,255 2,976

Occupancy rate(%) 75.0% 75.0% 80.0% 80.0%

ARR (LKR) 4,320 7,020 7,722 8,494Realisation Increase (%) 2.6% 0.0% 10.0% 10.0%

Other Revenues 3,079 3,695 4,434 5,320

Growth% 20% 20% 20%

Maldives Hotels

Rooms (No) 340 340 340 340

Increase (%) 0.0% 0.0% 0.0%

Room Revenues (LKR mn) 402 653 719 791

Occupancy rate(%) 75.0% 75.0% 75.0% 75.0%

ARR (LKR) 4,320 7,020 7,722 8,494

Realisation Increase (%) 0.0% 10.0% 10.0%

Other Revenues 1,323 1,587 1,905 2,286

Growth% 20% 20% 20%

Destination Management Revenues 2,530 3,162 3,953 4,941

Growth% 25% 25% 25%


In the resorts segment, JKH has an inventory of 800 rooms across the countrysideoutside Colombo, which have seen a spike in ARR in the second half of FY10. JKH―sMaldivian resorts have a total of 340 rooms. While the Maldives saw a drop in touristarrivals from the traditional European nations in FY10, these have been partly offset byimproved arrivals from China and other emerging destinations like Japan and Russia.

JKH―s Maldivian resorts thus witnessed a recovery from the fourth quarter of FY10 whichhas continued in FY11 as well.

JKH―s hotels business is complemented by its destination management services in SriLanka, the Maldives and India, where it has a 30% market share. Tour operator partnersinclude global players such as Thomas Cook, Kyoni, Hotel Plan and Virgin Holidays.This business reported a 45% growth in the number of passengers handled in FY10. Weexpect a 25% CAGR in revenues from destination management over FY10-FY13.

Growth in destination management coupled with higher hotel ARRs and occupancy ratesis expected to drive a 25% CAGR in the leisure business over FY10-FY13. EBIT margins forthe business are projected to nearly double from 13% in FY10 to 25% in FY13 as theimproved ARRs and occupancy rates flow largely to the bottomline. The company is

unlikely to see any significant capex in its city hotels over the next 3–4 years, though itdoes plan to expand its resorts, with a likely addition of 200 rooms per year.

Hotel operations complemented by

destination management in Sri Lanka,

Maldives and India




75

Fig 149 - Leisure segment sales trend

0

5,000

10,000

15,000

20,000

25,000

F Y 0 3

F Y 0 4

F Y 0 5

F Y 0 6

F Y 0 7

F Y 0 8

F Y 0 9

F Y 1 0

F Y 1 1 E

F Y 1 2 E

F Y 1 3 E

(20)

0

20

40

60

80

100

120

140



Fig 150 - Leisure segment EBIT trend

0

1,000

2,000

3,000

4,000

5,000

6,000

F Y 0 3

F Y 0 4

F Y 0 5

F Y 0 6

F Y 0 7

F Y 0 8

F Y 0 9

F Y 1 0

F Y 1 1 E

F Y 1 2 E

F Y 1 3 E

0

5

10

15

20

25

30

EBIT EBIT margin (R)(LKR mn) (%)


Retail to augment consumer business growth JKH―s consumer foods business, which includes soft drinks, ice creams, processed meats andretailing, has witnessed a recovery in FY11 after significant downtrading in premium brands

in the aftermath of the global recession. Incremental growth in the business is likely to comefrom the expanded consumer base in the northern and eastern regions of the country.

JKH is a leader in carbonated soft drinks (40–45% market share) and ice creams (65%market share) in Sri Lanka with its Elephant brand. The company is also a market leaderin the processed meats segment with a 75% share, under the Keells and Krest brands. Abulk of its revenues in the consumer foods segment is, however, derived from icecreams and soft drinks. JKH has a strong island-wide distributor network acrosssegments. We expect the consumer foods business to report a revenue CAGR of 10%over FY10-FY13 from LKR 6.7bn to LKR 8.9bn. EBIT margins currently stand at 6–7%which are likely to rise to 10–12% by FY13.

JKH also operates in the retail segment through the Keells Super chain of supermarkets. It

has 40 stores with an average area of 6,000sq ft and average sales of LKR 37,916/sq ft(FY10). We expect the company to add 10 stores per year and clock an average salesCAGR of 3% (per sq ft) over FY10-FY13. On the back of this robust expansion, weestimate a 25% CAGR in revenues from the retail business, with revenues rising fromLKR 9.1bn in FY10 to LKR 17.7bn in FY13. Private labels (currently 5% of retailturnover) are likely to contribute a higher share of revenues as the company hasintroduced several new private label products over the past two years. We expect animprovement in retail business EBIT margins from the current flat margins to 2–3% overFY13. The company is likely to incur capex of US$ 20mn in this business over the nexttwo years.

Fig 151 - Consumer Foods & Retail segment sales trend

0

5,000

10,000

15,000

20,000

25,000

30,000

F Y 0 3

F Y 0 4

F Y 0 5

F Y 0 6

F Y 0 7

F Y 0 8

F Y 0 9

F Y 1 0

F Y 1 1 E

F Y 1 2 E

F Y 1 3 E

(5)

0

5

10

15

20

25

30Sales Sales growth (R)(LKR mn) (%)


Fig 152 - Consumer Foods & Retail segment EBIT trend

0

500

1,000

1,500

2,000

2,500

3,000

F Y 0 3

F Y 0 4

F Y 0 5

F Y 0 6

F Y 0 7

F Y 0 8

F Y 0 9

F Y 1 0

F Y 1 1 E

F Y 1 2 E

F Y 1 3 E

0

2

4

6

8

10

12EBIT EBIT margin (R)(LKR mn) (%)


Market leader in soft drinks, ice creams

and processed meats

Retail chain Keells Super set for rapid

growth




76

Fig 153 - Retail store count and sales per sqft

4050

60

70

37,916

38,674

40,221

42,233

0

10

20

30

40

50

60

70

80

FY10 FY11E FY12E FY13E

35,000

36,000

37,000

38,000

39,000

40,000

41,000

42,000

43,000Reta il outle ts Sales pe r sqft (R) (LKR)

Source: Company

Property business to see stable margins

Over FY10 and FY11, 90% of the property business sales accrued from a singleresidential project called “Emperor Apartments‖. This project has now been fully sold bythe company, at an average rate of US$ 230/sq ft. We expect the next leg of growth tocome from the construction of a new apartment complex with three towers and 475apartments at Union Place, Colombo. Construction is likely to begin in April–May thisyear and will continue for 2–3 years. About 70% of the apartments have been pre-soldat a price of ~US$ 120/sq ft. We expect the property business to report 16.5% salesCAGR over FY10-FY13, with EBIT margins likely to remain stable at 25%. The companyhas invested US$ 10mn as land cost for the new apartment complex and expects toincur US$ 50mn as construction cost.

Going forward the end of the conflict presents many opportunities for the Propertybusiness of the group. Expectations of relatively low interest rates over the short tomedium term and increased willingness of banks to lend money is expected to spurgrowth in the property prices. Increased economic activity and the return of expatriateSri Lankans is likely to boost the rental market. This is likely to filter through to demandfor apartments as an increase in rentals is considered as a primary driver of real estateprices. The group will use its land bank to cater to the development opportunitiesavailable. The JKH group is in the process of identifying and evaluating opportunities toexpand its land bank both within and outside Colombo. JKH currently has 30 acres of prime land in Colombo with an estimated market value of US$ 200mn.

Fig 154 - Property segment sales trend

0

500

1,000

1,500

2,000

2,500

3,000

F Y 0 5

F Y 0 6

F Y 0 7

F Y 0 8

F Y 0 9

F Y 1 0

F Y 1 1 E

F Y 1 2 E

F Y 1 3 E

(100)(50)050100150200250300350



Fig 155 - Property segment EBIT trend

0

200

400

600

800

1,000

F Y 0 5

F Y 0 6

F Y 0 7

F Y 0 8

F Y 0 9

F Y 1 0

F Y 1 1 E

F Y 1 2 E

F Y 1 3 E

0

10

20

30

40

50

6070

EBIT EBIT margin (R)(LKR mn) (%)


Property business EBIT margins likely to

remain healthy at 25%




78

Valuation

SOTP-based price target of LKR 340

Considering the JKH group―s diversified presence, we have valued each of thebusinesses separately to fully capture their growth potential. JKH is currently trading at aP/E of 21.7x/15.9x FY12E/FY13E earnings. We initiate coverage on the stock with aMarch ―12 target price of LKR 340, providing a 15% upside from current levels.

Fig 158 - SOTP valuation

Basis BusinessFY13

(LKR mn)EPS

ValuationMethodology

Multiple(x)

Price

EPS

Transportation 3,826 6.2 P/E 15.0 92.5

Consumer Foods & retail 1,253 2.0 P/E 20.0 40.4

Leisure 4,512 7.3 P/E 20.0 145.5

Property 556 0.9 P/E 15.0 13.4

Financial Services 1,341 2.2 P/E 15.0 32.4

Sales Information Technology 1,915 3.1 P/Sales 1.0 3.1

Others 3,755 6.1 P/Sales 1.0 6.1Cash per share 4,355 7.0 7.0

Target Price (LKR) 340

CMP (LKR) 296

Upside / (Downside) (%) 15%

Rating BUY


Initiate with BUY rating and March ―12

price target of LKR 340




79

Key concerns

Significant dependence on the leisure segment JKH―s leisure business accounts for ~40% of capital employed, 25% of the group―srevenue and 30% of EBIT. Thus, the group―s performance is highly dependent on

tourism in the country.

Illiquid stock marketDuring the civil war, Sri Lanka―s stock market was highly illiquid with stagnatin gvolumes and fund flows. Only in the past couple of years, following resolution of theconflict, has liquidity emerged and investor interest increased. Any withdrawal of flowsremains a key risk for investors in such a market.

Company profile

Conglomerate with diverse business interests in Sri Lanka

JKH is Sri Lanka―s largest listed company with business interests in transportation,leisure, consumer foods & retail, financial services, information technology andplantation, amongst others. The company started as a produce and exchange broker inthe 1870s and has constantly reinvented itself to cater to the growth opportunities in theSri Lankan market.

Entire shareholding free float in nature JKH is a professionally run company and has no promoter group holding. Its entireshareholding is free float with the largest investor being an individual, Mr. S E Captain,who holds a 14.9% stake. A majority of the board of directors comprise independentnon-executive directors.




80

Consolidated financials

Profit and Loss statement Balance sheet

Y/E March (LKR mn) FY10 FY11E FY12E FY13ERevenues 47,980 58,381 70,397 83,727

Growth (%) 17.0 21.7 20.6 18.9

EBITDA 2,586 3,041 6,033 10,179

Growth (%) (10.4) 17.6 98.4 68.7

Depreciation & amortisation 2,298 2,515 2,935 3,313

EBIT 287 525 3,097 6,866

Growth (%) (63.7) 83.0 489.5 121.7

Interest 1,370 1,481 1,777 2,023

Other income 5,021 5,128 5,008 4,998

EBT 3,982 4,172 6,329 9,841

Income taxes 985 1,053 1,434 2,380

Effective tax rate (%) 24.7 25.2 22.6 24.2

Extraordinary items - - - -

Min into / inc from associates 2,205 2,914 3,555 4,088

Reported net income 5,201 6,033 8,450 11,549

Adjustments - - - -

Adjusted net income 4,045 6,033 8,450 11,549

Growth (%) 39.2 49.2 40.1 36.7

Shares outstanding (mn) 620.4 620.4 620.4 620.4

FDEPS (LKR) (adj) 6.5 9.7 13.6 18.6

Growth (%) 41.2 49.2 40.1 36.7

DPS (LKR) 3.0 3.0 3.0 3.0

Y/E March (LKR mn) FY10 FY11E FY12E FY13ECash and cash eq 3,013 1,196 1,812 3,424

Accounts receivable 9,934 12,156 14,465 17,204

Inventories 2,295 2,814 3,520 4,783

Other current assets 23 23 23 23

Investments 44,365 42,365 39,365 39,365

Gross fixed assets 34,565 40,563 47,760 54,238

Net fixed assets 34,565 40,563 47,760 54,238

CWIP 4,577 4,577 4,577 4,577

Intangible assets 2,556 2,556 2,556 2,556

Deferred tax assets, net - - - -

Other assets 1,907 2,335 2,816 3,349

Total assets 98,658 104,009 112,317 124,942

Accounts payable 16,699 19,194 22,180 25,233

Other current liabilities 6,430 6,430 6,430 6,430

Provisions 12,946 12,946 12,946 12,946

Debt funds 10,707 9,707 8,757 8,957

Other liabilities 2,044 2,044 2,044 2,044

Equity capital 620 620 620 620

Reserves & surplus 49,212 53,068 59,340 68,711

Shareholder's funds 49,832 53,688 59,961 69,332


BVPS (LKR) 80.3 86.5 96.7 111.8

Cash flow statement Financial ratios Y/E March (LKR mn) FY10 FY11E FY12E FY13E

Net income + Depreciation 5,312 3,996 4,712 5,336

Non-cash adjustments 1,238 1,721 3,471 6,095

Changes in working capital 3,245 1,325 2,491 (1,482)

Cash flow from operations 9,794 7,042 10,674 9,948

Capital expenditure (1,597) (5,998) (7,197) (6,478)

Change in investments 174 - - -

Other investing cash flow (671) - - -

Cash flow from investing (2,094) (5,998) (7,197) (6,478)

Issue of equity 797 - - -

Issue/repay debt - - - -

Dividends paid (1,224) (1,861) (1,861) (1,861)

Other financing cash flow (209) (1,000) (999) 2

Change in cash & cash eq 7,064 (1,817) 616 1,612

Closing cash & cash eq 3,013 1,196 1,812 3,424

Y/E March FY10 FY11E FY12E FY13E

Profitability & Return ratios (%)

EBITDA margin 5.4 5.2 8.6 12.2

EBIT margin 0.6 0.9 4.4 8.2

Net profit margin 8.4 10.3 12.0 13.8

ROE 8.5 11.7 14.9 17.9

ROCE 0.5 0.8 4.7 9.3

Working Capital & Liquidity ratios

Receivables (days) 60 59 57 58

Inventory (days) 22 21 22 26

Payables (days) 29 25 25 26

Current ratio (x) 2.1 1.7 1.5 1.6

Quick ratio (x) 1.2 0.8 0.7 0.7

Turnover & Leverage ratios (x)

Gross asset turnover 1.4 1.6 1.6 1.6

Total asset turnover 0.5 0.6 0.7 0.7

Interest coverage ratio 0.2 0.4 1.7 3.4

Adjusted debt/equity 0.2 0.2 0.1 0.1

Valuation ratios (x)

EV/Sales 4.1 3.4 2.8 2.3

EV/EBITDA 76.0 64.6 32.6 19.3

P/E 45.4 30.4 21.7 15.9

P/BV 3.7 3.4 3.1 2.6




81

Quarterly trend

Particulars Q3FY10 Q4FY10 Q1FY11 Q2FY11 Q3FY11

Revenue (LKR mn) 12,754 13,925 12,919 13,967 15,616

YoY growth (%) 37.03 40.65 28.33 24.33 22.44

QoQ growth (%) 13.53 9.18 (7.22) 8.11 11.80

EBITDA (LKR mn) 1,753 3,418 1,406 3,502 2,635

EBITDA margin (%) 13.74 24.55 10.88 25.07 16.87

Adj net income (LKR mn) 1,242 3,012 1,077 3,038 2,027

YoY growth (%) 57 35 56 401 63

QoQ growth (%) 105 143 (64) 182 (33)

Company profile

John Keells Holdings PLC is a diversified business operating in Sri

Lanka. The group's businesses include food and beverage,

transportation, tea and rubber plantations, tour operations, hotel

ownership and operations, share broking, investment banking,

computer hardware and software services, breeding of fresh water

fish, domestic and international trade, and property development.

Stock performance

0

50

100

150

200

250

300

350





l Buy




82

References

Mahinda Chintana Vision 2010, Department of National Planning, Govt. Of Sri Lanka

Sri Lanka – Millennium Development Goals, United Nations DevelopmentProgramme (UNDP)

Sri Lanka Labour Force Survey, Annual Report – 2009, Department of Census andStatistics

Roadmap – Monetary and Financial Sector Policies for 2011 and Beyond, CentralBank of Sri Lanka

Sri Lanka: Improving the Rural and Urban Investment Climate, ADB/World Bank

Annual Statistical Report (2009), Sri Lanka Tourism Development Authority

Budget Speech 2011, Ministry of Finance and Planning, Govt. Of Sri Lanka

Investment Policy Review – Sri Lanka (2004), United Nations Conference on Tradeand Development

Telecommunications Regulatory Commission of Sri Lanka, www.trc.gov.lk



Sri Lanka Diary1 January 2011

Dehiwala–Mount Lavinia: 30km from ColomboA group of us from the Religare equity research team

rang in the New Year at Sri Lanka―s capital city of

Colombo, where celebrations were

joyous as locals and tourists

alike ushered in the nation―s

second year of peace after

decades of strife. As the

New Year dawned, it was

time for us to leave the

celebrations behind and

head into the hinterland for a

taste of life in Sri Lanka―s rural

and semi-urban pockets. We drove

down to Dehiwala and Mount Lavinia which are

located just south of Colombo.

Dehiwala is home to Sri Lanka―s National Zoological

Gardens which remain one of Asia―s largest. The zoo

houses an exciting variety of wildlife and

we were able to spot an exotic

white tiger, several lions,

double-horned camels, a

stately giraffe, the elusive

hippopotamus and an

assortment of primates. But

the highlight of our visit was

an ‘Elephant Show― that ran to a

full house of 500 enthusiastic

visitors and saw the pachyderms kicking

off the evening with a lively game of football and

closing the show with some remarkable ‘disco― dance.

MOUNT LAVINIA

From Dehiwala, we started for Mount Lavinia, a popular seaside tourist spot. Mt. Lavinia has a breathtaking beachfront

and boasts of modern facilities blended with a magical touch of antiquity. The seafront is studded with attractive

colonial villas, the most popular being The Mount Lavinia Hotel which is a symbol of the legendary love of the British

Governor General of Ceylon, Sir Thomas Maitland, and the beautiful mestizo dancer, Lovina.

2 January 2011

Pinnawala Elephant Orphanage–Kandy: 120km from Colombo

On the next leg of our journey, we headed for Kandy,

the capital of the Central Province of Sri Lanka. En

route, we stopped at Pinnawala Elephant

Orphanage (90km from Colombo)—

among the country―s most popular

tourist destinations. Here,

elephant herds range about in asetting that―s as close to nature

as possible even as they are

closely monitored by mahouts

and volunteers. In a thrilling

experience, we were allowed to

feed some of the (not so little) cubs!

We headed for Kandy around noon. The Colombo–

Kandy road was a pleasure to travel on and gave us a

chance to admire Sri Lanka―s famed scenic beauty—

endless rubber plantations, emerald green paddy fields

and gently rolling hills. At steady intervals, we found

small shops that sold souvenirs of cane and

coconut fibre. The shops actually

fronted the artisans― homes.

These craftsmen surprised us

with their awareness of domestic politics and the

economy as well as their

keen interest in educating

their children. Most of the

youngsters help create the

souvenirs but also attend school.

After a few pit stops at these craft stores, we

drove on but not without a selection of the local

paintings and coconut elephant ‘sculptures―.



TEMPLE OF TOOTH RELIC, KANDY

We arrived at Kandy (1,640ft above sea level) at around

3pm. Kandy is known for the Buddhist Temple of Tooth

Relic, a UNSECO world heritage site. It was raining when

we reached The Temple of Tooth, shrouding the entiresetting in a beautiful mist. The temple was originally part of

the Royal Palace complex of the Kandyan Kingdom and is

now one of the holiest places of worship and pilgrimage for

Buddhists around the world.

Kandy―s economy is second only to that of Colombo. The

city houses branch offices of major banks and corporations, with a vibrant retail economy offering prominent brands

of textiles, FMCG, furniture, tea and jewellery. Government offices and research centres also dot the landscape. Of

course, Kandy―s markets cater to buyers not only of commercial goods but also of cultural artifacts.

GIRAGAMA TEA ESTATE AT PILIMATALAWA

Our last excursion was to the Giragama Tea Estate at

Pilimatalawala. Sri Lanka is the world―s fourth largest

producer of tea, with the industry being one of the

country―s main sources of foreign exchange and a

significant source of income for labourers. We learnt that

Ceylon tea is divided into three groups: high or upcountry

(Udarata), mid-country (Medarata), and low-country

(Pahatharata), based on where the crop is grown. Tea

produced in Sri Lanka carries the ‘Lion Logo― (as doesLion Beer, a favourite among the Lankan population).

Friendly employees showed us around the tea plantation

and explained the various stages involved in bringing the

finest quality brew to customers. We left the estate carrying with us the delicious aroma (and several packets) of Sri

Lankan tea along with memories of a most delightful journey.



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Religare Capital Markets – India Research

Suhas Harinarayanan

(91-22) 6766 [email protected]

Manoj Singla

(91-22) 6766 [email protected]

Co-Heads India Equity Product, Religare Capital Markets

sri lanka - leading from the front

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