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ACUITY STOCKBROKERS RESEARCH | SRI LANKA EQUITIES

Vallibel One

Diversified

Vallibel One: BUY

Source: Getty Images

Research Analyst
Samalka Athuraliya |

(+94) 112 206 254


samalka@acuitystockbrokers.com

ACUITY STOCKBROKERS RESEARCH | SRI LANKA EQUITIES

Investment Summary

Vallibel One

Vallibel One PLC: VONE.N/VONE SL Equity

VALLIBEL ONE PLC


Target Price

Rs. 28.5

Current Trading Price (Rs.)

Rs. 23.0

Bloomberg

VONE SL Equity

Market Capitalisation (Rs. Bn)

25.0

Market Capitalisation (USD. Mn)

178.8

Issued Quantity (Mn)

1,086.6

Year to Date Turnover (Rs. Mn)

764.4

Current Trading Range (Rs.)

23.0-23.5

31.7

13.3

All Time High (Rs.)


All Time Low (Rs.)

31 st March

Financial Year Ended


Key Financials
Period

FY 2013/14

FY 2014/15 FY 2015/16E FY 2016/17E

(LKR Mn except per share data)


Revenue

48,331

43,450

49,753

54,953

Revenue Growth (Y-o-Y)


Gross Profit

46%
14,655

-10%
17,618

15%
20,857

10%
23,284

GP Growth (Y-o-Y)

42%

20%

18%

12%

Profit Before Tax (PBT)

3,832

7,349

9,981

10,975

PBT Growth (Y-o-Y)


Net Profit

-6%
1,574

92%
2,891

36%
4,275

10%
4,712

Net Profit Growth (Y-o-Y)


EPS2

-27%

84%

48%

10%

1.45

2.66

3.93

4.34

NAVPS2

29.90

31.97

35.50

39.34

0.40

0.50

0.50

DPS

0.70

Note: 1. Adjusted for rights, splits, bonuses


2. Calculated on latest issued share capital

Sources: Company Annual Reports, Acuity Estimates


Price as at: 16/09/15

Our positive view on VONE is due to strong growth


prospects in both its Tiles & Sanitary Ware, and Banks &
Finance segments, while a complete recovery in Delmege
and a turnaround in the Plantations sector should further
boost value. Given the uncertainty behind VONEs Greener
Water project, and the lack of clarity on the Super Gains
tax though, we have refrained from incorporating the
impact of these in our valuation. VONE yields a total return
of 26.0% at our Target Price of LKR 28.5.

28

6000

21

4500

14

3000

1500

0
Jul-11

VONE

September 2015

Jul-14

Bullish on Growth Prospects for LFIN | We remain


positive on LFINs growth prospects in the mortgage
lending market and its traditional vehicle leasing segment.
LFIN should, in our view, benefit from offering customized
products to the countrys under-served customer base. We
expect the mortgage market to benefit from higher housing
demand, combined with the growth in debt-financing for
housing. We also expect continued positive performance in
LFINs traditional leasing segment, supported by higher
demand for three-wheelers and small cars. Our bullish
view is further strengthened by LFINs better-than-peer
diversification of its loan book, although we note that the
likely increase in interest rates in H215 and LFINs high
gold exposure remain downside risks. As such, we expect
LFINs loan book growth and above-industry-average
margins to support VONEs performance over our forecast
period.
BUY Rating on VONE | Backed by the positive outlook for
RCL & LFIN combined with the likely continuation of the
recovery at Delmege, we derive a Target Price of LKR 28.5
for VONE based on our SOTP valuation. We believe the
stock yields an attractive price appreciation of 23.7%,
which with a historical average dividend yield of 2.2%
translates to a total return of 26.0%.

Mr. K D D Perera

7500

Jul-15

ASPI Level

Price Rs.

35

Jul-13

Construction Industry and Export Markets to Drive


Topline Growth at RCL | We expect robust revenue
growth at RCL in the next 2 years, fuelled by growth in
construction coupled with expansion in its export markets.
Despite a weaker Q1, we believe construction activity will
pick up in H215, supported by a stable political
environment leading to improved consumption and
investment. Although an interest rate hike is likely in 2015,
we believe rates should remain broadly stable, and as such
should not hinder RCLs performance. Additionally, we
expect RCL to continue capitalizing on its strong market
position in the domestic tiles industry, although a potential
removal of CESS on Tile/Ceramic imports could dilute its
market share. RCLs revenue growth is also expected to
stem from higher demand for tiles in its export markets.
Lower fuel/electricity costs and RCLs cost management
efforts are thus expected to accompany VONEs topline
growth and help improve its EBIT margins to ~20.0-21.0%.

Top 10 Shareholders (as at 30th June 2015)

Four-Year Performance: VONE vs. ASPI

Jul-12

Diversified

63.48%

Employees Provident Fund

9.35%

Vallibel Investments (Private) Limited


Vallibel Leisure (Private) Limited

8.46%
8.46%

Bank of Ceylon A/c Ceybank Unit Trust

0.62%

Mercantile Investment and Finance PLC

0.48%

National Savings Bank


Mes Mellon Bank N. A. - UPS group Trust

0.30%
0.26%

Rosewood (Private) Limited - Account No 1

0.24%

Merill J Fernando & Sons (Private) Limited

0.21%

ASPI

Page 2

ACUITY STOCKBROKERS RESEARCH | SRI LANKA EQUITIES


Vallibel One

Table 0f Contents

Vallibel One
Investment Overview

| 4

Segment Review
Tiles and Sanitary Ware to Grow on Favorable Macro Factors

| 6

Banks & Finance to Benefit from Strong Loan Book Growth

| 11

Other: VONE Remains a Highly Diversified Conglomerate

| 16

Valuation
RCL and LFIN to drive VONEs Equity Value

Summary Financials

September 2015

Diversified

| 18

| 20

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ACUITY STOCKBROKERS RESEARCH | SRI LANKA EQUITIES


Vallibel One

Diversified

Investment Overview
RCL and LFIN to Determine VONEs Performance

LKR Mn

VONEs EBIT Margins Improve ~600bps to 17.37% in


FY 2014/15
50,000

50%

40,000

40%

30,000

30%

20,000

20%

10,000

10%

fuel and electricity costs.


Tiles & Sanitary Ware Supported by Cost Efficiencies
and Lower Fuel Costs
8,000
LKR Mn

The 6th largest Diversified company by market


capitalization, Vallibel Ones (VONE) business operations
span the countrys Construction, Banks & Finance,
Plantations and Healthcare & FMCG industries. While the
majority of total revenue is generated through the Groups
growth segments such as Tiles, Sanitary Ware and Banks &
Finance, VONE has also diversified into industries such as
Plantation (4.98% of total revenue), and Consumer,
Lifestyle & Healthcare (13.62%). We believe that due to
industry dynamics in Construction and Financial Services,
Royal Ceramics PLC (RCL) and L B Finance (LFIN) will
continue to remain the dominant contributors to the
Groups consolidated topline.

6,000
4,000
2,000

0
2012

2013

Gross Profit

2014

2015

2016E

EBIT
Source: VONE Annual Reports, Acuity Estimates

We thus estimate the Tiles and Sanitary Ware segments


reporting gross margins of 41.03% in FY 2015/16E
(39.71% in FY 2014/15), while EBIT margins should
improve to 21.19% in FY 2015/16E (cf. 20.10% in
FY 2014/15). Following the rationalization of its dealer
network meanwhile, we expect RCLs EBIT margins to
stabilize at ~22.0%, thereafter.

0%
2011

2012
Revenue

2013

2014

2015

EBIT Margin
Source: VONE Annual Reports

We believe strong revenue growth and stable margins will


drive RCLs value in the short term. We forecast RCL
revenue growing at a 3-year CAGR of 14.73%
(LKR 21.30Bn in FY 2016/17E) fuelled by growth in the
construction industry and expansion in RCLs export
markets. Based on our estimate for a sustainable GDP
growth rate of 6.80% in 2016-17E, we expect construction
activity in the country to be boosted by: (1) prospects in
the formerly war-stricken North/East; (2) increasing
demand for housing to cater to a rising population over the
next decade; and (3) the disparity between strong
economic growth and weak per capita tile consumption in
Sri Lanka. Furthermore, while we concede that an increase
in interest rates is likely in H215, we see rates remaining
broadly stable and believe that RCL should benefit from
this stability as it should help spur personal housing
construction. In addition to growth in Construction
activity, we also expect topline growth at RCL to stem from
its strong market position in the domestic industry and
expansion in its export markets.

VONEs medium-term prospects are also likely to be driven


by LFINs growth potential in the Mortgage Lending and
Vehicle Leasing segments. Despite LFINs heavy Gold loan
book, high competition from banks in the leasing segment
and the possible interest rate hike in H215, we remain
positive on the companys prospects due to its increased
focus on untapped markets such as mortgage lending.
Through mortgage lending, LFIN targets a thus far overlooked customer base due to their high risk profile. We
believe growth prospects in the mortgage lending market
are high due to: (1) higher demand for housing on the back
of rising population; and (2) significant growth in personal
housing loans in the recent past (loans disbursed for
housing has grown at a compounded growth rate of 4.66%
per quarter from March 2013-March 2015). Our positive
outlook on LFIN is further strengthened by the fact that
the company continues to focus on high interest earning
assets such as Pawning, Lease financing, Housing and SME
lending.
Lease Financing and Housing are Among the High
Interest Earning Assets
LFIN's Focus is on the High Interest Earning Assets

Pawning

Despite our bullish view on RCLs prospects, we remain


slightly cautious on the back of the possible removal of
CESS on Tile imports, which could change industry
dynamics. Nevertheless, we remain confident that RCLs
margins will improve over the next two years due to
strong revenue growth, good cost containment and low

Lease Finance
Residential Housing
SME Lending
0%

3%
6%
9%
Average Interest Rates

12%

15%
Source: CBSL

September 2015

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ACUITY STOCKBROKERS RESEARCH | SRI LANKA EQUITIES


Vallibel One

Diversified

Investment Overview
VONE Rated a BUY on SOTP Valuation
Moreover, we also expect LFINs loan book growth to be
supported by: (1) growth in three-wheeler leasing due to
lower fuel prices; (2) increase in small car sales due to
changes in tax regulation; and (3) potential in the Small
and Medium Enterprises (SME) segment. Our positive
outlook for the company is also backed by LFINs betterthan-peer diversification of its loan book combined with
its better than industry-average performance in Net
Interest Margins and Cost to Income Ratios. While we are
bullish on LFIN and believe that the Group has robust
short-medium term prospects, we remain slightly cautious
regarding its higher-than-peer Gold loan exposure (~1/5th
of its total lending portfolio), which we percieve as a
significant risk for the company.
Although earnings volatility has defined much of the recent
performance in the Consumer, Lifestyle and Healthcare
segments, we expect the signs of recovery seen in Q115 to
continue into the remainder of the year. Recent
restructuring efforts, lower fuel/electricity costs and the
likely increase in private consumption levels are expected
to improve performance in FY 2015/16E. We note though
that VONEs Plantation segment is likely to continue
weighing on Group margins due to several challenges in
the industry. Over-reliance on the Middle-Eastern markets
and the ongoing geo-political unrest in these markets,
coupled with low global commodity prices and domestic
industry concerns such as higher wages are likely to
dampen overall industry prospects. Despite these
challenges however, we remain positive on HOPLs
medium-term prospects as it focuses on: (1) investing in
replanting and upgrading its factories; and (2) crop
diversification including Palm Oil.
Driven by the strong short-medium term growth prospects
in VONEs subsidiaries and associates, we see a 26.0%
upside on the stock and recommend a 12M BUY. Based on
our SOTP valuation methodology, we have valued each of
VONEs business segments and derive a target price of LKR
28.5, which with an average historical dividend yield of
2.2% translates to a total return of 26.0%.
Rated BUY with a Total Return of 26.0%
Stock Price LKR

30.0

Target Price of LKR 28.5 Yields an


Upside of 23.7% on Current Price

25.0
20.0

Our value for RCL is based on a DCF valuation and we


derive a value of LKR 19.10 per share, which represents a
41.85% contribution to VONEs total equity value. Backed
by strong growth prospects and above industry-average
performance, we believe LFIN should continue to trade
above its sector average of 1.84x PBV, and therefore,
assign a target multiple of 1.92x (2016E). We thus derive a
value of LKR 18.04 per share for LFIN, which contributes
39.52% to total equity value. For Delmege meanwhile, we
assign a target multiple of 11.12x PER (2016E), as we
believe a discount to the Diversified sector PER of 15.89x
is warranted for this private diversified conglomerate. On
this basis, we derive a per share value of LKR 2.31 for
Delmege and believe that this is justified given the
expected turnaround in the business. Our target multiple
of 0.42x PBV (2016E) for HOPL is based on our view that
VONEs Plantations segment is currently fairly valued at
0.40x (2016E). Our target multiple compares with a peermean of 0.58x and is at the lower end of HOPLs historical
PBV range of 0.39-1.70x. We note that a turnaround in the
Plantations sector should however, lead to a re-rating and
boost HOPLs value in VONE. For our valuation of VONE
associates meanwhile, we have used a Justified PBV for
Sampath Bank and the market value of assets for Fortress
Resorts and Waskaduwa Beach Resort. Based on this, we
derive a per share value of LKR 5.18 for Sampath Bank and
LKR 0.45 for the Leisure associates. We do not assign a
value to the Groups Greener Water project, (despite
necessary approvals being obtained), as its feasibility and
previously disclosed concept is currently being reevaluated. Based on these assumptions therefore, we
assign a BUY rating on VONE and expect a total return of
26.0% on a 12M horizon (dividend yield of 2.2%).
VONE Valued Using a SOTP Valuation Method
Segment

Valuation
Method

Royal Ceramics
DCF
L B Finance
PBV
Delmege
Diversified PER
Horana Plantations
PBV
Sampath Bank
Justified PBV
The Fortress Resorts
Market Value
Waskaduwa Beach Resort Market Value
Equity Value
Adjustments
Price

Multiple
Value Per Share
(x)
(LKR Mn)
Value
-

20,752.2

19.10

1.92

19,599.8

18.04

11.12

2,504.7

2.31

0.42

607.5

0.56

5,631.7

5.18

253.1

0.23

240.5

0.22

49,589.4

45.64

(18,676.3)

(17.19)
28.45

Source: Acuity Estimates

15.0
10.0
5.0
0.0
Mar-12

Mar-13

Mar-14

Mar-15

Sep-15

12M TP

Source: Bloomberg, Acuity Estimates

September 2015

Our BUY recommendation on VONE is further supported


by a PER based relative valuation. VONE currently trades
at 8.83x PER, compared to its peer-average of 14.36x, a
significant discount of 38.52%. Backed by VONEs strong
earnings potential and price upside though, we believe this
discount is unwarranted compared to its historic discount
of 21.79% and should thus trade at a higher multiple.
Page 5

ACUITY STOCKBROKERS RESEARCH | SRI LANKA EQUITIES


Vallibel One

Diversified

Segment Analysis: Tiles & Sanitary Ware


Construction Sector Prospects Drive Tiles and Sanitary Ware Growth

In FY 2014/2015, Vallibel One (VONE) generated 37.23%


of its revenue through its subsidiary, RCL, which primarily
focuses on the manufacture of walltiles/floortiles (Tiles
segment), and bathware (Sanitary Ware). The cumulative
EBIT contribution from the Tiles and Sanitary Ware
segments to the Group amounted to LKR 3.25Bn in
FY 2014/2015 or 41.80% of total Group EBIT. As depicted
in the flow chart below, following RCLs acquisition of
Lanka Ceramics (CERA) in 2013, VONE has a stake in
Lanka Walltiles (LWL), Lanka Tiles (TILE) and RCL. The
acquisition of CERA leveraged RCLs market share further
within the domestic Tiles/Sanitary Ware space.
RCLs Acquisition of CERA Strengthens its Market
Share in the Local Tile Industry

Prospects for the Tiles and Sanitary Ware segments are


closely associated with the countrys building construction,
which is primarily driven by economic growth. Historic
data suggests a strong positive correlation (r) between
GDP growth and the Construction sector (r=0.98),
implying that the Tiles and Sanitary Ware industries are
closely tied to overall GDP and construction industry
growth.
Tiles Industry Closely Tied to Economic Growth
Value (Rebased to 100)

Domestic Construction Sector Prospects & Global


Tile Demand to Drive Revenue |

Construction Activity Picks


up Post-War

250

200
150
100
50
2007

2009

2010

2011

Gross Domestic Product

Vallibel One

2012

2013

2014

Construction sector
Source:
Source:Department
Departmentof
ofCensus
Censusand
andStatistics
Statistics

Royal Porcelain
(Pvt) Ltd (100%)

Rocell Bathware Ltd


(100%)

Lanka Ceramics (77%)

Lanka Walltiles (62%)

Lanka Tiles (68%)

Source: Annual Reports

RCLs Tiles and Sanitary Ware revenue increased at a


Source: Annual Report, Company Data
4-year CAGR of 33.45% over the period
2012-2015, driven
by higher construction activity, due to a rise in income
levels post-war. Construction activity was fuelled by major
government infrastructure projects combined with several
private sector activities, including tourism related
construction and housing projects. Revenue growth of
100.0% (reported in FY 2013/14) largely reflects the
effects of RCLs acquisition of a controlling stake in Lanka
Ceramic PLC (CERA) in May 2013. Revenue in 2015
however, increased by just 7.34% Y-o-Y, as the Group
faced some difficulties with its dealer network (which has
now been fully resolved), combined with a complete
overhaul of the Groups operating system.
We expect revenue growth at RCL to be driven by both
construction growth in the domestic market and
increasing focus on the higher-end export markets.

Sri Lanka recorded GDP growth of 7.35%1 in 2014, while


growth in the construction sector amounted to 20.22%
Y-o-Y. The contribution to GDP from the construction
sector also peaked at 9.69% last year, up ~100bps Y-o-Y.
Supported by favourable macro economic variables,
VONEs Tiles and Sanitary Ware segments reported
combined revenue growth of 100.0% Y-o-Y in
FY 2013/2014 (including acquisition related growth), and
further revenue growth of 7.34% Y-o-Y in FY 2014/15.
Despite a slowdown in construction activity in Q115 due
to government-delays on key projects, and weaker private
investments amid political uncertainty, we forecast GDP
growth at a sustainable rate of 6.80% for 2016E. We
believe this will be the primary determinant of RCLs Tiles
and Sanitary Ware segmental revenue growth for the next
two years. As such, we estimate a 3-year CAGR of 14.73%
over the period FY 2014/15-2016/17E.
High Post-War Construction Activity in Central
Province but the North and the East Lag Behind
Growth CAGR 2010-2012

RCL (51%)

2008

60%
45%

30%
15%
0%
WP
GDP

CP*

SG

NC

UP

Construction

NW

Avg. GDP

EP

SP

NP

Avg. Construction

*Construction growth CAGR for CP not displayed

Source: Economic and Social Statistics of Sri Lanka


Source: Economic and Social Statistics of Sri Lanka

September 2015

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ACUITY STOCKBROKERS RESEARCH | SRI LANKA EQUITIES


Vallibel One

Diversified

Segment Analysis: Tiles & Sanitary Ware


Demand for Personal Housing to Boost Topline Further
We believe medium-term growth prospects for the
countrys construction industry stem primarily from the
fact that: (1) there is wide variation in construction
industry growth rates at the provincial level; (2) disparity
between demand and supply in the housing industry; and
(3) Sri Lanka has one of the lowest per-capita tile
consumption levels in the region. Despite the overall
uptick in Sri Lankas post-war construction activity, much
of this growth has stemmed from the Central Province
(CP). Construction in the CP grew at a CAGR of 85.18%
between 2010-2012, compared to 25.56% in the East and
36.75% in the North. However, growth prospects for the
North/East regions appear robust and have in fact
outperformed growth in the Central Province (GDP growth
CAGR 2010-2012: CP-14.97% vs. North-19.10% & East26.85%). We thus believe growth potential for
construction activity in the North-East provinces remains
strong, particularly due to demand stemming from
resettlements and building rehabilitation. In addition to
domestic housing and village reconstuction however, we
expect the resurrection of projects such as the Achchuveli
Industrial Complex in Jaffna, to also drive construction
activity in the region. We also believe the rehabilitation of
the railway network, road development and continuous
progress in rural electrification should also benefit tourism
in the North/East, further supporting demand for
construction-related products. Consequently, we believe
that the North/East of the country is yet to achieve the
peak of its development, which in our view should further
support construction activity. We thus believe that RCL,
with its islandwide franchise and strong market position,
would be able to leverage on this potential.
Construction Activity Backed by Higher Demand for
Housing
Housing Units (Mn)

7.5

6.0

100000 Housing Units Per


Annum Required to Meet
Demand of 1.5mn Units by
2030

Replacement
Housing
0.5Mn

4.5
New
Housing
1.0Mn

3.0
1.5

0.0
2015

2030
Source:
Vertical
Living
Beyond
2020,
KPMG
Source:
Vertical
Living
Beyond
2020,
KPMG

We believe the housing gap in terms of demand and supply


should also drive construction activity over the next 15
years, leading to higher revenue streams for RCL.
According to the National Housing Policy, Sri Lanka needs
1.5Mn housing units by 2030, with 1.0Mn required to cater
to increasing population and 0.5Mn housing units for
replacement. As the current supply of housing is only a
September 2015

fraction of the demand, a 100000 units per annum is


required to fill the housing gap2. Additionally, driven by
the need for convenience and flexible living, KPMG expects
3800 units to be added to the market by condominium
developers. Although the household size in Sri Lanka has
declined from 5 persons per household in 1980 to 4 in
2010, the average household size (sq ft) has not declined
over the years, implying that demand for space per person
has increased.
Disparity between Per Capita Tile Consumption and
Economic Growth to Drive Domestic Sales
10.0

8.0

8.0

7.3
5.0

6.0
4.0

6.0

3.3

2.8
1.4

2.0

0.8

0.0

China

Vietnam
Indonesia
Sri Lanka
Source: ICCTAS (2013), World Bank, Acuity Research

Per capita tile consumption (sq.m)

Per capita GDP growth (%)

Source: ICCTAS (2013), World Bank, Company Data

Sri Lankas low per-capita tile consumption coupled with


its robust GDP growth potential also highlights strong
medium-term revenue streams for RCL. Given the
disparity between GDP growth and per capita tile
consumption, and our assumption of a sustainable
economic growth rate for Sri Lanka of 6.80% for 201617E, we believe that the country is yet to uncover the
growth potential of its tile industry. Sri Lankas per capita
GDP growth in 2013 was 7.25%1 Y-o-Y, slightly below that
of China, which recorded 7.70% Y-o-Y growth, but
significantly above that of Indonesia (5.60% Y-o-Y) and
Vietnam (5.50% Y-o-Y)3. Despite the higher-than-peer GDP
growth rate recorded by Sri Lanka however, the countrys
per capita tile consumption was considerably lower than
that of its regional peers who reported slower economic
growth. Sri Lankas per capita tile consumption in 2013
amounted to a mere 0.8 sq.m per person, compared to 2.8
sq.m per person in Vietnam and 1.4 sq.m per person in
Indonesia. The average per capita tile consumption is
generally boosted by larger scale construction, which in
turn is determined by higher income levels. Given that Sri
Lankas GDP per capita income is expected to increase to
US$4837 by 2018E4 (US$3239 in 2013) therefore, we
believe prospects for the overall tile industry are robust.
We also believe that the current low interest rate regime in
Sri Lanka is likely to buttress overall construction industry
prospects. Following the reduction of interest rates in
2013, credit to the private sector for construction activity
increased significantly. The chart below depicts a 700bps
decrease in the Average Weighted Prime Lending Rate
(AWPR) from March 2013 to March 2015. During the same
Page 7

ACUITY STOCKBROKERS RESEARCH | SRI LANKA EQUITIES


Vallibel One

Diversified

Segment Analysis: Tiles & Sanitary Ware


RCLs Global Expansion Plans Provide Further Buffer to Topline
With the Rocell Pty acquisition therefore, RCL is positioned
to capture on this demand and provide diversification to
RCL Groups existing exports to several of the top tile
importing countries (USA, France and the UAE).
The US Remains Top Importer (160Mn Square Meters)
of Global Tile Exports

450,000

12%

400,000

10%

350,000

8%

300,000

6%
Jun-12

Dec-12

Jul-13

Interest rates

Jan-14

Aug-14

250,000
Mar-15 Source: CBSL

Construction Loans

Source: CBSL

As such, we believe that the current low interest rate


environment should continue to drive private sector credit
for construction, which in turn should support revenue
growth through higher volumes at RCL. The Groups strong
market position meanwhile, should also help bolster
revenue.
RCL Now Eyes Top Tile Importing Countries to Expand
Globally
In addition to higher activity in the domestic construction
industry, we also anticipate revenue growth to stem from
RCLs increased focus on export markets. Currently, RCL
generates ~7.00% of its revenue from exports. Over the
years, however, RCL has faced several challenges in its
export markets due to high competition from lower priced
tiles entering the export market (domestic cost of
production is relatively higher), combined with slow
demand due to weak global economic conditions.
However, due to high growth potential within this space,
RCL has continued to increase focus on its exports and
recently invested in developing the market in Australia
through Rocell (Pty) Limited. Demand for tiles
in Company
Australia
Source:
Data
has been on the rise for multiple reasons including the
higher durability and lower carbon footprint (ie: tiles in
place of timber flooring) of floor-tiles.
Benefits of Tiles vs. Alternative Flooring
Higher Durability
Increasing Awareness on Environmental Concerns
Low Post-Installation Maintenance
Thinner and Lighter Tiles Save on Transportation Costs and Renovation Costs
Less Constraints for Tiles Cf. Timber (In Wet Areas)

Sq.m (Mn)

500,000

14%

150
100
50
0
2013
USA
Germany

Saudi Arabia
Russia

Iraq
Thailand

France
Nigeria
Source: Acuity
South Korea
UAEResearch
Source: Infotile (2013)

While global tile imports increased 5.47% Y-o-Y in 2013,


US imports increased 15.11% Y-o-Y driven primarily by
rising tile consumption within the country. Total tile
consumption in the US increased at a 4-year CAGR of
5.45% over 2010-2013, highlighting the strong demand
for tile exports5. Responding to the changing global
dynamics therefore, RCL expects to aggressively develop
its brands in the region in FY 2015/16E. RCLs current
focus on manufacturing larger sized, value-added tiles with
higher margins is aimed at meeting export market
requirements and is likely to boost topline growth due to
the higher premium these larger sized tiles command.
Tiles and Sanitary Ware Revenues to Grow 21.28%
Y-o-Y to LKR 19.62Bn in FY 2015/16E
24,000

160%
Source: Infotile (2013)

LKR (Mn)

16%

Loan value (LKR mn)

Avg. Quarterly AWPR (%)

Low Interest Rate Environment Leads to Higher


Construction Activity in the Country

18,000

120%

12,000

80%

6,000

40%

Growth Y-o-Y (%)

period, commercial banks loans and advances to the


construction industry increased at a quarterly
compounded growth rate of 4.42% (Mar13-Mar15). The
proportion of loans and advances used for construction
also increased to 17.10% in March 2015 from 14.40% two
years prior.

0%
2012

2013

2014

Revenue

2015

2016E 2017E

YoY Growth
Source: VONE Annual Reports, Acuity Research

In light of: (1) robust GDP prospects; (2) potential in the


domestic construction sector; and (3) growth in RCLs
export markets, we forecast revenue growth of 21.28%
Y-o-Y to LKR 19.62Bn for FY 2015/2016E. Given the
likelihood of a possible interest rate hike in H215 and its
implications however, we estimate revenue growth in
FY 2016/17E should moderate to 8.53% Y-o-Y. Our
estimates further assume that the volatility in revenue
growth in 2012-2015 (due to inorganic expansion), should
not continue in the near-term.

Source: Acuity Research

September 2015

Page 8

ACUITY STOCKBROKERS RESEARCH | SRI LANKA EQUITIES


Vallibel One

Diversified

Segment Analysis: Tiles & Sanitary Ware


Margins to Stabilize Following Extensive Cost Reduction Efforts

9,000

50%

7,500

47%

6,000

44%

4,500

41%

3,000

38%

1,500
0

Margin (%)

FY

35%
2012

2013

2014

Gross Profit

2015 2016E 2017E


Gross Margin
Source: VONE Annual Reports, Acuity Research

The Group also faced additional challenges relating to its


dealer network, which led to lower-than-expected margin
improvement in FY 2014/2015. We anticipate improved
Group results in FY 2015/2016E following the
rationalization of its dealer network. Largely owing to
savings achieved through better cost management (RCL
expects to save ~LKR 200Mn in FY 2015/2016E), we
forecast EBIT to grow at a 4-year CAGR of 31.65% to
Annual Reports, Acuity Research
LKR 4.16Bn in FY2015/2016E,Source:
yielding
a margin of
21.19% (vs. margin of 20.10% in FY 2014/2015).
Thereafter, we expect margins to stabilize at ~22.0%.
RCL EBIT to Grow at a 4-Year CAGR of 31.65% Amid
Stringent Cost Management
5,000

35%

4,000

30%

3,000

25%

2,000

20%

1,000

15%

Margin (%)

Following the CERA acquisition in May 2013, RCLs gross


margin declined from 47.80% in 2012 to 37.48% in 2014
(down 10 percentage points), weighed down by cost
inefficiencies at CERA. Post-consolidation (2015) however,
CERA reported a ~220bps Y-o-Y improvement in
consolidated gross margins due to RCLs restructuring of
CERAs activities, combined with the benefit of an energy
tariff reduction. We believe the continued recovery at
CERA should help further stabilize gross margins at RCL.
Supported by the streamlining of activities in CERA, the
resolution of supply-side issues and lower energy costs,
we forecast gross profit from the Tiles and Sanitary Ware
segments to increase to LKR 8.05Bn in FY 2015/2016E,
implying margin growth of ~130bps to 41.03%. Beyond
FY15/16E meanwhile, we expect GP margins to stabilize at
~41.50%.

LKR (Mn)

RCL, like much of the rest of the tiling industry is facing the
challenge of obtaining consistent and high quality raw
material due to a lack of streamlining in the mining and
quarrying industries. We note that this has led to weaker
production yields and thus resulted in an increase in the
cost of production. This in turn has also resulted in local
tile manufacturers such as RCL being unable to compete
with the low priced and poor quality imports, resulting in
pressure on margins. In 2014 however, with stricter
Source:
Annualauthorities,
Reports, Acuity Research
regulation being implemented by the
local
the
supply issue was for the most part resolved. Consequently,
VONEs Tiles and Sanitary Ware segments collectively
reported a gross profit of LKR 6.42Bn in FY 2014/15
(margin of 39.71%, up ~220bps Y-o-Y). The improvement
in margins was also driven by lower energy costs (which
account for ~40% of RCLs cost base), combined with
continued focus on cost efficiency improvements. For
instance, RCLs subsidiary, Lanka Tiles reported that the
company was able to reduce its total energy costs by
19.0% in FY 2014/2015, owing to the reduction in LP Gas
prices. Given RCL Groups significant production capacity,
we believe that it would be in a better position to negotiate
the price of its raw materials, thus allowing it to largely
contain its costs in the short-medium term.

Gross Profit Margins to Stabilize at ~41.50% in


2016/17E Following a Dip in FY 2013/14

LKR (Mn)

Cost Efficiencies & Lower Energy Costs Prop


Margins |

10%
2012

2013
EBIT

2014

2015 2016E 2017E


EBIT Margin
Source: VONE Annual Reports, Acuity Research

Source: Annual Reports, Acuity Research

September 2015

Page 9

ACUITY STOCKBROKERS RESEARCH | SRI LANKA EQUITIES


Vallibel One

Diversified

Segment Analysis: Tiles & Sanitary Ware


Low Quality, Cheap Imports Pressure RCL margins
Risk Analysis of Domestic Tiles Industry |
The main challenges currently faced by the local tiling
industry include: (1) the inadequately governed imported
tile market; (2) the lack of streamlining in the mining and
quarrying sector; (3) the possibility of margin erosion due
to high price sensitivity for tiles; and (4) the perception
that wall tiles are a luxury item.
Low Quality, Cheap Imports Account for 60.0% of Total
Market Share in July 2015

RCL, 34%

Imports, 60%

Mack
Tiles,
Source: Company Data (2015)
6%
Source: Company Data (2015)

One of the primary challenges to the local tile


manufacturing industry is the threat of cheap imports
from India, China and Indonesia. During April-July 2015,
imports accounted for 60.0% of Sri Lankas tile industry
(by volume), suggesting that the domestic tiles industry is
currently threatened by higher volumes of cheaper, low
quality imported tiles. This is in comparison to imports
accounting for ~35.0% of the tiles industry in 2009/10
and 52.0% in 2014/15. Imports are cheaper due to its poor
quality coupled with the lower cost of production (foreign
manufacturers use lower cost fuels such as coal and
Liquified Natural Gas). The GoSL however, has imposed a
CESS of 35.0% on imported tiles as a protectionist
measure for the domestic tile manufacturing market.
Although industry stakeholders believe this CESS should
be maintained in order to protect the domestic market,
there is a possibility that this could be removed entirely,
which could in turn negatively affect the local
manufacturing industry. Further, we believe that despite
its 34.0% market share in the industry, RCL faces the issue
of margin erosion due to the high price sensitivity of tiles
in the industry. As such, we note that the removal of the
CESS on imports could lead to a loss of market share for
RCL due to pressure on margins.
We note however that the devaluation of the LKR over the
recent weeks should benefit RCL in terms of: (1) higher
export revenue; and (2) a price hike in imported tiles
narrowing the gap between domestic and imported tile
prices. We believe the benefit is currently negligible
September 2015

considering that: (1) exports only account for ~7.0% of


total revenue for RCL; and (2) the devaluation over the
month is limited to ~4.0%. However, a further
devaluation in the LKR and continued expansion in RCLs
export markets should support its performance in the
future.
Lenient anti-dumping laws and countervailing duty
legislation also impacts the local tile manufacturing
industry as imported products are marketed at a lower
price than domestic selling prices. The local tiling industry
is primarily affected by cheap Chinese tiles (which account
for 70.0% import dumping) due to the lack of antidumping levies by the GoSL. As a result of the increased
threat of imports, RCL has faced significant pressure on its
margins over the years. In order to mitigate the impact of
these lower quality, cheaper imports, RCL currently splits
its sales in terms of its distribution network. As such, RCLs
products are made available to the end customers through
the Groups 140+ direct dealer network (which markets
smaller sized, lower margin tiles which compete with
imports) or its 95 own showrooms and franchised outlets
(markets mainly larger sized, higher margin tiles). The lack
of streamlining in the mining and quarrying sector also
negatively affects the domestic tiles industry, and the RCL
Group has continuously lobbied for better regulation in the
mining sector in order to achieve higher yields.
Lanka Walltiles (LWL) also faces the issue of lower
demand for wall tiles, on the back of a perceived notion in
Sri Lanka that wall tiles are a luxury item6. This is
reflected in the split in sales between wall and floor tiles in
the industry. Approximately 80.0% of the local tiles
industry consists of floor tiles, while the remaining 20.0%
is accounted for by wall tiles. As a result, most customers
replace wall tiles with floor tiles. Due to the lack of demand
for wall tiles, and a stock pile-up in the recent months,
Lanka Walltiles (LWL) has decided to convert 25.0% of its
plant capacity to produce floor tiles this year7. In an effort
to overcome this misconception however, LWL has
invested in a marketing campaign to stimulate demand for
wall tiles in the country. Although the additional marketing
campaigns should support future sales of wall tiles, it is
expected to weigh down on Group EBIT growth in FY
2015/2016E, and therefore could limit margin
improvement in the short term.
Note 1 Calculated Using the Base Year as 2002
Note 2 KPMG Vertical Living Beyond 2020
Note 3 www.worldbank.org
Note 4 www.imf.org
Note 5 Infotile
Note 6 Lanka Walltiles Annual Report 2015
Note 7 The Sunday Times, August 15, Some 25% in Lanka Walltiles Capacity
to be Converted to Floor Tiles

Page 10

ACUITY STOCKBROKERS RESEARCH | SRI LANKA EQUITIES


Vallibel One

Diversified

Segment Analysis: Banks and Finance


Private Sector Credit Growth to Continue in H215

In addition to RCL, VONE also holds a 51.0% shareholding


(effective holding of 64.29%) in LFIN, a Licensed Finance
Company (LFC), which provides financial solutions for
corporates, small and medium enterprises (SMEs) and
individuals. In FY 2014/15, VONE earned 33.71% of Group
revenue and 50.0% of Group EBIT from LFIN. LFCs and
Specialised Leasing Companies (SLCs) account for 7.0% of
Sri Lankas financial system, and by the end of 2014 the
sector comprised of 48 LFCs and 8 SLCs 8. Based on total
assets as at end-2014, LFIN had 7.80%8 of total market
share among LFCs.
VONE Enjoys Effective Holding of 64.29% in LFIN

In line with the Central Bank projection of private sector


credit growth in 2015E of ~ 15.50%, we expect credit
appetite to improve on the back of political and economic
stability (growth in H115 amounted to 15.03% Y-o-Y).
Although some upside pressure on interest rates is likely
given the current depreciation pressure on the LKR, we
still anticipate growth in private sector credit in 2016E.
LFCs Play a Bigger Role in Private Sector Credit in Q1
2015
Contribution to Pvt. Credit

Macro Variables Determine Changes in Financial


Segment Product Portfolio |

100%

30%

80%

24%

60%

18%

40%

12%

20%

6%

0%

0%
Q4 13

Q1 14

Q2 14

CB
LSB
CB Credit to Pvt. Sector

Q3 14

Q4 14

Q1 15

LFC
LFC Credit to Pvt. Sector
Source: CBSL
Source: Monthly Bulletin, CBSL

Source:Annual
AnnualReports
Reports
Source:

Political stability post the August General Elections


combined with favourable economic policies should fuel
growth in credit to the private sector, and we expect this to
drive topline growth at LFIN. Muted demand for private
sector credit has dominated much of 2014, but this trend
reversed during 2015 and we see this positive momentum
continuing into 2016E. Largely due to a decrease in
commercial banks pawning advances and higher access to
alternative funding sources, credit demand in H114 was
weak and by July 2014, private sector credit growth hit an
all-time low of 0.83% Y-o-Y. Towards the latter half of the
year though, credit demand picked up supported by the:
(1) credit-guarantee on Pawning Loans; and (2)
rationalization of the Standard Deposit Facility (SDF)
Window. Private sector credit consequently grew 8.83%
Y-o-Y by December 2014, and in April 2015 the CBSL
reduced policy rates further helping push private sector
credit levels back up to 17.60% Y-o-Y levels by May 2015.

Pvt. Credit Growth (Y-o-Y)

Growth in Credit to Private Sector Continues Post


Rate-Cut in April 2015
Reduction in Policy
Interest Rates

20%
15%
10%

SDF Window
Rationalized
Credit-Guarantee on
Pawning Loans

5%
0%
Jun'13

Sep'13 Dec'13 Mar'14 Jun'14

Within this backdrop, we expect LFIN to further solidify its


position within the Sri Lankan financial sector. LFCs have
continued to expand their position as key lenders to the
private sector and, as the decline in private sector credit
demand bottomed out in H214, lending to the private
sector by LFCs increased significantly. Growth in credit to
the private sector by LFCs amounted to a significant
18.72% Y-o-Y in H214 relative to 6.72% Y-o-Y by
Commercial Banks. In Q115, LFC credit growth amounted
to 27.59% Y-o-Y, while growth in Commercial Bank credit
was 13.88% Y-o-Y. In addition, the contribution to total
private sector credit from LFCs increased ~200bps to
16.33% in Q115 relative to 14.20% in Q113, while
contribution from more traditional banking institutions
dropped ~300bps to 71.34% in Q115. We thus believe
this increased trend towards credit from LFCs, which
caters primarily to segments not necessarily targeted by
more formal banking channels underscores the potential
within the industry. Sri Lankas lower-than-regional peer
average ratio of private sector credit to GDP meanwhile
implies the significant growth potential within the
domestic lending industry. During 2005-2009 for instance,
Sri Lankas private sector credit/GDP ratio amounted to
29.20% and decreased further to 28.20% during 20102014 in stark comparison to peers such as Bangladesh
(42.10%), India (51.10%) and Singapore (131.50%)3.
Therefore, we believe that the low private sector credit to
GDP levels imply space for growth and that the increasing
share of private sector credit that domestic LFCs provide
imply strong growth potential for key players such as
LFIN.

Sep'14 Dec'14 Mar'15


Source:
CBSL
Source:
CBSL

September 2015

Page 11

ACUITY STOCKBROKERS RESEARCH | SRI LANKA EQUITIES


Vallibel One

Diversified

Segment Analysis: Banks and Finance


Growth Prospects in Mortgage Lending to Drive LFIN Performance
In an effort to benefit from changing macro variables, LFIN
continuously makes strategic changes to its product
portfolio. Currently, LFINs focus on Loans and Receivables
is driven by growth potential in the Mortgage Loans
segment. LFINs lending portfolio includes, Gold loans,
vehicle loans and mortgage loans (ie: categorized as loans
and receivables) along with Lease Rentals Receivables and
Stock out on Hire. Lease Rentals and Stock out on Hire
accounted for 59.81% of LFINs lending portfolio, while
Loans and Receivables accounted for 40.19%.
LFINs Loan Book to Continue Upward Trajectory Amid
Growth in Loans and Leases
70,000

LKR Mn

56,000

LKR 2.41Bn, growing at a 3-year CAGR of 130.09% over


FY 2012/13-2014/15, supported by the low and stable
interest rate regime combined with LFINs aggressive
marketing campaigns. Through its Mortgage Loans
segment, LFIN intends to offer small ticket mortgage
facilities to customer segments overlooked by banks and
without access to formal banking channels. Following the
end of the internal conflict in Sri Lanka, the country
experienced a boom in its Construction industry. Although
construction or the purchase of a home is considered a
significant investment for an individual, over 90.0% 9 of the
Sri Lankan property market has been debt-free, while remortgaging homes is almost non-existent10. As of 2011, Sri
Lankas mortgage market accounted for 2.4% of GDP
compared with ~40.0% in Singapore10.
Demand for Housing Reflected through Growth in
Personal Housing Loans

42,000
28,000

45%

14,000

30%

0
2012

2013

Loans and Receivables

2014

2015

2016E

2017E

Lease Rentals and Stock out on Hire


Source: VONE Annual Reports, Acuity Estimates

Despite LFINs traditionally high exposure to Lease Rentals


and Stock out on Hire, the segment has faced increased
competition as traditional banks have also begun to
aggresively pursue the Hire Purchase/Leasing market.
LFINs strategic move to target other segments,
particularly within the Loans and Recievables segment is
thus aimed at countering the increased competition within
its more traditional leasing products.
Growth in Loans & Receivables Backed by Mortgage
Market Growth
100%
75%

50%
25%
0%
2012/13
Gold Loans

2013/14
Mortgage Loans

2014/15
Vehicle Loans

2015/16E
Other

Source: VONE Annual Reports

LFINs declining exposure to the Hire Purchase segment is


being replaced by the growing Loans and Receivables
segment, particularly stemming from the untapped growth
potential in the domestic mortgage market. LFINs
exposure to Mortgage Loans has been increasing over the
years, from 2.63% of gross Loans and Receivables in
FY 2012/13 to 10.34% in FY 2014/15. As of end March
2015, LFINs gross Mortgage Loan book amounted to
September 2015

15%
0%
-15%

-30%
2006

2007

2008 2009 2010 2011 2012


Personal Housing Loan Growth (%)

2013

2014

Source: CBSL Annual Reports

CBSL data indicates that housing loans contributed only


9.0% to total loans in 2010, declining from 14.0% in the
previous year. Since 2010, the contribution of housing
loans to total loans has hovered between 6.60-8.10%. The
low contribution of personal housing to total loans is in
our view attributable to factors such as: (1) poor access to
housing finance for middle-income groups; and, (2) high
housing costs for lower-middle income groups. The
mortgage markets extension to lower-income households
remains low in Sri Lanka, although this group includes
viable mortgage borrowers under more developed lending
schemes. We thus believe that the quarterly compounded
growth in personal housing (4.66% during the post-war
period March 2013 March 2015) has not achieved its full
potential. Although debt-financing remains relatively low
in Sri Lankas housing market, demand for housing
remains strong with data indicating that an additional 1Mn
housing units would be necessary to accommodate
population growth over the next 15 years, (population
expected to increase to 24Mn by 2030) and a further
0.5Mn housing units required as replacement. This implies
an estimated 100000 housing units per annum2, which we
believe will fuel demand for mortgage loans over the next
few years. Additionally, we believe LFIN should benefit
from its entry into the mortgage market given that it
Page 12

ACUITY STOCKBROKERS RESEARCH | SRI LANKA EQUITIES


Vallibel One

Diversified

Segment Analysis: Banks and Finance


Regulation Changes and Cheaper Fuel Drive Leasing Segment

Despite increased competition within the Leasing space,


we expect LFIN to continue focusing on its core business of
leasing as well as loans for vehicle purchases. Within the
Lease Rentals Receivables and Stock-out-on-Hire segment,
LFIN is currently shifting all its hire purchase facilities to
leasing mainly due to the exemption of finance leases from
VAT (mandated by the Budget 2015). This is due to the
lack of distinction between Hire Purchase and Finance
Leasing following the change in tax regulation. In our view,
growth in LFINs Leasing segment is expected to be
boosted by: (1) the strong rise in demand for small
vehicles (<1000 cc) and dual purpose vans due to reduced
import duties; (2) growth in the three wheeler leasing
market following fuel price reductions; and (3) favourable
macro factors leading to growth in microleasing.
Motor Car Sales in H115 Beat Full Year 2014 Sales
Amid Changes in Tax Regulations
100%
Motor Car
Sales in H1'15
Beats 2014
Full Year Sales

80%
60%

Lower Fuel Prices Drive New Registrations for Three


Wheelers in 2015
50,000

Three Wheeler Registrations Increase a


Staggering 63% Y-o-Y during Jan-April 2015
Driven by Lower Fuel Prices

180

40,000

160

30,000

140

20,000

120

10,000

100

LKR/Litre

Change in Tax Regulation and Lower Fuel Prices


Determine Growth in Leasing |

Additionally, motor car sales accounted for ~13.0% of


total new registrations at the end of June 2015, increasing
from a mere 9.0% at the end of 2014. Meanwhile, the
proposal to remove a depreciation table and the revision
of excise taxes in January 2015 has effectively led to a price
hike of hybrid vehicles. Despite the increase in prices and a
decline in fuel prices therefore, new hybrid / electric
vehicle sales between January and July increased a
significant 184.96% Y-o-Y in 2015, which we believe
should benefit LFIN in the current financial year, due to its
increased focus on hybrid vehicles. However, given that:
(1) a near-term increase in fuel prices is unlikely; (2) the
increase in import duty leading to higher prices of
hybrid/electric vehicles; and (3) the likelihood of an
increase in interest rates and a further depreciation of the
LKR, it is unlikely that LFIN would continue to benefit from
an increase in new registrations of hybrid/electric
vehicles. However, we expect demand for small cars to
remain relatively steady as low fuel costs should help
offset some of the negative pressure stemming from a
weaker LKR.

New Registrations (Jan - Apr)

targets customers overlooked by banks due to their high


risk profile. We therefore, estimate a 39.09% Y-o-Y growth
in gross mortgage loans in LFINs lending portfolio, thus
implying an increase in the composition of mortgage loans
as a percentage of total gross loans to 12.48% in
FY 2015/16E (from 10.34% in FY 2014/15).

80
2013

2014

2015

New Three Wheeler Registrations


LP 92 Avg. Price
Source: Mid-Year
Mid-Year Report
Report 2015
Source:
2015 (Ministry
(Ministry of
of Finance),
Finance), Ceypetco
Ceypetco

40%

20%
0%

2010
Motor Cars

2011

2012
Motor Tricycles

2013

2014

2015 (YTD
June)
Motor Cycles
Other
Source: Department of Motor Traffic

Source: Department of Motor Traffic

Reduced import duties on <1000cc vehicles is expected to


positively impact leasing-heavy LFCs, and finance
companies such as LFIN are expected to be particularly
affected by the demand for purchasing small cars on credit.
In an effort to improve the standard of living of low income
families, the Interim Budget of 2015 proposed a 15.0% tax
reduction for small cars with engine capacity of <1000 cc.
Following the tax reduction, there was a significant Y-o-Y
increase in motor car sales during Jan June 2015, which
we believe is primarily attributable to the sale of small cars
(i.e. engine capacity of less than 1000 cc.). During H115,
the Department of Motor Traffic reported motor car
registrations of 39695 units, in comparison to 38780
recorded in the twelve months ending Dec14 (+102.36%).
September 2015

We also believe LFINs Leasing segment prospects will be


boosted by robust potential in the three-wheeler market.
Statistics indicate a negative correlation between demand
for three wheelers and fuel price increases. Following the
January 2015 Presidential elections, LP 92 fuel prices were
reduced to LKR 117.0 (down 24.21% Y-o-Y from the
weighted average price of LKR 122.78 from Jan Apr
2015) and new registrations of three wheelers increased
by a significant 62.96% Y-o-Y to 39425 units during the
first four months of 2015. In contrast, when fuel prices
were at a higher price of LKR 162.0 (+0.82% Y-o-Y), during
Jan Apr 2014, new registrations of three wheelers
declined ~19.67% Y-o-Y, thus indicating the negative
correlation between fuel prices and demand for three
wheelers. Given that global fuel prices are expected to
remain low and stable in 2015/16E (EIA forecasts Brent
crude price of USD54.40-59.42/barrel in 2015-16E,
respectively) and LFINs low deliquency rates within the
three-wheeler leasing segment, we anticipate this
Page 13

ACUITY STOCKBROKERS RESEARCH | SRI LANKA EQUITIES


Vallibel One

Diversified

Segment Analysis: Banks and Finance


LFIN Benefits from a Diverse Portfolio

Three wheeler leasing is a constituent of LFINs micro


leasing service, which primarily focuses on small-scale
businesses and self-employed individuals (i.e. low-middle
level income earners) with sufficient income levels to
repay a loan. In addition to the leasing of three wheelers,
LFINs microleasing services also cater to motor bike
leasing. We believe: (1) the increasing disposable income
levels in Sri Lanka fuelled by lower fuel and electricity
costs; (2) the GoSLs higher focus on the Small and Medium
Enterprises (SME) sector and; (3) the expected stability
following the General Elections held in August, should
support LFINs loan portfolio growth even further. The
potential in the SME sector in particular, is likely to boost
LFINs portfolio growth and the microleasing segment
(which accounts for 47.15% of LFINs lease portfolio)
should benefit from the discrepancy between demand and
supply in the industry. SMEs are classified as entities with
an annual turnover of >LKR 600Mn and borrowings <LKR
200Mn, and account for ~80.0% of businesses in Sri
Lanka11. SMEs account for over 50.0% of GDP and 35.0% of
total employment in the country, but there is a segment
within this sector that does not have access to more
traditional forms of lending. Given this supply/demand
mismatch and LFINs island-wide branch network (100
branches in FY 2014/15), we see strong prospects within
this segment. However, we note downside risks which
could have a dampening effect on LFINs product portfolio
growth: (1) the directive issued by the CBSL to reduce the
Loan-to-Value ratio to 70% (from 85-90%)12 for the
purchase of motor vehicles; and (2) the possible increase
in interest rates in H215. In addition to a likely decline in
vehicle imports due to a weaker LKR, we also note that the
mandatory CBSL directive on the LTV ratio could also lead
to some pressure on LFINs margins.

Within the backdrop of both: 1) LFINs increased focus on


the Loans & Receivables (particularly Mortgages) segment;
and 2) its continued potential in the Leasing segment
therefore, we estimate LFINs total net loan book growing
11.87% Y-o-Y to LKR 63.02Bn in FY 2015/16E. Growth
should be supported by both, (1) Loans and Receivables
(+14.76% Y-o-Y); and (2) Lease Rentals and Stock out on
Hire (+9.93% Y-o-Y). Moreover, from a comparative
perspective, we believe LFINs lending portfolio is more
diversified relative to its peers, providing the Group with a
strong competitive advantage. As of the end of FY 2014/15
for instance, LFINs gross Leases and Hire Purchases
accounted for 66.62% of the total lending portfolio while
Loans and Receivables accounted for 33.38%. Peers such
as CFIN and PLC by contrast recorded 95.50% and 77.39%
of Leases and Hire Purchases during the same period,
while LOFCs lending portfolio primarily consisted of
Loans and Receivables (77.41%). We thus believe that
CFIN, PLC and LOFCs higher risk exposure to a single asset
class (relative to LFINs more diverse product portfolio),
provides LFIN with a strong competitive advantage and
should help further support topline growth.
LFIN Product Portfolio Seems More Diversified
Compared to Peer Group
Gross Loan Portfolio (%)

segment remaining a growth driver for the company.


LFINs low delinquecy rates are attributable to threewheelers being used for income generating purposes
(e.g. travelling & goods transportation) and due to lower
fuel prices significantly improving the customers
disposable income. Therefore, we believe LFINs growth in
the net lease rentals portfolio will be primarily aided by its
continued focus on the three-wheeler leasing service
under Micro Leasing. We expect this, combined with
higher demand for small cars to drive LFINs full year
leasing portfolio growth further (Q4 2014/15 net lease
rentals grew 11.23% Y-o-Y and 19.27% Y-o-Y in Q1
2015/16).

100%
75%
50%

25%

Source: Annual Reports

0%
LFIN

CFIN

Leases and Hire Purchases

PLC

LOFC

Loans and Receivables


Source: Annual Reports

In addition to better-than-peer diversification of loan


book, we also note that LFINs performance during
FY 2014/15 was also superior relative to the industry both
in terms of balance sheet strength as well as margins.
LFINs FY 2014/15 Performance Indicates a Strong
Balance Sheet and Margins
FY 2014/15 (%)

Industry
Average

LFIN

Source: Annual Reports, CBSL

Net Interest Margin

12.67%

7.91%

Cost to Income Ratio

39.45%

58.47%

Interest Income: Interest Expenses

2.30%

1.94%

Core Capital Ratio (Tier 1)

16.02%

11.22%

Total Capital Adequacy Ratio

19.70%

12.24%

Return on Equity

30.88%

20.32%

Source: Annual Reports, CBSL

September 2015

Page 14

ACUITY STOCKBROKERS RESEARCH | SRI LANKA EQUITIES


Vallibel One

Diversified

Segment Analysis: Banks and Finance


Large Exposure to Gold Loans Remains a Risk to LFIN
LFINs Increased Exposure to Gold Loans (Despite
Lower Gold Prices) Remains a Risk Factor |
Despite our overall bullish view on LFIN, we believe there
are a number of risk factors within the segment. We
highlight LFINs: (1) High exposure to Gold loans despite
low Gold prices; (2) Increased competition from more
traditional banks; and (3) The likelihood of an interest rate
hike, as important risk factors. Sri Lankas credit to the
private sector weakened during H114, primarily due to
lower pawning. However, following the guaranteeing of
pawning by the Central Bank of Sri Lanka in June 2014 and
a rationalization of the SDF window, private sector credit
growth has since improved. Pawning (i.e. Gold-backed
loans) in Sri Lanka gained particular popularity in the
rural regions as it represents a plausible asset to use as
collateral in order to access the countrys financial
markets. A large portion of borrowing against Gold was by
the lower income rural and agricultural communities, and
as such were primarily used for consumption.
Consequently, strong growth in demand for credit also led
to a rapid rise in economic activitiy in Sri Lanka. LFINs net
Gold loan book too grew at a 3-year CAGR of 37.23% (to
LKR 10671.74Mn) over FY 2010/11-2012/13, driven by
the rally in Gold prices. Following the crash in Gold prices
in 2013 however, the proportion of lending against Gold
declined due to the lower value of gold against which
credit could be lent, combined with a decline in Loan to
Value ratios. As a result, LFINs Gold loans contracted
24.97% Y-o-Y in FY 2013/14, as Gold prices declined
19.74% Y-o-Y.

Value (Rebased to 100)

Despite Lower Prices, LFINs Gold Loans Grew ~30.0%


Y-o-Y in FY 2014/15
Growth in Loan Book Despite Decline in Prices

200

150
100

necessary measures to improve its product portfolio and


mitigate the negative impact of lower prices. This is
particularly evident in LFINs Gold loan losses/gross Gold
loans ratio of 2.06% in FY 2014/15, which is significantly
lower than the 16.74% recorded in the previous year. The
continued increase in demand for Gold loans is also
apparent in the 20.45% Y-o-Y growth in the number of
customers for Gold loans in FY 2014/15. We forecast gross
Gold loans to grow at a modest 3-year CAGR of 5.58% over
FY 2014/15-2016/17E, resulting in a contribution of
42.04% of total gross loans in FY 2015/16E and 39.62% in
FY 2016/17E, declining from 44.76% in the last financial
year. Our modest growth forecast takes into account the
positive impact of increasing demand for Gold loans being
partially offset by the impact of a further decline in Gold
prices. Despite the recent bearishness in global equity
markets, investors have shown weak interest in the safehaven assets such as Gold, leading to the belief that Gold
prices could continue to decline. Given LFINs high Goldloan exposure therefore, we believe a further decline in
prices is likely to significantly increase risks to LFINs
product portfolio.
Meanwhile, LFCs including LFIN have also faced
increasing competition from the banking sector offering
services which were traditionally only offered by finance
companies. We identify this as a potential threat to LFINs
performance while also noting that the companys
continued focus on high-margin products for a higher
margin customer base should help overcome the issue of
increased competition, at least in the short-term.
Moreover, the likelihood of an interest rate increase in
H215, could negatively impact LFINs interest spreads due
to a greater asset/liability mismatch in the context that
long-term lending is on fixed rates relative to short-term
borrowings which are on floating rates. Higher interest
rates would also negatively impact the demand for LFINs
growth segments, mortgage lending, vehicle leasing and
microleasing.

50

2010/11

2011/12

2012/13

Average Gold Prices

2013/14

2014/15

Gold Loans

Source: Annual Reports, Bloomberg


Source: Annual Reports, Bloomberg

In FY 2014/15 however, despite a 5.99% Y-o-Y decline in


gold prices, LFINs Gold loan book made a partial recovery
(+29.64% Y-o-Y to LKR 10380.70Mn) towards the levels
seen prior to the Gold price crash. This was in contrast to a
~40.0% decline in the Gold loan book in the banking and
LFC sector. LFIN continues to grow its Gold loan book,
despite declining Gold prices, as it believes it has taken
September 2015

Note 8 CBSL Annual Report, 2014


Note 9 Sunday Times, April 2014, Real Estate Market segment: Middle Income
Note 10 Colombos Game Changing Skyline, Vox & Co.
Note 11 Daily FT, May 2015 - SMEs Will be Critical to Sustain our Economic
Growth in Next 5 Years
Note 12 LBO, September 2015 - Central Bank Directs Banks to Reduce Loan
Ratio on Motor Vehicles

Page 15

ACUITY STOCKBROKERS RESEARCH | SRI LANKA EQUITIES


Vallibel One

Diversified

Segment Analysis: Other


VONE Remains a Highly Diversified Conglomerate

While majority of VONEs revenues are generated through


Tiles, Sanitary Ware and Banks and Finance, its operations
also span across Plantation (4.57% of total revenue in Q1
2015/16), Consumer (5.94%), Lifestyle (3.74%),
Healthcare (5.07%) and Other (10.94%). We believe that
VONEs medium term prospects will be boosted further by
these diversified operations, namely the turnaround in
Delmege Group. While we remain relatively more subdued
on the Plantation segment earnings, we believe the Group
is diversified enough to withstand any short-term pressure
from this segment.

growth of 33.73% over Q1 2013/14 Q1 2015/16,


margins also improved to 7.26% in the latest quarter from
1.34% in Q1 2013/14. We believe the Group is likely to
continue benefitting from the ongoing cost reduction
efforts in the short-term, while its aggressive marketing in
in the domestic market should also help boost volumes.
Group strategies include: (1) Launching new channels of
distribution; (2) Introducing new products and services;
(3) Use of Push and Pull marketing strategies for high
gross margin products; (4) Strong working capital
management, and we believe that these initiatives are
likely to generate strong revenue streams, and thus remain
broadly positive on Delmeges medium-term prospects.
Strong Margin Improvement Visible at Delmege

Approx. 30.26% of VONEs Revenue is Generated


Outside of Tiles, Sanitary Ware and Banking

110

Healthcare

Lifestyle

Tiles

Consumer

LKR mn

Other
VONE
Benefits
from a
Well
Diversified
Portfolio

EBIT Improved at Quarterly Compounded


Growth Rate of 34% to Q1 2015/16

140

6%

80

4%

50

2%

20

0%

(10)

-2%

(40)

-4%

(70)

Plantation

Q1 2013/14

Sanitary wear
Banks &
Finance

Source: Annual Report


Source: Annual Report

Signs of Recovery Visible at Delmege Group |


VONE acquired 51.0% of the Delmege Group, a highly
diversified conglomerate in 2012, bringing its total
effective holding to 61.70%. The operations of Delmege
Group span six industries through fifteen legal entities.
Subsidiaries of the Group are engaged in manufacturing,
trading, shipping, logistics, airline and travel, and
insurance brokering. Following the acquisition, VONE
focused on re-engineering the operations of Delmege.
Consequently, in FY 2014/15, turnover from Consumer,
Lifestyle and Healthcare was LKR 5.92Bn (up 28.30%
Y-o-Y), despite facing challenges such as a change in
government policy, which affected the price of canned fish
(a significant revenue generator for the Group).
Management is currently focusing on minimizing costs and
strengthening sales. Both due to these cost reduction
efforts and lower fuel and electricity costs, the segment
reported EBIT of LKR 153.40Mn in the latest financial year,
improving from an EBIT of LKR 3.89Mn in the previous
year. On a cumulative basis therefore, VONEs EBIT from
Consumer, Lifestyle and Healthcare segments (which
largely consists of Delmege results), has continued to
improve. While EBIT improved at a compounded quarterly
September 2015

8%

Margin (%)

VONEs Diverse Portfolio of Operations to


Buttress Medium Term Prospects |

-6%
Q3 2013/14

Q1 2014/15

EBIT

Q3 2014/15

Q1 2015/16
Source:
Annual Reports

EBIT Margin (%)


Source: VONE Annual Reports

Near Term
Continues |

Pressure

on

Plantation

Sector

VONEs revenue from Plantations stems from Horana


Plantations (HOPL), which focuses on tea, rubber, timber
and diversified agricultural crops across estates in the
Central and Western provinces. The Plantations sector
faced several challenges during the financial year,
including adverse weather conditions and continued weak
trading conditions in the rubber sector. As a consequence,
HOPL recorded Profit after Tax of LKR 61.98Mn in
FY 2014/15, down 54.84% Y-o-Y. Despite rising domestic
costs of production and the global glut in tea supplies, the
easing of sanctions against Iran (Sri Lankas largest Tea
exporter) in mid 2015 remains a noteworthy development
for the overall industry. However, we expect HOPLs
performance in FY 2015/16E to continue to be weak on
the back of the declining tea prices, a possible wage hike,
and geo-political tension in Sri Lankas main export
markets. The industry is likely to be impacted further by
the go slow wage campaign, which led to a 10-day shut
down of tea factories during Q2 2015/16. The domestic
rubber industry also continued its weak trading
conditions, as local production declined for the 3rd
consecutive year on the back of weak international
demand combined with unfavourable weather conditions
Page 16

ACUITY STOCKBROKERS RESEARCH | SRI LANKA EQUITIES


Vallibel One

Diversified

Segment Analysis: Other


Plantation Sector to Weigh Down on Earnings in the Near Term
which led to disruptions in latex tapping. The GoSL
however, has implemented a guaranteed price system in
order to improve the domestic rubber industry, despite
weak demand. Despite the challenges faced by the
Plantations sector however, HOPL continued to invest in
replanting and upgrading its factories. Additionally,
management also focused on crop diversification, as it
completed the planting of palm oil (which, until recently,
supported regional plantation companies compensate for
losses in tea and rubber) in Neuchatel, Mirishena and
Halwatura. Demand for palm oil is on the rise in Sri Lanka,
particularly due to increasing coconut oil prices, which is a
close subsitute for palm oil. HOPL also initiated the
planting of fruits and vegetables. Therefore, despite shortterm challenges within the segment, we remain broadly
positive on the Groups medium-term prospects for the
Plantation segment.

September 2015

Page 17

ACUITY STOCKBROKERS RESEARCH | SRI LANKA EQUITIES


Vallibel One

Diversified

Valuation
Target Price of LKR 28.5 Yields a Total Return of 26.0%
Target Price of LKR 28.5 Based on a Sum-of-theParts Valuation |
We use a sum-of-the-parts (SOTP) valuation to arrive at
our target price for VONE and based on this methodology,
we derive a target price of LKR 28.5 per share, implying
total return of 26.0%. The valuation has been carried out
using a series of metrics ranging from DCF to relative
valuation (PBV & PER) to market based valuation (market
value of subsidiaries/associates). On this basis, RCL (Tiles
and Sanitary Ware segments) accounts for 41.85% of our
target equity value, while LFIN (Banks & Finance)
generates 39.52% of the value. We assume Sampath Bank
should contribute 11.36% to VONEs target value.
RCL and LFIN Contribute over 80% to VONEs Equity
Value
Delmege,
5.05%

Other, 2.22%

Sampath
Bank,
11.36%

Royal
Ceramics,
41.85%
L B Finance,
39.52%

Source: Acuity Estimates

We value RCL (Tiles and Sanitary Ware) using a DCF


valuation, and arrive at a value per share of LKR 19.10,
assuming a WACC of 13.89%. Given our positive outlook
on LFIN and its better-than-peer performance, we value
VONEs Banks & Finance segment assuming a target
Price/Book multiple of 1.92x and thus develop a per share
value of LKR 18.04. Our target multiple of 1.92x is above
the sector average of 1.84x, a premium we believe is
justified given that given that LFIN has historically traded
at a premium to its peer average. Given the volatility in
earnings, our value of LKR 2.31 per share for Delmege
(5.05% of VONEs equity value), is arrived at by
discounting the Diversified sector PER of 15.89x (i.e,
11.12x 2016E). Despite expecting a turnaround at
Delmege, we believe a discount on the sector PER is
warranted, given that it is a private diversified
conglomerate. However, we note that a complete overhaul
at Delmege would likely boost VONEs value further.
Similarly, although we note that a turnaround in the
Plantations sector should lead to a further boost in VONEs
value, given the current weakness in the industry believe
HOPL is fairly valued at 0.40x PBV, and as such assign a

September 2015

target multiple of 0.42x. At our assumed multiple, we


expect HOPL to contribute LKR 0.56 per share to VONEs
target price. For our valuation of Sampath Bank PLC
(effective holding of 14.95%) we have used a Justified PBV
and derive a value of LKR 5.18 per share; for the Groups
Leisure associates, Waskaduwa Beach Resort PLC
(20.22%) and The Fortress Resorts PLC (18.02%)
meanwhile, we have used the market value of assets as our
basis and develop a per share value of LKR 0.23 and 0.22,
respectively.
Our SOTP Valuation Indicates a Target Price of LKR
28.5 for VONE
Segment

Valuation
Method

Royal Ceramics
DCF
L B Finance
PBV
Delmege
Diversified PER
Horana Plantations
PBV
Sampath Bank
Justified PBV
The Fortress Resorts
Market Value
Waskaduwa Beach Resort Market Value
Equity Value
Adjustments
Price

Multiple
Value Per Share
(x)
(LKR Mn)
Value
-

20,752.2

19.10

1.92

19,599.8

18.04

11.12

2,504.7

2.31

0.42

607.5

0.56

5,631.7

5.18

253.1

0.23

240.5

0.22

49,589.4

45.64

(18,676.3)

(17.19)
28.45

Source: Acuity Estimates

Despite necessary approvals being obtained earlier this


year for the project to proceed, we have refrained from
incorporating revenue streams from Greener Waters in to
our VONE valuation, as the projects feasibility and
previously disclosed concept are being re-evaluated
following changes to regulations in tax exemptions.
Greener Water Ltd. (which was acquired in 2011) is the
leisure arm of VONE, under which investments have been
made towards hospitality projects. Its maiden investment
project lies on 14 acres in Negombo, and is designed as a
400 roomed five star hotel with 4 epicurean restaurants,
banquets, a tranquil spa, exquisite suites, fitness centres
and a water park. Since 2011 though, VONE has faced
several challenges pertaining to accessibility and
approvals, but the project was approved this year. Since
the project is yet to materialize and its continuity is
uncertain in light of changes in tax regulations, we have
valued VONE on its existing core business and have
excluded this project from our estimates. Therefore, on our
2016E estimates, we value VONE at LKR 28.5, yielding a
total return of 26.0% (Price Appreciation: 23.7% and
Dividend Yield: 2.2%).

Page 18

ACUITY STOCKBROKERS RESEARCH | SRI LANKA EQUITIES


Vallibel One

Diversified

Valuation
Risk to Valuation on a Super Gains Tax
Discount to Peers Expands Post Q215 Results, as
Growth Prospects Not Priced In
VONE's Expanded Discount to Peers
Unwarranted

PER (x)

18

14

10

6
Apr-13

Aug-13

Dec-13

Apr-14

Aug-14

VONE

Dec-14

Apr-15

Aug-15

Peer Avg.
Source: Bloomberg

On a relative basis too, we regard VONE as a BUY. VONE


has historically traded at a discount to its peers, and its
current PER of 8.83x which represents a 38.52% discount
to its peers is significantly wider compared with its
historic discount of 21.79%. As we expect the strong
performance recorded in FY 2014/15 (EPS growth of
83.69% Y-o-Y), to continue into FY 2015/16E (EPS growth
of 47.86% Y-o-Y) due to growth potential in both RCL and
LFIN, we believe that the upside potential on the stock
price does not warrant the current discount it is trading at.
We thus believe that VONE should trade closer to its
historic PER discount and as such expect the stock to trade
at a higher multiple.
Downside Risks to Valuation
While we remain positive on VONE and its prospects, we
highlight a number of downside risks to our valuation in
this section. We view: (1) the potential impact of the super
gains tax; (2) weaker-than-expected growth in
construction; (3) a higher-than-expected increase in
interest rates; (4) continued weakness in private
consumption/investment; and (5) the potential
developments around the Comprehensive Economic
Partnership Agreement (CEPA) between India and Sri
Lanka, as possible downside risks to VONEs value.
We believe the largest downside to our valuation will be
driven by the potential impact of a one-off super gains tax
proposed by the new government in its interim budget in
January 2015. Accordingly, a one-off super gains tax of
25.0% is proposed for companies which have earned over
LKR 2Bn in FY 2013/14. However, given the lack of clarity
on the finer details, we have not incorporated the impact
of this tax. We believe though, that a worst case scenario
could lead to an effective tax rate of ~50% (Super gains tax
25% + Corporate tax) but await clarification on the
proposal before incorporating any such scenario in to our
valuation.
September 2015

Page 19

Company Financials

ACUITY STOCKBROKERS RESEARCH | SRI LANKA EQUITIES


Vallibel One

Profit & Loss Statement

FY

Diversified

2013/14*

2014/15

2015/16E

2016/17E

Revenue

48,331

43,450

49,753

54,953

EBIT

5,149

7,546

9,931

11,470

576

1,146

1,272

1,378

LKR Mn (except per share data)

Share of Results of Equity Accounted Investees


Profit Before Tax

3,832

7,349

9,981

10,975

770

2,003

2,813

3,073

Profit Attributable to Equity Holders

1,574

2,891

4,275

4,712

EPS

1.45

2.66

3.93

4.34

FY

2013/14

2014/15

2015/16E

2016/17E

14,199

14,825

18,196

19,791

Sanitary Ware

1,125

1,354

1,426

1,504

Plantation

2,069

2,165

2,176

2,198

13,492

14,647

15,826

17,938

Tax

LKR Mn
Revenue (Excluding Associates)
Investment
Tiles

Banks & Finance

Segmental Performance

Leisure

Consumer

2,151

2,834

3,276

3,669

Lifestyle

1,288

1,394

1,578

1,786

Healthcare

1,175

1,691

2,364

2,837

Apparel

9,781

Other

3,051

4,540

4,911

5,231

EBIT (Excluding Associates)


Investment

(71)

(2)

(69)

(62)

2,452

2,859

3,769

4,255

Sanitary Ware

361

392

389

421

Plantation

220

123

58

66

Tiles

Banks & Finance

3,465

3,929

5,130

5,916

Leisure

(23)

(19)

(16)

(13)

Consumer

(61)

(32)

73

Lifestyle

64

90

103

152

Healthcare

96

172

227

Apparel

82

Other

31

322

385

434

2013/14

2014/15

2015/16E

2016/17E

Revenue Growth

46.0%

-10.1%

14.5%

10.5%

EBIT Growth

21.0%

46.5%

31.6%

15.5%

Net Profit Growth

-26.8%

83.7%

47.9%

10.2%

EBIT Margin

10.7%

17.4%

20.0%

20.9%

NP Margin

3.3%

6.7%

8.6%

8.6%

Dividend Yield

3.0%

1.7%

2.2%

2.2%

Growth & Ratios

FY

* Includes Results of Orit Apparels, Which was Disposed During FY 2014/15

September 2015

Source: Company Annual Reports & Acuity Estimates

Page 20

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