Thursday, February 18, 2010


Investment Summary

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

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

Sector profitability to recover: The sector was poised to mark strong earnings in FY10E owing to high commodity prices. But the growth was hindered by the estate labour wage hike which increased the cost of production by a near 20% with effect from April 2009. However we believe the +70% rise in tea and three-fold rise in rubber prices would be able to wither the negative effects of the cost of production to a certain
extent. With tea prices stabilising at current levels and rising rubber prices which would be sustainable in the long run, we forecast the sector to record a strong earnings during the coming quarters.

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

Tea Sector

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

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

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

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

Global tea prices in 2009 have been underpinned by a shortfall in output following drought conditions in the key growing regions. Nevertheless, strong underlying demand (despite the global economic slowdown) in the major consuming markets has also contributed to the positive price trend. We are of the opinion that tea prices are on a secular long term uptrend due to;
  • a fundamental global shortfall in supply, as very little new planting has taken place,
  • rising income levels in key consuming markets, and
  • a switch in consumption from other beverages to tea as the health benefits of the product is recognized.
Consequently, we forecast the NSA of tea at the Colombo Auctions to rise by 20% YoY to LKR361 per kg in 2009, by a further conservative 8% YoY to LKR390 per kg in 2010 and by 10% YoY to LKR429 per kg in 2011.

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

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

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

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

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

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

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

Increase in Cost of Production to be muted. Although non-wage costs (especially fertilizer and energy related expenses) rose by over 50% in 2008, the average Cost of Production (COP) of Sri Lankan tea increased by only a moderate 10.8% YoY to LKR262.60 per kg in the absence of a wage hike (wages account for around 55% of total cost of production of tea). This was also due to strong growth in output of over
4% YoY.

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

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

Whilst the hefty wage increase of around 40% has been implemented effective April 2009, an approximately 15% decline in non-wage costs (mainly on account of around a 30% decline in energy and fertilizer expenses) the COP in 2009 increased by a significant 17% YoY to LKR 307.6 per kg. However, with the full impact of the wage increase being accounted for in the year and the likely increase in non-wage costs on the back of global inflationary pressures, we estimate COP to rise by another 5.7% YoY to LKR 334.8 per kg in 2010. We also project COP to rise by a further 12% YoY to LKR 385.8 per kg in 2011 on the back of an equivalent rise in wage and non-wage costs.

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

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

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

Rubber Sector

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

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

In the two years prior to the global financial crisis, natural rubber prices at the Colombo Auctions rose sharply by 25% YoY to an average of LKR234.22 per kg in 2007 and a further 15% YoY to LKR 269.51 per kg in 2008 in tandem with the price of crude oil. In 2008, the price of RSS1 rose to a high of LKR 360 per kg in June, before collapsing to a low of LKR111.10 per kg in December following the global financial crisis.
However, some recovery was witnessed in December itself, with the price of RSS1 closing the year at LKR 150 per kg, enabling the price of the commodity to average LKR 269.51per kg in 2008, due to the severely affected last quarter.

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

Approximately two thirds of global natural and synthetic rubber production is utilized in automobile manufacture and hence the demand for the commodity is inextricably linked to the fortunes of that industry, in addition to the price of crude oil. Consequently, with the likely recovery in global economic growth in 2010 and further gains in crude oil prices, we are projecting the price of RSS1 to rise strongly by 30% YoY to
an average of LKR274.29 per kg in 2010 and further by 20% YoY to LKR 329.14 per kg in 2011.

Rubber production to rise steadily. Underpinned by remunerative prices, natural rubber output in Sri Lanka has risen strongly over the past five years, from 92 mn kgs in 2003 to a record 129.2 mn kgs in 2008, a CAGR of 7%. With prices rising steadily over the years, replanting and new-planting of rubber land has also continued to increase with the cultivated area being tapped for rubber rising from 86,000 hectares in 2003 to 95,500 hectares in 2008, a CAGR of 2%. Higher prices have also resulted in improved agricultural practices (such as proper and timely application of fertilizer, use of rain-guards, improved tapping techniques etc.) enabling yields of rubber plantations to rise from 1,068 kgs per hectare in 2003 to 1350 kgs per hectare in 2008, a CAGR of 5%.

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

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

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

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

However, following the hefty 40% wage increase in September 2009, COP of rubber is forecast to increase by a slower 4% YoY to LKR118.2per kg in 2009, with the approximate 30% decline in fertiliser and energy costs dampening the impact of higher labour costs. Nevertheless, with the full impact of the wage increase being accounted for in 2010 and the likely increase in non-wage costs on the back of global inflationary pres-
sures, we estimate COP to rise by a further 4% YoY to LKR123.02 per kg in the year. We also project COP to rise by a further 13% YoY to LKR138.8 per kg in 2011 on the back of an equivalent rise in wage and non-wage costs.

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

Oil Palm Sector

Oil palm to generate healthy margins. Cultivation of Oil Palm is carried out in Sri Lanka only on a very small scale, with just 4 of the 22 regional plantation companies operating a few small estates totalling 2876 hectares. The Crude Palm Oil (CPO) production of these estates is purchased by AEN (Private) Limited, a palm oil processing centre which manufactures Refined Palm Oil (RPO). AEN is a joint venture between Namunukula Plantations, Agalawatte Plantations and Elpitiya Plantations. However, palm oil manufacture is an important revenue and profit source for these companies as the commodity yields significant and stable gross margins/profits. Total output of CPO in 2008 increased by 32% YoY to 29.4 mn kgs.In 2007, the price of CPO averaged LKR20 per kg whilst cost of production was at LKR8.30 per kg, yielding a gross profit of Rs. 11.6 per kg. This converted to a hefty gross margin of 58%, a remuneratively high level by any industry standard. But the prices fell to LKR16 per Kg in mid 2008 which continued for nearly a year (till August 2009) on the back of decline in global demand created by recessionary pressures.

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

Opportunities in the green

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

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

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

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

Investment Recommendation

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

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

Rubber which used to generate the highest margins, faced the worst ever times ever on the back of global economic downturn which made the synthetic rubber (a by product of oil) cheaper and reducing the demand for natural rubber. This made the +50% margins enjoyed over the past years (since 2006) erode to 40% levels. Even though the prices picked up in the later part of 2009, backed by the slow recovery of global activity we believe the year round margin to stabilize at 40% and to increase to 56% in 2010E.

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

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

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

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