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Market resilient despite negative sentiment

The market continued its downward slide as the ASPI declined 20.29 points or 2.6% to 748.23 points, while the Milanka was down by 3.4% or 43.81 points to close the week at 1245.44 points. Looking back, the ASPI has slipped by 8% during the last month, despite fundamentally strong stocks trading at cheap levels. The market picked up during the latter part of the week, as the bargain hunters moved in.

We believe that the current selling pressure is due to the feeling among investors of the political uncertainty in the country, cautiousness regarding the peace process and also the global unrest due to a possible Gulf war.

The turnover was moderate at Rs.297.92 million at a daily average of Rs.55.18 million. Foreign buying amounted to Rs.26.35 million while the foreign sales were Rs.20.91 million, resulting in a net inflow of Rs.5.44 million.

ADB projects a 5% growth for 2003

The Asian Development Bank has projected GDP growth of 5.0% for 2003, which is lower than the Central Bank's projected growth of 5.5%. For year 2002, ADB expects the country would achieve a growth of 3% led by the resurgence in the services, tourism and shipping sectors. Our estimates still remain at 2.5%. The 3rd quarter 2002 GDP grew by a robust 5.3% as against a negative growth of 4.2% for the same period last year. With this healthy growth the cumulative growth for the first nine months of year 2002 stood at 2.7% as against 0.9% growth recorded during the first nine months of year 2001.

The ADB expects international trade to show moderate growth giving support to the manufacturing and services sectors. ADB projects exports to grow by 6.5% in the current year from a negative growth of around 2.4% for year 2002 while, projected growth for imports stands at 9.0% from current years marginal growth of 2.5%. ADB also feels that agricultural sector should perform well during the first half of the year given favourable weather conditions expected.

Inflation to be on a downward trend in the current year

The ADB also expects inflation to be on a downward trend in the current year and expects inflation rates to fall to 8.5% from previous year's 9.6%. It however remains concerned over the effects of the introduction of VAT on the wholesale and the retail segments. However in our view inflation would hover around 10.0% - 11.0% at least during the first half of the year given the increased prices of utilities, fuel and its indirect impact on food and other items. This was already evident in monthly statistics released by the Central Bank where inflation as measured by the CCPI has increased to 10.0% in January 2003 compared to 9.6% in December 2002.

Government's forecast budget deficit of 7.5% of GDP is achievable

ADB feels that the targeted budget deficit of 7.5% of GDP for current year is ambitious but achievable. In year 2002, the Government's revised deficit target was 8.9% of GDP but shortfall in privatisation proceeds led the government to resort to domestic borrowing. However in our view the 7.5% targeted figure looks too optimistic given the absence of any major privatisation programs for year 2003 and the shortfall in private remittances coupled with the overall economic downturn in the event of a second Gulf war.

HNB Stockbrokers GDP forecast remains at 4.5%

While we remain sanguine about the prospects that war may be averted, we would suggest that even if a compromise for peace can be reached, the level of brinkmanship that the world powers are currently standing at will make it difficult for them to come down from where they are at this point. A protracted process towards normalcy will continue to make markets jittery and to prolong and sustain high-energy prices. This would likely shave off a couple of points from GDP growth, hence our lower projection of 4.5% GDP growth for FY 2003, versus the ADB's 5.0% and the Central Bank's 5.5%.

Fourth quarter GDP growth is estimated to be around 5.0% - 5.5%

Meanwhile, we have learnt that GDP growth for the final quarter of year 2002 is expected to around 5.0% - 5.5% bringing the annual GDP growth for year 2002 to around 3.3% - 3.5%. This is in comparison to negative growth of 1.4% in year 2001. While it is evident from these figures that the country is on a healthy recovery path, short-term uncertainty may pin back economic growth in the short term.

Exports witness a healthy growth in December According to the Central Bank export earnings for the month of December 2002 was up by 27% to US $ 496.0 million while imports for the same month saw an increase of 52% to US $ 627.0 million compared with the corresponding month in 2001. However the full year figures still look weak due to the dismal performance during the first two quarters of year 2002. On aggregate, exports ended the year with a negative growth of 2.4% to US S 1.4 billion while imports recorded a marginal growth of 2.2% to US $ 6.1 billion.

The recovery process of the country's exports started in August 2002 and recorded a strong growth in both third and fourth quarters at 8% and 18% respectively. The recovery of imports started in July with growth of 8.4% and 25.3% for the third and fourth quarters respectively.

Garment sector the main contributor

Earnings from textiles increased by 21% to US $ 277.0 million in December due to a 2.4% increase in unit price and 1% increase in volumes. Meanwhile earnings from petroleum products saw a 96% increase due to the combined effect of 20% increase in unit price and 64% increase in volumes. Earnings from agricultural products increased by 8% due to increase in the exports of rubber, coconut and other items, but earnings from tea recorded a 1.2% decline due to lower export volumes due to tension in the Middle East.

Import of investment good increase by 136%

The import of consumer good increased by 38% in December 2002 compared December 2001 due to the increase in import of electrical items while import of food category increased only by 1%. Expenditure on textiles recorded a 17% growth over the same period last year. Meanwhile the highest growth came from the investments goods imports with a sharp 136% increase due to higher import of machinery and equipment (147%) building material (120%) and transport equipment (148%). This indirectly reflects a pick in the construction sector.

SLT Earnings up 28%

Sri Lanka Telecom Ltd (SLT) released its unaudited results for the FY 2002, with a 28% growth in profitability to Rs.2.7 billion. The telecom company recorded a 15% growth in the top line during the first nine months of 2002, and maintained similar growth during the last quarter as turnover reached Rs.25.38 billion.

Operating profits picked up 26% to Rs.7.95 billion from Rs.6.31 billion, mainly due to cost reductions. Total operating expenses increased by only 11%, while SLT managed to trim its interest expenses by 10% to Rs.2.806 billion, due to the repayment of two foreign loans. Both loans were at high interest rates and the repayment should reduce the annual interest cost by approximately Rs.450 million.

Goodwill write-off in Mobitel reflected in associate contributions Mobitel, SLT's fully owned subsidiary, which was an associate company for the first ten

months of the year, contributed negatively as income from associates declined from a profit of Rs.50 million to a loss of Rs.28 million. Mobitel became a fully owned subsidiary of SLT from November onwards, thus a line-to-line consolidation is carried out for the last two months. The reason for the loss is because goodwill already established in Mobitel's Balance sheet was fully written off during the period under review. This has cleared up goodwill in Mobitel's Balance sheet and cannot be considered as a negative aspect in terms of the performance of Mobitel.

Additional deferred tax expense in FY2002 due change in tax rate

Following the Budget Proposal 2003 announcements made in November 2002 the corporate tax rate applicable to the Company will be 30%. As a result, the tax effect of the deferred tax asset, amounting to Rs.453 million, has been recognised as an income tax expense in arriving at the results for the year.

This is something that had not yet been identified in the company's nine-month results release, and accounts for the only difference to our forecasts.

Cash outflow in terms of Tax, soon...

SLT enjoyed a Rs.16 billion worth deferred tax asset to off set cash outflows for taxation. The asset has diluted to Rs.2.7 billion as at December 31, 2002. The current trend is such that depreciation is more than capital allowances, thus not increasing the deferred tax asset. We expect the same trend to continue and once the deferred tax asset is fully diluted, SLT will be exposed to cash payment for taxation. This will add an additional burden towards company's cash flow. After incorporating this effect, our valuation based on Discounted cash flow (DCF) has declined to Rs.29 per share.

FY 2003 earnings to be strong

We expect SLT to make a net profit of Rs.3.7 billion during the FY 2003, up 37%, mainly due to Mobitel starting to contribute towards the growth and the restructuring of its borrowing expenses. However we believe that domestic revenue would continue to contribute towards the growth as well.

This will result in an FY 2003 EPS of Rs.2.10 per share and at the current market price of Rs.12.50, the PER will stand at 5.95x. This will be followed by a more lukewarm 4.7% net profit growth in FY2004.

No reason to change our positive long-term fundamental outlook SLT remains well positioned to take advantage of further economic development in Sri Lanka. Furthermore, once 100% subsidiary Mobitel is fully converted to GSM, we believe that it could become a major player in the mobile market.

We maintain our optimism for the long-term prospects of SLT. We have also pitched SLT as a long-term growth story, as evidenced by our forecasts and DCF valuation. However, we believe that near term weakness will prevail in the share price, reflecting the weak sentiment that is present in the market. This will compound investors' failure to be fully convinced of the stocks true value. We rate SLT as a Long Term Buy, as we do expect the stock to outperform the market over the next six months.

RCL improves profits Q-O-Q.

According to first nine months results of the FY 2002/03 turnover increased by 23.9% to Rs. 710.2 million. However, an increase in the cost of sales by 30.8% limited the gross profit to Rs. 227.0 million, which is an increase of 13.7% over the same period last year. Further, an increase in finance cost by over 372% to Rs. 42.8 million and provisions of Rs. 21.0 million for taxation resulted in a 62.0% decline in PAT to Rs. 26.1 million.

However, third quarter (period from Sept -Dec) recorded net earnings of Rs. 23.3 million as against Rs. 12.6 million recorded in the 2nd quarter (period from Jun - Sept) of the current financial year, which is an increase over 85%.

Second tile factory turned profitable

Start up cost of the second tile factory resulted in higher expenses in the initial stages of operation but this situation is expected to be reversed in the final quarter. Gross margins have improved during the period under review. The second tile factory has the capacity to produce 90,000 sq. ft per month. During the current period under review it has gradually increased the capacity utilisation and is currently running at 90% of total capacity. With the inclusion of the new factory RCL has the capacity to produce 2.0 million sq. ft per annum.

Tax holiday came to an end in FY 2000/2001

RCL's tax holiday came to an end in FY 2000/01, and the company was not liable to pay any tax on its earnings in FY 2001/02 due to brought forward tax losses. However RCL's earnings would be taxed from current year onwards. Nevertheless, the second tile factory has a 10-year tax holiday.

Outlook for FY 2003/04

Looking at the company's Q-O-Q results, it appears that RCL is on its way for a moderate recovery. However, on a Y-O-Y basis, RCL's profits would remain lower due to two reasons. Firstly, start up operations of the second tile factory resulted in higher initial expenses and working capital requirements. Secondly, higher finance costs would hold profits down until we witness a corresponding increase in sales. Additionally, the company's cost of production would increase significantly in the event of a war with Iraq. Energy cost comprises 25.0% of the cost of production.

Industry participants expect a considerable growth in demand for tiles in the current year although there was a drop of 2% in the construction industry during the first nine months of year 2002. The anticipated increase in growth is well supported by recently released import export data by the Central Bank where investments good have witnessed a Y-O-Y increase of 139% for the month of December 2002 which also includes building materials (up by 120%).

to be continued...

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