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ACUITY STOCKBROKERS RESEARCH | SRI LANKA EQUITIES

Vallibel One Diversified

Research Analyst

Samalka Athuraliya |(+94) 112 206 [email protected]

Vallibel One: BUY

Source: Getty Images

mailto:[email protected]:[email protected]

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September 2015 Page 2



Investment Summary

Four-Year Performance: VONE vs. ASPI

0

1500

3000

4500

6000

7500

0

7

14

21

28

35

Jul-11 Jul-12 Jul-13 Jul-14 Jul-15

A S P I L e v e l

P r i c e R s .

VONE ASPI

Top 10 Shareholders (as at 30t

June 2015)Mr. K D D Perera 63.48%

Employees Provident Fund 9.35%

Vallibel Investments (Private) Limited 8.46%

Vallibel Leisure (Private) Limited 8.46%

Bank of Ceylon A/c Ceybank Unit Trust 0.62%

Mercantile Investment and Finance PLC 0.48%

National Savings Bank 0.30%

Mes Mellon Bank N. A. - UPS group Trust 0.26%

Rosewood (Private) Limited - Account No 1 0.24%

Merill J Fernando & Sons (Private) Limited 0.21%

Vallibe

lOnePLC:VONE.N/VONESLEquity

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

All Time High1

(Rs.) 31.7

All Time Low1

(Rs.) 13.3

Financial Year Ended 31st March

Key FinancialsPeriod 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) 46% -10% 15% 10%

Gross Profit 14,655 17,618 20,857 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) -6% 92% 36% 10%

Net Profit 1,574 2,891 4,275 4,712

Net Profit Growth (Y-o-Y) -27% 84% 48% 10%

EPS2

1.45 2.66 3.93 4.34

NAVPS2

29.90 31.97 35.50 39.34

DPS 0.70 0.40 0.50 0.50 Note: 1. Adjusted for rights, splits, bonuses Sources: Company Annual Reports, Acuity Estimates

2. Calculated on latest issued share capital 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 Delmegeand a turnaround in the Plantations sector should further

boost value. Given the uncertainty behind VONE’s Greener

Water project, and the lack of clarity on the Super Gainstax 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.

Construction Industry and Export Markets to Drive

Topline Growth at RCL | We expect robust revenuegrowth at RCL in the next 2 years, fuelled by growth inconstruction coupled with expansion in its export marketsDespite a weaker Q1, we believe construction activity will

pick up in H2’15, supported by a stable politicalenvironment leading to improved consumption andinvestment. Although an interest rate hike is likely in 2015we believe rates should remain broadly stable, and as suchshould not hinder RCL’s performance. Additionally, we

expect RCL to continue capitalizing on its strong marketposition in the domestic tiles industry, although a potentialremoval of CESS on Tile/Ceramic imports could dilute itsmarket share. RCL’s revenue growth is also expected tostem from higher demand for tiles in its export marketsLower fuel/electricity costs and RCL’s cost managementefforts are thus expected to accompany VONE’s toplinegrowth and help improve its EBIT margins to ~20.0-21.0%

Bullish on Growth Prospects for LFIN | We remainpositive on LFIN’s growth prospects in the mortgage

lending market and its traditional vehicle leasing segmentLFIN should, in our view, benefit from offering customizedproducts to the country’s under-served customer base. Weexpect the mortgage market to benefit from higher housingdemand, combined with the growth in debt-financing forhousing. We also expect continued positive performance inLFIN’s traditional leasing segment , supported by higherdemand for three-wheelers and ‘small’ cars. Our bullishview is further strengthened by LFIN’s better-than-peerdiversification of its loan book, although we note that thelikely increase in interest rates in H2’15 and LFIN’s high

gold exposure remain downside risks. As such, we expectLFIN’s loan book growth and above-industry-averagemargins to support VONE’s performance over our forecastperiod.

BUY Rating on VONE | Backed by the positive outlook forRCL & LFIN combined with the likely continuation of therecovery at Delmege, we derive a Target Price of LKR 28.5for VONE based on our SOTP valuation. We believe thestock 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%.

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Vallibel One

Investment Overview

Segment Review

Tiles and Sanitary Ware to Grow on Favorable Macro Factors

Banks & Finance to Benefit from Strong Loan Book Growth

Other: VONE Remains a Highly Diversified Conglomerate

Valuation

RCL and LFIN to drive VONE’s Equity Value

Summary Financials

Table0fConte

nts

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The 6th largest Diversified company by marketcapitalization, Vallibel One’s (VONE) business operations

span the country’s Construction, Banks & Finance,Plantations and Healthcare & FMCG industries. While themajorit y of total revenue is generated through the Group’sgrowth segments such as Tiles, Sanitary Ware and Banks &Finance, VONE has also diversified into industries such asPlantation (4.98% of total revenue), and Consumer,Lifestyle & Healthcare (13.62%). We believe that due toindustry dynamics in Construction and Financial Services,Royal Ceramics PLC (RCL) and L B Finance (LFIN) willcontinue to remain the dominant contributors to theGroup’s consolidated topline.

VONE’s EBIT Margins Improve ~600bps to 17.37% in

FY 2014/15

0%

10%

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30%

40%

50%

0

10,000

20,000

30,000

40,000

50,000

2011 2012 2013 2014 2015

L K R M n

Revenue EBIT Margin

We believe strong revenue growth and stable margins willdrive RCL’s 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 theconstruction industry and expansion in RCL’s exportmarkets. Based on our estimate for a sustainable GDPgrowth rate of 6.80% in 2016-17E, we expect constructionactivity in the country to be boosted by: (1) prospects inthe formerly war-stricken North/East; (2) increasingdemand for housing to cater to a rising population over thenext decade; and (3) the disparity between strongeconomic growth and weak per capita tile consumption inSri Lanka. Furthermore, while we concede that an increasein interest rates is likely in H2’15, we see rates remainingbroadly stable and believe that RCL should benefit from

this stability as it should help spur personal housingconstruction. In addition to growth in Constructionactivity, we also expect topline growth at RCL to stem fromits strong market position in the domestic industry andexpansion in its export markets.

Despite our bullish view on RCL’s prospects, we remainslightly cautious on the back of the possible removal ofCESS on Tile imports, which could change industrydynamics. Nevertheless, we remain confident that RCL’smargins will improve over the next two years due tostrong revenue growth, good cost containment and low

fuel and electricity costs.

Tiles & Sanitary Ware Supported by Cost Efficienciesand Lower Fuel Costs

0

2,000

4,000

6,000

8,000

2012 2013 2014 2015 2016E

L K R M n

Gross Profit EBIT

We thus estimate the Tiles and Sanitary Ware segmentsreporting gross margins of 41.03% in FY 2015/16E(39.71% in FY 2014/15), while EBIT margins shouldimprove to 21.19% in FY 2015/16E (cf. 20.10% inFY 2014/15). Following the rationalization of its dealernetwork meanwhile, we expect RCL’s EBIT margins tostabilize at ~22.0%, thereafter.

VONE’s medium-term prospects are also likely to be drivenby LFIN’s growth potential in the Mortgage Lending andVehicle Leasing segments. Despite LFIN’s heavy Gold loanbook, high competition from banks in the leasing segmentand the possible interest rate hike in H2’15, we remain

positive on the company’s prospects due to its increasedfocus on untapped markets such as mortgage lending.Through mortgage lending, LFIN targets a thus far over-looked customer base due to their high risk profile. Webelieve growth prospects in the mortgage lending marketare high due to: (1) higher demand for housing on the backof rising population; and (2) significant growth in personalhousing loans in the recent past (loans disbursed forhousing has grown at a compounded growth rate of 4.66%per quarter from March 2013-March 2015). Our positiveoutlook on LFIN is further strengthened by the fact thatthe company continues to focus on high interest earningassets such as Pawning, Lease financing, Housing and SMElending.

Lease Financing and Housing are Among the High

Interest Earning Assets

0% 3% 6% 9% 12% 15%

SME Lending

Residential Housing

Lease Finance

Pawning

Average Interest Rates

LFIN's Focus is on the High Interest Earning Assets

Source: VONE Annual Reports

Source: VONE Annual Reports, Acuity Estimates

Source: CBSL

Investment Overview

RCL and LFIN to Determine VONE’s Performance

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Moreover, we also expect LFIN’s loan book growth to besupported by: (1) growth in three-wheeler leasing due to

lower fuel prices; (2) increase in small car sales due tochanges in tax regulation; and (3) potential in the Smalland Medium Enterprises (SME) segment. Our positiveoutlook for the company is also backed by LFIN’s better -than-peer diversification of its loan book combined withits better than industry-average performance in NetInterest Margins and Cost to Income Ratios. While we arebullish on LFIN and believe that the Group has robustshort-medium term prospects, we remain slightly cautiousregarding its higher-than-peer Gold loan exposure (~1/5th of its total lending portfolio), which we percieve as asignificant risk for the company.

Although earnings volatility has defined much of the recentperformance in the Consumer, Lifestyle and Healthcaresegments, we expect the signs of recovery seen in Q1 ’15 tocontinue into the remainder of the year. Recentrestructuring efforts, lower fuel/electricity costs and thelikely increase in private consumption levels are expectedto improve performance in FY 2015/16E. We note thoughthat VONE’s Plantation segment is likely to continueweighing on Group margins due to several challenges inthe industry. Over-reliance on the Middle-Eastern marketsand the ongoing geo-political unrest in these markets,coupled with low global commodity prices and domesticindustry concerns such as higher wages are likely to

dampen overall industry prospects. Despite thesechallenges however, we remain positive on HOPL’smedium-term prospects as it focuses on: (1) investing inreplanting and upgrading its factories; and (2) cropdiversification including Palm Oil.

Driven by the strong short-medium term growth prospectsin VONE’s subsidiaries and associates, we see a 26.0%upside on the stock and recommend a 12M BUY. Based onour SOTP valuation methodology, we have valued each ofVONE’s business segments and derive a target price of LKR28.5, which with an average historical dividend yield of2.2% translates to a total return of 26.0%.

Rated BUY with a Total Return of 26.0%

0.0

5.0

10.0

15.0

20.0

25.0

30.0

Mar-12 Mar-13 Mar-14 Mar-15 Sep-15 12M TP

S t o c k P r i c e L K R

Target Price of LKR 28.5 Yields an

Upside of 23.7% on Current Price

Our value for RCL is based on a DCF valuation and wederive a value of LKR 19.10 per share, which represents a

41.85% contribution to VONE’s total equity value. Backedby strong growth prospects and above industry-averageperformance, we believe LFIN should continue to tradeabove its sector average of 1.84x PBV, and therefore,assign a target multiple of 1.92x (2016E). We thus derive avalue of LKR 18.04 per share for LFIN, which contributes39.52% to total equity value. For Delmege meanwhile, weassign a target multiple of 11.12x PER (2016E), as webelieve a discount to the Diversified sector PER of 15.89xis warranted for this private diversified conglomerate. Onthis basis, we derive a per share value of LKR 2.31 forDelmege and believe that this is justified given theexpected turnaround in the business. Our target multiple

of 0.42x PBV (2016E) for HOPL is based on our view thatVONE’s Plantations segment is currently fairly valued at0.40x (2016E). Our target multiple compares with a peer-mean of 0.58x and is at the lower end of HOPL ’s historicalPBV range of 0.39-1.70x. We note that a turnaround in thePlantations sector should however, lead to a re-rating andboost HOPL’s value in VONE. For our valuation of VONEassociates meanwhile, we have used a Justified PBV forSampath Bank and the market value of assets for FortressResorts and Waskaduwa Beach Resort. Based on this, wederive a per share value of LKR 5.18 for Sampath Bank andLKR 0.45 for the Leisure associates. We do not assign avalue to the Group’s Greener Water project, (despite

necessary approvals being obtained), as its feasibility andpreviously disclosed concept is currently being re-evaluated. Based on these assumptions therefore, weassign a BUY rating on VONE and expect a total return of26.0% on a 12M horizon (dividend yield of 2.2%).

VONE Valued Using a SOTP Valuation Method

Segment Valuation

Method

Multiple

(x)

Value

(LKR Mn)

Per Share

Value

Royal Ceramics DCF - 20,752.2 19.10

L B Finance PBV 1.92 19,599.8 18.04

Delmege Diversified PER 11.12 2,504.7 2.31

Horana Plantations PBV 0.42 607.5 0.56

Sampath Bank Justified PBV - 5,631.7 5.18

The Fortress Resorts Market Value - 253.1 0.23Waskaduwa Beach Resort Market Value - 240.5 0.22

Equity Value 49,589.4 45.64

Adjustments (18, 676. 3) (17. 19)

Price 28.45

Our BUY recommendation on VONE is further supportedby a PER based relative valuation. VONE currently tradesat 8.83x PER, compared to its peer-average of 14.36x, asignificant discount of 38.52%. Backed by VONE’s strongearnings potential and price upside though, we believe thisdiscount is unwarranted compared to its historic discountof 21.79% and should thus trade at a higher multiple.

Source: Bloomberg, Acuity Estimates

Source: Acuity Estimate

Investment Overview

VONE Rated a BUY on SOTP Valuation

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Source: Department of Census and Statistics

Source: Annual Report, Company Data

Source: Economic and Social Statistics of Sri Lanka

Domestic Construction Sector Prospects & Global

Tile Demand to Drive Revenue |

In FY 2014/2015, Vallibel One (VONE) generated 37.23%of its revenue through its subsidiary, RCL, which primarilyfocuses on the manufacture of walltiles/floortiles (Tilessegment), and bathware (Sanitary Ware). The cumulativeEBIT contribution from the Tiles and Sanitary Waresegments to the Group amounted to LKR 3.25Bn inFY 2014/2015 or 41.80% of total Group EBIT. As depictedin the flow chart below, following RCL’s acquisition ofLanka Ceramics (CERA) in 2013, VONE has a stake inLanka Walltiles (LWL), Lanka Tiles (TILE) and RCL. Theacquisition of CERA leveraged RCL’s market share furtherwithin the domestic Tiles/Sanitary Ware space.

RCL’s Acquisition of CERA Strengthens its MarketShare in the Local Tile Industry

Vallibel One

RCL(51%)

Lanka Ceramics (77%)

Lanka Walltiles (62%)

Royal Porcelain

(Pvt) Ltd (100%)

Rocell Bathware Ltd

(100%)

Lanka Tiles (68%)

RCL’s Tiles and Sanitary Ware revenue increased at a 4-year CAGR of 33.45% over the period 2012-2015, drivenby higher construction activity, due to a rise in incomelevels post-war. Construction activity was fuelled by majorgovernment infrastructure projects combined with severalprivate sector activities, including tourism relatedconstruction and housing projects. Revenue growth of100.0% (reported in FY 2013/14) largely reflects the

effects of RCL’s acquisition of a controlling stake in LankaCeramic PLC (CERA) in May 2013. Revenue in 2015however, increased by just 7.34% Y-o-Y, as the Groupfaced some difficulties with its dealer network (which hasnow been fully resolved), combined with a completeoverhaul of the Group’s operating system.

We expect revenue growth at RCL to be driven by bothconstruction growth in the domestic market andincreasing focus on the higher-end export markets.

Prospects for the Tiles and Sanitary Ware segments areclosely associated with the country’s building construction,

which is primarily driven by economic growth. Historicdata suggests a strong positive correlation (r) betweenGDP growth and the Construction sector (r=0.98),implying that the Tiles and Sanitary Ware industries areclosely tied to overall GDP and construction industrygrowth.

Tiles Industry Closely Tied to Economic Growth

50

100

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250

2007 2008 2009 2010 2011 2012 2013 2014 V a l u e ( R e b a s e d t o 1 0 0 )

Gross Domestic Product Construction sector

Construction Activity Picks

up Post-War

Sri Lanka recorded GDP growth of 7.35%1 in 2014, whilegrowth in the construction sector amounted to 20.22%Y-o-Y. The contribution to GDP from the constructionsector also peaked at 9.69% last year, up ~100bps Y-o-Y.Supported by favourable macro economic variables,VONE’s Tiles and Sanitary Ware segments reportedcombined revenue growth of 100.0% Y-o-Y inFY 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 Q1’15 dueto government-delays on key projects, and weaker privateinvestments amid political uncertainty, we forecast GDPgrowth at a sustainable rate of 6.80% for 2016E. Webelieve this will be the primary determinant of RCL’s Tilesand Sanitary Ware segmental revenue growth for the nexttwo 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

0%

15%

30%

45%

60%

WP CP* SG NC UP NW EP SP NP G r o w t h C A G R 2 0 1 0 - 2 0 1 2

GDP Construction Avg. GDP Avg. Construction

*Constructiongrowth CAGR for CP not displayed

Construction Sector Prospects Drive Tiles and Sanitary Ware Growth…

Segment Analysis: Tiles & Sanitary Ware

Source: Annual Reports

Source: Department of Census and Statistics

Source: Economic and Social Statistics of Sri Lanka

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Source: ICCTAS (2013), World Bank, Acuity Research

Source: Vertical Living Beyond 2020, KPMG

We believe medium-term growth prospects for thecountry’s construction industry stem primarily from the

fact that: (1) there is wide variation in constructionindustry growth rates at the provincial level; (2) disparitybetween demand and supply in the housing industry; and(3) Sri Lanka has one of the lowest per-capita tileconsumption levels in the region. Despite the overalluptick in Sri Lanka’s post -war construction activity, muchof 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 and36.75% in the North. However, growth prospects for theNorth/East regions appear robust and have in factoutperformed growth in the Central Province (GDP growthCAGR 2010-2012: CP-14.97% vs. North-19.10% & East-26.85%). We thus believe growth potential forconstruction activity in the North-East provinces remainsstrong, particularly due to demand stemming fromresettlements and building rehabilitation. In addition todomestic housing and village reconstuction however, weexpect the resurrection of projects such as the AchchuveliIndustrial Complex in Jaffna, to also drive constructionactivity in the region. We also believe the rehabilitation ofthe railway network, road development and continuousprogress in rural electrification should also benefit tourismin the North/East, further supporting demand forconstruction-related products. Consequently, we believethat the North/East of the country is yet to achieve thepeak of its development, which in our view should furthersupport 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

0.0

1.5

3.0

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6.0

7.5

2015 2030

H o u s i n g U n i t s ( M n )

New

Housing

1.0Mn

100000 Housing Units Per

Annum Required to MeetDemand of 1.5mn Units by

2030

Replacement

Housing0.5Mn

We believe the housing gap in terms of demand and supplyshould also drive construction activity over the next 15years, leading to higher revenue streams for RCL.According to the National Housing Policy, Sri Lanka needs1.5Mn housing units by 2030, with 1.0Mn required to caterto increasing population and 0.5Mn housing units forreplacement. As the current supply of housing is only a

fraction of the demand, a 100000 units per annum isrequired to fill the housing gap2. Additionally, driven by

the need for convenience and flexible living, KPMG expects3800 units to be added to the market by condominiumdevelopers. Although the household size in Sri Lanka hasdeclined from 5 persons per household in 1980 to 4 in2010, the average household size (sq ft) has not declinedover the years, implying that demand for space per personhas increased.

Disparity between Per Capita Tile Consumption and

Economic Growth to Drive Domestic Sales

3.3 2.8

1.40.8

8.0

5.06.0

7.3

0.0

2.0

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10.0

China Vietnam Indonesia Sri Lanka

Per capita tile consumption (sq.m) Per capita GDP growth (%)

Sri Lanka’s low per-capita tile consumption coupled withits robust GDP growth potential also highlights strongmedium-term revenue streams for RCL. Given thedisparity between GDP growth and per capita tileconsumption, and our assumption of a sustainableeconomic growth rate for Sri Lanka of 6.80% for 2016-17E, we believe that the country is yet to uncover thegrowth potential of its tile industry. Sri Lanka’s per capitaGDP growth in 2013 was 7.25%1 Y-o-Y, slightly below thatof China, which recorded 7.70% Y-o-Y growth, butsignificantly above that of Indonesia (5.60% Y-o-Y) andVietnam (5.50% Y-o-Y)3. Despite the higher-than-peer GDPgrowth rate recorded by Sri Lanka however, the country’sper capita tile consumption was considerably lower thanthat of its regional peers who reported slower economicgrowth. Sri Lanka’s per capita tile consumption in 2013amounted to a mere 0.8 sq.m per person, compared to 2.8sq.m per person in Vietnam and 1.4 sq.m per person inIndonesia. The average per capita tile consumption isgenerally boosted by larger scale construction, which inturn is determined by higher income levels. Given that SriLanka’s GDP per capita income is expected to increase toUS$4837 by 2018E4 (US$3239 in 2013) therefore, webelieve prospects for the overall tile industry are robust.

We also believe that the current low interest rate regime inSri Lanka is likely to buttress overall construction industryprospects. Following the reduction of interest rates in2013, credit to the private sector for construction activityincreased significantly. The chart below depicts a 700bpsdecrease in the Average Weighted Prime Lending Rate(AWPR) from March 2013 to March 2015. During the same

Demand for Personal Housing to Boost Topline Further…


Source: Vertical Living Beyond 2020, KPMG

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

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Source: CBSL

Source: Company Data

Source: Acuity Research

Source: Infotile (2013)

period, commercial banks’ loans and advances to the construction industry increased at a quarterly

compounded growth rate of 4.42% (Mar‘13-Mar’15). Theproportion of loans and advances used for constructionalso increased to 17.10% in March 2015 from 14.40% twoyears prior.

Low Interest Rate Environment Leads to Higher

Construction Activity in the Country

250,000

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500,000

6%

8%

10%

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14%

16%

Jun-12 Dec-12 Jul-13 Jan-14 Aug-14 Mar-15

L o a n v a l u e ( L K R m n )

A v g . Q

u a r t e r l y A W P R ( % )

Interest rates Construction Loans

As such, we believe that the current low interest rateenvironment should continue to drive private sector creditfor construction, which in turn should support revenuegrowth through higher volumes at RCL. The Group’s strongmarket position meanwhile, should also help bolsterrevenue.

RCL Now Eyes Top Tile Importing Countries to Expand

Globally

In addition to higher activity in the domestic constructionindustry, we also anticipate revenue growth to stem fromRCL’s increased focus on export markets. Currently, RCLgenerates ~7.00% of its revenue from exports. Over theyears, however, RCL has faced several challenges in itsexport markets due to high competition from lower pricedtiles entering the export market (domestic cost ofproduction is relatively higher), combined with slowdemand due to weak global economic conditions.However, due to high growth potential within this space,RCL has continued to increase focus on its exports andrecently invested in developing the market in Australia

through Rocell (Pty) Limited. Demand for tiles in Australiahas been on the rise for multiple reasons including thehigher durability and lower carbon footprint (ie: tiles inplace of timber flooring) of floor-tiles.

Benefits of Tiles vs. Alternative Flooring

Higher Durability

Increasing Awareness on Environmental Concerns

Low Post-Installation Maintenan ce

Thinner and Lighter Tiles Save on Transportation Costs and Renovation Costs

Less Constraints for Tiles Cf. Timber (In Wet Areas)

With the Rocell Pty acquisition therefore, RCL is positionedto capture on this demand and provide diversification to

RCL Group’s existing exports to several of the top tileimporting countries (USA, France and the UAE).

The US Remains Top Importer (160Mn Square Meters)

of Global Tile Exports

0

50

100

150

2013

S q . m

( M n )

USA Saudi Arabia Iraq France Nigeria

Germany Russia Thailand South Korea UAE

While global tile imports increased 5.47% Y-o-Y in 2013US imports increased 15.11% Y-o-Y driven primarily byrising tile consumption within the country. Total tileconsumption in the US increased at a 4-year CAGR o5.45% over 2010-2013, highlighting the strong demandfor tile exports5. Responding to the changing globadynamics therefore, RCL expects to aggressively developits brands in the region in FY 2015/16E. RCL’s currenfocus on manufacturing larger sized, value-added tiles withhigher margins is aimed at meeting export markerequirements and is likely to boost topline growth due tothe 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

0%

40%

80%

120%

160%

0

6,000

12,000

18,000

24,000

2012 2013 2014 2015 2016E 2017E

G r o w t h Y - o - Y

( % )

L K R ( M n )

Revenue YoY Growth

In light of: (1) robust GDP prospects; (2) potential in thedomestic construction sector; and (3) growth in RCL’export markets, we forecast revenue growth of 21.28%Y-o-Y to LKR 19.62Bn for FY 2015/2016E. Given thelikelihood of a possible interest rate hike in H2’15 and itimplications however, we estimate revenue growth inFY 2016/17E should moderate to 8.53% Y-o-Y. Ouestimates further assume that the volatility in revenuegrowth in 2012-2015 (due to inorganic expansion), shouldnot continue in the near-term.

RCL’s Global Expansion Plans Provide Further Buffer to Topline


Source: CBSL

Source: Acuity Research

Source: Infotile (2013

Source: VONE Annual Reports, Acuity Researc

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Source: Annual Reports, Acuity Research



Cost Efficiencies & Lower Energy Costs Prop

Margins |

RCL, like much of the rest of the tiling industry is facing thechallenge of obtaining consistent and high quality rawmaterial due to a lack of streamlining in the mining andquarrying industries. We note that this has led to weakerproduction yields and thus resulted in an increase in thecost of production. This in turn has also resulted in localtile manufacturers such as RCL being unable to competewith the low priced and poor quality imports, resulting inpressure on margins. In 2014 however, with stricterregulation being implemented by the local authorities, thesupply issue was for the most part resolved. Consequently,VONE’s 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 improvementin margins was also driven by lower energy costs (whichaccount for ~40% of RCL’s cost base), combined withcontinued focus on cost efficiency improvements. Forinstance, RCL’s subsidiary, Lanka Tiles reported that thecompany was able to reduce its total energy costs by19.0% in FY 2014/2015, owing to the reduction in LP Gasprices. Given RCL Group’s significant production capacity,we believe that it would be in a better position to negotiatethe price of its raw materials, thus allowing it to largelycontain its costs in the short-medium term.

Following the CERA acquisition in May 2013, RCL’s grossmargin declined from 47.80% in 2012 to 37.48% in 2014(down 10 percentage points), weighed down by costinefficiencies at CERA. Post-consolidation (2015) however,CERA reported a ~220bps Y-o-Y improvement inconsolidated gross margins due to RCL’s restructuring ofCERA’s activities, combined with the benefit of an energytariff reduction. We believe the continued recovery atCERA should help further stabilize gross margins at RCL.Supported by the streamlining of activities in CERA, theresolution of supply-side issues and lower energy costs,we forecast gross profit from the Tiles and Sanitary Waresegments to increase to LKR 8.05Bn in FY 2015/2016E,

implying margin growth of ~130bps to 41.03%. BeyondFY15/16E meanwhile, we expect GP margins to stabilize at~41.50%.

Gross Profit Margins to Stabilize at ~41.50% in FY

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

35%

38%

41%

44%

47%

50%

0

1,500

3,000

4,500

6,000

7,500

9,000

2012 2013 2014 2015 2016E 2017E

a r g i n (

)

L K R ( M n )

Gross Profit Gross Margin

The Group also faced additional challenges relating to itsdealer network, which led to lower-than-expected marginimprovement in FY 2014/2015. We anticipate improvedGroup results in FY 2015/2016E following therationalization of its dealer network. Largely owing tosavings achieved through better cost management (RCLexpects to save ~LKR 200Mn in FY 2015/2016E), weforecast EBIT to grow at a 4-year CAGR of 31.65% toLKR 4.16Bn in FY2015/2016E, yielding a margin of21.19% (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

10%

15%

20%

25%

30%

35%

0

1,000

2,000

3,000

4,000

5,000

2012 2013 2014 2015 2016E 2017E

a r g i n (

)

L K R ( M n )

EBIT EBIT Margin

Margins to Stabilize Following Extensive Cost Reduction Efforts


Source: VONE Annual Reports, Acuity Research

Source: VONE Annual Reports, Acuity Research

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Source: Company Data (2015)

Risk Analysis of Domestic Tiles Industry |

The main challenges currently faced by the local tilingindustry include: (1) the inadequately governed importedtile market; (2) the lack of streamlining in the mining andquarrying sector; (3) the possibility of margin erosion dueto high price sensitivity for tiles; and (4) the perceptionthat wall tiles are a luxury item.

Low Quality, Cheap Imports Account for 60.0% of Total

Market Share in July 2015

RCL, 34%

Mack Tiles,

6%

Imports, 60%

One of the primary challenges to the local tilemanufacturing industry is the threat of cheap importsfrom India, China and Indonesia. During April-July 2015,imports accounted for 60.0% of Sri Lanka’s tile industry(by volume), suggesting that the domestic tiles industry iscurrently threatened by higher volumes of cheaper, lowquality imported tiles. This is in comparison to importsaccounting for ~35.0% of the tiles industry in 2009/10and 52.0% in 2014/15. Imports are cheaper due to its poorquality coupled with the lower cost of production (foreignmanufacturers use lower cost fuels such as coal andLiquified Natural Gas). The GoSL however, has imposed aCESS of 35.0% on imported tiles as a protectionistmeasure for the domestic tile manufacturing market.Although industry stakeholders believe this CESS shouldbe 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 localmanufacturing industry. Further, we believe that despiteits 34.0% market share in the industry, RCL faces the issueof margin erosion due to the high price sensitivity of tilesin the industry. As such, we note that the removal of theCESS on imports could lead to a loss of market share forRCL due to pressure on margins.

We note however that the devaluation of the LKR over therecent weeks should benefit RCL in terms of: (1) higherexport revenue; and (2) a price hike in imported tilesnarrowing the gap between domestic and imported tileprices. We believe the benefit is currently negligible

considering that: (1) exports only account for ~7.0% oftotal revenue for RCL; and (2) the devaluation over themonth is limited to ~4.0%. However, a furtherdevaluation in the LKR and continued expansion in RCL’sexport markets should support its performance in thefuture.

Lenient anti-dumping laws and countervailing dutylegislation also impacts the local tile manufacturingindustry as imported products are marketed at a lowerprice than domestic selling prices. The local tiling industryis primarily affected by cheap Chinese tiles (which accountfor 70.0% import dumping) due to the lack of anti-dumping levies by the GoSL. As a result of the increasedthreat of imports, RCL has faced significant pressure on itsmargins over the years. In order to mitigate the impact ofthese lower quality, cheaper imports, RCL currently splitsits sales in terms of its distribution network. As such, RCL’sproducts are made available to the end customers throughthe Group’s 140+ direct dealer network (which marketssmaller sized, lower margin tiles which compete withimports) or its 95 own showrooms and franchised outlets(markets mainly larger sized, higher margin tiles). The lackof streamlining in the mining and quarrying sector alsonegatively affects the domestic tiles industry, and the RCLGroup has continuously lobbied for better regulation in themining sector in order to achieve higher yields.

Lanka Walltiles (LWL) also faces the issue of lowerdemand for wall tiles, on the back of a perceived notion inSri Lanka that wall tiles are a ‘luxury item’6. This isreflected in the split in sales between wall and floor tiles inthe industry. Approximately 80.0% of the local tilesindustry consists of floor tiles, while the remaining 20.0%is accounted for by wall tiles. As a result, most customersreplace wall tiles with floor tiles. Due to the lack of demandfor wall tiles, and a stock pile-up in the recent months,Lanka Walltiles (LWL) has decided to convert 25.0% of itsplant capacity to produce floor tiles this year7. In an effortto overcome this misconception however, LWL hasinvested in a marketing campaign to stimulate demand forwall tiles in the country. Although the additional marketingcampaigns should support future sales of wall tiles, it isexpected to weigh down on Group EBIT growth in FY2015/2016E, and therefore could limit marginimprovement in the short term.

Note 1 – Calculated Using the Base Year as 2002

Note 2 – KPMG – Vertical Living Beyond 2020

Note 3 –www.worldbank.orgNote 4 – www.imf.org

Note 5 –Infotile

Note 6 – Lanka Walltiles Annual Report 2015

Note 7 – The Sunday Times, August ’15, S ome 25% in Lanka Walltiles Capacityto be Converted to Floor Tiles

Low Quality, Cheap Imports Pressure RCL margins


Source: Company Data (2015)

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Source: Monthly Bulletin, CBSL

Source: CBSL

Macro Variables Determine Changes in Financial

Segment Product Portfolio |

In addition to RCL, VONE also holds a 51.0% shareholding(effective holding of 64.29%) in LFIN, a Licensed FinanceCompany (LFC), which provides financial solutions forcorporates, small and medium enterprises (SMEs) andindividuals. In FY 2014/15, VONE earned 33.71% of Grouprevenue and 50.0% of Group EBIT from LFIN. LFCs andSpecialised Leasing Companies (SLCs) account for 7.0% ofSri Lanka’s financial system, and by the end of 2014 thesector comprised of 48 LFCs and 8 SLCs8. Based on totalassets as at end-2014, LFIN had 7.80%8 of total marketshare among LFCs.

VONE Enjoys Effective Holding of 64.29% in LFIN

Political stability post the August General Electionscombined with favourable economic policies should fuelgrowth in credit to the private sector, and we expect this todrive topline growth at LFIN. Muted demand for privatesector credit has dominated much of 2014, but this trend

reversed during 2015 and we see this positive momentumcontinuing into 2016E. Largely due to a decrease incommercial banks’ pawning advances and higher access toalternative funding sources, credit demand in H1 ’14 wasweak and by July 2014, private sector credit growth hit anall-time low of 0.83% Y-o-Y. Towards the latter half of theyear 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 CBSLreduced policy rates further helping push private sectorcredit levels back up to 17.60% Y-o-Y levels by May 2015.

Growth in Credit to Private Sector Continues Post

Rate-Cut in April 2015

0%

5%

10%

15%

20%

Jun'13 Sep'13 Dec'13 Mar'14 Jun'14 Sep'14 Dec'14 Mar'15

P v t . C r e d i t G r o w t h ( Y - o - Y )

Credit-Guarantee onPawning Loans

SDF Window

Rationalized

Reduction in PolicyInterest Rates

In line with the Central Bank projection of private sectorcredit growth in 2015E of ~ 15.50%, we expect creditappetite to improve on the back of political and economicstability (growth in H1’15 amounted to 15.03% Y-o-Y).Although some upside pressure on interest rates is likelygiven the current depreciation pressure on the LKR, westill anticipate growth in private sector credit in 2016E.

LFCs Play a Bigger Role in Private Sector Credit in Q1

2015

0%

6%

12%

18%

24%

30%

0%

20%

40%

60%

80%

100%

Q4 13 Q1 14 Q2 14 Q3 14 Q4 14 Q1 15 C o n t r i b u t i o n t o P v t . C r e d i t

CB LFCLSB LFC Credit to Pvt. SectorCB Credit to Pvt. Sector

Within this backdrop, we expect LFIN to further solidify itsposition within the Sri Lankan financial sector. LFC ’s havecontinued to expand their position as key lenders to theprivate sector and, as the decline in private sector creditdemand bottomed out in H2’14, lending to the privatesector by LFC’s increased significantly. Growth in credit tothe private sector by LFC’s amounted to a significant18.72% Y-o-Y in H2’14 relative to 6.72% Y-o-Y by

Commercial Banks. In Q1’15, LFC credit growth amountedto 27.59% Y-o-Y, while growth in Commercial Bank creditwas 13.88% Y-o-Y. In addition, the contribution to totalprivate sector credit from LFC’s increased ~200bps to16.33% in Q1’15 relative to 14.20% in Q1’13, whilecontribution from more traditional banking institutionsdropped ~300bps to 71.34% in Q1’15. We thus believethis increased trend towards credit from LFC ’s, whichcaters primarily to segments not necessarily targeted bymore formal banking channels underscores the potentialwithin the industry. Sri Lanka’s lower-than-regional peeraverage ratio of private sector credit to GDP meanwhileimplies the significant growth potential within the

domestic lending industry. During 2005-2009 for instance,Sri Lanka’s private sector credit/GDP ratio amounted to29.20% and decreased further to 28.20% during 2010-2014 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 toGDP levels imply space for growth and that the increasingshare of private sector credit that domestic LFC’s provideimply strong growth potential for key players such asLFIN.

Private Sector Credit Growth to Continue in H2’15

Segment Analysis: Banks and Finance


Source: CBSL

Source: CBSL

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In an effort to benefit from changing macro variables, LFINcontinuously makes strategic changes to its product

portfolio. Currently, LFIN’s focus on Loans and Receivablesis driven by growth potential in the Mortgage Loanssegment. LFIN’s lending portfolio includes, Gold loans,vehicle loans and mortgage loans (ie: categorized as loansand receivables) along with Lease Rentals Receivables andStock out on Hire. Lease Rentals and Stock out on Hireaccounted for 59.81% of LFINs lending portfolio, whileLoans and Receivables accounted for 40.19%.

LFIN’s Loan Book to Continue Upward Trajectory AmidGrowth in Loans and Leases

0

14,000

28,000

42,000

56,000

70,000

2012 2013 2014 2015 2016E 2017E

L K R M n

Loans and Receivables Lease Rentals and Stock out on Hire

Despite LFIN’s traditionally high exposure to Lease Rentalsand Stock out on Hire, the segment has faced increasedcompetition as traditional banks have also begun toaggresively pursue the Hire Purchase/Leasing market.LFIN’s strategic move to target other segments ,particularly within the Loans and Recievables segment isthus aimed at countering the increased competition withinits more traditional leasing products.

Growth in Loans & Receivables Backed by Mortgage

Market Growth

0%

25%

50%

75%

100%

2012/13 2013/14 2014/15 2015/16E

Gold Loans Mortgage Loans Vehicle Loans Other

LFIN’s declining exposure to the Hire Purchase segment isbeing replaced by the growing Loans and Receivablessegment, particularly stemming from the untapped growthpotential in the domestic mortgage market. LFIN’sexposure to Mortgage Loans has been increasing over theyears, from 2.63% of gross Loans and Receivables inFY 2012/13 to 10.34% in FY 2014/15. As of end March2015, LFIN’s gross Mortgage Loan book amounted to

LKR 2.41Bn, growing at a 3-year CAGR of 130.09% overFY 2012/13-2014/15, supported by the low and stable

interest rate regime combined with LFIN ’s aggressivemarketing campaigns. Through its Mortgage Loanssegment, LFIN intends to offer small ticket mortgagefacilities to customer segments overlooked by banks andwithout access to formal banking channels. Following theend of the internal conflict in Sri Lanka, the countryexperienced a boom in its Construction industry. Althoughconstruction or the purchase of a home is considered asignificant investment for an individual, over 90.0%9 of theSri Lankan property market has been debt-free, while re-mortgaging homes is almost non-existent 10. As of 2011, SriLanka’s mortgage market accounted for 2.4% o f GDPcompared with ~40.0% in Singapore10.

Demand for Housing Reflected through Growth in

Personal Housing Loans

-30%

-15%

0%

15%

30%

45%

2006 2007 2008 2009 2010 2011 2012 2013 2014

Personal Housing Loan Growth (%)

CBSL data indicates that housing loans contributed only9.0% to total loans in 2010, declining from 14.0% in theprevious year. Since 2010, the contribution of housingloans to total loans has hovered between 6.60-8.10%. Thelow contribution of personal housing to total loans is inour view attributable to factors such as: (1) poor access tohousing finance for middle-income groups; and, (2) highhousing costs for lower-middle income groups. Themortgage market’s extension to lower-income householdsremains low in Sri Lanka, although this group includesviable mortgage borrowers under more developed lendingschemes. We thus believe that the quarterly compoundedgrowth in personal housing (4.66% during the post-war

period March 2013 – March 2015) has not achieved its fullpotential. Although debt-financing remains relatively lowin Sri Lanka’s housing market, demand for housingremains strong with data indicating that an additional 1Mnhousing units would be necessary to accommodatepopulation growth over the next 15 years, (populationexpected to increase to 24Mn by 2030) and a further0.5Mn housing units required as replacement. This impliesan estimated 100000 housing units per annum2, which webelieve will fuel demand for mortgage loans over the nextfew years. Additionally, we believe LFIN should benefitfrom its entry into the mortgage market given that it

Source: CBSL Annual Reports

Growth Prospects in Mortgage Lending to Drive LFIN Performance


Source: VONE Annual Reports, Acuity Estimates


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Source: Mid-Year Report 2015 (Ministry of Finance), Ceypetco

Source: Department of Motor Traffic

targets customers overlooked by banks due to their highrisk profile. We therefore, estimate a 39.09% Y-o-Y growth

in gross mortgage loans in LFINs lending portfolio, thusimplying an increase in the composition of mortgage loansas a percentage of total gross loans to 12.48% inFY 2015/16E (from 10.34% in FY 2014/15).

Change in Tax Regulation and Lower Fuel Prices

Determine Growth in Leasing |

Despite increased competition within the Leasing space,we expect LFIN to continue focusing on its core business ofleasing as well as loans for vehicle purchases. Within theLease 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 fromVAT (mandated by the Budget 2015). This is due to thelack of distinction between Hire Purchase and FinanceLeasing following the change in tax regulation. In our view,growth in LFIN’s Leasing segment is expected to beboosted by: (1) the strong rise in demand for smallvehicles (

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Source: Annual Reports, CBSL

LFIN Benefits from a Diverse Portfolio


segment remaining a growth driver for the company.LFIN’s low delinquecy rates are attributable to three-

wheelers being used for income generating purposes(e.g. travelling & goods transportation) and due to lowerfuel prices significantly improving the customers’disposable income. Therefore, we believe LFIN ’s growth inthe net lease rentals portfolio will be primarily aided by itscontinued focus on the three-wheeler leasing serviceunder Micro Leasing. We expect this, combined withhigher demand for small cars to drive LFIN’s full yearleasing portfolio growth further (Q4 2014/15 net leaserentals grew 11.23% Y-o-Y and 19.27% Y-o-Y in Q12015/16).

Three wheeler leasing is a constituent of LFIN’s micro

leasing service, which primarily focuses on small-scalebusinesses and self-employed individuals (i.e. low-middlelevel income earners) with sufficient income levels torepay a loan. In addition to the leasing of three wheelers,LFIN’s microleasing services also cater to motor bikeleasing. We believe: (1) the increasing disposable incomelevels in Sri Lanka fuelled by lower fuel and electricitycosts; (2) the GoSL’s higher focus on the Small and MediumEnterprises (SME) sector and; (3) the expected stabilityfollowing the General Elections held in August, shouldsupport LFIN’s loan portfolio growth even further. Thepotential in the SME sector in particular, is likely to boostLFIN’s portfolio growth and the microleasing segment

(which accounts for 47.15% of LFIN ’s lease portfolio)should benefit from the discrepancy between demand andsupply in the industry. SMEs are classified as entities withan annual turnover of >LKR 600Mn and borrowings

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Source: Annual Reports, Bloomberg

LFIN’s Increased Exposure to Gold Loans (DespiteLower Gold Prices) Remains a Risk Factor |

Despite our overall bullish view on LFIN, we believe thereare a number of risk factors within the segment. Wehighlight LFIN’s: (1) High exposure to Gold loans despitelow Gold prices; (2) Increased competition from moretraditional banks; and (3) The likelihood of an interest ratehike, as important risk factors. Sri Lanka’s credit to theprivate sector weakened during H1‘14, primarily due tolower pawning. However, following the guaranteeing ofpawning by the Central Bank of Sri Lanka in June 2014 anda rationalization of the SDF window, private sector creditgrowth has since improved. Pawning (i.e. Gold-backedloans) in Sri Lanka gained particular popularity in the

rural regions as it represents a plausible asset to use ascollateral in order to access the country’s financialmarkets. A large portion of borrowing against Gold was bythe lower income rural and agricultural communities, andas such were primarily used for consumption.Consequently, strong growth in demand for credit also ledto a rapid rise in economic activitiy in Sri Lanka. LFIN ’s netGold loan book too grew at a 3-year CAGR of 37.23% (toLKR 10671.74Mn) over FY 2010/11-2012/13, driven bythe rally in Gold prices. Following the crash in Gold pricesin 2013 however, the proportion of lending against Golddeclined due to the lower value of gold against whichcredit could be lent, combined with a decline in Loan to

Value ratios. As a result, LFIN’s Gold loans contracted24.97% Y-o-Y in FY 2013/14, as Gold prices declined19.74% Y-o-Y.

Despite Lower Prices, LFIN’s Gold Loans Grew ~30.0%Y-o-Y in FY 2014/15

50

100

150

200

2010/11 2011/12 2012/13 2013/14 2014/15

V a l u e ( R e b a s e d t o 1 0 0 )

Average Gold Prices Gold Loans

Growth in Loan Book Despite Decline in Prices

In FY 2014/15 however, despite a 5.99% Y-o-Y decline ingold prices, LFIN’s Gold loan book made a partial recovery(+29.64% Y-o-Y to LKR 10380.70Mn) towards the levelsseen prior to the Gold price crash. This was in contrast to a~40.0% decline in the Gold loan book in the banking andLFC sector. LFIN continues to grow its Gold loan book,despite declining Gold prices, as it believes it has taken

necessary measures to improve its product portfolio andmitigate the negative impact of lower prices. This is

particularly evident in LFIN’s Gold loan losses/gross Goldloans ratio of 2.06% in FY 2014/15, which is significantlylower than the 16.74% recorded in the previous year. Thecontinued increase in demand for Gold loans is alsoapparent in the 20.45% Y-o-Y growth in the number ofcustomers for Gold loans in FY 2014/15. We forecast grossGold loans to grow at a modest 3-year CAGR of 5.58% overFY 2014/15-2016/17E, resulting in a contribution of42.04% of total gross loans in FY 2015/16E and 39.62% inFY 2016/17E, declining from 44.76% in the last financialyear. Our modest growth forecast takes into account thepositive impact of increasing demand for Gold loans beingpartially offset by the impact of a further decline in Goldprices. Despite the recent bearishness in global equitymarkets, investors have shown weak interest in the safe-haven assets such as Gold, leading to the belief that Goldprices could continue to decline. Given LFIN’s high Gold-loan exposure therefore, we believe a further decline inprices is likely to significantly increase risks to LFIN ’sproduct portfolio.

Meanwhile, LFC’s including LFIN have also facedincreasing competition from the banking sector offeringservices which were traditionally only offered by financecompanies. We identify this as a potential threat to LFIN’sperformance while also noting that the company’scontinued focus on high-margin products for a highermargin customer base should help overcome the issue ofincreased competition, at least in the short-term.

Moreover, the likelihood of an interest rate increase inH2’15, could negatively impact LFIN’s interest spreads dueto a greater asset/liability mismatch in the context thatlong-term lending is on fixed rates relative to short-termborrowings which are on floating rates. Higher interestrates would also negatively impact the demand for LFIN’sgrowth segments, mortgage lending, vehicle leasing andmicroleasing.

Note 8 – CBSL Annual Report, 2014Note 9 – Sunday Times, April 2014, Real Estate Market segment: Middle Income

Note 10 – Colombo’s 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 LoanRatio on Motor Vehicles

Large Exposure to Gold Loans Remains a Risk to LFIN


Source: Annual Reports, Bloomberg

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Source: Annual Report


VONE Remains a Highly Diversified Conglomerate

Segment Analysis: Other

VONE’s Diverse Portfolio of Operations toButtress Medium Term Prospects |

While majority of VONE’s revenues are generated throughTiles, Sanitary Ware and Banks and Finance, its operationsalso span across Plantation (4.57% of total revenue in Q12015/16), Consumer (5.94%), Lifestyle (3.74%),Healthcare (5.07%) and Other (10.94%). We believe thatVONE’s medium term prospects will be boosted further bythese diversified operations, namely the turnaround inDelmege Group. While we remain relatively more subduedon the Plantation segment earnings, we believe the Groupis diversified enough to withstand any short-term pressurefrom this segment.

Approx. 30.26% of VONE’s Revenue is GeneratedOutside of Tiles, Sanitary Ware and Banking

Tiles

Sanitary wear

Banks &

Finance

Plantation

Consumer

Lifestyle

Healthcare

Other

VONE

Benefits

from a

Well

Diversified

Portfolio

Signs of Recovery Visible at Delmege Group |

VONE acquired 51.0% of the Delmege Group, a highlydiversified conglomerate in 2012, bringing its totaleffective holding to 61.70%. The operations of DelmegeGroup span six industries through fifteen legal entities.Subsidiaries of the Group are engaged in manufacturing,trading, shipping, logistics, airline and travel, andinsurance brokering. Following the acquisition, VONEfocused 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 ingovernment policy, which affected the price of canned fish(a significant revenue generator for the Group).Management is currently focusing on minimizing costs andstrengthening sales. Both due to these cost reductionefforts and lower fuel and electricity costs, the segmentreported EBIT of LKR 153.40Mn in the latest financial year,improving from an EBIT of LKR 3.89Mn in the previousyear. On a cumulative basis therefore, VONE’s EBIT fromConsumer, Lifestyle and Healthcare segments (whichlargely consists of Delmege results), has continued toimprove. While EBIT improved at a compounded quarterly

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 tocontinue benefitting from the ongoing cost reductionefforts in the short-term, while its aggressive marketing inin the domestic market should also help boost volumes.Group strategies include: (1) Launching new channels ofdistribution; (2) Introducing new products and services;(3) Use of “Push and Pull” marketing strategies for highgross margin products; (4) Strong working capitalmanagement, and we believe that these initiatives arelikely to generate strong revenue streams, and thus remainbroadly positive on Delmege’s medium-term prospects.

Strong Margin Improvement Visible at Delmege

-6%

-4%

-2%

0%

2%

4%

6%

8%

(70)

(40)

(10)

20

50

80

110

140

Q1 2013/14 Q3 2013/14 Q1 2014/15 Q3 2014/15 Q1 2015/16

M a r g i n ( % )

L K R m n

EBIT EBIT Margin (%)

EBIT Improved at Quarterly CompoundedGrowth Rate of 34% to Q1 2015/16

Near Term Pressure on Plantation Sector

Continues |

VONE’s revenue from Plantations stems from HoranaPlantations (HOPL), which focuses on tea, rubber, timberand diversified agricultural crops across estates in theCentral and Western provinces. The Plantations sectorfaced several challenges during the financial year,including adverse weather conditions and continued weaktrading conditions in the rubber sector. As a consequence,HOPL recorded Profit after Tax of LKR 61.98Mn inFY 2014/15, down 54.84% Y-o-Y. Despite rising domesticcosts of production and the global glut in tea supplies, theeasing of sanctions against Iran (Sri Lanka’s largest Tea

exporter) in mid 2015 remains a noteworthy developmentfor the overall industry. However, we expect HOPL’sperformance in FY 2015/16E to continue to be weak onthe back of the declining tea prices, a possible wage hike,and geo-political tension in Sri Lanka’s main exportmarkets. The industry is likely to be impacted further bythe go slow wage campaign, which led to a 10-day shutdown of tea factories during Q2 2015/16. The domesticrubber industry also continued its weak tradingconditions, as local production declined for the 3rd consecutive year on the back of weak internationaldemand combined with unfavourable weather conditions

Source: Annual Report


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which led to disruptions in latex tapping. The GoSLhowever, has implemented a guaranteed price system in

order to improve the domestic rubber industry, despiteweak demand. Despite the challenges faced by thePlantations sector however, HOPL continued to invest inreplanting and upgrading its factories. Additionally,management also focused on crop diversification, as itcompleted the planting of palm oil (which, until recently,supported regional plantation companies compensate forlosses in tea and rubber) in Neuchatel, Mirishena andHalwatura. Demand for palm oil is on the rise in Sri Lanka,particularly due to increasing coconut oil prices, which is aclose subsitute for palm oil. HOPL also initiated theplanting of fruits and vegetables. Therefore, despite short-term challenges within the segment, we remain broadly

positive on the Group’s medium-term prospects for thePlantation segment.

Plantation Sector to Weigh Down on Earnings in the Near Term…

Segment Analysis: Other

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Target Price of LKR 28.5 Based on a Sum-of-the-

Parts Valuation |

We use a sum-of-the-parts (SOTP) valuation to arrive atour target price for VONE and based on this methodology,we derive a target price of LKR 28.5 per share, implyingtotal return of 26.0%. The valuation has been carried outusing a series of metrics ranging from DCF to relativevaluation (PBV & PER) to market based valuation (marketvalue of subsidiaries/associates). On this basis, RCL (Tilesand Sanitary Ware segments) accounts for 41.85% of ourtarget equity value, while LFIN (Banks & Finance)generates 39.52% of the value. We assume Sampath Bankshould contribute 11.36% to VONE’s target value.

RCL and LFIN Contribute over 80% to VONE’s EquityValue

Royal

Ceramics,

41.85%

L B Finance,

39.52%

Sampath

Bank,

11.36%

Delmege,

5.05%Other, 2.22%

We value RCL (Tiles and Sanitary Ware) using a DCFvaluation, and arrive at a value per share of LKR 19.10,assuming a WACC of 13.89%. Given our positive outlookon LFIN and its better-than-peer performance, we valueVONE’s Banks & Finance segment assuming a targetPrice/Book multiple of 1.92x and thus develop a per sharevalue of LKR 18.04. Our target multiple of 1.92x is abovethe sector average of 1.84x, a premium we believe isjustified given that given that LFIN has historically tradedat a premium to its peer average. Given the volatility inearnings, our value of LKR 2.31 per share for Delmege(5.05% of VONE’s equity value), is arrived at by

discounting the Diversified sector PER of 15.89x (i.e,11.12x 2016E). Despite expecting a turnaround atDelmege, we believe a discount on the sector PER iswarranted, given that it is a private diversifiedconglomerate. However, we note that a complete overhaulat Delmege would likely boost VONE’s value further.

Similarly, although we note that a turnaround in thePlantations sector should lead to a further boost in VONE’svalue, given the current weakness in the industry believeHOPL is fairly valued at 0.40x PBV, and as such assign a

target multiple of 0.42x. At our assumed multiple, weexpect HOPL to contribute LKR 0.56 per share to VONE’s

target price. For our valuation of Sampath Bank PLC(effective holding of 14.95%) we have used a Justified PBVand derive a value of LKR 5.18 per share; for the Group’sLeisure associates, Waskaduwa Beach Resort PLC(20.22%) and The Fortress Resorts PLC (18.02%)meanwhile, we have used the market value of assets as ourbasis 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

Multiple

(x)

Value

(LKR Mn)

Per Share

ValueRoyal Ceramics DCF - 20,752.2 19.10

L B Finance PBV 1.92 19,599.8 18.04

Delmege Diversified PER 11.12 2,504.7 2.31

Horana Plantations PBV 0.42 607.5 0.56

Sampath Bank Justified PBV - 5,631.7 5.18

The Fortress Resorts Market Value - 253.1 0.23

Waskaduwa Beach Resort Market Value - 240.5 0.22

Equity Value 49,589.4 45.64

Adjustments (18, 676. 3) (17. 19)

Price 28.45

Despite necessary approvals being obtained earlier this

year for the project to proceed, we have refrained fromincorporating revenue streams from Greener Waters in toour VONE valuation, as the project’s feasibility andpreviously disclosed concept are being re-evaluatedfollowing changes to regulations in tax exemptions.Greener Water Ltd. (which was acquired in 2011) is theleisure arm of VONE, under which investments have beenmade towards hospitality projects. Its maiden investmentproject lies on 14 acres in Negombo, and is designed as a400 roomed five star hotel with 4 epicurean restaurants,banquets, a tranquil spa, exquisite suites, fitness centresand a water park. Since 2011 though, VONE has facedseveral challenges pertaining to accessibility andapprovals, but the project was approved this year. Sincethe project is yet to materialize and its continuity isuncertain in light of changes in tax regulations, we havevalued VONE on its existing core business and haveexcluded this project from our estimates. Therefore, on our2016E estimates, we value VONE at LKR 28.5, yielding atotal return of 26.0% (Price Appreciation: 23.7% andDividend Yield: 2.2%).

Source: Acuity Estimates

Source: Acuity Estimates

Target Price of LKR 28.5 Yields a Total Return of 26.0%

Valuation

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Discount to Peers Expands Post Q2‘15 Results, asGrowth Prospects Not Priced In

6

10

14

18

Apr-13 Aug-13 Dec-13 Apr-14 Aug-14 Dec-14 Apr-15 Aug-15

P E R ( x )

VONE Peer Avg.

VONE's Expanded Discount to PeersUnwarranted

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

has historically traded at a discount to its peers, and itscurrent PER of 8.83x which represents a 38.52% discountto its peers is significantly wider compared with itshistoric discount of 21.79%. As we expect the strongperformance recorded in FY 2014/15 (EPS growth of83.69% Y-o-Y), to continue into FY 2015/16E (EPS growthof 47.86% Y-o-Y) due to growth potential in both RCL andLFIN, we believe that the upside potential on the stockprice does not warrant the current discount it is trading at.We thus believe that VONE should trade closer to itshistoric PER discount and as such expect the stock to tradeat a higher multiple.

Downside Risks to Valuation

While we remain positive on VONE and its prospects, wehighlight a number of downside risks to our valuation inthis section. We view: (1) the potential impact of the supergains tax; (2) weaker-than-expected growth inconstruction; (3) a higher-than-expected increase ininterest rates; (4) continued weakness in privateconsumption/investment; and (5) the potentialdevelopments around the Comprehensive EconomicPartnership Agreement (CEPA) between India and SriLanka, as possible downside risks to VONE’s value.

We believe the largest downside to our valuation will bedriven by the potential impact of a one-off super gains tax proposed by the new government in its interim budget inJanuary 2015. Accordingly, a one-off super gains tax of25.0% is proposed for companies which have earned overLKR 2Bn in FY 2013/14. However, given the lack of clarityon the finer details, we have not incorporated the impactof this tax. We believe though, that a worst case scenariocould lead to an effective tax rate of ~50% (Super gains tax25% + Corporate tax) but await clarification on theproposal before incorporating any such scenario in to ourvaluation.

Source: Bloomberg

Risk to Valuation on a Super Gains Tax

Valuation

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FY 2013/14* 2014/15 2015/16E 2016/17E

LKR Mn (except per share data)

Revenue 48,331 43,450 49,753 54,953

EBIT 5,149 7,546 9,931 11,470

Share of Results of Equity Accounted Investees 576 1,146 1,272 1,378

Profit Before Tax 3,832 7,349 9,981 10,975

Tax 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

LKR Mn

Revenue (Excluding Associates)

Investment 0 0 0 0

Tiles 14,199 14,825 18,196 19,791

Sanitary Ware 1,125 1,354 1,426 1,504Plantation 2,069 2,165 2,176 2,198

Banks & Finance 13,492 14,647 15,826 17,938

Leisure 0 0 0 0

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 0 0 0

Other 3,051 4,540 4,911 5,231

EBIT (Excluding Associates)

Investment (71) (2) (69) (62)

Tiles 2,452 2,859 3,769 4,255

Sanitary Ware 361 392 389 421

Plantation 220 123 58 66

Banks & Finance 3,465 3,929 5,130 5,916

Leisure (23) (19) (16) (13)

Consumer (61) (32) 8 73

Lifestyle 64 90 103 152

Healthcare 2 96 172 227

Apparel 82 0 0 0

Other 31 322 385 434

FY 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%

P r o f i t & L o s s S t a t e m e n t

S e g m e n t a l P e r f o r m a n c e

G r o w t h & R a t i o s

* Includes Results of Orit A arels, Which was Dis osed Durin FY 2014 15 Source: Company Annual Reports & Acuity Estimates

Company Financials

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Research Team

Chethana Ellepola(+94) 112 206 [email protected]

Anjula Nawarathna

(+94) 112 206 [email protected]

Aethra de Silva(+94) 112 206 [email protected]

Samalka Athuraliya(+94) 112 206 [email protected]

Anouk Weerasinghe(+94) 112 206 [email protected]

Sales Team

Deva Ellepola(+94) 112 206 220/[email protected]

Prashan Fernando


Kapila Pathirage(+94) 112 206 227/[email protected]

Naren Godamunne


Arjuna Dasanayake(+94) 112 206 [email protected]

Amarasena Liyanage


Susil Fernando


Chathura Siyambalapitiya


S. Vasanthakumar

(+94) 112 206 250/[email protected]

Disclaimer:

“ Distributed in Sri Lanka and abroad by Acuity Stockbrokers (Private) Limited (ASB) and its authorized representatives. ASB isfully owned by Acuity Partners (Pvt) Ltd (APL) and APL is a joint venture of DFCC Bank and Hatton National Bank PLC. The

Information contained herein has been compiled from sources that ASB (“The Research Institution”) believes to be reliable but none of the Research Institution holds itself responsible for its completeness or accuracy. It is not an offer to sell or a solicitationof an offer to buy any securities. The Research Institution and its affiliates and its officers and employees may or may not have aposition in or with respect to the securities mentioned herein.

The Research Institution and its affiliates may from time to time have consulting relationship with any company, which is beingreported upon. This may involve the Research Institution providing significant corporate finance services or acting as thecompany’s official or sponsoring broker.

All opinions and estimates included in this report constitute judgment as of this date of the Research Institution and are subjectto change or amendment without notice. The Research Institution has the copyright for this report and the views herein cannotbe reproduced and/or distributed in any form without the explicit (written or otherwise) permission from Research Institution.

Dhammika Wanniarachchi(+94) 112 206 [email protected]

Shivane Wijayaratnam


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