• Market concerns about a free float 
• Pumped up!
• Two banks under one holding company?
• Hopes pinned on NSB
• New provisions to accounting standards
• Mind Your Business
• The tragedy of our paddy
• The flavour gets sweeter
• News
• World on your palm

Comment

Market concerns about a free float 

By the Business Editor

Heading their list of concerns is the fact that with the country continuously nursing a balance of payment deficit (or a current account deficit) and with dollar reserves dipping, a free float of the rupee leaves the door wide open for speculative raids.

The Central Bank last week widened the trading band of the dollar rupee exchange rate from 5%-8%, which is an effective two per cent depreciation on the Central Bank's middle rate on the dollar. 

So far this year, the rupee has depreciated by 15.6% on the annualised interbank spot rate. The interbank spot, a benchmark in currency trading, is the rate at which commercial banks trade with a two-day settlement agreement. Currency is also traded on an immediate cash payment or an agreement to settle the next day, tomorrow (TOM).

The Central Bank's middle rate, has also depreciated by 11.4% (annualised.)

In comparison, last year the spot depreciated only by 5.6% and the middle rate by 6.4%.

This year, the Central Bank has been tinkering with the dollar rupee-trading band in what is seen as a forerunner to a free float. 

The Central Bank, which announced the buying and selling rates of the dollar on a daily basis, and operated on a 2% trading band, widened this trading band to 5% this June and resumed announcing fixed rates for the dollar in November again.

These moves have inevitably given rise to speculation and comment in the market with some players believing that the Central Bank is toeing the multilateral agency line, while others say that the Bank is using the exchange rate to protect interest rates.

A head of treasury of a leading foreign commercial bank said that if capital controls are not removed, in a country where the import bill is higher than export earnings, someone has to intervene and sell the dollar shortfall. 

"Is the Central Bank going to intervene? What is the Central Bank's intervention policy?" he asked.

Another head of treasury of a leading local commercial bank said that in a free economy where almost everything save the flour and fuel prices are market determined, why not the dollar? 

But he was emphatic that a free float will only be safe if the country's economic fundamentals are sound and the banking sector is efficient and well regulated.

"For example the country should have a manageable current account deficit or a surplus, if we are to control speculation on the currency, he said.

While it is a fact that countries like the USA have a sizeable trade deficit they are strong in reserves and can control speculation on their currency, he added. 

Some analysts also believe that huge reserves are not necessary and that they should be capitalised or invested.

But overall the market and analysts agree that with reserves now being very low, economic fundamentals not too healthy, a free float of the currency is premature.

Some analysts also say that in the present context with the reserves going down the evaluation is as good as a float. 

Those who have the ability to do so will hold the currency abroad to arbitrage.

This is where the balancing mechanism comes into play where dollar interest rates are compared with the devaluation of the rupee or the cost of borrowing, they said.

Pumped up!

Groceries and medicine from a gas station? Yes, and why not? It is commonly the case overseas, and soon might be the case here too. 

If you had ever passed Havelock Road in the past Six months, you would have caught sight of a yellow gas station that looked like a picture off a foreign magazine. 

That was the result of a bold new initiative that, according to Lanka Auto Gas Industries (Laughs) Chairman, W.K.H. Wegapitiya, went against local supermarketeers advice, Sri Lanka to get her first 24 hour superstore. 

The first of five such "convenience stores" to be established in Colombo, the 24 hour filling station, express service station, grocery and pharmacy in one concept is not a new idea. The concept has been around for generations in many parts of the world and is very popular for its convenience. 

Mr. Wegapitiya said that the decision to open a chain of 24 hour convenience stores was made to facilitate the 'night owls' or the increasing number of corporate employees who worked late into the night. He said that surprisingly, a relatively large share of his sales was after 10 pm when all other shops and supermarkets were closed. He added that this was in contrast to the picture supermarket owners had painted for him when he sought their views on the 24-hour supermarket concept. 

Mr. Wegapitiya said that he hoped to open five more convenience stores in Colombo and thereafter he said that all new stations would follow the new concept. Mr. Wegapitiya said that an estimated Rs. 20 million of internal funds was pumped into the idea. 

Auto Gas Lanka already operate 11, 24 hour gas stations. 

Meanwhile, Laughs is one of the four companies to enter the recently liberated gas industry. With an investment of over Rs. 500 million. Mundogas S.A., Caltex Ceylon Ltd. have also received the green light form PERC to set up LPG gas operations. 

Two banks under one holding company? 

The final decision to put forward a set of proposals to the Central Bank was made last week after a series of discussions by the two boards of the banks, DFCC's General Manager, Mr. Nihal Fonseka told the Sunday Times Business.

The joint proposals are to allow the banks to benefit from synergies and lay the foundation for a stronger and larger financial services group, an announcement to the Colombo Stock Exchange jointly signed by Mr. Nihal Fonseka and Commercial Bank's MD, A. L. Gooneratne says.

The concept of a holding company structure would allow the banks to easily cross sell their products, Mr. Fonseka said. 

Since there is no precedent in Sri Lanka on having a holding company structure for two banks the Central Bank will obviously have to study the proposals carefully before a decision on the entire set of proposals is made, Mr. Fonseka said. The DFCC bank owns 29.8% of the Commercial Bank. 

Hopes pinned on NSB

By Chanakya Dissanayake

The reform is expected to increase the private sector access to finance and reduce the government's dependency on NSB funds. The government is also expected to appoint a working committee comprising NSB, the Central Bank and the Ministry of Finance to study the possibility of NSB increasing it's participation in the privet sector. The ADB funding will be provided in the form of a program loan to the government to finance training costs and change management. Deputy Resident Representative ADB , Joseph Zveglich told Sunday Times Business( STB), " This program is aimed at removing the financing constraints the private sector is facing and making an efficient use of the NSB's large deposit base".

NSB's General Manager, Mr. N.B.S.B. Balalle told the STB, " We have been looking at the all possible methods of investing in the privet sector, but it will not be at the expense of quality". NSB is allowed by statute to invest upto 40% of it's portfolio in the private sector. Currently NSB's privet sector investments stands at 18% of it's portfolio. NSB will provide loans only if the loan is secured by a bank guarantee or a credit rating.

According to the mandate given to NSB, it is only required to invest 60% of its portfolio in the government securities. " Even in our corporate plan we have stated that we need to increase our lending to the private sector. We have a difficulty in finding suitable borrowers. But now there is an awareness about NSB's corporate lending and more companies are coming to us", Mr Balalle further added. ADB's Private Sector Development Project will also facilitate PERC reforms and liberalisation of the labour market in Sri Lanka. The initial phase of this program will be implemented during 2000-2002. 

New provisions to accounting standards 

Accounting to the revised SLAS-3, the profit and loss account paid L account will be renamed "the income statement". Also in addition to current requirement of published financial statement comprising the P and L, balance sheet and the cash flow statement, a separate "changes in equity" statement will have to be published. It will disclose the changes in the safe holders funds during a year. It will disclose the changes in the shareholders funds during a year. This statement will give a complete picture of the changes in reserves, retained profits and the effects of share issues and dividend payments to share holders funds during a year.

In the income statement it is mandatory to disclose the cost of sales, administration costs and the sales and distribution costs. The statement will disclose the path form turnover to bet profit in detail. Earlier in the published accounts, companies were able to disclose only the operating profits and certain other costs in the notes to accounts. 

The disclosure of the cost of sales would enable the inv4stors to calculate the gross profit margins. However there is also the possibility of the company unfavorably affected by the competitors gaining information about it's margins.

"Some public quoted companies which follow International Accounting Standards have already been complying with the new standards for some time voluntarily", said Maryam Marikkar of SJ Associates. The requirement of disclosing cost of sales has been introduced initially as SLAS-5 few years ago.

The SLAS-34 has been introduced to standardised different methods of EPS calculation that companies adopt. It has formally standardised the concept of calculating the "Diluted EPS". 

Diluted EPS is calculated considering the future effects of employee share options, conversion of hybrid dent instruments into equity etc. SLAS has also standardised weighted average methods used to calculate EPS in the event of mid year share issues.

Although the new standards will increase the complexity of the published financial statements to a layman, it is expected to increase the ability of the corporate investor to make an informed decision. " This is the new trend. On a global context there is a belief that non-disclosure of certain expenses can leased to unnecessary padding up of expenses. Also the new standards will enable comparisons between companies in the same sector", said Ajith Cabraal, Former President SLICA. "On the contrary, the disclosure of these expenses could be unfairly advantageous for the competitors.

But the International Accounting Standards Committee has felt that the overall positive effects of these disclosures are greater than their negative effects.

Mind Your Business

No fly zone

But the initial investment is substantial and banks are hesitant to cough up the finances because the flights can get grounded at anytime because of the uncertain security situation, executives say...

VTZs on the cards

Towards this end, policy planners have come up with the idea that there should be areas designated as virtual free trade zones for the IT industry, offering tax concessions and the like.

But there is one snag- the location of the zone. 

Several politicians want the zone located in their electorates and this tug-o-war is delaying a decision...

Beware of the trend

Rupees and dollars are slowly but steadily being siphoned away from the Colombo bourse by investors and now the outflow trend is reaching significant proportions.

Some brokers are worried because if the trend continues they will be out of business and only those brokers who are subsidiaries of larger companies will be left, they say...

The tragedy of our paddy

The high growth in the first half of this year is partly accounted for by the low growth in the first half of last year. Since the economy began to grow in the second half of last year, the slower growth is mainly due to its comparison with a higher rate of growth in the third quarter of last year. Not withstanding this, agriculture's poor performance is worthy of comment.

The performance of the agricultural sector recorded a decline of 0.6 per cent in the third quarter compared to the performance of last year's third quarter. 

The main reasons for this were declines in paddy production, rubber, fish and milk. 

Tea and coconut production continued to increase. Rubber production this year has been poor the entire year despite rubber prices showing an upward trend. 

In the first nine months of this year, rubber production declined by 9 per cent. In contrast, coconut production increased by 11 per cent and tea production is heading for a new peak production of around 300 million kilograms. 

The decline in paddy production is noteworthy in the context of the euphoric statements of the government and even rash expectations of exporting rice. The Yala crop, which fell in the third quarter, recorded a decline of about 10 per cent compared to that of the last Yala. 

Consequently paddy production this year was 2787 thousand metric tons, a decline from last year's record crop of 2856 thousand metric tons. This decline of 16.5 per cent has resulted in this year's production being inadequate to meet our consumption requirements. While imports of rice are not imminent, as rice stocks are still high owing to large imports earlier this year, rice imports may be needed early next year before the next Maha harvest.

The decline in paddy production has several important lessons for us. First of all politicians should not mislead the people on basic economic conditions. The government was celebrating the high paddy crop of last Maha, without focusing on the serious problems of marketing paddy in a context of a market surplus; not due to local production, but due to large imports earlier in the year. 

Ironically the increase in paddy production was itself partly responsible for the decline in the next harvest. The inability to sell their produce at a reasonable price created difficulties for the farmer. They were unable to afford the needed inputs, particularly fertilizer. Consequently fertilizer applications were below the optimum. The low applications of fertilizer, quite apart from decreasing production, even created other agronomic problems in some paddy growing areas. 

Paddy has not been a profitable crop for sometime. For most farmers, in many parts of the country, their small sized paddy holdings do not generate adequate incomes to keep the home fires burning. An already low profitable crop turned particularly unprofitable when paddy purchase prices fell as low as Rs 8 to 9 per kilogram. These prices were below the cost of production of paddy. Stagnant yields, high costs of production, shortage of labour to work the muddy fields and marketing failures, are among the reasons for the poor performance in paddy. These are the problems that have to be faced, if the lower paddy production of last Yala is not to turn itself into a declining trend in paddy production.

We hope the scientists who met at the two day Rice Symposium 2000, concluded on Friday, addressed their minds to these issues and have worked out a comprehensive strategy to ensure the viability of paddy farming. 

We hope their vision of a "Second Leap Forward" would be a reality in this decade.

While manufacturing is progressing well due to a boost to our main export industries, domestic agriculture, as the crops for local consumption are called, are undoubtedly ridden with serious problems. The economy's growth may receive a set back if we are unable to ensure increases in production of food crops, particularly paddy. 

The tragedy of our inability to increase agricultural production is not a mere statistic in our national accounts, it is an indicator of low incomes and poverty of a large number of people in the country. Therein lies the urgent need for increased productivity in, and better prices for our paddy.

The flavour gets sweeter

By Isuru Gunasekara

Effective holdings considered for conglomerates

When calculating the conglomerates 'exposure to plantations in terms of hectarage, we have taken the effective holding of the parent conglomerate in each plantations company. In John Keells Holdings '(JKH 's) case, for example, we have taken into account the holding that RPK Management Services has in Kegalle and Maskeliya Plantations, and then considered the holding that JKH has in RPK. We have then converted this holding to hectares of exposure. The same goes for its holding in Namunukula Plantations.

It is interesting to see the difference between the conglomerates effective exposure to plantations and the actual cultivated area of their plantations. For example, JKH has Maskeliya, Namunukula and Kegalle under it, which have a total of over 15,000ha of tea; however,JKH has effective exposure to only around 3,700ha.

Profitability of the conglomerates mismatched

The profitability of the conglomerates has been calculated by taking their profits from the plantations sector and then dividing it by their area of exposure. However, due to the inconsistency of different conglomerates when reporting profit figures from different sectors, these numbers are slightly mismatched. For example, JKH reports plantations profits after tax, while Hayleys reports income before tax for its plantations business.

Management fees key to conglomerates 'profitability

The difference in profitability between the conglomerates and the plantations itself is striking. It is almost contradictory, as the plantations companies, with obviously more exposure in terms of hectarage, are less profitable than the conglomerates. The reason for this is the management fees that are charged by the managing agent (ie the parent conglomerate).Therefore, conglomerates are able to reap higher profits from the sector with relatively low exposure in terms of area.

Dividends -One way to go

Of our core-coverage plantations companies, Maskeliya and Balangoda have the best dividend yields -12.5%in fy 01 jf (year-end March)for Maskeliya and 11.2%in fy 00 jf (year-end December)for Balangoda. 

However, it is important that investors do not expect plantations companies to provide a steady dividend income stream, given the volatility in their profits; rather, they should view them as long-term investments for capital gains. Nevertheless, it may be noted that, regardless of profits, Maskeliya has always maintained good dividends in the past.

Of the conglomerates, Richard Pieris has the most attractive dividend yield. However, dividend yield figures for conglomerates are low when compared to those of the plantations companies. 

The RoE for all plantations companies seems to be broadly in the same range. For bigger companies, such as conglomerates, it is a much more difficult task to increase RoE. It is not uncommon to see the RoE for plantations companies reach 40%-50%levels during years of high profits.

EV/EBITDA also helps

Using a cash-flow-based ratio, EV/EBITDA is another useful valuation tool that shows us how cheap or expensive a company is relative to others. On this valuation, Balangoda and Watawala are significantly cheaper than the rest.

Retailers play a key role in plantations stocks

It is important to recognise the role that retail investors play in plantations stocks. One reason for the high volatility of the plantations index is the activity of the retail investors. As a result, orthodox valuations might not always seem significant in the plantations sector. For example, retail investors like stocks that are cheap in absolute terms, which they can buy more in terms of quantity. Therefore, stocks that are cheaper in absolute terms are typically more volatile. This provides good trading possibilities. In this context, we like Kelani Valley and Watawala.

Retailer investors also like high-EPS-growth stories. Therefore, plantations companies that are growing off a low base, such as Watawala and Kelani Valley, would be their favourites in the sector. As a result, although Maskeliya is a great long-term growth story, it is unlikely to see short-term speculative trading potential. This is due to its low EPS growth this year, a result of its high profits last year. Retail investors also like companies with high exposure to low-grown hectarage, as they are known to fetch higher prices at the auctions. Balangoda is one such company.

Retail investors also seem to trade heavily on positive or negative new flows. For example, when negative news in the form of the wage increase hit the sector, retail investors sold down the index at an alarming rate.

Conglomerates trading at higher multiples

Due to their diversified exposure, conglomerates generally trade at higher multiples than pure plantations companies. On average, the conglomerates are trading at 6.5x fy 01 and 5.5x fy 02 earnings compared with 4.3x and 3.7x for plantations. 

Among conglomerates, Hayleys is the cheapest in terms of PER multiples, at 5.5x fy 01 and 4.5x fy 02 earnings. This is due mainly to the profit revision for the group, a result of its excellent 1q01 profits.

Issues

In the recent past, there have been two important issues for the plantations industry. One is the setting up of the Indo-Lanka Free Trade Agreement (ILFTA) and the other is the wage negotiation between the plantations companies and the estate unions.

The ILFTA
Great potential

A key event for the industry in 2000 was the tying up of the ILFTA. The crux of the deal is that Sri Lanka would be able to export up to 15m kg pa (11.25m kg in 2000 as the agreement we assigned only in April)to India at preferential tariff rates. This has opened up a huge market for the island. In 1999,Sri Lanka exported only 1.7m kg of tea to India -a pointer to the extent of untapped potential.

Sri Lanka is trying to push for India to include Mumbai and Chennai as designated ports (both sea and air)in addition to the already specified ports of Calcutta and Cochin. Maharashtra and Gujarat ar among the highest tea-drinking areas and shipments to Mumbai (which is in Maharashtra and is also adjacent to Gujarat) will help Sri Lanka to access these markets better rather than channelling them via Calcutta or Cochin. However, despite strong prospects for Ceylon tea in India, it is unlikely that the full quota be utilised soon. This is due to the fact that Sri Lankan exporters will have to find interested buyers who have the retail network to market Ceylon tea. Effective promotion of Ceylon tea in the heavy tea-drinking markets in India is the need of the hour.

Under the ILFTA,all exports -whether in the form of bulk tea, tea packets or tea bags -should consist of 100%-pure Ceylon tea. Meanwhile, exporters who ship teas under the scheme are required to obtain a certificate from the Department of Commerce stating that the teas are of Sri Lankan origin. 

The ILFTA was followed by several other agreements with other key buyers of Sri Lankan teas, such as Ukraine and Egypt. An agreement on the lines of the ILFTA is also being negotiated with Pakistan. These developments, coupled the rupee devaluation, have boosted demand for Sri Lankan tea and have helped to revive the industry.

Wages are a crucial factor for the industry

Wages make up about 60%of the total COP in the plantations industry. Therefore, it is crucial to keep an eye on the progress of wage hikes. The recently-settled wage negotiations were a much-talked-about topic among investors. We highlight below the key aspects of the settlement.

A possible 20%increase in tea estate wages

Since January 1998,tea estate workers have been earning Rs 95 plus Rs 6 of Price Share Supplement (PSS)per day, while rubber estate workers have been earning Rs95.00 per day. According to the new agreement, tea estate workers 'base wage of Rs 95 will be increased to Rs 101;further, they would earn an additional Rs 8 if their monthly attendance is between 85%and 90%,or Rs 14 if it is above 90%.On top of this, they would continue to earn the PSS of Rs 6.Hence,an employee with over 90%attendance would now earn Rs 121 per day.This implies a 20%increase in daily wages.If a worker does not meet the minimum criteria of at least 85% attendance to qualify for the incentive,he would receive Rs 107 per day (ie the base wage of Rs 101 plus the PSS of Rs 6).

Rubber estate workers -A wage increase of up to 18%

Rubber state workers will see their base pay increase from Rs 95 to Rs 98,along with the same attendance incentives as the tea estate workers.Therefore, a rubber state worker with over 90%attendance would now earn Rs 112 per day, an increase of 18%.The base increase, of Rs 6 for tea estate workers and Rs 3 for rubber estate workers, will be paid as a lump sum, with effect from 1 January 2000 (ie Rs 6 or Rs 3 times the number of days worked since 1 January).However, the attendance incentive will only be paid from 1 April 2000.The EPF and ETF contribution of 12%and 3%respectively,will only be applicable to the base wages, and will be effective from 1 June 2000.This agreement will be in effect until 30 June 2002.

As mentioned above, the agreement increases wages for tea estate workers by up to 20%and for rubber estate workers by up to 18%.Although this increase is lower than that demanded by the workers (30%by tea workers and 21%by rubber workers),it is higher than the increases that they have received in the past. We believe this is a positive outcome for estate workers.

All workers unlikely to take full advantage 

According to some of the plantations companies, the current percentage of workers reporting for work over 85%of the time is less than 15%of the workforce, and attendance over 90%is less than 10%of the workforce. They feel that, following the agreement, the proportion of 'over-90%attendance employees ' will increase to a maximum of 20%of the workforce and the proportion of 'over-85%attendance employees 'will increase to a maximum of 30%of the workforce. However, from past experience, they also feel that this increase in attendance will only last for a few months; as the excitement dies down, the workers are likely to go back to their previous attendance schedules. One reason for this could be that some of the workers are also employed elsewhere for rest of the time, where they might actually be getting higher wages. Thus, even with the new wage increment, we feel they are unlikely to significantly change their other employment schedules.

COP will not increase to fearful heights

In view of this outlook, we believe that plantations companies would be paying the highest wage of Rs 121 for the tea workers and Rs 112 for the rubber workers to only a very small percentage of the workforce. Although it would actually be beneficial to the companies to have a higher turnout, because it would increase production, this view also implies that the labour component of COP would not increase as much as previously feared. We expect the actual increase in COP for the companies to be about 16%every two years, although it would differ for each company.

A win-win situation

Overall, it 's a win-win situation. Estate workers willing to improve their attendance record can now increase their earnings by additional 18%-20%.On the flip side, if workers actually increase their attendance after this settlement, plantations companies stand to benefit from higher production, hence justifying the higher labour expense. That's the beauty of attendance-related wages.

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