3Q2011 corporate results: What to expect?

In the absence of any significant news, the Sri Lanka bourse continued to trade on a lacklustre note with the ASPI and MPI falling by 2.2% and 1.7%WoW to close the week at 6,550 and 5,878.

With the majority of investors sitting in the wings, turnover declined by 23%WoW to Rs. 6.8 b with trading in Laugfs Gas, John Keells Holdings and Softlogic collectively accounting for 46% of the week’s total.

Losers outpaced gainers with Asian Alliance, Infrastructure Developers and Blue Diamond declining by 29.1%, 26.7% and 16.0% offsetting gains in SMB Leasing (W), Autodrome and Sinhaputhra which advanced by 33.3%, 14.6% and 12.5% respectively.

Global markets meanwhile breathed a sigh of relief during the week on the prospect of a much more co-ordinated move by policymakers to recapitalise the region’s banking system although Standard & Poor’s downgrade of Spain’s long-term credit rating by a notch on Friday however could however renew concerns regarding the extent of Europe’s fiscal woes in the coming week.

With the 3Q2011 corporate results in the offing, we expect the ASPI to change course over the next few weeks from its narrow downward biased movement to a broader range bound upper trajectory. We advise investors to be brave and take the leap by carefully selecting sectors, sub sectors and stocks that would benefit fully from the domestic growth story.

We recommend an asset allocation strategy focusing on key sectors such as Banking & Finance, manufacturing, Diversified and Hotels which we believe would outperform the market and generate alpha on a sustainable basis.

Although the majority of the quarterly 3Q2011 corporate results are unlikely to start rolling in until at least the next couple of weeks, we would like to summarise our earnings outlook as follows;

While earnings growth will be broadly similar to 2Q2011, we expect the quality of earnings to improve during the 3Q2011 with greater contribution from core operations spearheading the earnings drive while non-core activities will largely play second fiddle.

Consolidated margins will improve both on a YOY and QoQ basis on the back of core growth in operations which would smoothen out the prospect of relatively lower other income generation.

Overall earnings will be up by 25-30% fuelled by growth from the banking, diversified, manufacturing and tourism sectors.

3Q2011 earnings will serve as market trigger

Our expectation of a sanguine outlook for 3Q2011 corporate earnings will continue to lend support to market valuations and as we move deeper into the 4Q, this should provide the necessary trigger for the bourse to gradually commence its re-rating process.

Ahead of this, we advise investors to start their bottom up stock selection process concentrating on stocks that have a robust business model focusing on domestic consumer demand. In this respect, we advise investors to focus on companies with largely monopolistic attributes and strong brand loyalty within sectors and sub-sectors that are both growth and resilient.

We reiterate the need to construct a diversified portfolio of mainly growth stocks that have strong top line revenue growth and sustainable margins and directly benefit from the domestic demand story.

Buy on the pullback

Descending to the 6,500 support level, it is easy to shy away from the market on the conviction that it may lose further ground due to the lack of any relevant support.

While we don’t rule out the possibility of a marginal decline on the back of retail selling in certain counters, we are nevertheless sufficiently convinced that the 3Q2011 results should garner interest from select institutional and foreign investors who may adopt a cherry picking approach focusing on counters that present strong and sustainable value in high growth and defensive sectors.

Sector outlook – Volume growth will be key

The Government’s pro-business policies and emphasis on fiscal responsibility and investment-driven growth should provide a strong macroeconomic backdrop for the majority of sectors to report double digit growth.

On a sector basis, we believe that conventionally defensive sectors such as Telecoms may experience a slowdown in top line growth exacerbated by downward pressure on margins due to intense price competition.

Conversely, we believe that several of the traditionally more cyclical sectors such as Manufacturing and Tourism could generate highly attractive defensive attributes, such as strong volume growth, pricing power and lower gearing levels which should beef up margins while generating sustained cash flow.

We reiterate the need however to concentrate on a bottom up stock selection process in order to identify companies that will outperform within our overweight sectors. We advise investors to seek investments with a robust business model, strong brand loyalty, monopolistic attributes and sustainable growth both at the top line and bottom line.

Our sector themes are as follows:

Manufacturing

As the prime beneficiary of robust domestic economic growth, we continue to hold an Overweight position on the manufacturing sector, which will be supported by a new replacement cycle that will raise the top line growth of sector companies considerably. We believe that any commodity pricing pressures will be offset by process efficiencies which will result in improved margins for the sector.

This combined with strong volume growth will allow the industry to generate strong double digit earnings growth. The sector has been largely tracking the market and is currently trading at a PE of 17X, a tad above market multiples. We maintain our Overweight recommendation.

Banking & Finance

Strong capitalisation, healthy loan/deposit ratios and ample liquidity provides a robust structural backdrop for firm growth in the banking sector. With economic activity expected to remain strong across the majority of sectors and consumption and investment continuing to gather pace, we expect the banking sector to record double digit growth over the medium to longer term.

Loan growth should accelerate over the coming years, underpinned by strong macroeconomics and a steady extension of private sector credit as Sri Lanka’s middle class expands and private consumption soars.

Meanwhile on the liabilities side, long-term deposits are likely to continue to account for a large proportion of the deposit base placing a limited reliance on expensive short-term financing thereby providing a solid base to expand credit growth.

Although we expect private sector credit growth to continue to push the loan/deposit ratio higher, we believe that the ratio is still not high enough to cause any significant concern at this stage, particularly given the solid macro scenario. However we remain vigilant with respect to any over-extension in credit without a corresponding rise in deposits. The sector has underperformed the market and is currently trading at a PE of 14X, at a 16% discount to the market. We remain Overweight.

Diversified

Top line revenues in the diversified sector should continue to remain strong within double digit levels on the back of healthy growth in the manufacturing, logistics and hotel sectors notwithstanding the slowdown in global consumption.

At a time of increasing macro-economic challenges for global economies, pricing power will be key for Sri Lanka’s diversified sector companies to maintain margins and secure long-term competitive advantage amidst rising international competition. The sector is currently trading at a PE of 19X, at a 15% premium to the market which we believe is justified. We remain Overweight on the sector.

Hotels

Bucking the downward trend in the global travel industry, tourist arrivals to Sri Lanka continues to surprise on the upside recording double digit growth which in turn has resulted in the majority of hotels recording strong top line as well as bottom line growth.

A rise in disposable incomes of the middle income segment has also contributed considerably to the Food &Beverage subsector enabling hotels to record significantly higher margins. Although relatively high ARRs could have a negative impact on tourist traffic, indications are that arrivals would continue to gain momentum over the few months as we head deeper into the winter season.

In the longer term however, with the addition of new capacity to the industry, we believe that ARRs may decline to more competitive levels. Notwithstanding this however, we do not expect any significant reduction in earnings for at least the industry leaders as we believe that volume growth should largely offset lower ARRs leading to a stabilisation of margins.

Meanwhile, we believe that the Government’s introduction of ETA requirements for tourists is unlikely to dampen volume growth in the longer term although we do expect some discontent amongst industry operators and tourists alike in the short term which however is unlikely to result in any significant compression in traffic numbers.

The sector is currently trading at a PE of 30X, at a 76% premium to the market. We remain Overweight on only selected counters within the industry.

Telecoms

While factors such as favourable demographics, rising disposable income and a desire to avail hi-tech telecom services have been fostering growth in the telecom sector, we remain wary however, regarding the industry’s ability to generate significant top line growth in the medium term given the fact that penetration rates appear to be currently at the top of the cycle.

Slower volume growth combined with heightened competition in the sector could lead to downward pressure on margins and a slowdown in earnings momentum. Competition appears to have intensified among the telecom operators seeking new business expansion and customer retention strategies to sustain or gain higher market share which has exerted downward pressure on prices. This could have a negative impact on ARPUs if sufficient volume growth is not maintained.

Furthermore, with large capex and marketing costs and the new subscriber addition growth expected to be fuelled mainly by lower call rate offerings, the ongoing price competition could place strong downward pressure on margins in turn squeezing earnings growth prospects. The sector is currently trading at a PE of 28X, at a 68% premium. We remain underweight on the sector.