Market Focus
Royal Ceramics down to HOLD

We met with the senior management of Royal Ceramics (RCL) during the week to get an update on their current operations and the outlook for the next 12-18 months. We understand that the impressive 50% growth in revenues during 4Q98 was mainly driven by a strong 40% growth in domestic sales volumes on the back of large discounts and aggressive marketing efforts. Revenues were also supported by marginally higher export volumes to quality conscious niche markets and the introduction of higher value added products. While future growth is also likely to be dependent on increasing domestic sales volumes, the company is expected to differentiate its products by developing more high value added products to increasingly target upper-middle class quality conscious niche markets.

Demand for domestic ceramic tiles from the industrial segment (mainly large commercial buildings) has however declined due to the general sluggishness of the construction industry, and more importantly, the availability of relatively high quality imported tiles at increasingly competitive prices following the recent regional currency devaluations. Nevertheless, demand from households - particularly in the outstations - has picked up sharply during the past 6-12 months, with RCL being the main beneficiary due to its well established and strong distribution/marketing network in the outstation/semi-urban areas. However, with RCL's chief competitors Lanka Tiles (TILE) also expected to focus on the local market during FY99 and an ever increasing quantum of tile supplies being directed toward the domestic market in view of the extensive price competition in export markets, we feel that RCL is unlikely to meet our 25% domestic sales volumes target. With the company already operating at close to maximum capacity, we believe that a 15-18% volume growth is more reasonable, and even that is likely to entail a further erosion of margins.

While RCL is likely to benefit by at least 1-2% in the short term following the replacement of the 18% turnover tax on sales with the 12.5% goods and services tax from this April, we thus still expect the company's operating margins to fall from 14.6% in FY98 to around 13.5% in FY99. Given the likelihood of increasingly stiff price competition within both the local and export markets, we also expect RCL's margins to come under further pressure during the next two years and to fall to around the 10% levels. Hence, we our cutting the company's FY99 and FY00 net profit forecasts by 12% and 16% to Rs. 86 mn (+14% YoY) and Rs. 94 mn (+9% YoY) respectively.

Given the negative sector outlook and bearish investor sentiment, we do not believe that the share will outperform the market over the next six months. However, given a relatively undemanding PE of 4.3X FY99E and a high dividend yield of 16%, any further significant market under-performance also looks equally unlikely and we are thus only downgrading our recommendation to HOLD.

The Central Bank's Spot Rates for transactions with Commercial Banks announced on the morning of August 20, 1998 were as follows:

The approximate middle exchange rates of following currencies calculated on the basis of cross rates quoted by Gulf International Bank, Bahrain as it appeared in Reuters Financial Information System on August 20, 1998 were as follows:

Average rates at which the following currencies were quoted by Commercial Banks in Colombo for Telegraphic Transfers at mid-day on August 20, 1998 were as follows:

Average Weighted Prime Lending Rate (AWRP) and Lowest Prime Rate (LPR)
The Average Weighted Prime Lending Rate (AWPR) during the week ended August 14th, 1998 was 15.0 per cent for all banks. The Lowest Prime Rate among banks during this week was 12.3 per cent.

Average Weighted Deposit Rate of Commercial Banks (AWDR)
The Average Weighted Deposit Rate (AWDR) of Commercial Banks for the month ended June 31st, 1998 was 9.6 percent.