Earnings outlook for Kegalle, Kotagala plantation companies

John Keells Stock Brokers (JKSB) last week came up with its outlook for two leading plantation companies, Kegalle and Kotagala, based on the first quarter performance. Here are excerpts from the JKSB analysis:

Kegalle Plantations Plc

Sharp rise in rubber prices during 1QFY11 led to a significant growth in earnings amounting to Rs. 125 million compared to Rs. 47 million in the comparative period. The tea segment accounted for as much as 54% of total turnover while rubber accounted for 44%.

Although the tea segment accounts for a larger share of turnover, the rubber segment accounted for as much as 78% of group gross profit, recording a gross margin of 39% in 1QFY11 compared to 23% in 1QFY10. Gross profit from the tea segment took a beating consequent to the wage hike in September 2009 which reduced margins to just 8.8% from 15% in 1QFY10.

Tea production during the 1QFY11 improved considerably indicating a 14% growth over 1QFY10 while rubber output too increased 5% despite erratic weather conditions. KGAL witnessed a 95% y-o-y increase in rubber NSA in 1QFY11 while tea recorded a marginal growth of only 3% due to increased supply in the market.

KGAL has approximately 3,971 hectares (revenue extent) allocated for rubber production and its product mix is dominated by centrifuged latex which accounts for around 60% of total rubber production. Around 10% of its production is in the form of sole crepe which is fully exported.

The company also has around 1,317 hectares (revenue extent) of tea with around 972 hectares being allocated for high grown tea production. KGAL has a good mix of tea production with around 45% of it being high grown, 30% being low grown and the remainder being medium grown teas.

During the quarter, KGAL witnessed an increase in administrative expenses amounting to 41% while management fees to its holding company too increased sharply by 104% with the increase in operating profits.

Outlook

Improved weather conditions are likely to boost rubber production in the coming quarters which are unlikely to have a significant impact on rubber prices given the global shortage and increased demand from countries such as China.

With regard to the tea segment, inclement weather in tea growing areas has adversely affected the crop intake which should help prices to remain attractive at around Rs. 350 – 375 levels. With the beginning of the quality season, KGAL’s high grown teas should fetch higher prices which should boost segment’s earnings, while contributing to group’s bottom line. Given the above market dynamics, we conservatively expect KGAL to post around Rs. 395 million for FY11E, a y-o-y growth of around 8%. With mainly the rubber crop expected to increase in the coming quarters, KGAL exhibits high potential for increased earnings. This translates in to an EPS of Rs. 15.80. At a price of Rs. 147, the counter is trading at a P/E of 9.25x FY11E earnings, a discount of around 26% to the sector.

Kotagala Plantations Plc

Kotagala Plantations Plc (KOTA) posted Rs. 56 million in PAT for 1QFY11, declining 7% over the comparative quarter albeit an 18% increase in revenue driven by high commodity prices. The fall in earnings was attributed to the increase in cost of production over the 1QFY10 due to the wage hike that was finalised in September 2009, retrospective from April 2009.

Revenue from the tea segment which comprises both high and low grown teas improved marginally over the comparative quarter accounting for as much as 77% of total revenue (87% in 1QFY10) while revenue from rubber more than doubled despite a 3.5% decline in quantity due to erratic weather conditions.

Rubber prices grew over twofold during 1QFY11 from 1QFY10 levels to average close to Rs. 400 per kg. However, tea production rose about 5.5% over 1QFY10. The growth in tea output in the industry pushed prices lower during the period. KOTA experienced a marginal fall of 1% in NSA for tea during the quarter.

As noted previously, the wage hike had a significant impact on the gross margins of the tea segment which reduced to 9.5% in 1QFY11 from 23% during the comparative quarter in FY10. The rubber segment recovered sharply on the back of rising rubber prices which led to a margin of 28% compared to a loss in 1QFY10.

Despite lower gross margins at group level, operating profit in 1QFY11 recorded a 4% yoy growth thanks to significant savings on administrative expenses due to better efficiency. Certain cost items that were previously included under administrative expenses have been transferred to direct costs, thereby reducing the indirect costs. Net finance costs remained high during the quarter as long term interest bearing borrowings almost doubled from the end of 1QFY10.

In January 2010, the company acquired a 19.84% stake in C. W. Mackie PLC and a 41.7% stake in York Hotels (Kandy) Ltd. on March 2010.

Outlook

KOTA, with around 4,989 hectares under rubber cultivation, is one of the larger rubber producers in the country.

The company produces both latex crepe and sole crepe, both of which have seen sharp increase in price levels. The company is now fully equipped to manufacture all 3 kinds of sheet rubber; pale crepe, sole crepe and RSS. In addition to its current product portfolio of tea and rubber, KOTA has embarked on a program of utilising its uncultivated bare land in the low country with Palm oil in FY11. Initially, around 110 hectares will be cultivated and it is expected to increase up to 1,000 hectares in the coming years, which should have a positive impact on group earnings in the medium term.

KOTA’s tea production is dominated by high grown teas which account for as much as 75% while the remainder is low grown teas. With the beginning of the quality season, high grown prices have improved around 11% from the end of the June quarter, while low grown averages too rose by around 6%.

We conservatively expect KOTA to post approximately Rs. 387 million in earnings to equity for FY11 which translates in to an EPS of Rs. 12.11. At a price of Rs. 93, the counter is trading at a P/E of 7.7x FY11E earnings.