CFA Institute Research Challenge Hosted in Sri Lanka University of Colombo

University of Colombo Student Research Exchange: Colombo Stock Exchange This report is published for educational purposes only by Sector/Industry: Telecommunication students competing in the CFA Society Sri Lanka Investment Research Challenge, part of CFA Institute Global Investment Research Challenge Dialog Axiata PLC

Date 30/09/2013 Ticker: DIAL.SL Recommendation: BUY

Price: LKR 8.50 Price Target: LKR 10.96

MARKET DATA Highlights 52 Week Price Range LKR 9.00/7. 80 Dividend Yield 2012 4%  We issue a buy recommendation for the stock of Dialog Axiata PLC (DIAL) of LKR 10.96: The Shares Outstanding 7,985,206,000 current trading price is leading to an upside of 29%. The growth of revenue between the years of (Excluding the 2012A to 2016E is CAGR 12.2%. Here it is noticeable that the mobile segment revenue is the main ESOS) contributor towards the growth of revenue with a prior breakeven all new subscriber revenue would Market 66,778,984,448 directly contribute to profits of the business. The trailing P/E stands at 11.1 and EV/EBITDA at 4.5. Capitalization (Rs) The Company is a typical dividend-paying firm, with dividend yield of 4% in 2012. Average annual 166,457,872 Volume  Revenue growth prospects: Keeping up with trends and innovations as a service provider in the ever As a % of 2.08% changing technology business DIAL is able to maintain a steady growth in its revenue portfolio. The outstanding shares significant YOY growth in 2012A of 24.1% in revenue is expected the slow down to a level of 11% Parent Holding 83.3% in 2013E. The expected large investment in data sector makes a significant impact on this change. The growth in revenue in the mobile and DBN sectors which generate revenue with data, solely Public float 14.7% contributes to YOY 10.4% in 2013E. (1) 4G/LTE introduction to increase the data speed and usage of customers and continuous investments in infrastructure; (2) Innovations in the e-commerce segment of the business; (3) Strategic investments in Information Communication Technology, are all contributors towards this growth. FINANCIAL DATA EBITDA/Revenue 33%  Strong financial position: Liquidity position of dialog is maintained continuously at a stable rate (X) therefore, there would be a sound business continuity of DIAL. EBITDA margin amounting to 37.7% PB(x) 1.8 times in 2013E to 48.3% in 2018E. The ROA is continued to grow from 7%-11% in 2013E to 2018E. EPS of 2012 0.75 is expected to show positive signs at 2018E at LKR 2.09. PER (X) 11.1 EV/EBITDA (X) 4.5  Main risk issues are: the changes made to the floor price by the TRC, relaxing the price band, Earnings per share .75 USD/LKR exchange rate fluctuation, technological changes, first mover innovations duplication, and Dividend per share .33 macro economic conditions affecting customer trends. Gearing 39%

Debt to Total Capital 1.44 times Return On Equity 16.2% Forecast Summary Source: Company data, CSE 2011A 2012A 2013E 2014E 2015E 2016E 2017E Revenue (MN) 45,412 56,345 62,552 71,443 81,146 89,260 96,401 EBITDA (MN) 16,511 18,357 23,568 29,059 34,968 39,978 45,101 PAT (MN) 4,869 6,030 4,263 7,336 10,703 12,450 14,598 Per share(LKR) Earnings 0.61 0.75 0.53 0.92 1.34 1.56 1.83 Dividend 0.25 0.34 0.25 0.35 0.42 0.63 0.81 Returns (%) Total Asset 7% 7% 5% 7% 9% 10% 11% Total Equity 15% 16% 11% 16% 20% 20% 21%

Source: Team estimates, Company data Source: CSE 2013 DATA

Important disclosures appear at the back of this report 1 CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013 Investment Summary

Bullish on DIAL We issue a buy recommendation on DIAL with a target price of LKR 10.96 an upside movement of 29%. DIAL is Figure 1- EBITDA increasingly investing in infrastructure supporting a boom in the small screen data and large screen data revenue margin segments together with the recent joint venture with anything.lk in to the E-commerce market. DIAL’s optimistic movement as the countries competitive quad player seeks to reap the benefits of improving economic and political stability. Therefore we expect DIAL which is currently trading at a 22% discounted EV/EBITDA and 44% discounted PE to see a growth in the stock price.

Valuation method As our primary valuation method we utilize the Discounted Cash Flow (DCF) and peer comparison method is applied as a secondary valuation to support the value arrived in the primary valuation. In our opinion DCF correctly reflects the value of a cash rich industry with heavy investments to drive revenue.

Reinvention through strategic acquisitions Source: Team estimates In recent years group capital expenditure was directed mainly towards the expansion of High Speed Mobile

Broadband Services, Fixed Broadband services, and Optical Fiber Network. 2012 saw an assortment of business

creation initiatives including the acquisition of Suntel Limited, launch of eZ Cash - Sri Lanka’s first Mobile

Money and Payment service, acquiring a stake in Digital Commerce Lanka (Private) Limited, acquisition of Sky Figure 2 – Coverage TV, introduction of per-day Prepaid Television Service and launching HD Television services. We believe these of Dialog ventures signify Dialog’s foray in to the space of Digital Commerce and the strategic intent of the Group to expand its operations in the future through the use of other well established organizations.

Prospects in telecommunications sector As a revenue driven business mobile services subscribers have reached a level in which penetration has reach 96% in the world. With the high entry barriers in fixed costs the threat of new competitor entering into the business is minimum. The large number of player in the sector creates a favorable rivalry which leads towards a more creativity and innovation in the telco industry. The governments’ encouragement towards the industry further strengths the growth potential of the industry with the government’s economic policy paper(Road Map 2013)stating that Sri Lanka can reach the goal of becoming a billion dollar IT/BPO industry by 2016. Importantly, ICT literacy has reached 40 % from around 5% in 2005.

Financial position As the largest FDI investment in Sri Lanka DIAL is a listed company with high foreign transactions in terms of financials. The confidence foreign banks have on the parent with a high credit rating gives DIAL the opportunity

to borrow foreign sources with low interest rates. The large debt portfolio (USD 200Mn at low interest rate) which Source: Company data is obtained by DIAL for expansion of the diversity of the business gives investors the signals that the business would grow with high liquidity. As the OCBC bank loan matures in 2018E to be USD 200MN, DIAL shows that it is capable of making timely payments for these loans. Figure 3 - Dividend per share and dividend Stable dividend distribution payout ratio With investors being concerned on the return on individual investments the dividend payment for FY12 was LKR .33 with a dividend payout ratio of 45%. It is stated that for future investments internally generated funds would be used therefore, a significant effect on the dividend payout could be expected. Therefore, the dividend payout ratio is expected to drop to 37% 2014E. But dividend per share for 2014E to be at a rate of LKR .35 making sure that the individual investors are kept satisfied with their long term investment.

Downside of the valuation In the background of an upside movement in the share price investors should be aware of the possible adverse influences from high level of capital expenditure incurred, the over dependence on the CEO of DIAL as the visionary leader while looking at the parent company owning 83% stake of DIAL which has brought cheap financing sources to DIAL thus far and a brand name.

Sourc e: Team estimates

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CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013

Figure 4 - DIAL Share price movement and Information Flow

Source: CSE data (2012-2013)

Valuation

We predict a 29% upside movement in DIAL with share price moving up to LKR 10.96. As our primary valuation Table 1 - Valuation we have used the DCF method and in order to support our recommendation and for completeness a peer DCF Valuation LKR 10.96 comparison with a relative valuation is obtained. However we do not base our recommendation on the relative Relative valuation due to; Valuation LKR12.70 (SLTL) Relative  High investments required - Telco industry requires heavy investments to keep pace with the Valuation LKR14.60 advancements in the environment in order to support a growth in its top-line. Therefore a valuation based (Foreign) on cash flow would be appropriate more than a relative valuation based on earnings. Source: Team estimates  Inadequate comparisons – SLTL is the only comparable listed company in the CSE. However firstly it is 49.5% government control with high political influence therefore price behaviors would highly sensitive to Table 2 - Market turnover any political information and share prices movement would be seen as slightly distorted. Secondly looking SLTL DIAL at the turnover SLTL is comparatively is a low liquid stock with low level of turnover. (table 2) Therefore WTD 3,191 203,309 it is SLTL price being correctly priced is debatable.

MTD 99,362 968,895 DCF Valuation YTD 3,092,460 166,946,512 We use the Free Cash Flow to Firm (FCFF) in our valuation model as DIAL is expecting changes in its capital structure firstly since we are using historical data to predict the Free Cash Flow (FCF) FCFF growth rate would Source: Team estimates reflect fundamentals more clearly than FCFE which reflect fluctuating amounts in leverage, secondly in a forward looking context the required return on equity might be expected to be more sensitive to changes in leverage than Table 3 - WACC changes in the WACC, making the use of a constant discount rate. Rf 12.0% WACC – DIAL is a low geared company with positive credit ratings. Management is promising a target capital

Beta 1.1 structure of 50:50 Debt to Equity capital structure. (Appendix 06. A)

Market Risk Premium 9% Ke (Cost of Equity) - We have utilized the CAPM method in estimating the WACC as we expect the market to be efficient. Therefore we have used the 5 year T- bond rate(11.17%) of 12.0% adjusted for taxes, and a Beta value of Tax Adjusted Kd 13% 1.1 using the past data however as the industry matures we expect beta to vary between 0.9 – 1.1. Risk Premium Source: Team estimates (Rp) of 9% was assumed based on country risk premium (Appendix 06. B)

Table 4 - Cost of debt Kd (Cost of Debt) – DIAL is enjoying low cost of debt due to the positive credit ratings (AAA(lka) – Fitch) and Interest Weight the parent company in Berhad enables DIAL to have access to low foreign currency loan. It finances 70% of loan requirement through foreign loans therefore in our opinion DIAL is exposed foreign exchange loss for which we Local 20% 30% have included a 4% average LKR/USD depreciation to the trend in the past floating lending rate the inflation rates Loan subjective to change in the US. (Appendix 06. C) Foreign 10% 70% Loan Terminal Growth Rate (TGR) – We expect a low TGR at 1% as DIAL is operating in mature industry with low Source: Team estimates availability to grow in the long term as the markets saturate and with high level of rivalry.

3 CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013 FCFF – FCFF is expected to be very low and negative in FY13 and FY14 due to the heavy capital expenditure high data growth, DTV revenue growth and through other inventions in to the digital space through its E-commerce /M-commerce arm. (Appendix 4)

Table 5 - Valuation FY13E FY14E FY15E FY16E FY17E FY18E EBIT(1-t) 7,392,427 9,697,667 12,681,208 15,088,810 17,446,933 19,778,914 Depreciation 14,871,640 17,650,747 20,049,829 22,226,990 24,575,756 26,590,923 FAinv (19,679,663) (28,971,271) (25,071,834) (22,709,178) (24,494,396) (21,023,933) WCinv 863,005 1,461,534 621,555 2,113,420 567,380 457,431 NCF 3,447,409 (161,323) 8,334,757 16,720,041 18,095,673 25,803,334 TGR 168,560,764 (1%) Source: Team estimates

Table 6 - Peer Multiples Secondary Valuation – Peer Comparison EV/ PE PB D In order to support our recommendation in the DCF method we calculate the intrinsic value of DIAL based on its EBIDA E local peer SLTL. However due to the lack of comparable peers within the country we have taken regional market % leaders to our valuation not overlooking the differences in the penetration levels, market conditions and macro factors within the individual countries. ( Appendix 5) DIAL 4.5 11.1 1.8 40 :SL SLTL 5.2 We base our relative valuation on trailing P/E, EV/EBITDA and P/B for our peer companies. Trailing P/E is 19.87 1.47 33 :SL 2 commonly used by analysts and investors in determining the intrinsic value of a share as earnings power is BHARTI 17. 30.0 11.0 23 considered to be the driver for value creation therefore we have placed a 35% weight. However EV/EBITDA is :IN 0 less sensitive to the effects of financial leverage therefore comparable across companies with varying capital RCOM 16. 46.07 1.08 85 :BO 97 structures Hence we have placed a 50% weight. P/B was used as a valuation multiple because this industry is ADVANC 10. 13.0 mainly driven by the capital expenditure made on assets we have weight it at 15% due to the effect of different 17.05 49 :TB 23 6 business structures and varying useful life of assets being sensitive to this multiple. We have not based our Source: Annual Report data valuation on the dividend yield (DY) as DIAL re-invests majority of its earnings in capex to support the

continuous improvement in technology the bottom line of future earnings. Table 7 - Relative value on SLT Comparative to SLTL, DIAL is trading at trailing PE of 79% and 31% and 36% discounted EV/EBITDA and 18% Multi Pric Weig Value premium PB. In our opinion with the international bandwidth expansion project together with lying of fiber optic ple e ht (P*W cables the competitive advantage enjoyed by SLTL is removed while reducing DIALs operational cost by a (P) (W) ) considerable percentage. Therefore we expect DIALs EPS growth to improve in the future which would drive the share price upward hence we forecast a relative value of LKR12.36 on currently oversold DIAL share. (Table 5) EV/ 12.2 50% 6.12

EBIT 4 We looked at our regional peers with similar corporate characteristics by discounting the multiple by 30% to DA adjust for difference in market conditions and macro factors. P/E 14.9 35% 5.22

0 P/B 6.85 15% 1.03 Risk to our valuation Our valuation under the DCF is heavily depended on the terminal value. However we 12.39 assigned a conservative TGR of 1% despite assuming a TGR of 0% by a pessimistic investor due to the cut throat Source: Team estimates competition and the saturation in the target market in our opinion currently DIAL is trading at a discount. Secondly our valuation is sensitive to the WACC of 16.5% however continued bearish outlook in the market or Table 8- Relative value on peer dampening macro economic conditions causing the risk outlook of the country to worsen and causes an increase in Multiple Price Weight Valu the WACC to 18% we see current market prices to be mispriced and an upward move is expected. e

EV/ 17.09 50% 8.54 EBITD A P/E 11.72 35% 4.10 P/B 20.70 15% 3.10 15.75

Source: Team estimates

4 CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013

Figure 5 - Variation in the Valuation

Source: Team estimates

Business Description Dialog Axiata PLC, a subsidiary of Axiata Group Berhad (Axiata), operates Sri Lanka’s largest and fastest growing mobile telecommunications network representing approximately 3% of the total market capitalization of the CSE, positioning the company within the top 10 largest companies in terms of market capitalization. Company was incorporated in 1993 as a private limited liability company bearing the name of MTN networks (Private) limited. In 2004 DIAL was listed in the CSE and by the year 2010 changed its name as Dialog Axiata PLC. The operations of Dialog Axiata PLC include Mobile, International and Tele-Infrastructure businesses. The Company delivers advanced mobile telephony and high speed mobile broadband services to a subscriber base in excess of 7.7Mn Sri Lankans, via a 2.5G and 3G/3.5G networks as well as 4G communication networks supporting the very latest in multimedia and mobile internet services.

Figure 6- Revenue Subsidiaries segments Dialog Axiata supplements its market leading position in the Mobile Telecommunications sector with a robust footprint and market presence in Sri Lanka’s Fixed Telecommunications and Digital Television markets through its fully owned subsidiaries Dialog Broadband Networks (Private) Limited (DBN) and Dialog Television (Private) Limited, (DTV).

Dialog Mobile Dialog mobile with a customer base of over 7.5 million, provides the best in mobile coverage, with over 2600 base stations spanning all provinces. In addition customers are linked to over 200 global destinations via international roaming, including 3G services. The Company also holds the distinction of being the first service provider in South Asia to launch 3G and HSPA+ services, and most recently Mobile 4G services based on FD-LTE technology contributing more than 80% of the total revenue of the group. Source: Company data

Dialog Broadband Networks DBN the second largest fixed Telecommunication provider contributed 8% to the total revenue in the year 2012. DBN has the distinction of being the first telecommunication operator in Sri Lanka to launched 4th generation

LTE High Speed Broad band Services. DBN remained dilutive to the Group at NPAT level, but registered significant improvements in revenue and operational performance on the back of strong revenue and synergies achieved through acquisition, merger and operational consolidation of Suntel Limited.

Figure 7- Share Dialog TV ownership Dialog TV which is the smaller contributor to the total revenue of Dialog Axiata PLC comparing with other segments, is the market leader in Sri Lanka’s Pay TV sector. DTV supports a broad array of international and local content in both Standard Definition (SD) and High Definition (HD) formats alongside a wide portfolio of Sri Lankan television channels and delivers high quality infotainment to a viewer base in excess of 275000 Sri Lankan Households.

Other Operations Dialog Axiata has the distinction of being the first mobile operator in Sri Lanka to be awarded a Payment Systems Source: Company data Provider license by the Central Bank of Sri Lanka, based on which it operates eZ Cash, the country’s pioneering mobile money service.

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CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013 The Dialog Group also established a position of strength in Sri Lanka’s Digital Commerce space through a Joint Venture (Digital Commerce Lanka) encompassing Sri Lanka’s leading daily deals site Anything.lk and the incumbent e-commerce properties of the Dialog Group WoW.lk, ibuy.lk and tradenet.lk. Figure 8 - Composition of free float Dialog Axiata PLC’s Management The CEO Dr.Wijayasuriya counts over 17 years experience in technology related business management. Under his leadership company has achieved many awards and also expanded the business into several categories. Other members in the team also have greater experience and knowledge related to the area they are handling which have contributed and will contribute to the continuous success of Dialog Axiata PLC. Other Headings Relevant to Dialog

Corporate governance safeguarding the best interest of shareholders and other stakeholders To uphold accountability and sound internal control systems Dialog Axiata follows an internally generated Code of Corporate governance which includes all regulatory and non regulatory standards. The Maintaining the highest standards of business integrity, professionalism and ethical values is strictly followed by this code. The Securities & Exchange Commission and the Institute of Chartered Accountants Sri Lanka were instrumental in drafting the Corporate Governance Listing Rules, which are applicable to listed companies via the Colombo Stock Exchange Listing Rules. Therefore all criteria on this Code of Best Practice on Corporate Governance are evident on the corporate conduct of DIAL.(Appendix 8)

Source: Company data Assuring a sustainable future For business continuity DIAL follows a strict sustainability policy where a three-fold incorporation of Sustainability: into the core of our operations, into the consciousness of every employee, and in every facet of the business is followed. To ensure the proper conduct of the organization in terms of sustainability DIAL prepares an Figure 9- Sustainabile aspects annual sustainability report under the guidelines of the Global Reporting Initiative (GRI). Within the past few years DIAL has made progress with achieving partially sustainable targets set for the company where a fair percentage of the targets have created a competitive advantage for the company.(Appendix 9 )

Giving back through corporate responsibility Dialog operates with Triple Bottom Line spheres in economic, social and environmental performance to adhere to its commitments. As a service provider DIAL has a large responsibility towards one of its largest stakeholders in the business its customers who come from all walks of life. Therefore, DIAL gives high priority to this cause of including everyone despite the demographic location to access of information and communication. Through further innovation and creation DIAL looks into different aspects of social issues which could be mitigated through proper allocation of technology.

Source : Company data Conditional drivers of additional upside

Figure 10- Mobile-cellular Possible consolidation of the industry. DIAL as the market leader on mobile communication has a well Penetration 2013 established position in the market and sees little threat from other player. Where-as small players are facing many difficulty in keeping up their businesses due to over heads. Therefore, there is high possibility the industry would soon consolidate to a fewer number of player with time. In such instance DIAL would be at an advantage if it acquires a small player due to the need of ever growing spectrum. Further through future consolidations there adverse affects of unfair competition would reduce to a favorable condition

Growth through innovation. The R&D of DIAL keep innovating added services to give customers with better features on a regular basis taking the company and industry to grater heights. As the first mover in the industry in the past in many instances DIAL has been able to capture a larger customer base on based on the innovation and push strategy. By attracting a loyal customer base DIAL is able to maintain such a relationship by providing various VAS.

Partnerships for inorganic growth. DIAL has been serving in the telco industry so far with many partnerships and it looks at improving and entering into more in the future. (1) Over The Top (OTT) content providers entering into data and content sharing agreements (2) partnership through integration with parties in the ICT industry (3) looking into cloud computing technology generation.

Source : ITU/ICT indicators database

6 CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013 Industry Overview and Competitive Positioning

. It is often aligned on the left Current situation of the Industry in the words of Brahima Sanou, Director of the ITU Telecommunication or right of the page, or located Development Bureau “I am pleased to present the latest ICT facts and figures which shows continued and almost at the top or b universal growth in ICT uptake. Every day we are moving closer to having almost as many mobile-cellular Figure 11: Subscriber subscriptions as people on earth. This is exciting news. The mobile revolution is empowering people in composition of service developing countries by delivering ICT applications in education, health, government, banking, environment and providers business. Let us all celebrate this mobile miracle that I have no doubt will hasten our pace towards sustainable development”

In 2013, there are almost as many mobile-cellular subscriptions as people in the world, with more than half in the Asia-Pacific region (3.5billion out of 6.8 billion total subscriptions). As global mobile-cellular penetration approaches 100% and market saturation is reached, growth rates have fallen to their lowest levels in both developed and developing countries. Mobile-cellular penetration rates stand at 96% globally; 128% in developed countries; and 89% in developing countries. (Figure 10)

Growth in Internet Protocol Traffic Total global Internet users will reach an estimated 2.7 billion worldwide by end of 2013. In developing countries, the number of Internet users will have more than tripled between 2007 and 2013, to reach more than 1.8 billion. Source: Company data Despite this rapid growth, however, less than a third of inhabitants in the developing world will be online by end of 2013. In 2013, IP traffic is expected to grow by some 14’000 petabytes/month, the equivalent of twice the global cumulated traffic over the whole decade from 1994 to 2003 (According to Telegeography data) These tremendous volumes are driven by growth in the number of connected people and devices, and the growing Figure 12 :Global GDP vs availability of abundant, diversified, and in most cases free, online content. In 2012, the number of individuals Global Telecom using the Internet reached the milestone of 2.7 billion people according to the ITU and the total number of applications downloaded over all types of mobile devices is estimated to have surpassed 50 billion. (ABI Research 2012)

High barriers to entry and high exit barriers It comes as no surprise that in the capital-intensive telecom industry the biggest barrier to entry is access to finance. To cover high fixed costs a lot of cash is typically required. When capital markets are generous, the threat of competitive entrants escalates. When financing opportunities are less readily available, the pace of entry slows. Meanwhile, ownership of a telecom license can represent a huge barrier to entry. There is also a finite amount of "good" radio spectrum that lends itself to mobile voice and data applications. In addition, it is important to remember that solid operating skills and management experience is fairly scarce, making entry even more difficult.

Subscriber acquisition and retention costs (SARCs) are likely to remain high so long as six telecom operators compete for Sri Lanka’s 21 million population. High SARCs should affect challengers more than incumbents

Source: IMF (which benefit from greater economies of scale). Profitability pressure also stems from higher energy costs and inflationary pressures since early 2012, as well as higher regulatory levies. ] Figure 13- Vertical to Telecom Sector growth still outpacing GDP growth horizontal integration The potential of shaking business confidence everywhere in the world has risen to new heights, and the IMF lowered its growth forecast and is warning of recession risks due to downward revision of global GDP. Economic readings are worrisome everywhere but the U.S., but so far the impact on global telecom and enterprise remains tame, and considerable growth in capex can be forecasted according to the principal analyst for mobile infrastructure and carrier economics at Infonetics Research. Globally, mobile service revenue is the main growth engine in the overall telecom. (Figure 12)

Shift from vertical integration to horizontal integration-supplier power reduce Consumers and businesses are more demanding, expecting always-on service everywhere, forcing operators to boost network capacity and connectivity. Industries are becoming increasingly digitized, demanding new services

Source: Company data like mobile payment platforms and cloud computing. Vertically integrated technologies, on which operators have long depended, are growing increasingly modular and open and the telecom ecosystem is becoming more competitive. These challenges and opportunities are creating a fundamental shift among operators from the vertically integrated business models that dominated the industry for most of the past century. Now, four distinct, though by no means mutually exclusive, horizontal business models designed to take full advantage of the opportunities are emerging: Network Guarantors, Business Enablers, Experience Providers, Global Multi- marketers. (Appendix 10)

7 CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013 Figure 14- Sri Lanka vs DIAL Marketing, sales and customer care are becoming entirely digital Subscriber Growth The web is nowadays the most important marketing, sales and customer care channel for operators. According to eMarketer, telecom brands are the most successful at engaging consumers through online advertising. In fact, telecom advertisements achieve a click-through rate six times that of standard online banners, thus providing a high ROI. Customer self-service is regarded as highly profitable for operators, since the bottom-line savings in online self-service are between 40-90%. In addition, when the self-service system is well designed, it can help with customer retention and provide up-selling and cross-selling opportunities. This high efficiency achieved by the existing service providers, weaken the entry of new comers.

Power of up- stream suppliers Unarguably, the telecommunication operators will not be in existence if there were no telecom equipment suppliers for the business of the former largely and mainly dependent on their ability to transmit voice and data effectively which is done through the telecom equipment. But a single supplier becomes less powerful with a large number of equipment makers around. There are enough vendors, arguably, to dilute bargaining power. The telecom equipment industry was the first industry where private Chinese companies successfully expanded overseas. Beginning in the late 1990s, Chinese firms began to establish a presence in foreign markets. After more

Source -TRC than a decade of growth, Chinese firms now account for more than 30% of the global market. These cheap alternatives make the telecom operators powerful. Figure 15-Competitive position Economic support Sri Lankan Economy is growing at 6.8% (June 2013) as per the State Statistics Office. Rubber, paddy, mining, transport, hotels, banking and finance, wholesale, retail, textile, apparel sectors showed high performance as up- to-date while tea, fishing, coconut showed contracted performance. Despite the inflationary situation telco industry has grown by 8.9% which is a considerable growth. With the globalization and fast growth in technology, we can hardly find a person without a mobile to make their life easy. Our idea is that Sri Lankan Telco industry has promising prospects and with the growth in the economy telco industry would further expands.

Cut Throat Competition With the massive industry deregulation coupled with flexible credit opened doors for the new entrants, this lead

Market the industry to be more competitive than before. Nearly everybody already pays for phone services, so all share % 38 25 22 8 7 competitors now must provide customers with lower prices and more exciting services. Sri Lanka’s Telecom Revenue industry has been overcrowded during the last couple of years and this remains the key medium-term risk to share % 55 28 17 - - telecom operators in the country. Source Industry data Sri Lanka’s mobile industry is one of the most competitive markets in the region with five operators competing for Figure 16 – Internet a total addressable population of approximately 21.7 million and the competition among the five operators, subscriber growth fixed and Dialog, Mobitel, Etisalat, Airtel and Hutch is expected to remain high in years ahead. With Bharti Airtel, India’s mobile biggest mobile operator launching its operations in Sri Lanka later in 2008 the other 4 operators engaged in different strategies to block Airtel’s entry. With existing players reducing the prices so low and Airtel being well equipped to face that, ultimate result was the Price war.

Dialog is Sri Lanka’s undisputed Mobile Market Leader-positioning In terms of revenue and market share dialog is well above its competitors (with 55% revenue share and 38% market share). Further, dialog has the widest distribution network within the country with the highest number of arcades, service centers and outlets spread through-out the country. With Dialog’s strategic acquisition of Suntel in 2012, it was ranked as the 2nd largest player in the fixed telecommunications sector in Sri Lanka. High fixed cost increases rivalry since total costs are mostly fixed costs and high exit barriers place high cost in abandoning Source TRC the product (asset specificity) Figure 17 – Porters five forces DIAL, one of the largest companies on the Colombo Stock Exchange contributes towards 3.08% of the total market capitalization.(with the distinction of being the first on the Colombo stock market with a market capitalization exceeding $1 billion) DIAL also contributes for more than 40% of the market capitalization of the telecommunication sector. Being Sri Lanka's largest foreign direct investor with a total FDIs exceeding US$ 1.5 billion during the last two decades. It also had entered into infrastructure investment agreements totaling to US$ 150 million with the Board of Investment (BoI). Company has switched on its 4G LTE Network in Colombo— said to be the first LTE pilot network in Southern Asia.

Sri Lanka reduces broadband tax to promote internet use Sri Lanka has been ranked No.1 in the world with the lowest entry level fixed broadband charges according to a report published by the International Telecommunication Union in 2012. Sri Lanka has achieved this global rating for broadband charges within a short period of time after the TRC took steps to ensure subscribers got value for

Source – Team estimates(Appendix 11) 8 CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013 money and entry prices were affordable to as many people. Telecommunication levy on the internet and broadband services was reduced by 50% from Jan 1st 2013 from 20% - 10%. The Director General of TRC pointed out that 1.2 million Sri Lankans use internet now in Sri Lanka and the government aims to increase it to three million by 2015.

Financial Analysis Figure 18 - Growth in data segment Revenue: DIAL has been able to realize superlative results over the years recording a strong growth across all sectors. Group revenue demonstrated a 24%YoY growth in 2012 while revenue CAGR in years 2008-2012 was ca. 11.6%. Our predictions suggest YoY revenue will decrease in the voice sector over the coming years as a result of saturated voice penetration and aggressive competition, and DTV will only be able to sustain its market share through economies of scale and price advantages. However, this will be compensated by the growth in other sectors as group CAPEX has been directed mainly towards an assortment of business creation initiatives such as the introduction of 4G technology, High Speed Mobile Broadband Services, Optical Fibre Network, the international cable landing station and Investment in new submarine cable to boost international bandwidth We believe these ventures signify Dialog’s foray in to the space of Digital Commerce and the strategic intent to expand its operations through cost reductions. Thus we expect a CAPEX to Revenue of 30% and 40% in 2013 and 2014 respectively and a ratio around 25%-30% is expected to be maintained for the rest of the forecasted

period. Source: TRCSL and Student Estimates Data segment (mobile and fixed broadband) is anticipated to be the main revenue driver in the near future as the Figure 19 - CAPEX and data market penetration is expected to grow at a 2013-15E CAGR of 35% as a result of increase in data Return penetration (2012 - 6.7% to 2015E – 23%), increase in smartphone penetration as smartphone users are expected to spend more time on the internet than on traditional calls and SMS’s and regional trends. DBN is expected to achieve consolidated benefits to costs while subscriber growth potential in terms of corporate customers is high post acquisition. Implementation of high speed 4G technology is expected to convert subscribers to DIAL and forecasted economic developments are likely to attract a larger number of high income earning corporate personnel contributing revenue CAGR of 9% 2013-15E.In line with its past trends International telephony revenue is expected to grow at a CAGR of 14% 2013-15E which is justified by low international tariffs and the fact that Sri Lanka is poised to become one of the largest knowledge hubs in the world.

Margins and Performance: In 2012 Group EBITDA increased only by a mere 11% YoY and EBITDA margin dropped 3 percentage points. However the potency of the group is emphasized by the astounding 23.2% growth in PAT including non-cash exceptional items such as translational foreign exchange losses and network modernization related impairment charges. But these extraordinary growth rates are expected to be held back in Source: Company data, student estimates 2013 (YoY reduction of 29%) as the company is opting for a 2% revenue tax following the expiry of the tax

holiday along with volatile finance costs. We predict that the EBITDA and NP margins will remain at levels Figure 20 – Growing Margins similar to 2012 (refer Appendix 13 for a detailed ratio analysis) while EBITDA and NP will grow at CAGR of 16% and 32% respectively in 2013-18E. We anticipate these predictions will hold in the absence of dramatic strategic acquisitions and investments.

ROA and ROE performance is expected to be relatively flat in 2013-14E. Low levels of performance are attributable to the large investments in fixed assets made continuously to secure revenue and the plough back of retained earnings. But ROE is expected to increase to an average 20% after 2014E as the quantum of investments begins to reap benefits.

Debt: Over the years DIAL has maintained a Gearing and Debt ratio at around 70% along with a strong interest Source: Company data, student estimates cover (6 times of EBIT in 2012). Our forecasts depict that future investments will be funded through a combination of debt and retained earnings and DIAL will attempt to maintain a debt equity ratio of 50%. The Figure 21 – Debt Capacity high dependency on debt financing for strategic expansion is justifiable as most of this debt is acquired at a very low interest rate from DIAL’s parent company in Malaysia, a healthy cash balance and lucrative investments that adds up to a strong asset base.

Cash generation and Liquidity: In line with previous years cash from investing activities is expected to remain negative as a result of high CAPEX. Cash flow from financing activities mainly consisting of borrowings and the repayment of borrowings is expected to be positive as a result of the USD 200mn syndicated term loan, other rupee loans and an estimated 40% dividend payout ratio (well below the 45% in 2012). DIAL’s liquidity ratios are expected to improve from their current low levels (current ratio 0.86 and cash ratio 0.46 in 2015E) as a result of a strong cash base. A comparison of DIALs key performance indicators is illustrated in table 9 below. Source: Company data, student estimates

9

CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013 Table 09: Peer Financial Ratios Figure 22 – Cash flow EBITDA NP Margin Capex/ Revenue Debt/Equity Current Ratio ROE patterns Margin DIAL 33% 11% 31% 64% 0.54 16% SLT 33% 7% 33% 25% 0.92 7% Airtel 33% 6% 20% 129% 1.89 9% AIS 43% 25% 8% 47% 1.05 84% Reliance 32% 5% 29% 96% 0.56 2%

Source: Bloomberg, Company data Investment Risks

Source: Company data, student estimates Regulator risk - Telco industry in Sri Lanka is highly regulated with a floor price as well as heavy duties as VAT, Table 10- Mobile Cellular income taxes and licensing fee. Relaxation of the floor price with the current over populated industry or an increase Tariff in the effective tax rates from current level of 15% to 25% could hurt the top line as well as the NP of DIAL. The overcrowding in the industry with 5 mobile operators, 3 operators providing fixed telephony and pay TV providers ols Country Value in an addressable population of 21mn is situation in the industry attributable to regulator risk together with Rank $ regulators independence from the political frame work draws our concerns. 04 Bangaladesh 0.03 Forex – We expect the LKR to depreciate by 6% against the USD (Appendix). DIAL holds over 80% loan in USD Sri Lanka 0.04 05 causing major exchange losses. (Appendix 14) 06 India 0.04 ASPI Volatility – CSE has been facing major shocks with high volatility in share prices. CSE is highly sensitive 43 Malyasia 0.19 towards the foreign investors therefore economic and political changes especially in the US would affect the 91 United 0.37 volatility of the local index. This overall behavior of the index could affect DIALs share prices to be highly volatile Kingdom resulting in share prices to trade at a discounted value. Source: Company data Demand Assumptions – Our valuation is highly sensitive towards the GDP growth rate, Computer literacy and Figure 23 USD/LKR 2008- purchasing power of the consumers. Telco considered the engine of technological enhancement of the country is 2013Sep highly correlated with the macro economic conditions. Major revenue generating sources for Data, DBN and DTV are seen from business as BPOs and hotel projects, dampening GDP growth would affect the revenue in this segment as well further deterioration of purchasing power caused through an inflation rate in excess of 7% would cause the revenue of DIAL to decline. 87% of its revenue is generated through voice however with the replacement of its cash cow with cheap third party mobile applications is a threat DIAL would face.

Rivalry – DIAL was experiencing a low ARPU growth because of the low tariffs in operation (Table 10). We see consolidations taking place in the future taking away the prevailing cut throat price war we see this as a positive in terms of DIALs top line which could cause an increase in the RPU. However we see potential threat of other forms Source: CB Sri Lanka of competition such as number portability which if introduced enables the consumer to move between networks freely. We see reasonably a less threat to DIAL as it is the market leader in introduction of new technology with a Figure 11- Likely hood and reasonably loyal customer base. impact Risks Likely Impa Rati hood Longer Payback - DIAL has shown signs of heavy Capex in FY13 FY14 and FY15 causing the high level of ct ng depreciation cost in their financial statement as well as liquidity risk with non - recoverability of its investments in Regulator 1 5 H risk the future. Forex 1 5 H ASPI 2 3 M Parent company linkages – Axiata Bhd is the parent of DIAL claiming 83% ownership of DIAL creates both Volatility positive and negative impact on DIAL. DIAL uses Axiata brand name in its business activities which has enabled Demand 3 5 H Assumpti DIAL to obtain a AAA(lka)Fitch rating creating a positive impact of having access to cheap debt financing, ons however we also identify the risk with a large controlling parent in the event of DIAL loses its status as the Rivalry 1 5 H subsidiary of Axiata it would face a liquidity crisis. Longer 1 5 H Payback Parent 5 5 H company linkages (Likely hood of a risk occurring: 5 – very unlikely 1 – very probable / Impact: 5 – High impact 1 – Low Imapct) Source: student estimates

10

CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013

Appendix – Table of Content page

HISTORICAL AND PRO FORMA FINANCIAL STATEMENTS 12 – 14

Appendix 01 : Statement of Comprehensive Income

Appendix 02 : Balance sheet

Appendix 03 : Statement of Cash Flow

VALUATION 15 - 19

Appendisx 04 – Valuation

Appendix 05 – Business Model

Appendix 07 : Peer Comparison

OTHER TOPICS 20 – 22

Appendix 08 – Corporate Governance

Appendix 09 – Sustainability Report

INDUSTRY OVERVIEW AND COMPETITIVE POSITIONING 23 - 24

Appendix 10– Horizontal Business Models

Apendix 11 – Porter’s five forces

Appendix 12 – SWOT of Sri Lanka

FINANCIAL ANALYSIS 25

Appendix 13 – Key Financial Ratios

INVESTMENT RISK 26

Appendix 14 – Foreign Exchange loss expected

Appendix 15 – Risk Mitigation

ABBREVIATION 27

11 CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013 HISTORICAL AND PRO FORMA FINANCIAL STATEMENTS

Appendix 1: Statement of Comprehensive Income (In millions)

(LKR 000 000) 2010 2011 2012 2013E 2014E 2015E 2016E 2017E 2018E Revenue 41,423 45,412 56,345 62,552 71,443 81,146 89,261 96,402 103,150

Direct costs 23,600 24,949 32,216 35,029 39,294 43,413 46,416 48,683 50,543 Gross profit 17,822 20,463 24,129 27,523 32,149 37,733 42,845 47,719 52,606 Gross profit Margin 43% 45% 43%

Distribution Costs 5,432 6,265 7,601 8,423 9,621 10,927 12,020 12,982 13,890

Administrative Costs 7,112 8,074 9,865 10,556 11,295 12,085 13,292 14,448 15,700

Other Income 134 83 138 153 175 199 219 236 253 Operating Profit 5,413 6,207 6,801 8,697 11,409 14,919 17,752 20,526 23,269 Finance Costs – Net 125 769 2,727 3,683 2,782 2,332 3,107 3,355 3,604 Share of (loss)/profit associates 0 10 9 2 4 6 4 4 4 Profit before income tax 5,538 5,448 4,066 5,016 8,631 12,593 14,648 17,175 19,670 Income Tax 490 579 1,965 752 1,295 1,889 2,197 2,576 2,951 Profit for the year 5,047 4,870 6,030 4,263 7,336 10,704 12,451 14,598 16,720 Other comprehensive income 0 19 9 0 0 0 0 0 0 Total comprehensive income for the year 5,047 4,888 6,021 4,263 7,336 10,704 12,451 14,598 16,720 Margin 12% 11% 11% 7% 10% 13% 14% 15% 16%

EBITDA 11,468 16,512 18,357 23,569 29,060 34,969 39,979 45,102 49,860 EBITD Margin 28% 36% 33% 38% 41% 43% 45% 47% 48%

EPS 0.63 0.61 0.75 0.53 0.92 1.34 1.56 1.83 2.09 DPS 0.25 0.34 0.21 0.34 0.46 0.62 0.73 0.84 0.25 Dividend payout ratio 32% 42% 45% 40% 37% 34% 40% 40% 40%

Source: Company Documents, Student Estimates

12 CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013 Appendix 2: Balance Sheet In millions (LKR 000 000) 2010 2011 2012 2013E 2014E 2015E 2016E 2017E 2018E Non- Current Assets 56,820 55,084 69,727 74,539 85,864 90,839 91,328 91,254 85,694 Property plant and equipment 53,014 51,128 59,064 64,207 76,107 81,661 82,733 83,248 78,282 Intangible assets 3,757 3,869 10,386 10,051 9,470 8,885 8,295 7,699 7,098 Investment in associates 0 45 242 245 250 257 264 271 278 Available for sale financial asset 31 31 31 31 30.596 30.596 30.596 31 31 Amounts due from related companies 18 12 5 6 6 6 6 6 6

Current Assets 15,340 21,143 20,953 22,075 27,661 33,448 41,511 53,339 72,822

Inventories 271 409 284 309 346 383 409 429 446

Trade and Other receivables 9,635 10,281 12,022 12,562 13,284 15,045 16,553 17,873 19,124

Cash and cash equivalents 5,434 10,452 8,647 9,204 14,031 18,020 24,548 35,037 53,252

Total assets 72,160 76,227 90,680 96,614 113,525 124,287 132,838 144,593 158,516

Stockholders' Equity 29,902 33,194 37,182 38,805 44,488 52,530 61,394 71,064 81,997 Stated capital 28,104 28,104 28,104 28,104 28,104 28,104 28,104 28,104 28,104 Shares in ESOS Trust -1,991 -1,991 -1,991 -1,991 -1,991 -1,991 -1,991 -1,991 -1,991 Dividend reserve - ESOS Trust 260 292 331 384 436 488 541 593 645 Retained earnings 3,529 6,789 10,737 12,308 17,939 25,928 34,740 44,358 55,238

Non-current liabilities 23,539 21,078 14,478 24,519 33,116 32,916 30,397 30,964 32,637

Borrowings 20,672 17,018 12,094 21,964 30,334 29,885 28,028 28,471 30,026

Deferred tax liabilities 1,571 1,973 0 0 0 0 0 0 0

Retirement benefit obligation 391 444 587 652 723 803 0 0 0

Provision for other liabilities 620 587 814 814 814 814 814 814 814

Deferred revenue 286 1,057 983 1,090 1,245 1,414 1,555 1,680 1,797

Current liabilities 18,718 21,955 39,020 33,290 35,921 38,842 41,048 42,565 43,882

Trade and other payables 13,841 15,837 26,164 27,725 30,221 32,993 36,973 39,133 41,093

Current income tax liabilities 14 64 24 188 324 472 549 644 738

Borrowings 4,864 6,055 12,833 5,377 5,377 5,377 3,525 2,788 2,052 Total liabilities 42,257 43,033 53,499 57,809 69,037 71,757 71,445 73,529 76,520

Total Equity and Liabilities 72,160 76,227 90,680 96,614 113,525 124,287 132,838 144,593 158,516

Source: Company Documents, Student Estimates

13 CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013 Appendix 3: Statement of Cash Flows In millions (LKR 000 000) 2010 2011 2012 2013E 2014E 2015E 2016E 2017E 2018E Cash generated from operations 14,789 17,087 21,727 24,736 31,023 36,192 38,515 41,743 45,315 Interest received 86 384 347 307 307 307 412 450 488 Interest paid -665 -355 -286 -1,371 -1,370 -1,556 0 0 0 TDC refunds received -95 1,650 0 0 0 0 0 0 0 Tax paid 210 -106 -126 -588 -1,159 -1,740 -2,120 -2,481 -2,857 Retirement benefit obligation paid -43 -20 -80 0 0 0 0 0 0 Net cash generated from operations 14,283 18,640 21,583 23,083 28,801 33,203 36,807 39,712 42,946

Purchase of property, plant and equipment -78 -8,335 -17,248 -18,766 -28,577 -24,344 -22,315 -24,100 -20,630 Purchase of intangible assets -23 -385 -161 -114 -114 -114 -114 -114 -114

Investment in associates -13 -11 -156 0 0 0 0 0 0 Expenditure incurred on capital work- in-progress -6,689 0 0 0 0 0 0 0 0 Acquisition of subsidiary, net of cash acquired 0 0 -3,363 -800 -280 -560 -280 -280 -280 Proceeds from sale of subsidiary 0 69 0 0 0 0 0 0 0 Proceeds from sale of property, plant and equipment 55 10 63 0 0 0 0 0 0 Net cash used in investing activities -6,748 -8,651 -20,864 -19,680 -28,971 -25,018 -22,709 -24,494 -21,024 Repayment of finance leases -26 -6 -11 0 0 0 0 0 0 Repayment of borrowings -7,899 -3,161 -3,917 -16,931 -7,256 -6,700 -5,360 -4,676 -5,651 Proceeds from borrowings 3,492 1,096 4,885 26,800 15,627 6,251 3,503 5,118 7,207 Net Current Borrowings 0 0 0 -7,456 0 0 -1,852 -737 -737 Redemption of rated cumulative redeemable preference shares -1,250 -1,250 -1,250 0 0 0 0 0 0 Dividend paid to equity holders -343 -1,629 -2,036 -2,687 -1,705 -2,714 -3,639 -4,980 -5,839 Dividend received by ESOS Trust 0 32 40 52 52 52 52 52 52 Dividend paid to rated cumulative redeemable - preference shareholders 0 -177 -83 0 0 0 0 0 0 Direct cost on share issue 0 0 -38 -5 0 0 0 0 0 Net cash used in financing activities -6,025 -5,095 -2,409 -227 6,718 -3,111 -7,296 -5,222 -4,968 Net (decrease) / increase in cash and cash equivalents 1,510 4,893 -1,691 3,176 6,546 5,072 6,799 9,993 16,951 Movement in cash and cash equivalents At start of the year 3,019 4,476 9,406 8,647 9,204 14,031 18,020 24,548 35,037 (Decrease) / increase 1,510 4,893 -1,691 3,176 6,546 5,072 6,799 9,993 16,951 Exchange (losses) / gains on cash and cash equivalents -53 37 -347 -2,619 -1,719 -1,083 -271 496 1,264 At end of the year 4,476 9,406 7,368 9,204 14,031 18,020 24,548 35,037 53,252

Source: Company Documents, Student Estimates

14 CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013 Valuation Appendix 04 – Valuation

Present value of firm 103,551,812 Debt 24,926,896 Cash 8,647,069 Investment in Associates 242,173 Present value of equity 87,514,158

No. of shares 7,985,206 Value per share 10.96 Upside in share price 28.9%

2013E 2014E 2015E 2016E 2017E 2018E

Revenue 62,552,334 71,443,271 81,146,238 89,260,862 96,401,731 103,149,852

YoY growth 14.2% 13.6% 10.0% 8.0% 7.0%

EBIT 8,696,973 11,409,021 14,919,068 17,751,541 20,525,803 23,269,310

EBIT margin 13.9% 16.0% 18.4% 19.9% 21.3% 22.6%

EBIT (1-t) 7,392,427 9,697,667 12,681,208 15,088,810 17,446,933 19,778,914

Effective tax rate 15.0% 15.0% 15.0% 15.0% 15.0% 15.0%

Depreciation 14,871,640 17,650,747 20,049,829 22,226,990 24,575,756 26,590,923

As a % of revenue 23.8% 24.7% 24.7% 24.9% 25.5% 25.8%

Capital expenditure (19,679,663) (28,971,271) (25,017,834) (22,709,178) (24,494,396) (21,023,933)

Capex to revenue 31.5% 40.6% 30.8% 25.4% 25.4% 20.4%

Working capital 863,005 1,461,534 621,555 2,113,420 567,380 457,431 investment -1.4% -2.0% -0.8% -2.4% -0.6% -0.4%

Net cash flow 3,447,409 (161,323) 8,334,757 16,720,041 18,095,673 25,803,334

Terminal value 168,560,764

Discount factor 0.8587 0.7373 0.6331 0.5436 0.4668 0.4008

PV 2,960,138 (118,942) 5,276,551 9,088,948 8,446,370 77,898,747

15 CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013 Appendix 05 – Business Model

Revenue Subscriber ARPU Market Share Segment Mobile Subscriber growth of 2%CAGR over FY13E – FY18E ARPU growth of 9%CAGR 48% 1. Voice Saturating with current penetration levels nearing over FY13E – FY18E (57% Revenue 100% 1.RPU would deteriorate share) 2.Data revenue to increase mainly due to 2.MoU would increase as the Expect – Data  Smartphone penetration FY18E - 40% rate cuts make mobile usage revenue to cheaper increase to 25% -  Growing middle class 30% of total revenue

Broadband and Subscriber growth of 2%CAGR over FY13E – FY18E ARPU growth of 4%CAGR 16% Fixed line 1.100% penetrated. But DIAL is targeting the corporates over FY13E – FY18E (2nd player in with Suntel acquisition. With the economic development we 1.4G perceived as a high speed terms of revenue expect the growth in the service and industry sector. internet. DIAL’s broadband share) 2.4G technology is expected to attract competitor’s internet revenue would improve users.

Pay TV Subscriber growth of 23%CAGR over FY13E – FY18E ARPU growth of 0%CAGR 75% 1. DIAL’s current marketing campaign penetrates in to low over FY13E – FY18E (Market leader) income earning population. 1. Still at the initial stage of the 2. Improving entertainment industry and the hotel industry industry cycle. which subscribe to DTV over competitive pay TV brands 2. making offers with rate cuts 3. Technological advancements and Number of channels and pre – paid options being offered is more compared to competitors. introduced

Joint Venture – Anything.lk – CAGR 15% Joint venture with Anything.lk was entered in to in the FY 12. This venture enhances the E-Commerce and M-Commerce segments of the country. In our opinion this is a revenue source that could expect a boom in its performance with the  rapid increase in Smartphone penetration

 Increasing SMEs

 GDP growth.

Appendix 06 - WACC

A) WACC Computation Financing Cost Weight Value Method Ke 21.0% 0.5 10.5% Kd 13.0% 0.5 6.5% DCF 16.5%

 Current capital structure - Debt 40% and Equity 60%.  Target Capital Structure – Debt 50% and Equity 50%

B) Cost of Equity Estimation We assume the capital market to be efficient therefore we utilize the CAPM in estimating the Ke.

Risk Free (Rf) 12%

Beta 1.1

16 CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013 Market Risk Premium (Rp) 9%

Risk Free Rate - 5 Year T – Bond rate

DIAL Beta Calculation

 Past 6 Year Beta – 1.065  Expect Beta – 0.9 – 1.1 (Due to behavior of DIAL’s share with the ASPI coupled with the maturing industry with great potential to reduce risk we expect DIAL’s beta to be trading in the range of 0.9 – 1.1.)

Market Risk Premium Calculation Method 01 - Country Bond Default Spread adjust the mature market risk premium for the emerging market default spread.

Therefore in arriving at Sri Lankan equity risk premium we have added 4% Sri Lankan Bond default spread to US risk premium of 4.8%. (Source : (A. Damodaran) - http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html)

Method 02 – Relative Country Risk Premium

According to this method we add the relative country risk (Standard deviation of Equity/Standard deviation of Bond) to the risk premium of the mature market.

Sri Lanka Country risk premium 6% US risk Premium 6% Total 12% (Source : http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html)

17 CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013

Method 03 – Macro – economic conditions

Variables

Expected Inflation (EINFL) 6%

Expected growth rate in real earnings per share (EGREPS) 8%

Expected growth rate in PE (EGPE) 0

Expected income component (EINC) 12%

Risk Free rate (Rf) 10%

 Expected Inflation and Expected growth rate in real earnings per share was estimated based on the senior government officials statements made regarding the economic.

 Expected growth rate in PE – we assume the capital market to be efficient in the long run therefore the growth in PE to be 0.

 Expected income component was arrived at by assuming the average turnover in the CSE over the period of past 6 years.

 Risk Free rate is the 5 year T – Bond rate offered by the Central Bank.

EINFL) (1+EGREPS)(1+EGPE) – 1]+ ENIC} – Rf

Conclusion

Historically Sri Lanka’s Rp moves between 5% - 9% during a bearish market Rp of 8% could be observed. However we are optimistic on DIAL risk premium at 9% as DIAL being a company with a 3.09% of total market capitalization with a large public float and good governance would be highly attractive to foreign investors.

C) Cost of Debt Estimation

Debt Category Loan Interest Rate Interest Cost Sri Lankan Rupee Loan 15,626,926 11%* 1,718,962 USD Loan 30,825,000 2%* 616,500 Total 46,451,926 2,335,462 *Interest rate for Sri Lankan rupee loan was assumed at the AWPLR and the USD loan interest was the average interest rate DIAL had in its previous USD loans

Cost of debt adjusted for Taxes (Kd) Kd 5% Tax 15% Kd(1-t) 4.27%

18 CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013

Appendix 07 – Peer Comparison

A) Peer Company Business Characteristic Comparison

DIAL:SL SLTL:SL RCOM:BO BHAR:IN ADVANC:TB Market Position Market Leader and Government 49.5% Second largest Market leader and Market leader and First mover control Competitive player in the market First mover First Mover in Fixed line (44%Subscriber market share 54% Revenue share) Network Coverage 2G – 97% 2G – 97% 2G – 100% 2G – 100% 2G–100% 3G – 82% 3G – 80% 3G - 3G - 3G – Yet to introduce 4G – Introduced in 4G –introduced in 4G – introduced in 2012 2012 2013 April Subscriber CAGR Mobile – 6.63% Megaline – 4.67% Wireless – 35% Mobile – 45% 7.0% Fixed – 32% CDMA – (3.1%) Broadbad – 14% Broadband –15% TV – 21% Broadband - 28% TV – 160% PEOTV – 65% Revenue Model Mobile – 87% Megaline – 52% Wireless – 67% Voice Revenue – Voice – 72% Fixed – 7% CDMA – 26.7% Broadband – 33% 78% Non Voice – 20.2% TV – 5% Broadband – 17.4% Other – 22% International – 3.1% PEOTV – 3.5% Capex 4G network, Fiber 4G , Next Infrastructure Increase global Obtaining the license optic and Generation Network sharing agreements, foot print – African to operate International implementing all Introducing of countries Roll out of 3G Bandwidth access network in to Reliance 3G Tablet 3G and 4G roll out a single platform, Fiber optic cables, Internet protocol enabled PEO Tv facility,

Dividend 40% Payout ratio 37.9% Payout ratio 34.2% Payout Ratio 9% Payout ratio 100% Payout ratio Tele density 79.82% 79.82%

B) DIAL Value Relative to SLTL

Company PE EV/EBITDA PB SLTL 19.87 5.32 1.47 DIAL 11.1 4.5 1.8 Discount 44% 15% (22%)

Peer DIAL Price W Price * W Multiple (Accounting Information) Peer PE 14.98 0.35 5.24 19.87 0.75 Peer 12.23 0.5 6.12 EV/EBITDA 5.32 2.30 Peer P/B 6.84 0.15 1.03 1.47 4.66

19 CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013 12.39

C) DIAL Relative to Bharathi Airtel, Reliance and Advance Info Systems

Company PE EV/EBITDA PB BHAR:IN 20.32 16.82 10.51 RCOM:BO 46.50 11.88 1.08 ADVANC:TB 17.05 10.23 13.66 Discount 40% 40% 40% Adjusted Multiple 18.65 5.05 7.79

Price Base Peer DIAL Price W Price * W Multiple (Accounting Information) Peer PE 11.72 0.35 4.10 16 0.75 Peer EV/EBITDA 17.09 0.5 8.54 7 2.30 Peer P/B 20.70 0.15 3.10 4 4.66 15.75 OTHER TOPICS

Appendix 08: Corporate governance

Code of Best Practice on Corporate Governance was developed by the The Securities & Exchange Commission and the Institute of Chartered Accountants as Corporate Governance Listing Rules, which are applicable to listed companies via the Colombo Stock Exchange Listing Rules. While the Listing Rules provide regulation and legal framework for Corporate Governance, this Code is meant to provide the operational structures / processes for discharging Corporate Governance activities.

Dialog Axiata plc follows the criterion which has to be followed with care as adhering to the code is of utmost importance for the firm in terms of conduction a fair and transparent organization.

Section 1 : The Company Dialog Axiata plc Directors The Board Every public company should be headed by an effective Board, which Covered should direct, lead and control the Company. Chairman And Chief There are two key tasks at the top of every public company – conducting Covered Executive Officer (CEO) of the business of the Board, and facilitating executive responsibility for management of the Company’s business. There should be a clear division of responsibilities at the head of the Company, which will ensure a balance of power and authority, such that no one individual has unfettered powers of decision. Chairman’s Role The Chairman’s role in preserving good Corporate Governance is Covered crucial. As the person responsible for running the Board, the Chairman should preserve order and facilitate the effective discharge of Board functions. Financial Acumen The Board should ensure the availability within it of those with Covered sufficient financial acumen and knowledge to offer guidance on matters of finance. Board Balance It is preferable for the Board to have a balance of Executive and Non- Covered Executive Directors such that no individual or small group of individuals can dominate the Board’s decision- taking Supply Of Information The Board should be provided with timely information in a form and of Covered a quality appropriate to enable it discharge its duties.

20 CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013 Appointments To The Board There should be a formal and transparent procedure for the appointment Covered of new Directors to the Board. Re Election All Directors should be required to submit themselves for re-election at Covered regular intervals and at least once every three years. Appraisal Of Board Boards should periodically appraise their own performance in order to Covered Performance ensure that Board responsibilities are satisfactorily discharged. Disclosure Of Information In Shareholders should be kept advised of relevant details in respect of Covered Respect Of Directors Directors. Appraisal Of Chief Executive The Board should be required, at least annually, to assess the Covered Officer (CEO) performance of the CEO. Directors’ Remuneration Remuneration Procedure Companies should establish a formal and transparent procedure for Covered developing policy on executive remuneration and for fixing the remuneration packages of individual Directors. No Director should be involved in deciding his/her own remuneration. The Level And Make Up Of Levels of remuneration of both Executive and Non-executive Directors Covered Remuneration should be sufficient to attract and retain the Directors needed to run the Company successfully. A proportion of Executive Directors’ remuneration should be structured to link rewards to corporate and individual performance. Disclosure Of Remuneration The Company’s Annual Report should contain a Statement of Covered Remuneration Policy and details of remuneration of the Board as a whole Relations With Shareholders Constructive Use Of The Boards should use the AGM to communicate with shareholders and Covered Annual General Meeting should encourage their participation. (AGM) And Conduct Of General Meetings Major Transactions Further to compliance with the requirements under the Companies Act, Covered directors should disclose to shareholders all proposed corporate transactions, which if entered into, would materially alter/vary the Company’s net assets base or in the case of a company with subsidiaries, the consolidated group net asset base. Accountability And Audit Financial Reporting The Board should present a balanced and understandable assessment of Covered the Company’s financial position, performance and prospects. Internal Control The Board should maintain a sound system of internal control to Covered safeguard shareholders’ investments and the Company’s assets. Audit Committee The Board should establish formal and transparent arrangements for Covered considering how they should select and apply accounting policies, financial reporting and internal control principles and maintaining an appropriate relationship with the Company’s Auditors. Code Of Business Conduct Companies must adopt a Code of Business Conduct & Ethics for Covered & Ethics directors, and members of the senior management team and must promptly disclose any waivers of the Code for directors or others. Corporate Governance Directors should be required to disclose the extent to which the Covered Disclosures Company adheres to established principles and practices of good Corporate Governance. Section 2 : Shareholders Institutional Investors Shareholder Voting Institutional shareholders have a responsibility to make considered use Covered of their votes and should be encouraged to ensure their voting intentions are translated into practice. Evaluation Of Governance When evaluating Companies’ governance arrangements, particularly Covered Disclosures those relating to board structure and composition, institutional investors should be encouraged to give due weight to all relevant factors drawn to their attention. Other Investors

21 CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013 Investing/ Divesting Individual shareholders, investing directly in shares of companies Covered Decision should be encouraged to carry out adequate analysis or seek independent advice in investing or divesting decisions. Shareholder Voting Individual shareholders should be encouraged to participate in General Covered Meetings of companies and exercise their voting rights.

Appendix 09 : Sustainability Reporting

The Global Reporting Initiative (GRI) is a leading organization in the sustainability field. GRI promotes the use of sustainability reporting as a way for organizations to become more sustainable and contribute to sustainable development.

Within the years DIAL has been able to set targets as well as make progress to the set targets to an extent,

Economic  Introduce Vendor Code of Conduct - Vendor CoC introduced, incorporating requirements specified by ISO14001/SA8000.  Increase local procurement to 60% of total procurement -Local procurement spent was 37%.

Social  Increase regional employees to 25% of total employee base - Regional employee base increased to 23%.  Introduce human rights training- Few trainings on anti-sexual harassment were conducted.  Review whistle blowing policy and implement changes - Operationalization of whistle blowing policy reviewed through employee focus-group discussions.  Distribute Sinhala and Tamil code of conduct booklets

Environment  Add 5 Green Base Stations to network -5 new sites added during 2012.  350 M-waste collection points by 2014 -120 collection points by end 2012.  Implement Environment Management System - Aspect-impact analysis complete.  Increase e-bill subscriber base by 25% - Achieved a 1222% growth in the e-bill subscriber base. Percentage of e-bill subscribers increased from 1.58% to 20.93% in 2012 of the total base.  Reduce water consumption in office sites by 10% -Water consumption reduced by 7%. This maybe a result of the modified data capturing system.  Add 300 more free cooling and hybrid sites to network - 70 more free cooling and hybrid sites added.  Introduce carbon calculator for customers-DIAL will carry this target to 2013 as progress was not made against the stated target.

Det Norske Veritas AS (‘DNV’) had also been commissioned by the Management of Dialog Axiata PLC for the assessment of Sustainable business in their conclusion it was stated that Dialog Axiata PLC Sustainability Report - 2012, provides a fair representation of the Company’s sustainability policies, objectives, management approach and performance during the reporting year. And it was confirmed that the Report generally meets the requirements for GRI application level A+.

22 CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013 INDUSTRY OVERVIEW AND COMPETITIVE POSITIONING Appendix 10 : Horizontal Business Models Network Guarantors Offering network infrastructure and related services to other players Capabilities:  Cost efficiency in the operation of their infrastructure  Scalability in replicating their technology platforms and operating models  Reliability in terms of network and IT availability and quality  Smoothly integrated IT platforms and applications

What next: Building these capabilities requires operators to make large investments in new fiber and LTE infrastructure, which may limit competitors to government-led networking companies and operators willing to share costs with other like-minded players.

Business Enablers Monetize assets by opening up their infrastructures and extending their business strategy.

Capabilities:  Ability to broker and manage relationships with different partners, offering tailored services to each  Flexibility and willingness to cater to the needs of partners with different business models  Capacity for aggregating platforms and services into attractive packages for its partners  Willingness to partner with others to augment portfolio of offerings  What next: Incumbents that have embraced the concept and plan to open up their networks and assets to third parties should build on their partner management and wholesaling capabilities. Experience Providers Offer the best combination of targeted applications and content, and a high level of user experience.

Capabilities:  Ability to develop innovative new applications and services  Willingness to dedicate themselves to creating the best customer experience possible, including the ability to develop world-class user interfaces.  Capacity for excellent customer management and service

What next: This model may be the most difficult for telecom operators to follow, given their lack of experience and questionable track record in creating truly innovative new businesses. Moreover, the competition is already fierce.

Global Multi marketers The largest telecom operators that have a real opportunity to expand their businesses into multiple segments and markets, through a combination of the three models discussed above. The goal: to build value by creating synergies among different segments and markets, by managing their portfolios effectively, and by replicating the necessary capabilities from market to market.

Capabilities:  Proficiency in going global—organizing, operating, and marketing across many different geographies, and thus thinking both globally and locally  Capacity to develop different business models and accompanying capabilities that can be replicated in different markets without increasing overall complexity  What next: Competition among these players will likely be limited to those that already have significant scale, and the willingness to reorganize to push that scale even further.

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Conclusion Operators must begin making the strategic choices necessary to determine their future direction, deciding which of the four models—or combination of models—works for them. This decision should depend, in part, on whether they can effectively leverage the capabilities they already possess, and, in part, on careful consideration of their ability to build new ones.

Appendix 11 : Porter’s 5 Forces

Threat of new entrants . High barriers to enter the market 2 . High customer loyalty to the current service provider 1 . Finite amount of good radio spectrum 2 . Ownership of telecommunication license 2 . Expensive start-up costs 2 Average 9/5 = 2.5 Bargaining power of suppliers-less . Limited pool of talented managers and engineers 1 . A number of large equipment makers around 2 . Cheap Chinese Alternatives 2 Average 5/3 = 1.6 Bargaining power of buyers-moderate . Market is over populated with 5 service providers 2 . Less switching cost 5 . High customer loyalty 2 . Differentiation is less 4 . Single customer has less or no power 2 Average 15/5 = 3 Rivalry among existing firms . Asset specificity 4 . High exit barriers 4 . High fixed cost 4 Average 12/3 = 4 Threat of substitutes . Availability of OTT content providers and cable telecommunication providers 4 . Easy and cheap access to data and internet via substitutes 3 Average 7/2 =3.5

Appendix 12 : SWOT of Sri Lanka Strengths Weaknesses  Advantage of multiple undersea cables ( this will help it  Broadband penetration remains below the average of other mitigate to the next generation network developing nations  Ranked only behind India ( in the SAARC region ) in the  Geographical coverage of high speed fixed internet services for global networked readiness index households remains below 50%  NBN rollout is a landmark achievement for the region  Capability to provide sophisticated communications solutions through world –class optical fiber connectivity as well as wired and wireless broadband technology. Opportunities Treats  Rapid growth in the economic, social and cultural sectors  Increase in fuel prices  Significant improvements infrastructure  Hikes in energy costs  Ability to cater to the trends of internet enabled products  Rise of other input cost  New hope for development and nation- building  Increase in operating costs ( mainly driven by inflationary  National ICT targets have been clearly defined as 75% ICT factors like the exchange rate risk) literacy

24 CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013  The e-Government project continues on a positive note FINANCIAL ANALYSIS

Appendix 13 : Key Financial Ratios

(LKR 000 000) 2010 2011 2012 2013E 2014E 2015E 2016E 2017E 2018E Liquidity Ratios

Current Ratio 0.82 0.96 0.54 0.66 0.77 0.86 1.01 1.25 1.66

Quick ratio 0.81 0.94 0.53 0.65 0.76 0.85 1.00 1.24 1.65

Cash ratio 0.29 0.48 0.22 0.28 0.39 0.46 0.60 0.82 1.21 Efficiency Ratios

Asset Turnover 0.57 0.60 0.62 0.65 0.63 0.65 0.67 0.67 0.65 Inventory turnover 95.12 71.36 82.47 86.90 91.25 93.59 93.59 93.59 93.59

Inventory turnover days 3.84 5.11 4.43 4.2 4.0 3.9 3.9 3.9 3.9

Receivable turnover 4.03 4.36 4.56 4.68 4.87 5.21 5.14 5.07 5.00

Receivable turnover days 90.53 83.72 80.00 78 75 70 71 72 73

Payable turnover 7.20 9.64 8.08 7.93 7.77 7.45 7.30 7.16 7.02

Payable turnover days 50.68 37.84 45.20 46 47 49 50 51 52

Cash conversion cycle 134.97 117.23 117.27 118.90 119.25 114.59 114.59 114.59 114.59 Profitability Ratios

GP Margin 43% 45% 43% 44% 45% 47% 48% 50% 51% NP Margin 12% 11% 11% 7% 10% 13% 14% 15% 16% EBITDA Margin 28% 36% 33% 38% 41% 43% 45% 47% 48% EBIT Margin 13% 14% 12% 14% 16% 18% 20% 21% 23% ROA 7% 7% 7% 5% 7% 9% 10% 11% 11% ROE 17% 15% 16% 11% 16% 20% 20% 21% 20% Solvency Ratios

Debt Ratio 59% 56% 59% 60% 61% 58% 54% 51% 48% Debt/equity 78% 63% 64% 70% 80% 67% 53% 46% 41%

Interest Cover 21.88 5.2 2.24 2.18 3.69 5.65 5.04 5.39 5.69 Cash Flow Ratios

CAPEX/Revenue 19% 19% 31% 30% 40% 30% 25% 25% 20% Cash flow to debt 34% 43% 40% 40% 42% 46% 52% 54% 56% CFO/CAPEX (Internal financing of CAPEX) 181% 220% 123% 123% 101% 136% 165% 165% 208%

25 CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013 Investment Risk Appendix 14 – Foreign Exchange Loss

LKR has depreciated by 4.5% since the beginning of FY13 however do not expect a further currency depreciation because firstly according to the Central Bank of Sri Lanka the 3 month forward USD exchange rate is at LKR 135.6 secondly in our opinion with the NSB USD bond inflow CBSL would be able to maintain the LKR. However with the economic changes expected in US with the possible tapering Quantitative Easing (QE) we could expect these conditions to change in the extended period of our forecast. Following of table shows the inflation rate and interest rate parity between the two countries.

US Sri Lanka Inflation Rate 1.7% - 2.0% 6% - 7% Therefore we assume the currency to depreciate at 5%- 6% or more in the future considering the inflation rate interest rate differential between US and Sri Lanka.

The graph 1 shows the LKR NEER and REER movement during the reporting period. REER and NEER is the relative exchange rate against a basket of goods in selected foreign currencies. REER is the rate adjusted for the inflation rate. It is clear that the LKR is depreciating from the uptick trend in the REER and NEER charts.

In addition the current situation in the BOP and the government’s financing we could conclude that LKR would see a further depreciation. Following graphs are indicative of the debt servicing ratio of the country and the net foreign inflows. This is indicative of the high demand for USD during the forecasted period causing the LKR to further depreciate. Therefore in our opinion LKR depreciation could be expected to be greater than our estimate. (Graph 2)

*2013 figures are as at June Graph 2 – USD/LKR and Export/Foreign Debt Graph 1 – Reer Neer

Appendix 14 : Risk Mitigation

26 CFA Society Sri Lanka Investment Research Challenge Student Research October 1, 2013 ABBREVIATIONS CAGR Compounded Annual Growth Rate Capex Capital Expenditure CAPM Capital Asset Pricing Model COS Cost of Sales DBN Dialog Broad band Network DCF Discounted Cash Flow DIAL Dialog Axiata PLC DTV Dialog TV DY Dividend Yeild EBIT Earnings Before Interest and Tax EBITDA Earnings Before Interest Tax Depreciation and Amortization EV Enterprise Value FCF Free Cash Flow FCFE Free Cash Flow the Equity FCFF Free Cash Flow to Firm FDD Frequency Division Duplex FDI Foreign Direct Investment FD-LTE Long Term Evolution GP Gross Profit GRI Global Reporting Initiative HDTV High Definition Television HSPA High Speed packet Access ICT Information Communication Technology Kd Cost of Debt Ke Cost of Equity LKR Lanka Rupee OTT Over the top players PB Price to Book Value PE Price Earnings Ratio PESTEL Political, Economic, Socio Cultural, Technological, Environmental and Legal R&D Research and Development SLTL Sri Lanka Telecom Telco Telecom TGR Terminal Growth Rate TRC Telecommunication Regulatory Commission USD United State of America Dollar WACC Weighted Average Cost of Capital

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Disclosures: Ownership and material conflicts of interest: The author(s), or a member of their household, of this report does not hold a financial interest in the securities of this company. The author(s), or a member of their household, of this report does not know of the existence of any conflicts of interest that might bias the content or publication of this report. Receipt of compensation: Compensation of the author(s) of this report is not based on investment banking revenue. Position as a officer or director: The author(s), or a member of their household, does not serve as an officer, director or advisory board member of the subject company. Market making: The author(s) does not act as a market maker in the subject company’s securities. Disclaimer: The information set forth herein has been obtained or derived from sources generally available to the public and believed by the author(s) to be reliable, but the author(s) does not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security. This report should not be considered to be a recommendation by any individual affiliated with CFA Society of Sri Lanka, CFA Institute or the CFA Institute Research Challenge with regard to this company’s stock.

CFA Institute Research Challenge

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