Ceylon Tobacco Company PLC (CTC.N0000) · Ceylon Tobacco Company PLC 3 A capital market development...

Sri Lanka | Beverage, Food & Tobacco EQUITY RESEARCH

Initiation of coverage 31 October 2013

Ceylon Tobacco Company PLC (CTC.N0000)

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A capital market development initiative by the Colombo Stock Exchange in association with Amba Research

Steady flames Ceylon Tobacco Company PLC (CTC) is the largest publicly traded company on the Colombo Stock Exchange (CSE) by market capitalization, and holds a monopoly on manufacturing, marketing and distributing cigarettes in Sri Lanka. CTC is majority owned by its parent company British American Tobacco PLC (BAT), which holds an 84.1% stake. We forecast CTC’s net revenue to grow at a 10.5% CAGR over 2013E-2015E, and its EBIT margin to improve 146bps to 69.5% in 2015E. Our growth forecasts are driven mainly by CTC’s ability to adjust retail cigarette prices higher than tax increases and its strategy to continue growing its higher-value brands. We believe the proposed new health-related packaging regulation, if enacted, will only have a limited short-term impact. Our DCF and relative valuation analyses suggest a share price range of LKR557-848, compared with the share price of LKR1,125 as of 30 October 2013.

CTC’s net revenue will likely grow at a 10.5% CAGR through 2015E on the back of price increases. We expect net revenue growth to be driven primarily by growth in

higher-value brands, such as Dunhill, and the company’s ability to increase cigarette prices by a higher amount than government levy increases. Thus far, CTC has been able to pass cost increases directly to consumers, with the blended price per cigarette increasing at a 13.2% CAGR over 2011-2013E (higher than the increase in government levies per stick of 12.2%). We expect this trend to continue over our forecast period. However, we believe there is a limited market for higher-value brands in Sri Lanka and that CTC may be restricted in continuing to pass on cost increases to the consumer through price hikes without significantly impacting volumes. We forecast cigarette volumes to decline at a 2.0% CAGR over 2013E-2015E (vs. an annualized decline of 1.6% recorded over 2008-2012). In addition, we believe there will be only a modest impact on volumes in the short term if the regulation concerning the graphic labeling of cigarette packs is enacted, since the majority (roughly 95%) of cigarettes are sold as loose sticks.

We estimate the EBIT margin to expand 146bps through 2015E despite cost pressures. We expect CTC to post an EBIT margin of 69.5% by 2015E, on the back

of the company’s strategy to drive sales of higher-value brands that enjoy greater margins. In addition, margin expansion should be supported by further price increases and numerous cost-saving measures that have already been implemented. However, the EBIT margin could be pressured by the LKR’s depreciation against the USD as CTC is heavily dependent on imported resources – such as filters and printing and packaging materials – which make up roughly a third of its cost base.

Strong free cash flow generation should ensure sustained high dividend payouts. We expect CTC’s strong free cash flow (FCF) generation to continue and

grow at an 8.4% CAGR over 2013E-2015E, with the FCF-to-net sales percentage to remain at approximately 40% over the period. We expect CTC to continue to maintain a dividend payout ratio close to 100% and provide an average dividend yield of 4.8% over 2013E-2015E, as there is no indication at present about planned strategic investments beyond the maintenance of its core business.

We establish a valuation range of LKR557-848. CTC currently trades at LKR1,125,

up 58.4% YoY. Our DCF analysis yields a valuation range of LKR557-810, inclusive of potential upside and downside factors. Furthermore, our P/E valuation suggests that CTC currently trades at a 2014E P/E of 20.3x – a 45.9% premium to its two-year historical average. We establish a P/E-derived valuation range of LKR694-848 by factoring in a 10% premium and a 10% discount to the two-year average P/E to account for potential positive and negative factors, respectively.

Key statistics CSE/Bloomberg tickers

Share price (30 Oct 2013)

No. of issued shares (m)

Market cap (USDm)

Enterprise value (USDm)

Free float (%)

52-week range (H/L)

Avg. daily vol. (shares,1yr)

Avg. daily turnover (USD

‘000)

CTC.N0000/CTC SL

LKR1,125

187

1,608

1,530

15.9

1,383/703

11,252

79

Source: CSE, Bloomberg Note: USD/LKR=128.9 (average for the one year ended 30 October 2013)

Share price movement

Source: CSE, Bloomberg

Share price performance

3m 6m 12m

CTC 5% 40% 58%

All Share Price Index -2% -1% 8%

S&P SL 20 -5% -3% 9%


Summary financials

LKRm (year end 31 Dec) 2012 2013E 2014E

Net revenue 19,202 21,444 23,791

EBITDA 13,247 14,858 16,609

EBIT 13,057 14,658 16,395

Net profit 8,177 9,243 10,358

Recurrent EPS 43.65 49.34 55.30

ROE (%) 233.9 216.8 196.7

P/E (x) 18.4 22.8 20.3

Source: CTC, Amba estimates

75%

100%

125%

150%

175%

200%

Oct-12 Jan-13 Mar-13 Jun-13 Aug-13 Oct-13

CTC S&P SL20 ASPI

Ceylon Tobacco Company PLC

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Table of Contents

CTC to continue net revenue growth at a 10.5% CAGR over 2013E-2015E, beating declining volumes........................... 3

Increasing cigarette prices offset impact to revenue from declining volumes ....................................................................................... 3 CTC’s net revenue growth driven by effective portfolio management ................................................................................................... 6 Growing health concerns about smoking may impact any significant revenue upside ......................................................................... 7 Upside and downside risks to CTC’s revenue growth .......................................................................................................................... 8

EBIT margin to expand 146bps through 2015E despite growing cost pressures ................................................................ 9

Margin expansion fueled by growth in higher-value brands and price increases .................................................................................. 9 Downside risks to margins .................................................................................................................................................................. 10

Strong free cash flow generation should ensure continued high dividend payout to investors ......................................... 11

Zero debt position provides a low-risk base ready for expansion when warranted ............................................................................. 12

We establish a valuation range for CTC shares of LKR557-848 ....................................................................................... 13

DCF analysis yields a valuation range of LKR557-810 per share ....................................................................................................... 13 P/E analysis yields a fair value range of LKR694-848 per share ........................................................................................................ 15 Relative valuation data used as a measure of comparison ................................................................................................................ 16

Share price performance .................................................................................................................................................... 17

Earnings release focus areas ............................................................................................................................................. 18

Appendix 1: CTC in the tobacco industry ........................................................................................................................... 19

CTC holds a monopoly in manufacturing, marketing and distributing cigarettes in Sri Lanka ............................................................ 19 Global tobacco landscape .................................................................................................................................................................. 20

Appendix 2: Company overview......................................................................................................................................... 23

CTC’s brand portfolio .......................................................................................................................................................................... 23 Management strategy, transparency and governance ........................................................................................................................ 24 Shareholding structure ....................................................................................................................................................................... 25 Board of directors ............................................................................................................................................................................... 25

Appendix 3: Key financial data ........................................................................................................................................... 26

Appendix 4: SWOT analysis .............................................................................................................................................. 29

Fact Sheet .......................................................................................................................................................................... 30


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CTC to continue net revenue growth at a 10.5% CAGR

over 2013E-2015E, beating declining volumes

We expect CTC to maintain its strong historical growth in net revenue and forecast a 10.5% CAGR over 2013E-2015E to LKR25.9bn in 2015E. The company’s revenue growth should be driven mainly by sustained price increases – we forecast the blended price per stick to grow at an 11.3% CAGR through 2015E – despite volumes declining at a 2.0% CAGR over the forecast period. Although we expect the government to increase levies at an 8.7% CAGR over 2013E-2015E, CTC has historically managed to consistently pass on this increased cost burden to consumers, and we anticipate this trend to continue.

Figure 1: CTC’s net revenue to grow at a 10.5% CAGR over 2013E-2015E despite dropping volumes


Increasing cigarette prices offset impact to revenue from declining

volumes

In terms of CTC’s overall brand portfolio, the average blended price per stick grew significantly at a 13.9% CAGR over 2008-2012 and we expect this to continue to increase at an 11.3% CAGR through 2015E, necessitated by continued increases in government levies. With the majority of smokers belonging to the lower-income demographic, these price increases have had a notable impact on affordability and has consequently resulted in decreasing volumes, except in 2010 and 2011 – when CTC witnessed a jump in volumes with the opening up of the country’s north and east regions following the end of the civil war in 2009. Upon successfully covering these new markets by the end of 2011, CTC returned to its previous declining volume trend and recorded a YoY drop of 4.3% during 2012.

3,600

3,800

4,000

4,200

4,400

4,600

0

5,000

10,000

15,000

20,000

25,000

30,000

2010 2011 2012 2013E 2014E 2015E

Sticks (m) LKRm

Net revenue (LHS) Stick volumes (RHS)

We forecast revenue growth at a 10.5% CAGR through 2015E driven by price increases


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Figure 2: Net revenue continues to increase its contribution to gross revenue


Figure 3: Average blended price per stick to continue increasing at an 11.3% CAGR over 2013E-2015E while volumes decline


Figure 4: Stick prices have been increasing rapidly over the past five years

Stick prices as at 31 December (LKR)

Pre

miu

m

Brand 2008 2009 2010 2011 2012 Oct-2013

Dunhill 17 19 21 24 27 32

Dunhill Switch* - - - 25 27 34

B&H 17 19 21 24 27 32

JPGL 16 18 20 22 25 28

Mid

Pall Mall** 13 14 16 17 20 NA

Bristol*** - - - - 17 20

Lo

wer Four Aces 9 10 12 13 16 18

Three Roses 4 4 6 6 8 12

Capstan 4 4 6 6 8 10

Source: CTC

* Dunhill Switch was launched in late 2011

** Pall Mall was discontinued in August 2013

*** Bristol was relaunched in October 2012

15%

20%

25%

-

40,000

80,000

120,000

160,000

2008 2009 2010 2011 2012 2013E 2014E 2015E

LKRm

Gross revenue (LHS) Net revenue (LHS) Net revenue as a % of gross revenue (RHS)

4,000

4,200

4,400

4,600

4,800

-

5

10

15

20

25

30

2007 2008 2009 2010 2011 2012 2013E 2014E 2015E

Sticks (m) Price per stick (LKR)

Tax component (LHS) CTC's share (LHS) Stick volumes (RHS)


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We believe price increases are not imposed uniformly across the company’s individual brands and are done based on aggregate demand and the respective target markets for each brand. For example, while John Player Gold Leaf’s (JPGL) price has increased by an 11.8% CAGR over 2009-2012, Dunhill has increased 12.3% over the same period. Capstan and Three Roses have seen a much higher price increase at an 18.9% CAGR, albeit from a lower price base. These two brands make up the majority of the lower-end segment of CTC’s brand portfolio and are positioned in that price bracket to counter the large demand for cheap, illicit cigarettes. As part of CTC’s brand strategy, we believe the company will focus on continuing to grow its higher-value brands and will limit the supply of the lower-end brands to the market.

As a result of successive price increases across the portfolio, Sri Lankan cigarette prices are among the most expensive in Asia, as illustrated in Figure 6, while its tobacco levies are the highest in Southeast Asia. This high cost is further highlighted when we consider Sri Lanka’s lower GDP per capita when compared with other emerging Asian countries. CTC’s revenue inflows also experience some pressure due to the considerably lower cigarette consumption rate per person in Sri Lanka. The annual per capita consumption of cigarettes in Sri Lanka is 195, compared with Pakistan’s 468 and Indonesia’s 1,085, as per the Tobacco Atlas report, a comprehensive annual research report sponsored by the World Lung Foundation and the American Cancer Society.

CTC is a key contributor to government revenue in Sri Lanka, contributing approximately 6.0-7.5% to national tax revenue annually. Given the stringent policies imposed at present with regard to selling, consuming and advertising alcohol and tobacco, it is unlikely that CTC’s monopoly status would be threatened. Furthermore, CTC’s position has been supported by the efforts of the local excise agencies, who have continued to effectively minimize illicit cigarettes entering the market. However, as part of the key policies to control tobacco consumption in the country, the government, through the National Authority on Tobacco and Alcohol (NATA), has continually increased tobacco levies and restrictions on smoking areas. Nonetheless, there is a delicate balance between tax increases and their subsequent effect on overall tax revenue, as the increases in price will result in greater volume declines, and consequently, downward pressure on revenue that will not be offset by further price increases.

Sri Lankan cigarette prices and tobacco levies are among the highest in Asia

Figure 5: Sri Lanka has the highest tobacco-related duties in the Southeast Asian region, 2012

Figure 6: Sri Lanka has one of the highest cigarette prices in Asia

Source: WHO Report On The Global Tobacco Epidemic, 2013 Source: www.cigaretteprices.net, October 2013

0% 25% 50% 75% 100%

Sri Lanka

Bangladesh

Thailand

Indonesia

Myanmar

Maldives

India

Nepal

Excise tax % All other taxes %

1.0 1.0 1.0 1.0 1.3 1.5

1.8 1.9 2.0 2.0 2.0 2.6 2.7

3.2

4.0 4.4

0

1

2

3

4

5

6

US$/Pack


6


Figure 7: CTC is a key contributor to the government’s tax revenue

Source: CTC, Central Bank of Sri Lanka (CBSL), Amba estimates

CTC’s net revenue growth driven by effective portfolio

management

CTC is currently focused on growing its premium, higher-priced brands in order to sustain revenue growth. While the company has the ability to increase production volumes of its lower-end brands in order to boost stick sales among more price conscious consumers, we believe management will not go ahead with such a move, preferring instead to increase awareness and promote its more expensive offerings. Further, we expect more mid-range cigarette smokers to continue to migrate to buying premium cigarette brands such as Dunhill and JPGL due to a growing consciousness about maintaining a favorable social image. Additionally, we believe smokers of cheaper cigarettes will upgrade to mid-priced brands as per capita disposable incomes continue to rise.

CTC is able to achieve growth in net revenue by focusing on the higher-value brands in its portfolio. JPGL, CTC’s flagship brand, is the company’s third most expensive and highest-selling product and contributes approximately 83% to the company’s total stick sales. JPGL volumes grew at a 1.1% CAGR over 2009-2012 while its price increased by a 11.8% CAGR over the same period. However, during 2012, JPGL volumes declined 5.2% YoY – its largest drop in the recent past, which had a significant impact on CTC’s overall volumes. The impact to revenue was partially offset by the increase in price by 13.6% in the same period.

Figure 8: JPGL contributes 83% to CTC’s total stick sales

Source: CTC

0%

2%

4%

6%

8%

0

20,000

40,000

60,000

80,000

2007 2008 2009 2010 2011 2012 2013E

LKRm

CTC tax payment (LHS) CTC's contribution to govt. tax revenue (RHS)

78% 79% 81% 84% 83%

22% 21% 19% 16% 17%

-

5

10

15

20

25

30

0%

20%

40%

60%

80%

100%

2008 2009 2010 2011 2012

LKR

JPGL volume (LHS) Other brands volume (LHS) Price per stick (RHS)

Smoker migration to higher-priced brands should also contribute to revenue growth


7


Since the introduction of the innovative Dunhill Switch brand, which features a filter that allows the smoker to enjoy a second taste, in late-2011 as part of CTC’s premium segment, sales in this segment have increased significantly, albeit from a lower historical base. Dunhill volumes increased at a 55.0% CAGR over 2009-2012 while prices increased at a 12.3% CAGR over the same period. Dunhill has been able to increase its market share in CTC’s portfolio, in terms of sales volumes, to 1.6% in 2012 from 1.0% in 2011, partly due to the introduction of Dunhill Switch, with the brand currently accounting for approximately 50% of Dunhill volumes. Dunhill is the most expensive product in CTC’s portfolio and enjoys the highest margins, and has therefore been able to partially offset the decline in revenue caused by volume declines among other brands.

Figure 9: Dunhill volumes increased at a 55.0% CAGR and its price at a 12.3% CAGR over 2009-2012

Source: CTC

Growing health concerns about smoking may impact any

significant revenue upside

The number of smokers in Sri Lanka has been on a steady decline; CTC’s management believes the average daily consumption has reduced from 8-9 sticks per day in 2008 to 6-7 sticks currently. In addition to the rising prices of cigarettes, another reason for the drop in consumption has been the growing awareness of the health issues related with smoking. Authorities such as NATA have carried out numerous campaigns to increase public awareness of the ill effects of tobacco use. The Global Youth Tobacco Survey (GYTS) conducted in 2011 noted that 69.6% of Sri Lankan students had been educated in class about the dangers of smoking. With the enactment of the smoking ban, which prohibits smoking in public areas that include enclosed public places such as restaurants and social clubs, the negative image of smoking has been further emphasized.

The ministry of health in Sri Lanka plans to introduce legislation enforcing the introduction of health warnings with graphic labeling that covers 80% of the area of cigarette packaging. CTC has appealed against this measure and the Supreme Court has issued a stay order suspending the implementation of the regulation until 22 January 2014. If the packaging regulation is passed by the Supreme Court, we believe the impact will be minimal, as roughly 95% of cigarettes are sold in loose stick form. Globally, similar packaging laws have been passed, such as the landmark plain packaging case in Australia enforced in 2012 whereby cigarette companies have had to sell their product in logo-free plain packages; however, the negative impact has only been in the short term followed by a normalizing effect in the long term.

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20

30

40

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80

0

5

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25

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2008 2009 2010 2011 2012

Sticks (m) LKR

Price per stick (LHS) Stick volumes (RHS)

Increasing concerns and awareness regarding the ill effects of smoking contributes to volume decline


8


Upside and downside risks to CTC’s revenue growth

Increasing per capita income driving volumes – As the per capita GDP income in Sri Lanka continues to rise (the Central Bank of Sri Lanka [CBSL] is targeting USD4,000 by 2016 from USD2,923 in 2012), smokers may increase their average daily consumption in line with this rise in disposable income.

Changes in tax rate hikes – The government may reduce the rate of tax increase in order to avoid any eventual negative impact on total tax revenues; this move may decrease the rate of volume decline witnessed in the recent past. However, if the government increases taxes significantly, there could be a substantial drop in volumes, as the cost of cigarettes may become unaffordable to many smokers. Consequently, this may result in a fall in CTC’s revenue as price increases may not be able to offset the larger drop in volumes.

Packaging laws and health concerns – The regulation concerning the graphic labeling on cigarette packs, if enforced, could increase awareness of the risks of smoking among consumers and increase the negative image of the product, hence resulting in a drop in volumes. Further, the public’s greater awareness of the risks of tobacco use has caused the number of smokers to drop. This rate of decline could gather pace due to more prevalent health campaigns by the NATA and the health ministry.

Rising disposable income levels may ease revenue pressure, while further increases in tax rates would lead to even higher cigarette prices


9


EBIT margin to expand 146bps through 2015E despite

growing cost pressures

We forecast CTC’s EBIT margin to experience modest growth through 2015E driven by its strategy of focusing on higher-value brands and limiting the supply of brands in the lower-end segment. Further, the company’s ability to pass on incremental costs through price increases will enable CTC to improve margins despite cost pressures – mainly from the increasing cost of raw material imports and energy price hikes.

Figure 10: We forecast CTC’s margins to post modest growth through 2015E


Margin expansion fueled by growth in higher-value brands and

price increases

We expect CTC’s EBIT margin to expand 146bps through 2015E to reach 69.5%. Growing sales of higher-margin brands, such as Dunhill and JPGL, should support this margin expansion and drive EBIT growth over the forecast period.

The company’s margin could, however, be pressured due to its reliance on raw material imports, which account for roughly one-third of CTC’s cost base, as the cost of these imports has been steadily rising over the recent past. The company imports filters and printing and packaging material, which are charged high duty tariffs, and currently lack suitable substitutes from local sources. Furthermore, the recent depreciation of the LKR against the USD (down 2.6% YTD), a trend we expect to continue, could further exacerbate the impact of import costs. In addition, increases in energy prices (electricity and fuel) could further pressure margins. Management indicated that tobacco leaf purchase costs, which accounts for about one-third of CTC’s total costs, has been increasing at a rate marginally lower than inflation. The company sources all its tobacco requirements from local farmers.

However, CTC could reduce its operating cost base by implementing further improvements to various aspects of its supply chain, such as the use of three-shift operations and enhanced logistics operations, which have already reaped cost benefits since their respective introductions. Such cost-saving measures could therefore improve CTC’s profitability.

20%

40%

60%

80%

100%

2007 2008 2009 2010 2011 2012 2013E 2014E 2015E

Gross margin EBIT margin Net margin

We expect CTC’s EBIT margin to expand through increased focus on higher-margin brands, such as Dunhill


10


Figure 11: We expect CTC’s EBIT margin to expand 146bps over 2013E-2015E


Downside risks to margins

Higher-than-normal rate of increase in government levies, which CTC may not be able to pass on to consumers completely, may have a negative impact on profit potential (current and future sales volumes).

Prolonged periods of drought in Sri Lanka may lead to a poor harvest of tobacco and force the company to import its tobacco leaf requirements at a much higher cost. Over the past ten years, however, CTC has imported tobacco leaves only in 2008, according to management.

Further depreciation of the LKR may negatively impact margins, as one-third of its total costs is attributed to filters and packaging that are imported.

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2010 2011 2012 2013E 2014E 2015E

YoY growth/margin LKRm

EBIT (LHS) YoY growth (RHS) EBIT margin

Government tax hikes and continuing devaluation of the LKR could exert increased pressure on CTC’s margin


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Strong free cash flow generation should ensure continued

high dividend payout to investors

We expect CTC’s FCF to grow at an 8.4% CAGR over 2013E-2015E, compared with a historical CAGR of 22.6% over 2008-2012. We also expect CTC’s FCF-to-net sales percentage to average around 40% over 2013E-2015E, in line with 2012 levels. CTC has historically been able to enjoy a negative net working capital due to its relatively higher accounts payable, which is attributable to timing differences in settling tax levies. In addition, CTC’s supply chain has been streamlined to hold only the most efficient amount of inventory and to proactively adjust production volumes to cater to demand. Furthermore, the company has not indicated plans for any major capex investment over the short to medium term and currently operates on a maintenance capex basis.

Figure 12: CTC’s FCF to grow at an 8.4% CAGR over 2013E-2015E


CTC is well-known for being one of the highest dividend yielding companies trading on the CSE – we forecast the company to achieve a dividend yield of 4.3% in 2013E, compared to the three-year average yield of 7.6% over 2010-2012; our lower yield estimate is primarily due to the stock’s higher share price which has rallied since mid-2013. CTC has historically maintained a payout ratio close to 100% and we expect this trend to continue, as the company has indicated that it has no plans for any strategic investments in the foreseeable future, which may dilute this payout as funds would then be diverted to the new investments. We expect the company’s EPS to grow at an 11.8% CAGR over 2013E-2015E.

Figure 13: We expect CTC to maintain its almost 100% dividend payout ratio


30%

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50%

0

2,000

4,000

6,000

8,000

10,000

12,000

2010 2011 2012 2013E 2014E 2015E

LKRm

Free cash flow (LHS) % of net revenue (RHS)

27.2

35.1

43.7 49.3

55.3 60.9

27.2

34.6

45.2 48.8

53.6 59.1

0

10

20

30

40

50

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70

2010 2011 2012 2013E 2014E 2015E

LKR

EPS DPS

Stable cash generation should ensure CTC remains a strong dividend play


12


Zero debt position provides a low-risk base ready for expansion

when warranted

CTC has maintained a zero debt structure since 2011, which provides a low-risk base to the organization. In addition, CTC’s stable financial position is evident through its current ratio, which has shown a steady increase to an estimated 1.3x in 2013E from 1.1x in 2008. This combination of stable financial ratios places CTC in a favorable position to finance any potential future investments as part of its strategic plans, as debt funding could be obtained relatively easier and at attractive rates without placing too much strain on its balance sheet. In addition, CTC’s internally generated funds could be utilized to fund such investments, as the company currently maintains an almost 100% dividend payout ratio.


13


We establish a valuation range for CTC shares of LKR557-

848

We establish a 12-month valuation range of LKR557-848 per share, based on our current earnings outlook for CTC shares, compared with the share price of LKR1,125 as of 30 October 2013. In our view, the stock’s current valuation premium partly reflects the market’s expectation of continued high dividend yield, particularly in the backdrop of declining interest rates. We arrive at our valuation range by applying scenario analysis to a DCF valuation, and using a P/E-based relative valuation approach. For comparison, we also assess CTC’s valuation levels relative to a group of international peers. For factors that will provide an upside/downside to this stated valuation range, please refer to pages 14 and 15 of the report.

Figure 14: Valuation range analysis provides a range of LKR557-848 per share (current share price of LKR1,125)

Source: CTC, Bloomberg, Amba estimates

DCF analysis yields a valuation range of LKR557-810 per share

In valuing CTC shares, we applied a DCF approach. Our base-case assumption of a risk-free rate of 10.7% and a market risk premium of 5.0% yields a value per share of LKR671. Adjusting these assumptions (to allow for bull- and bear-case scenarios) implies a valuation range of LKR557-810.

Other elements of our valuation approach include the following:

CTC’s current capital structure comprises 100% equity. We have assumed a 90% equity and 10% debt target capital structure.

Figure 15 reflects our DCF assumptions for CTC’s valuation. We have estimated the following:

EBIT and FCF figures throughout the explicit and fade periods.

Terminal value at 2021E, calculated by applying a terminal growth rate to unleveraged FCF as of 2021E.

Finally, we arrived at our enterprise value (EV) by discounting the unleveraged FCF values over the explicit and fade periods at the WACC.

694

557

703 1,383

848

810 1,125

450 650 850 1,050 1,250 1,450

52-week range

P/E analysis

DCF

Our base-case assumption includes a risk-free rate of 10.7% and a market risk premium of 5.0%


14


Figure 15: Amba DCF assumptions schedule (base-case)

WACC assumptions

2014E (LKRm)

Target capital structure 90/10 EBIT total 16,395

Cost of equity 15.2% FCF 9,588

Cost of debt 12.0% Terminal value (undiscounted) 161,430

Effective tax rate 40.4% EV 115,323

WACC 14.4%

Source: Amba estimates

Taking into consideration the upside and downside risks discussed on pages 7 and 10, we arrive at the following bull- and bear-case scenarios (shown in Figure 16) to establish our valuation range of LKR557-810:

Bull-case scenario: The potential upside we estimate assumes only a 1.0% annualized decline in local cigarette volumes over the explicit forecast period compared to the base-case assumption of a 2.0% decline. In addition, we estimate cigarette prices will increase at a 13.3% CAGR compared to the base-case of an 11.3% CAGR. This would lead to a net revenue CAGR of 14.0% over 2013E-2015E (compared with the 10.5% base-case forecast) and an assumed 2.5% upside to the base-case EBIT margin.

Bear-case scenario: The potential downside we estimate assumes a decline at a 3.0% CAGR in local cigarette volumes compared to the base-case figure of 2.0%. In this scenario, we estimate only a 9.3% CAGR for price increases compared to the base-case of an 11.3% increase. This would lead to a net revenue CAGR of 7.1% over 2013E-2015E (compared with the 10.5% base-case figure) and an assumed 2.5% downside to the base-case EBIT margin.

Figure 16: Cigarette stick volumes and price analysis assumptions – bull- and bear-cases

Base-case Bull-case Bear-case

2012 2013E 2014E 2015E 2013E 2014E 2015E 2013E 2014E 2015E

Volume - no. of sticks m (local) 4,303 4,217 4,133 4,050 4,260 4,218 4,175 4,174 4,049 3,928

YoY growth (%) -4.4% -2.0% -2.0% -2.0% -1.0% -1.0% -1.0% -3.0% -3.0% -3.0%

Volume - no. of sticks m (export) 7 7 8 9 7 8 9 7 8 8

YoY growth (%) 155.5% 10.0% 10.0% 10.0% 12.0% 12.0% 12.0% 8.0% 8.0% 8.0%

Price - per stick LKR (local) 19 22 24 26 22 25 28 21 23 25

YoY growth (%) 13.6% 12.0% 12.0% 10.0% 14.0% 14.0% 12.0% 10.0% 10.0% 8.0%

Price - per stick LKR (export) 19 22 24 26 22 25 28 21 23 25

YoY growth (%) 13.6% 12.0% 12.0% 10.0% 14.0% 14.0% 12.0% 10.0% 10.0% 8.0%

Revenue - local 82,642 90,708 99,561 107,327 93,270 105,264 116,717 88,179 94,087 98,566

Revenue - export 128 158 195 236 164 209 263 153 181 211

Total gross revenue 82,770 90,866 99,756 107,563 93,434 105,474 116,980 88,332 94,268 98,777

Government levies 63,569 69,422 75,965 81,640 71,150 80,055 88,496 67,707 72,021 75,219

Net revenue 19,202 21,444 23,791 25,922 22,283 25,419 28,484 20,625 22,247 23,558

YoY growth (%) 12.8% 11.7% 10.9% 9.0% 16.0% 14.1% 12.1% 7.4% 7.9% 5.9%


Our bull-case considers a lower rate of cigarette volume decline in tandem with a higher-than estimated price rise over the explicit forecast period


15


P/E analysis yields a fair value range of LKR694-848 per share

CTC’s 12-month forward P/E multiple has ranged between 6.7x and 25.0x since November 2010. The share’s two-year average historical forward P/E stands at 13.9x, while the stock currently trades at a 2014E multiple of 20.3x (based on our 2014E EPS forecast) – a 45.9% premium to its two-year historical average.

Figure 17: CTC has traded at a 12-month forward P/E multiple of between 6.7x and 25.0x over the past three years

Source: CTC, Bloomberg

In determining a P/E valuation range, we applied the following two scenarios:

Optimistic scenario: Under this scenario, we applied a potential upside by assuming a lower rate of cigarette sales volume decline and a higher rate of price increases. In addition, we assume government levies will increase at a lower rate than in previous years. CTC’s EBIT margin should also see further potential upside on the back of increasing sales of higher-value brands and price increases above the rise in taxes. We applied a 10% premium to the two-year historical forward P/E average and arrived at a multiple of 15.3x. Applied to our 2014E forecast EPS, this leads to a share price of LKR848.

Pessimistic scenario: Here we assume a 10% discount to the current two-year average, implying that CTC will trade at a multiple of 12.5x. This could be justified by mainly the higher decline in cigarette volumes and the inability to increase stick prices at the historical rate. This could be exacerbated by further increases in government levies and the inability to pass on costs to the consumer without a resulting signficant drop in volumes. This scenario also accounts for higher-than-anticipated increases in overhead costs, which could exert pressure on margins. Applying this multiple to our 2014E EPS estimate of LKR55.30, we arrive at a fair value of LKR694 per share.

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In our optimistic scenario, we apply a 10% premium to account for increased sales of higher-margin brands boosting the EBIT margin


16


Relative valuation data used as a measure of comparison

Figure 18 presents CTC’s valuation metrics relative to its peers. CTC trades at a 26.6% premium to the average of its peers based on P/E valuation metrics. The share trades at a 2014E P/E multiple of 20.3x compared with the peer group average of 16.1x.

Figure 18: CTC trades at a 2014E P/E multiple of 20.3x

P/E EPS CAGR

Company name Country 2011 2012 2013E 2014E 2015E 2014E-2015E

Ceylon Tobacco Company PLC Sri Lanka 12.6x 18.4x 22.8x 20.3x 18.5x 11.1%

Imperial Tobacco UK 12.3x 33.7x 10.9x 10.2x 9.5x 10.5%

Philip Morris International Inc USA 16.0x 16.1x 16.2x 14.6x 13.2x 9.9%

Altria Group Inc USA 15.2x 14.0x 14.8x 13.8x 12.9x 5.8%

British American Tobacco UK 19.5x 15.8x 15.2x 14.1x 12.9x 7.0%

Japan Tobacco Japan 19.9x 13.8x 16.6x 15.3x 13.8x 9.8%

KT&G Corp South Korea 13.3x 13.2x 13.6x 11.1x 11.7x 8.0%

BAT Malaysia Bhd Malaysia 19.8x 22.2x 21.8x 20.9x 20.6x 3.3%

Gudang Garam Tbk Indonesia 24.4x 27.0x 15.8x 13.6x 12.1x 12.8%

ITC India India 27.9x 28.2x 31.9x 31.0x 26.1x 8.0%

Mean 18.7x 20.4x 17.4x 16.1x 14.8x 8.4%

Median 19.5x 16.1x 15.8x 14.1x 12.9x 8.0%

High 27.9x 33.7x 31.9x 31.0x 26.1x 12.8%

Low 12.3x 13.2x 10.9x 10.2x 9.5x 3.3%

Source: CTC, Bloomberg, Amba estimates

Note: Imperial Tobacco has a financial year-end of 30 September; Japan Tobacco and ITC India year-ends are 31 March

While the companies in the peer set are not a perfect match in terms of size and monopolistic features, they provide some measure of comparison with other regional and international tobacco companies. The peers are of a much larger size in terms of market capitalization than CTC.


17


Share price performance

CTC shares closed at LKR1,125 on 30 October 2013, LKR415 higher than 12 months earlier and up 58.4%, compared to a 7.6% rise in the All Share Price Index (ASPI) and a 9.3% increase in the S&P SL 20 over the same period. The share has experienced a price spike since May 2013 which we believe may be due to piqued foreign buying interest.

Figure 19: CTC experienced a recent spike due to increased interest from foreign buyers


As shown in Figure 20, over the past three years, CTC has significantly outperformed the overall indices – which have actually been on a decline when compared with their respective values three years ago.

Figure 20: CTC vs. key indices

3m 6m 1 year 2 years 3 years

CTC 5% 40% 58% 186% 209%

ASPI -2% -1% 8% -6% -12%

S&P SL 20 -5% -3% 9% -1% -16%


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ASPI (LHS) S&P SL20 (LHS) CTC (RHS)


18


Earnings release focus areas

Here is a checklist of the items that investors should track in the next – and subsequent – quarterly earnings release. We will closely track CTC’s performance across these key areas, and will revise our forecasts and update our valuation range in earnings update notes.

Tobacco business

1. Has there been a significant decline in the total volume of cigarette sticks sold compared to the historical rate of decline?

2. What is the change in volumes of higher-value brands?

3. Have cigarette prices changed during the period?

4. Has there been an increase in the government levies? If so, how has this impacted the net revenue?

5. Has CTC’s free cash flow generation been higher than historical figures?

6. Has there been any change in the operating cost structure?

7. Are there any variations in the dividend payout ratio?

8. Has CTC taken on any debt?


19


Appendix 1: CTC in the tobacco industry

CTC holds a monopoly in manufacturing, marketing and distributing

cigarettes in Sri Lanka

Cigarette consumption in Sri Lanka is on the decline, mainly due to the rising cost of cigarettes (driven by increasing excise duties), macroeconomic challenges, such as increased cost of living, and growing health awareness of the adverse effects of smoking (with efforts being led by the National Authority on Tobacco and Alcohol [NATA] and the health ministry). CTC’s sales volumes grew at a CAGR of 3.5% over 2010-2011, as the northern and eastern regions of the country opened up following the end of the civil war in 2009. In 2012, volumes dropped 4.3% YoY, reverting to the downward trend in overall volumes, which experienced a decline of 1.6% CAGR over 2008-2012. Cigarette prices over the past five years have been rising consistently – at a CAGR of 13.9% over 2008-2012. The prices increases thus far imposed by CTC have been higher than the hike in excise duties, as the company has been able to pass on the increased cost to consumers, given the relatively inelastic nature of demand for cigarettes. However, we believe the element of inelasticity is waning due to the frequent price revisions over the few past years, which have made these products less affordable for lower-income consumers, who make up the major portion of tobacco consumers. Sri Lanka currently has the highest tobacco-related excise duties in Southeast Asia and one of the highest cigarette prices in Asia. In terms of CTC’s volumes, management believes its marketable space is roughly 4.3bn sticks, excluding the beedi (sticks of tobacco wrapped in a brown tendu leaf) market that is not seen as a contestable segment given the demographics and lower income levels of consumers, and illicit cigarettes.

Demographics and consumer analysis

In 2012, Sri Lanka had a population of roughly 20.3m, of which close to 70.0% were adults. Smoking tobacco is prevalent among 29.9% of male and 0.4% of female adults, as per the WHO Report on the Global Tobacco Epidemic 2013. These figures include illicit cigarettes and beedis. In terms of daily cigarette smoking, prevalence among adults is broken down as 18.6% of males and 0.2% of females and consume on average two to three cigarettes.

Since 95% of cigarettes are sold as loose sticks, ensuring their wide availability is crucial for CTC’s business – typical Sri Lankan smokers, most of whom are from the lower-income segment, do not keep excess cigarettes and buy on an as-needed basis, generally after meals or after a hot beverage. However, consumers may increasingly be compelled to now reduce their cigarette consumption due to the rising price of cigarettes, a negative social image, increased restrictions on smoking in public areas and greater awareness of the health hazards associated with smoking.

Regulations and ongoing law suits

With the enactment of the Tobacco Control Act in 2006, the NATA was established to control tobacco consumption, which involved placing restrictions such as the prohibition of smoking in public places. Restrictions such as these help create a negative image of smoking, in addition to spreading awareness about the health hazards involved.

The minister of health, under the Tobacco Control Act, introduced a regulation that required a pictorial health warning to be printed on both sides of every cigarette packet, package or carton containing cigarettes, covering at least 80% of the total area of the package. CTC has challenged this regulation in court; currently, the Supreme Court has issued a stay order until 22 January 2014 in view of the pending hearing of the related cases.

Since the tobacco industry accounts for 6.0-7.5% of the government’s total tax revenue, the local authorities are quite vigilant in regulating the industry and cracking down on illegal practices, such as illicit cigarettes, that affect this revenue stream. Illicit and smuggled cigarettes are estimated to constitute 9% of the total market demand currently, according to the Tobacco Atlas.


20


Untapped local tobacco demand

The size of the Sri Lankan beedi market is estimated to be 2bn sticks in 2012. Beedi is consumed mainly by low-income groups in the country’s rural areas, and the majority of consumers fall in the 40+ age group. It is primarily a cottage industry product and costs LKR1-2 per stick, compared to CTC’s lowest priced offering of LKR10 per stick. CTC does not see beedi as a contestable space, given the demographics and income levels of this consumer group. The decline in the number of beedi smokers has been accelerating over the years with younger smokers more inclined to smoke cigarettes due to the higher social status associated with cigarettes as well as the greater health risks posed by beedi.

Global tobacco landscape

According to CTC’s parent company British American Tobacco (BAT), the global tobacco market is valued at around USD723bn currently, and the industry produces about 5.5tn cigarettes per year. Cigarette volumes in developed countries continue to decline, as awareness of health hazards grows. Recent trends indicate that smokers are consuming fewer cigarettes per smoker, and the smoking segment as a percentage of the population is declining in more developed markets. However, we believe sustained volume growth is widely predicted in emerging markets, driven by population growth and rising disposable income.

Between 2001 and 2012, global cigarette volumes increased at a 0.7% CAGR, while retail values grew at a 7.4% CAGR, as shown in Figure 21. Euromonitor International, an international market intelligence company, predicts that over the next five years, the global cigarette industry will continue to grow, with volumes predicted to increase by 3.0% and value by 49.0%.

Figure 21: Historical trend in the global cigarette market (2001-2012)

Source: Euromonitor International, 2012

Global trends

Cigarette sales in the past seven years have been shifting from developed markets such as Western Europe, where the prevalence of smoking is on the decline and tobacco companies’ operations are more strictly regulated by government policies, to emerging markets such as Asia and Africa, where tobacco companies take full advantage of relatively more lax regulatory environments, growing populations and increasing incomes. Between 2005 and 2012, the Asian Pacific region increased its share of global cigarette sales to 62.4% from 54.9% while the Middle East and Africa also accounted for an increased 7.0% of total sales in 2012, up from 6.7% in 2005, while the sales share in all other regions declined, as shown in Figure 22.

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21


Figure 22: Shift in the global cigarette market to Asia Pacific over 2005-2012


Key global markets and tobacco companies

The five largest cigarette-consuming nations – China, Russia, the US, Indonesia and Japan – accounted for 60% of the total volume of cigarettes sold in 2012. Seven of the ten largest cigarette markets in 2012 were in emerging markets, including four in the Asian Pacific region, as shown in Figure 23.

While cigarette sales are increasing in emerging markets, industry market shares are consolidating and a few international companies are increasingly controlling the market. In 2001, a little more than 50% of global market sales were controlled by transnational tobacco companies (TTC), growing to 79% by 2012. Five companies – China National Tobacco Corporation (CNTC), Philip Morris International (PMI), British American Tobacco (BAT), Japan Tobacco International (JTI) and Imperial Tobacco – have dominated the international cigarette market over the past decade, as shown in Figure 24.

Western Europe 11.6%

North America

7.8% Middle East

& Africa 6.7%

Latin America

4.9%

Eastern Europe 13.6%

Australasia 0.5%

Asia Pacific 54.9%

2005

Western Europe 8.8%

North America

5.5%

Middle East and Africa

7.0%

Latin America

4.1%

Eastern Europe 11.8%

Australasia 0.4%

Asia Pacific 62.4%

2012

Figure 23: Top 10 cigarette markets by volume, 2012 Figure 24: Companies’ shares in the global cigarette market, 2012

Country Retail volume (m sticks)

China 2,477,932

Russia 374,136

USA 287,121

Indonesia* 203,116

Japan 197,485

India 102,127

Philippines 100,547

Vietnam 99,687

Turkey 95,332

South Korea 88,989


* Excluding hand-rolled kreteks Source: Euromonitor International, 2012

Note: CNTC = China National Tobacco Corporation, PMI = Philip Morris International, BAT = British American Tobacco, JTI = Japan Tobacco International, Imperial = Imperial Tobacco

CNTC 41%

Other 21%

Imperial 4%

JTI 8%

BAT 11%

PMI 15%


22


Innovation: electronic cigarettes

Electronic cigarettes (e-cigarettes) are electronic inhalers, which are meant to be a safer alternative to conventional tobacco smoking. E-cigarettes use a mechanism that heats up a liquid solution, releasing either nicotine or a flavored vapor.

The global market for e-cigarettes is growing rapidly and is estimated to be worth USD2bn, as per Euromonitor International 2012. E-cigarette sales (current global cigarette market share of 0.4%) could outpace traditional cigarette sales (88.1%) by 2047. Until recently, the larger tobacco companies were not involved in the e-cigarette market. In April 2012, Lorillard, the American tobacco giant, bought privately held e-cigarette maker Blu Ecigs for USD135m and in December 2012, BAT acquired CN Creative Ltd, a UK company that develops e-cigarette technologies. RJ Reynolds, a subsidiary of Reynolds American – the second-largest tobacco company in the US, is also currently developing its own e-cigarette technology.

It remains to be determined whether the longer-term objective of e-cigarettes is to stop the smoking of tobacco or to stop the use of nicotine altogether. Medical researchers and public health agencies note that not enough evidence is available to establish the safety of e-cigarettes or their long-term effects.


23


Appendix 2: Company overview

Ceylon Tobacco Company PLC (CTC) is the largest publicly traded company on the Colombo Stock Exchange (CSE) by market capitalization, which stood at LKR210.7bn (USD1.6bn) as of 30 October 2013. CTC holds a monopoly in manufacturing, marketing and distributing cigarettes in Sri Lanka and contributes roughly 6.0-7.5% of total government tax revenue. The company’s parent and principal shareholder British American Tobacco PLC (BAT) holds a controlling 84.1% stake in CTC.

BAT opened its first branch in Colombo in 1906 and CTC was incorporated in 1932 and listed on the CSE in 1954. Since 1952, CTC has been growing tobacco in Sri Lanka through its network of farmers and is currently able to maintain a sustainable supply by producing its entire leaf requirement locally. Through CTC’s diverse product portfolio, the company is able to offer a range of products to cater to different consumer disposable income levels. Its brands include Dunhill, Benson & Hedges and John Player Gold Leaf (JPGL) for the high-end market, Pall Mall and Bristol for the mid-market segment and Four Aces, Three Roses and Capstan for the lower-end market. JPGL is CTC’s mainstream brand and continues to be the most valuable brand in terms of revenue generation. JPGL contributes to approximately 83% of total stick sales of CTC’s entire brand portfolio.

CTC recorded LKR19.2bn in net revenue for 2012, a 17.1% CAGR over 2008-2012. The group generated EBIT of LKR13.1bn in 2012, representing a 36.1% CAGR over 2008-2012.

CTC’s brand portfolio

Premium brands

Dunhill

During 2012, CTC improved volumes in its premium segment 45.0% YoY, mainly driven by growth in the Dunhill range. Although Dunhill’s contribution to market share is significantly lower compared to JPGL, its positive growth prospects in the long term and higher margins continue to add value to CTC’s portfolio. The key focus of this brand is to establish an up-market image and continue to grow the premium segment of CTC’s portfolio. One of the top product innovations introduced by the company is Dunhill Switch, which was launched in Sri Lanka during 4Q12, the first country to do so in South Asia. The new product consists of the switch technology, which provides consumers two tastes in one cigarette. This value addition has fuelled the product to be the top growth driver of the Dunhill range.

Figure 25: CTC’s net revenue grew at a 17.1% CAGR over 2008-2012

Figure 26: CTC’s EBIT grew at a 36.1% CAGR over 2008-2012

Source: CTC Source: CTC

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24


Lucky Strike

In line with Sri Lanka’s aim of being a leading tourism destination, Lucky Strike, an iconic American brand since 1871, was introduced during 2011 as a tactical brand to cater to growing demand by European tourists for American flavor blends.

Benson & Hedges (B&H)

B&H is positioned in the premium end of CTC’s brand portfolio and is one of the oldest international cigarette brands, with a well-known brand identity. The B&H market in Sri Lanka, however, is quite limited and the value contribution to the portfolio is relatively small.

John Player Gold Leaf (JPGL)

JPGL is CTC’s core brand and contributes approximately 83% of value to its portfolio. JPGL falls in the high-priced category segment and continues to show a growth trend, aided by the innovation of the brand through new packaging and the introduction of the menthol variants through the thread mentholation technology, as well as its long legacy in the Sri Lankan market.

Mid-level brand

Bristol

In order to ensure that CTC’s portfolio remains relevant to consumers with respect to the context of high market prices, Bristol was re-launched in 4Q12 and positioned as a value-for-money product. Bristol was first launched by BAT in 1948, but was later rebranded as Viceroy during 2006.

Lower-end brands

Four Aces, Capstan and Three Roses

The three brands are positioned at the lower-end of the market and mainly operate as a counter to the demand for cheap illicit cigarettes. All three brands have shown marginal volume growth in the recent past.

New products

The introduction of new products is managed through the parent company, BAT, which is currently investing in research and development to introduce lower-risk products that cater to popular market demand. In 2012, BAT acquired CN Creative, a UK-based company exploring the development of innovative electronic cigarette technology. In addition, BAT’s subsidiary, Nicoventures is looking at launching alternate nicotine-based products that pose lower health risks.

Management strategy, transparency and governance

CTC has successfully maintained a monopoly on manufacturing, marketing and distributing cigarettes in Sri Lanka. CTC’s current focus is on growing its revenue mainly through price increases to counter volume decline and by shifting into higher-priced brands such as Dunhill.

The company’s disclosure with regard to its brand portfolio is insufficient to arrive at accurate calculations and forecasts – items such as the breakdown of revenue and volumes in the range of brands are not publicly disclosed. Further, it would be more useful if these breakdowns were disclosed on a quarterly basis, as they are currently only published annually.


25


Shareholding structure

The parent company (BAT), which is the largest shareholder, holds 84.1%, while institutional investors (both domestic and international) hold 96.0% of CTC’s shares.

Figure 27: CTC is 84.1% owned by BAT; FTR Holdings is the second-largest shareholder with an 8.3% share

Source: CTC, as of June 2013

Note: Directors hold 0.12% of shares

The top-five shareholders as of June 2013 are presented below:

Name of shareholder Description Stake

British American Tobacco Holdings(Sri Lanka) BV Parent company 84.1% FTR Holdings SA A Swiss-based subsidiary of Philip Morris International Inc. 8.3%

Pershing LLL SA Averbach Grauson & Co. Subsidiary of the Bank of New York Mellon Corporation (a New York-based brokerage firm)

0.9%

HSBC INTL NOM Ltd – SSBT-Wasatch Frontier Frontier and emerging markets fund 0.6% HSBC INT NOM Ltd – Coupland Cardiff Funds PLC Specialist Asian fund management company 0.6%

Source: CTC

Board of directors

As of March 2013, CTC’s board comprised seven directors. Their details are provided below:

Name of Director Description

Mr. Susantha Ratnayake He is the chairman of CTC as well as the chairman and CEO of John Keells Holdings PLC (JKH), the largest listed Sri Lankan conglomerate. He was appointed to the CTC board in 2006.

Mr. Felicio Ferraz He was appointed the managing director and CEO in March 2013. He brings 19 years of expertise working with BAT, and has worked in BAT Caribbean & Central America for the past four years.

Mr. Ariful Islam He was appointed to CTC’s board of directors in March 2012 as the finance director. He has worked for British American Tobacco (BAT) since July 1997.

Mr. Mobasher Raza He was appointed to CTC’s board in November 2007 as a non-executive director. He has been with BAT for the past 33 years.

Mr. Ariyaratne Hewage He has been a member of CTC’s board of directors as a non-executive director since April 2008.

Ms. Premila Perera She was appointed to CTC’s board in January 2013 as a non-executive director. She is currently a partner and the head of tax services at KPMG in Sri Lanka.

Mr. Henry Koo He was appointed to CTC’s board of directors in February 2013 as a non-executive director.

Source: CTC

British American Tobacco Holdings

84.1%

FTR Holdings 8.3%

Pershing LLL 0.9%

Others 6.7%


26


Appendix 3: Key financial data

Summary group financials (LKRm)

INCOME STATEMENT 2011 2012 2013E 2014E 2015E

(For the year ended 31 December)

Gross revenue 76,151 82,770 90,866 99,756 107,563

Net revenue 17,023 19,202 21,444 23,791 25,922

Gross profit 14,618 16,595 18,683 20,860 22,869

EBITDA 10,920 13,247 14,858 16,609 18,235

EBIT 10,725 13,057 14,658 16,395 18,005

EBT 11,115 13,703 15,520 17,392 19,164

Net profit 6,571 8,177 9,243 10,358 11,413

BALANCE SHEET 2011 2012 2013E 2014E 2015E

(As at 31 December)

Current assets

Cash and cash equivalents 559 373 5,179 5,314 5,414

Short term investments 7,231 7,567 4,033 4,033 4,033

Accounts receivable 1,948 2,472 2,953 3,276 3,570

Inventories 2,202 2,771 3,166 3,362 3,501

Total current assets 11,940 13,182 15,331 15,984 16,518

Non-current assets

Property, plant and equipment 1,553 1,635 1,734 1,870 2,021

Intangible assets 6 4 2 2 2

Other non-current assets 274 205 248 248 248

Total non-current assets 1,833 1,843 1,984 2,120 2,271

Total assets 13,773 15,025 17,315 18,105 18,789

Current liabilities

Short term debt - - - - -

Accounts payable 5,710 6,903 7,766 8,245 8,587

Income tax payable 3,334 3,521 4,005 4,005 4,005

Other current liabilities 896 902 95 95 95

Total current liabilities 9,939 11,326 11,866 12,345 12,687

Non-current liabilities

Long term debt - - - - -

Postretirement benefit obligation 3 2 2 2 2

Other non-current liabilities 255 281 336 336 336

Total non-current liabilities 258 284 338 338 338

Total liabilities 10,197 11,610 12,204 12,683 13,025

Equity

Common share capital 1,873 1,873 1,873 1,873 1,873

Retained profit 1,703 1,542 3,238 3,549 3,891

Total equity 3,576 3,415 5,111 5,422 5,764

Total liabilities and equity 13,773 15,025 17,315 18,105 18,789


27


CASH FLOW STATEMENT 2011 2012 2013E 2014E 2015E

(For the year ended 31 December)

Operating activities

Net cash flow from operating activities 7,998 8,131 9,231 9,535 10,393

Investing activities

Purchase of PPE and intangible assets (218) (276) (315) (350) (381)

Interest received 384 589 696 997 1,159

Disposal of PPE and intangible assets 4 4 14 - -

Net cash flow from investing activities 171 316 395 647 778

Financing activities

Debt issuance/(repayment) - - - - -

Interest paid (2) (3) - - -

Dividends paid to common shareholders (7,003) (8,295) (8,353) (10,047) (11,071)

Net cash flow from financing activities (7,005) (8,298) (8,353) (10,047) (11,071)

Net increase/(decrease) in cash and cash equivalents 1,164 149 1,272 134 101

Key ratios

2011 2012 2013E 2014E 2015E

Growth

Revenue growth (%) 25.0 12.8 11.7 10.9 9.0

EBITDA growth (%) 34.2 21.3 12.2 11.8 9.8

EBIT growth (%) 35.1 21.7 12.3 11.8 9.8

EBT growth (%) 35.6 23.3 13.3 12.1 10.2

Net profit growth (%) 28.9 24.4 13.0 12.1 10.2

Recurrent diluted EPS growth (%) 28.9 24.4 13.0 12.1 10.2

Margins

Gross margin (%) 85.9 86.4 87.1 87.7 88.2

EBITDA margin (%) 64.1 69.0 69.3 69.8 70.3

EBIT margin (%) 63.0 68.0 68.4 68.9 69.5

EBT margin (%) 65.3 71.4 72.4 73.1 73.9

Net profit margin (%) 38.6 42.6 43.1 43.5 44.0

ROE (%) 181.5 233.9 216.8 196.7 204.1

Liquidity and efficiency

Current ratio (x) 1.2 1.2 1.3 1.3 1.3

Total asset turnover (x) 1.2 1.3 1.2 1.3 1.4

Gearing and cash flow

FCF yield (%) 9.4 5.2 4.2 4.4 4.8

Net debt/FCF(x) 1.0 1.0 1.0 1.0 0.9

Valuation

P/E (x) 12.6 18.4 22.8 20.3 18.5

P/BV (x) 23.1 43.9 41.2 38.9 36.6

EV/Sales (x) 4.9 4.4 8.2 7.4 6.8

EV/EBITDA (x) 7.7 6.3 11.8 10.6 9.7

EV/EBIT (x) 7.8 6.4 12.0 10.7 9.8

EV/FCF (x) 10.8 10.7 19.7 19.2 17.6

Dividend yield (%) 7.8 5.6 4.3 4.8 5.3

Dividend cover (x) 1.0 1.0 1.0 1.0 1.0


28


Per share data 2011 2012 2013E 2014E 2015E

Recurrent diluted EPS (LKR) 35.1 43.7 49.3 55.3 60.9

Common DPS (LKR) 34.6 45.2 48.8 53.6 59.1

Book value per share (LKR) 19.1 18.2 27.3 28.9 30.8

Net operating cash flow per share 42.7 43.4 49.3 50.9 55.5

Net cash flow per share 6.2 0.8 6.8 0.7 0.5



29


Appendix 4: SWOT analysis

Strengths Weaknesses

CTC is backed by a multinational corporation, BAT, and is the monopoly operator in the industry

Strong brand recognition

Addictive nature of the product

Strong cash flow generation and negligible debt position

Government’s reliance on the company to provide roughly 6.0-7.5% of total tax revenue

Established farming system with network of farmers and collectors, as well financing and training schemes

Decline in cigarette sales volumes

Reliance on raw material imports, such as filters, printing and packaging material, which have no local substitututes

Opportunities Threats

Growth in higher-end cigarette brands, such as Dunhill

Introduction of alternate/innovative tobacco products

High levies may lead to a reduction in the affordability of cigarettes

Increasing awareness of health hazards may prevent public from smoking due to campaigning by health authorities and the NATA

Local beedi production and illicit imports

Restrictive policies related to smoking


30


Fact Sheet

Sri Lanka investment environment overview

Sri Lanka’s economy has been on an upward trajectory since the end of the three-decade civil war in May 2009. Sri Lanka currently boasts South Asia’s highest GDP growth, conducive fiscal and monetary policy, and favorable socio-economic conditions, which together create an attractive investment destination.

Figure 1: Sri Lanka's GDP projected to increase at a 7% CAGR 2012-2016E

Figure 2: GDP per capita to increase 33% by 2016E

Source: Central Bank of Sri Lanka, Department of Census and Statistics Source: Central Bank of Economic and Social Statistics of Sri Lanka 2012, Road Map 2013 - Central Bank of Sri Lanka

Figure 3: Annual core inflation post-war has averaged 6.7%, government targeting mid-single digit levels in the medium term

Figure 4: CBSL expects the rupee to stabilize in the medium term despite recent volatility

Source: Department of Census and Statistics, Central Bank of Sri Lanka Source: Bloomberg

Figure 5: Fiscal deficit target of 5.2% of GDP for 2014E Figure 6: Debt-to-GDP to fall to 71% by 2015E

Source: Central Bank of Sri Lanka Source: Central Bank of Sri Lanka

6.8 6.0

3.5

8.0 8.2

6.4

7.5 8.0 8.3 8.5

0123456789

2007

2008

2009

2010

2011

2012

2013E

2014E

2015E

2016E

%

0

1,000

2,000

3,000

4,000

5,000

2005

2006

2007

2008

2009

2010

2011

2012

2016

E

USD

8.5

7.7

13.6

7.0 7.0 6.9 5.8

0

2

4

6

8

10

12

14

16

2006 2007 2008 2009 2010 2011 2012

%

100

150

200

250

Jan-07 May-08 Sep-09 Feb-11 Jun-12 Oct-13

LKR/USD LKR/EUR LKR/GBP

0%

4%

8%

12%

0

200

400

600

2006

2007

2008

2009

2010

2011

2012

2013E

2014E

LKRbn

Fiscal Deficit LKR bn As a % of GDP

102 102 91 88 85 81 86 82 79 79 78 75 71

0

20

40

60

80

100

120

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013E

2014E

2015E

%


31


The Sri Lankan equity market offers a rare and attractive alternative to investors in an investment era impacted by economic growth worries. Backed by the country’s robust economic growth, the Sri Lankan capital market is well set to offer attractive returns to investors who are keen to be a part of this emerging market success story. There are several strong incentives for entering the Sri Lankan capital market.

Figure 7: Post war, the ASPI has significantly outperformed global and developed market indices

Figure 8: Post war, the ASPI has also outperformed some of the best-performing regional indices

Source: Bloomberg *Note: All figures re-based to 1 July 2009

Source: Bloomberg *Note: All figures re-based to 1 July 2009

Figure 9: The CSE’s market capitalization has doubled since 2009

Figure 10: The government anticipates FDI inflows to reach USD2bn in 2013, a 19% CAGR 2009-2013E

Source: Bloomberg, Central Bank of Sri Lanka Source: Ministry of Finance and Planning, Board of Investment of Sri Lanka

Figure 11: Most sector P/Es are below market average and historical valuations

Figure 12: Trend is similar on a P/BV value

Source: Colombo Stock Exchange Source: Colombo Stock Exchange

0

80

160

240

320

400

Jul-09 May-10 Mar-11 Feb-12 Dec-12 Oct-13

ASPI Dow Jones FTSE 100

MSCI World DAX

0

100

200

300

400

Jul-09 May-10 Mar-11 Feb-12 Dec-12 Oct-13

ASPI Bombay (BSE 500)

Jakarta (JCI) Philippines (PASHR)

Thailand (SET) Hanoi (VNINDEX)

MSCI Emerging Market Index

1,092

2,211 2,214 2,168 2,467

0

1,000

2,000

3,000

2009 2010 2011 2012 2013(October)

LKRbn

827 601 516

1,066

1,338

2,000

0

500

1,000

1,500

2,000

2,500

2008 2009 2010 2011 2012 2013E

USDm

0

30

60

90

120

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2011 2012 2013 Average market P/E 2010-2013

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2011 2012 2013 Average market P/BV 2010-2013


32


IMPORTANT DISCLAIMER

This document has been prepared on behalf of the Colombo Stock Exchange (“CSE”) by Amba Research Lanka Private Limited (“Amba”) and is sponsored by the CSE. The views expressed in this document are those of the authors based on available and accessible information from the public domain and do not represent those of the CSE. Please note, inter alia, that with the publication of this document on the CSE website, www.cse.lk, neither Amba , as author, nor CSE (as sponsor) intend to assume and are not assuming any responsibility or liability (including under contract, common law or tort) to any party arising out of or with respect to this document. This document is not intended to, and does not form part of any contract with anyone (including a contract between author and reader/recipient) and no one shall have any right (contractual or otherwise) to enforce any claim in relation to the document either directly or indirectly.

Except as otherwise indicated, you may only view and print one copy of the document for your own personal, non-commercial use. You may not copy, store [either in hardcopy or in an electronic retrieval system] transmit, transfer, broadcast, publish, reproduce, create a derivative work from, display, distribute, sell, license, rent, lease or otherwise transfer any of the contents to any third person (including, without limitation, to others in your company or organization) whether for direct or indirect commercial or monetary gain or otherwise without the prior written permission of Amba and CSE.

This document does not contain any investment advice nor does it constitute an offer to buy, sell or hold any of the investment product(s)/asset class (es) mentioned herein. Prospective investors are required to possess sufficient knowledge when evaluating the advantages and risks inherent to such investment product(s)/asset class(es) mentioned herein and to take into consideration their circumstances and financial position when assessing the suitability of such investments.. Prior to making an investment decision, prospective investors are strongly advised to obtain independent advice from competent legal, financial, tax, accounting and other professionals. Amba and CSE shall not be held liable in any manner for any direct, indirect or consequential loss that may arise as a result of investing in the investment product(s)/asset class (es) mentioned herein. Amba and CSE expressly disclaim any fiduciary responsibility or liability for any consequences, financial or otherwise from any reliance placed on the information in this document. The investment product(s)/asset class (es) described in this document may not be eligible for sale or subscription within a particular jurisdiction or to particular categories of investors. This document is not intended for distribution to a person or, within a jurisdiction where such distribution would be restricted or illegal. It is the responsibility of any person reading this document to observe all applicable laws and regulation of the relevant jurisdiction. Neither Amba, nor CSE, shall be responsible for any error which may have occurred at the time of printing of this document. The information set out in this document is subject to change without notice.

The information contained herein has been obtained from sources believed to be reliable and Amba and CSE make no warranty, expressed or implied, as to the accuracy, timeliness, completeness or correct sequencing of the information.

This document does not purport to list all of the terms and conditions, nor to identify or define all or any of the risks that would be associated with the purchase or sale of the investment product(s)/asset class (es) described herein. Please note that any price levels, rates, simulations, illustrations, terms or conditions contained herein are indicative only, and may vary in accordance with changes in market conditions. All the information included in this document is current at the time of preparing this document and subject to change at any time. Any forecast, projection or forward looking statement made in this document embodies assumptions and predictions about future events that by their nature cannot be verified as facts. They are not necessarily indicative of future or likely performance, of investment product(s)/asset class (es), countries, markets or companies. Any past market conditions or product performances may not be representative of future market conditions or product performances.

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