Ceylon Tobacco Company Report

Ending the market contraction era held for the past 12 quarters, Ceylon Tobacco (CTC SL : LKR999.0) saw its volumes grow 11% YoY in 1Q2015 benefitted by capture of smuggled cigarette volumes together with salary increases in the public sector and reduction in the prices of numerous necessities including fuel. Therefore in the short term, we expect continuing renewal in volumes mainly driven by capture of market share from smuggled imports and growing disposable incomes among the mass consumers. Sri Lanka being a destination with highest prices in the world has resulted in the cigarette being less inelastic as consumption of cigarettes may take up a significant portion of a consumer’s wallet. Further aiding volumes in the medium to long term could be the unregulated low priced beedi market which currently eats into an equal share as CTC; 42% of the country’s total tobacco market, in the event regulators take action to minimize this currently tax evading market. The price of a beedi stick is c.LKR2.0 as against CTC’s lowest priced product of LKR10.0. Thus we revise up our 2015E recurring net profit by 7.5% to LKR9,738.8 mn (up 13% YoY) and 2016E normalized net earnings by 9% to LKR10,366.3 mn (up 6.4% YoY). Thereby the share trades at 19.2X 2015E net profit and 18.1X 2016E earnings whilst yielding dividends of 3.7%-5.4% for 2015E-2016E and generating highest ROEs in the Colombo Bourse. Further CTC trades at an attractive multiple among British American Tobacco (BAT) subsidiaries worldwide and subsidiaries of competitors. Therefore taking into consideration its growth prospects, we upgrade our recommendation to a BUY.

Its product range includes the high end Dunhill and Benson & Hedges and mid-range John Player Gold Leaf which accounts for +85% of the total volumes whilst Bristol and Capstan compete as the value for money and low end products respectively. The group’s value proposition lies chiefly with Dunhill which has significantly widened its market share to +1.5% of total volumes. CTC saw its revenues grow c.9%, 2010-2014 in spite of the volume dip of 4.3%, 6.0% and 11.6% YoY respectively seen from 2012-2014. The BAT unit remains the single largest tax payer to the government, as c.75% of its revenues are paid as excise duties. Therefore as revenue collection measures for state coffers, CTC has witnessed annual price increases ranging from 7% to 16% over the past 3 years. Thus in contrast to volumes dipping the monopoly player has been able to increase its revenues annually. However 2014 saw a revenue dip due to a mere 7% price increase as against 2012 and 2013 which saw 13-16% price increases by way of bi-annual revisions. Therefore for 2014-2016E, we expect a forward gross revenue CAGR of c.9% based on our assumptions of c.9% and 3% volume growth for 2015E-2016E. However we believe that a price increase in 4Q2015 would be unlikely due to the low inflationary environment, whilst 2016E could give rise to a price increase in line with prevailing inflation.

Margins have been up trending with GP margins widening from 83% to 88% (% of net revenue), 2010-2014 whilst we expect further expansion to 88.8% levels in 2015-2016E. This has been backed by a better brand mix by shifting consumers to high and mid product range. Further EBIT margins have widened from 58% in 2010 to 65% in 2014 due to well-maintained costs whilst we anticipate operating margins to remaining at current levels. With the company now complying to cover 80% of its product pack area with pictorial warnings in line with regulatory instructions, CTC would witness a marginal increase in its packing costs.

CTC has been maintaining a dividend policy of 100% payout throughout the years. However dividends would encounter a short term hiccup due to the one off Super Gains Tax payment due to be paid in 2Q-3Q2015, although dividends would return to normalcy in 2016E yielding 5.4%.