Ceylon Tobacco Company Initiation Report

Ceylon Tobacco Company INITIATING COVERAGE
COMPANY REPORT
SELL EQUITY
TARGET RESEARCH-SRI LANKA
(LKR) 582
12 Month Price Target: 623 CTC SL
CLOSE (LKR)EQUITY 1,035
Current Price: 1,003 Consumer Staples – Tobacco
DOWNSIDE 44%
Date: 8 May, 2015
Unremarkable Future Prospects at an FY (LKR Mn) 2012 2013 2014 2015E

Net Revenue 19,202 21,618 21,739 22,707
Exorbitant Price…
EBIT 13,055 14,508 14,183 15,191
Divestment Case Net Profit 8,175 9,140 8,619 9,388
Earnings growth restricted by prevailing price and volume EPS 43.65 48.80 46.01 50.12
dynamics… Change in EPS 24.4% 11.8% -5.7% 8.9%
Industry revenue is approaching maximum levels due to significant declines
Net Revenue
in stick volumes caused by consistent price hikes, intensifying regulation 23.2% 24.2% 24.8% 25.0%
and negative socio-cultural perception of cigarettes. State-sponsored Margin
awareness campaigns are highlighting the personal and economic costs of EBIT Margin 68.0% 67.1% 65.2% 66.1%
tobacco use and decreasing prevalence is found as incomes and education Dividend Payout 99.8% 99.9% 85.9%* 99.9%
levels rise. Less affluent smokers will more likely seek unregulated markets
such as Beedi, which has witnessed a resurgence in demand. 1,300 Share price performance** 10%
Valuation 0%
Counter trading at unsustainable 8.8x firm revenue, SELL 1,200
CTC:SL is currently trading at a trailing PER of 22x (TTM) EPS of LKR 46, and -10%
is priced at a 61% premium to our current fair value estimate of LKR 623. 1,100
Our estimate is a weighted average of DCF and Relative Valuation -20%
techniques incorporating volatility in government excise price increases and 1,000
demand responsiveness in terms of price and income elasticity. -30%
Catalysts 900 -40%

Mar-14 Jun-14 Sep-14 Dec-14
Future increases in taxes and anti-tobacco legislation…
CTC Share Price Relative to S&P SL20 (RHS)
Regulatory measures will impact CTC’s business in the medium term. These
include imposition of 80% Graphic Health Warnings on product packs and Share price performance 1 month 3 month 12 month
extensions of public smoking bans. Cigarette prices could be further
Absolute -3.9% -1.1% -9.2%
increased after the scheduled elections in April 2015. The new government
Relative to ASI 0.6% 0.8% -10.8%
has indicated a tougher stance on the local tobacco industry, which includes
control of Beedi.
Next results Mar-15
Comment Market Capitalization (LKR Mn) 187,886
Despite the downside, dividend pay-out is certain… Current P/E 21.8
CTC’s operations annually generate large cash flows for shareholders, Average monthly turnover volume 6,255
mainly due to the addictive nature of its products and the almost 100% pay-
Annual volume velocity 0.04%
out ratio. The company remains the second largest publicly traded entity in
Sri Lanka, and the largest single contributor to state revenue through excise, Free float 15.87%
levies and income taxes. We believe that the smoking saturation of the 12m price range (LKR low/high) 960/1,250
domestic market is real and the majority of customers are sensitive to price, Largest Shareholder BAT 84.1%
and/or health awareness legislation which is eroding the long term value of
Shares in Issue 187,323,751
the firm’s operations.
*Dividend in 2014 affected by one-off super-gain tax. Data is for base
Analyst: Rahul Hundlani – rahulh@jb.lk case scenario – see page 24 of this report for more details
Important disclosures are included in page 29 of this report **Source for Cover Page Data: CSE, JBS Estimates
Produced by: JB Securities Corporate Governance Score ★★★★★

Distributed by: Jefferies Group LLC
150, St. Joseph’s Street, Colombo 14, Sri Lanka. T: +94 11 2490900, E: jbs@jb.lk, W: www.jbs.lk May 2015
Ceylon Tobacco Company PLC
Table of Contents
Investment Hypothesis ................................................................................................................ 2
Local Tobacco Industry Overview ................................................................................................. 4
Tobacco In Sri Lanka ............................................................................................................................ 4
Size of the Market................................................................................................................................ 4
Consumption – Demographics and Products ...................................................................................... 5
Year End Retail Prices (LKR) ................................................................................................................. 6
Product Availability .............................................................................................................................. 6
Taxation of Tobacco............................................................................................................................. 6
Regulatory Framework ........................................................................................................................ 7
Tobacco Products in Sri Lanka – 2015 ................................................................................................. 8
Market Price-Volume Dynamics ............................................................................................................ 9
High Prices a drag on modest incomes.............................................................................................. 10
Exports to grow steadily, but have lower margins ............................................................................ 12
Threat of Substitutes – Mainly Beedi ................................................................................................ 13
Illicit Market and E-cigarettes ............................................................................................................ 14
Health, Social and Political Factors leading to declines in Prevalence AND Persistence .................. 15
Public Health Initiatives implemented through NATA....................................................................... 15
Negative Externalities of Tobacco Consumption............................................................................... 16
Pricing Power Erosion ................................................................................................................ 17
Operating Margins Under Pressure ............................................................................................. 21
Valuation ................................................................................................................................... 23
Discounted Cash Flow Analysis (DCF) ................................................................................................ 23
Relative Valuation .............................................................................................................................. 25
Regional Peer Analysis ....................................................................................................................... 25
CTC as a Dividend Play ....................................................................................................................... 25
Valuation Summary – Fair Value as of Mar 24th 2015 ....................................................................... 26
Appendix:.............................................................................................................................................. 27
E-Cigarettes........................................................................................................................................ 27
Historical Excise Tax Duties – Per Thousand Sticks ........................................................................... 28
Comparison of Tobacco Alternatives in Sri Lanka ............................................................................. 28
Ceylon Tobacco Company’s “Crop to Consumer” Supply Chain ....................................................... 28
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Investment Hypothesis
Our intrinsic value estimate of Ceylon Tobacco Company (CTC) is LKR 623 per share, which is a 38%
discount to the current market price of LKR 1,003. The counter currently trades at 22x FY ‘14
Earnings and almost 9x FY ‘14 Net Revenue. Barring any serious missteps, we feel that our estimate
better captures the long term value potential of CTC‘s tobacco business operations.
We think it will be difficult for CTC to grow revenues significantly in the future. The ability and
willingness of Sri Lanka’s predominantly low-income smoking demographic to absorb further tax-led
price increases is limited, particularly in the current environment of significant social and political
censure of cigarettes. Stick volumes declined by 11% YoY in 2014. The firm is unable to compete with
cheaper, unregulated tobacco substitutes– particularly in rural areas where home-made sticks like
Beedi are widely available. Taxes comprise >70% of the retail price of all CTC products and are
increased by a specific rupee value at least annually. Accordingly, the company has focused on value-
growth in key aspiration and premium brands (Gold Leaf and Dunhill) as a lever for growth, but we
believe the lack of affluent smokers will inhibit significant up-trading behavior going forward. Future
operational efficiency gains are limited, particularly in the short and medium term as the firm must
deal with lower handling volumes and rising direct material costs.
Volume declines in key markets beginning to overwhelm persistent price increases…
CTC’s flagship brand John Player Gold Leaf (JPGL) represents 85% of the production mix and doubled
in price since 2009, losing 20% of volumes since 2011. JPGL prices are one of the highest globally
both on a USD and PPP adjusted basis, when comparing the most popular brand of cigarettes
between countries. Despite brand-enhancement through innovative variants (Gold Leaf Special and
Gold Leaf Click) and pack re-designs, the firm’s price-sensitive core customer base is declining. Low
disposable income growth, state sponsored awareness and negative perception programs, as well as
bans on smoking in ‘enclosed’ public areas have reduced consumption of JPGL. Many older and less
affluent users are also switching consumption to domestically produced Beedi cigarettes (cut
tobacco rolled in tendu leaf into smaller-sized sticks, legal but unregulated, taste and price driven)
that have tripled in volume since 2007 and now comprise 42% of all smoking tobacco sticks sold.
Pricing power erosion and lack of ‘premium smokers’ will slow gross margin growth…
CTC cannot increase its own prices significantly above quantity excise taxes – as they have done
consistently in the past - without witnessing a strong drop in stick volumes from its core
customers/brands. The dearth of affluent smokers in the country means the majority of customers
are more vulnerable to a constantly appreciating product portfolio. Dunhill, CTC’s premium brand
introduced in 2005, still accounts for just 2% of total volumes despite concerted investment in
innovative product varieties (Dunhill Lights, Dunhill Switch, Dunhill Ice, etc.).
Operating margins squeezed in the short term…
Manufacturing costs have been controlled diligently in the recent past which fuelled significant EBIT
margin expansion: the average production cost per cigarette increased just 10% from 2008-2013,
while Net Prices (after all levies) increased 93%. Crucially, total volumes decreased only 10% during
this five year period, compared with a single 11% drop during 2014 that is now pressuring per-stick
costs. More than 40% of the total cost structure is relatively fixed (employee, factory, and regulation
related expenses) and the increased cost and higher requirement of material in premium sticks is
likely to overwhelm purchasing benefits from lower handling volumes. All non-leaf materials are also
currently imported, which we feel is at risk of inflation through a depreciating LKR. The company’s
major sources of productivity gains such as automation and efficient purchasing decisions are close
to exhaustion, while future initiatives are likely to only marginally add-value in the medium term.
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Catalysts and possible downside to the valuation

Share Price Dynamics: Time - Correction to continue
As per our valuation model the majority of the value accrues through earnings generated by “assets
on the ground,” since we do not foresee a need for capacity expansion due to volume decline. Thus,
we anticipate a time-correction rather than a price-correction for the counter. We do not anticipate
a major price correction because the shareholding structure is supportive of the current price level
since the public float is dominated by long term institutional investors and there is less participation
from retail investors due to the high nominal price of the share, which translates to an absence of
significant speculative activity and leveraged positions. We do not expect a major drop in earnings,
and the implementation of graphic health warnings on cigarette packs (increased from 60% to 80%
coverage in February 2015) from the beginning of 2015 is unlikely to be a major change since almost
95% of cigarette sticks are purchased individually. The absence of significant negative price catalysts
and the downside protection offered by consistent dividends may prevent a significant drop in value,
but the limited upside potential of the businesses will cause the counter to underperform in terms of
its price in the future, in our view.
Risks to the recommendation
 An Urbanization effect (currently more than 80% live outside major cities) and Income effect
could slow volume declines, as well as making price less of a factor.
 The current healthy Dividend Yield (around 4.5%) could be attractive to investors.
 The Imposition of higher taxes on Beedi (current tax incidence is around 8 - 10%), would
shift some volumes back to CTC products.
 Low female smoking penetration (<2%) could increase over time, opening a new market.
 Favorable improvement in gross margins due to lower levels of taxes (per stick) in the future.
 Innovative products utilizing variants such as ‘switch’ technology to preserving volumes
among loyal customers – at higher margins.
 We have evaluated CTC as a pure-play tobacco company and while it is possible that the
company diversifies operations into other sectors, we think this is highly unlikely.
Context for the Valuation

Total YoY volume declines were in 4% in 2012, 6% in 2013 and then 11% in 2014 which caused the
first drop in industry gross revenue for more than two decades. This is symptomatic of changes in
the market dynamic that is contracting and shifting demand to unregulated markets. Our valuation
of the business operations of Ceylon Tobacco is reflective of the repositioning of the company and
the limited prospects for revenue and margin growth from its key products.
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Local Tobacco Industry Overview

Tobacco in Sri Lanka
Ceylon Tobacco Company (CTC), a subsidiary of multinational British American Tobacco (BAT) is the
sole legal manufacturer and distributor of tobacco products in Sri Lanka. The only other tobacco
alternatives are available through informal or illicit markets. Chewing tobacco mixed with betel
‘quid’ leaf, and home-made ‘Beedi’ sticks (cut tobacco rolled in tendu leaf into smaller-sized sticks,
taste and price driven) have historically been popular with elderly, low-income and rural
demographics. The illicit market is comprised of domestically produced ‘white cigarettes’ and
international brands smuggled into the country. While sales lost to the illicit market is a significant
concern for the tobacco industry globally, smuggling into Sri Lanka must take place by sea and is
therefore more effectively controlled by state authorities. The illicit market is still in its nascent stage
and believed to represent <5% of CTC volumes.
CTC has enjoyed a monopoly over the traditional cigarette market since its incorporation in 1932,
successfully listing on the Colombo Stock Exchange in 1954 and was the most valuable counter on
the Colombo Stock exchange for a period in 2013. CTC sold around 3.59 billion cigarette sticks in Sri
Lanka in 2014, down 11% YoY - the fastest recorded drop in a decade of decline.
Size of the Market

In 2014, CTC’s operations accounted for 90% of Sri Lanka’s LKR 100 Billion observable smoking
tobacco industry (including informally produced and lightly taxed slim Beedi cigarettes), providing
LKR 73.6 billion to the state budget through various levies1. However, CTC brands make up just 53%
of the estimated 6.8 Billion tobacco sticks sold in 2014 (Figure 1) due to the large difference in price
between their cheapest offering (Capstan: LKR 10.00) and Beedi that sells for LKR 1.50 – 3.00 despite
a similar number of puffs per stick.
Beedi sticks are slimmer and therefore contain less tobacco per mm (see Appendix- 3). Beedi is
usually smoked without a filter, increasing the considerable health risk to consumers and therefore a
target for future legislative regulation and increased taxes. In 2014, an estimated 3.2 billion Beedi
sticks, and just under 3.6 billion CTC cigarettes were sold.
Illicit market volumes are difficult to estimate accurately, but are currently estimated to be 3-5 % of
CTC’s demand. It includes “white cigarettes” produced illegally and smuggled international brand
names, and consumption incentives are increasing as a result of continual tax hikes on CTC’s
products.
Beedi Volumes have almost caught up to tradtional cigarettes...

5
4
Billions of Sticks
2
Beedi Volumes
1 CTC Volumes
0
2009 2010 2011 2012 2013 2014
Figure 1- Total Smoking Tobacco Industry Volumes (Source: JBS Estimates)
1
One-off super-gain tax not included
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Consumption – Demographics and Products

Tobacco consumption in Sri Lanka is related to lower levels of education and income, and cigarettes
are consumed almost entirely by men. Beedi and chewing tobacco are consumed by the lowest-
earning demographic and have more significant female participation outside of major urban areas.
Beedi has witnessed a recent resurgence, with volumes growing more than 200% since 2007,
benefitting from being outside price and product regulations that affect CTC.
There are estimated to be just under two million daily cigarette smokers in Sri Lanka2, with adult
prevalence rates estimated to be 12%, of whom around 70% smoke daily.3 The overwhelming
majority of smokers are males, with female smoking penetration less than 2%. Smokeless tobacco is
more common amongst females, and total prevalence among adults is estimated to be around
15.8%. Prevalence is significantly higher in rural areas4 where awareness of health risks posed by
smokeless tobacco is significantly lower. Total smoking tobacco prevalence (includes Beedi) of 15%
indicates that most Beedi smokers consume cigarettes as well, but cigarette smokers are less likely
to smoke Beedi. Youth groups are a target for smoking-awareness campaigns, and are increasingly
likely to consume alternate forms of tobacco indicated by a 10.5% prevalence of all tobacco products
for ages under 15, compared with just 1.5% for cigarette prevalence. Generally, cigarette use
amongst the younger and less affluent demographics have witnessed the strongest decline in Sri
Lanka over the last decade, in line with government awareness initiatives.
The low-income bias of the country’s smokers is illustrated in part by sales of the ‘premium’ Dunhill
brand accounting for just 2% of volumes since its introduction in 2005. Capstan (10% of volumes) is a
value-for-money brand that offers limited protection against Beedi and illicit cigarettes, but this is
seen as a limited contestable space by management due to large differences in taxes and other
regulations. Instead, the firm is focused on promoting up-trading amongst existing customers
through investments in key brands. New products have been introduced recently with mixed success
such as Gold Leaf ‘Click’ and Dunhill ‘Switch,’ – innovative variants that provide the ability to infuse
the stick with menthol, and Gold Leaf Special – a differentiated offering in the traditional Gold Leaf
segment promising superior leaf blends. Dunhill Cigars are also available, but failed to gain any
significant traction in the market. The Bristol brand was re-introduced to the market in 2012 as a
mid-range alternative, and sells for LKR 20.00 with the aim of mitigating down-trading and
protecting company margins from declining JPGL sales.
2
World Health Organization. 2013. Report on the Global Tobacco Epidemic 2013: Sri Lanka
3
Alcohol and Drug Information Center (ADIC) Sri Lanka. 2014. Trend Survey on Tobacco.
4
Somatunga L C, Sinha D N, Sumanasekera P, Galapatti K, Rinchen S, Kahandaliyanage A, Mehta F R,
Jayasuriya-Dissanayake. 2012. Smokeless Tobacco Use in Sri Lanka, N L. Indian J Cancer 2012; 49L 357-63
P aP ga eg e| |5 6
Year End Retail Prices (LKR)
Stick
CTC Brand 2008 2009 2010 2011 2012 2013 2014
Length
Dunhill 17 19 21 24 27 32 33
Dunhill Switch 25 27 34 35
84 mm
B&H 17 19 21 24 27 32 33
JPGL 16 18 20 22 25 28 30
Pall Mall 13 14 16 17 20 DISCONTINUED
72mm
Bristol 17 20 22
Four Aces 67mm 9 10 12 13 16 18 20
Three Roses 4 4 6 6 8 12 14
60 mm
Capstan 4 4 6 8 8 10 10
Figure 2- Year End Retail Prices for CTC Brand Names in LKR (Source: CTC)
Product Availability
The company has been losing total volumes incrementally for the past two decades but has
effectively grown its distribution and retail network to cover over 76,000 selling points through 16
distributors nationwide. An estimated 95% of cigarettes in Sri Lanka are sold loose, outside the
modern trade of supermarkets. This restricts the ability of the company to offer a wide range of
products, as informal retailers are often unable and/or unwilling to hold large volumes of many
different brands. Hence, depending on the purchasing demographic, consumers must often choose
between the ubiquitous Gold Leaf and either premium Dunhill or low-end Capstan. Beedi is sold in
over 140 regional brands and are widely available along with Betel Leaf Quid, in many informal retail
outlets. These alternatives are most common in rural areas – outside the wealthier western province
where CTC accrues around half of its total sales.
Taxation of Tobacco
There is a strong social mandate in Sri Lanka to heavily regulate and tax the tobacco industry. The
National Authority on Tobacco and Alcohol (NATA) was formed in 2006 and is responsible for
controlling tobacco consumption and negating public health costs related to tobacco induced
diseases. Taxation of CTC products is based on stick length and is an important lever for the NATA as
total receipts have historically been the leading contributor to state revenue (8% in 2014) in Sri
Lanka.
Taxes comprise >70% of the retail prices of all brands. The NATA revises the applicable specific excise
tax at least annually, and recently consolidated the VAT and NBT ad-valorem taxes into a more
inclusive quantity excise tax, which further incentivizes CTC to sell premium cigarettes (JPGL and
Dunhill are the same length and taxed the same).
The growth of the market opportunity in Sri Lanka is under threat from anti-tobacco legislation
leading to flat tax revenues in 2014 (Figure 3), but the significance of tobacco tax revenue to state
coffers means that a succession of local governments have worked closely with BAT to protect
common interests. Tax revenue maximization policies in order to protect volumes through managed
price increases are likely in the future.
P aP ga eg e| |6 7
Tax Revenue contributions have stagnated…

Sticks (Mn) (LKR Bn)
Tobacco Excise Tax
NATA formed to control
6,000 tobacco consumption
contributions have increased 70
more than 200% since 2000
5,000 60
50
4,000
40
3,000
30
2,000
20
1,000 10
0 0
1970 1980 1990 1995 2000 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Year
Figure 3- CTC Historical Stick Volumes and Excise Tax Contributions (Source: Ministry of Finance and Planning, Alcohol
and Drug Information Center)
Regulatory Framework
Sri Lanka was the first Asian country and fourth nation to sign the WHO Framework Convention on
Tobacco Control (WHO FCTC) in September 2003, and the NATA has implemented several of its most
stringent tobacco control directives including >70% taxation, the recent graphic health warnings on
packs and comprehensive bans on marketing, promotion and placement of tobacco products.
Smoking is also currently banned in all ‘enclosed’ public places in the country and recent initiatives
of the new cabinet has increased the graphic health warning ban to cover 80% of the front and back
of packs.
State sponsored awareness campaigns are increasingly common in Sri Lanka, particularly catering to
the youth and rural demographics. The current inclusive excise tax on JPGL is LKR 21.61, 72% of its
LKR 30.00 retail price. State intervention in the industry has prevented the typical market incentives
that encourage production, and cigarette stick volumes have been in decline since reaching their
peak in the early nineties. Tax (and CTC) revenue growth has been carefully managed, overcoming
falling volumes through incremental price hikes actively directed by the government through the
NATA. There exists no disclosed formula for cigarette price increases, and policy is therefore
vulnerable to the prevailing attitudes of ruling political incumbents, who however recognize the
need to balance a predictable source of tax revenue with public health and social costs. The newly
elected president of Sri Lanka was personally honored by the World Health Organization in 2013 for
his commitment to the anti-tobacco campaign during his tenure as the Minister of Health.
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Tobacco Products in Sri Lanka – 2015

The following table lists all the significant, legal tobacco products available in the country:
Product/Brand Stick Length Price (LKR) Volume (Bn)
(mm)
Dunhill 84 33.0
0.07
Dunhill Switch 84 35.0
John Player Gold Leaf Special/Click 84 31.0/32.0
3.05
John Player Gold Leaf 84 30.0
Benson & Hedges 84 33.0
Bristol 72 22.0
Four Aces 67 20.0 0.47 (around

65% from
Capstan)
Three Roses 60 14.0
Capstan 60 10.0
Alternative Tobacco Products in Sri Lanka

Beedi 50 1.0 – 2.5 3.2
Betel Quid n/a 15.0 – 20.0

with Tobacco
Figure 4- Price and Popularity of Tobacco Products in Sri Lanka as of Mar 2015 (Source: CTC, JBS Estimates)
P aP ga eg e| |8 9
Market Price-Volume Dynamics

We think that CTC’s ability to increase revenues on the back of higher retail prices will be limited
going forward. The firm’s customers –who predominantly belong to low-income and low-education
demographics- are being pressured by continual excise-led price hikes that have doubled the
average blended price per stick sold since 2008. This reduces the affordability of the firm’s key
products, and shifts demand to significantly cheaper, unregulated markets such as home-made
Beedi sticks. Current cigarette smoking prevalence is around 12% (WHO 2013) in Sri Lanka more
similar to Western Europe than other emerging markets - and a growing awareness and regulatory
environment that highlights the social and economic cost of tobacco consumption is accelerating
declines in the number of sticks demanded from current and prospective smokers.
Accordingly, increasing price elasticity of demand for CTC cigarettes is being observed. The firm has
been unable to sustain its previous growth rates: Net Revenues increased 0.6% (YoY) in 2014,
compared with 12.6% (2013), 12.8% (2012) and 25% (2011) YoY increases in last four years (Figure
5). Other than a temporary uptick in volumes due to resumption of sales in the North and East at the
end of the civil conflict in 2009, volumes have been declining steadily: -11% (2014), -6.2% (2013) and
-4.2% (2012), and begun to overwhelm price increases. We believe that future consumption caused
by increases in disposable incomes will be overwhelmed by consistent price and regulatory
legislation.
LKR (Bn) Revenue growth threatened by Sticks (Bn)
100 4.90
low volumes...
4.70
80
4.50
60 4.30
4.10
40 3.90
3.70
20
3.50
0 3.30
2007 2008 2009 2010 2011 2012 2013 2014
CTC Net Revenue Government Levies Stick Volumes
Figure 5- Revenue Breakup and Volume Trend 2007-2014 (Source: CTC)
LKR
30.00 Trends in Key 'per-stick' Metrics...
25.00 Gross Revenue

20.00
Government Taxes
15.00
10.00
Net Revenue
5.00
Production Cost
0.00
2007 2008 2009 2010 2011 2012 2013 2014
Figure 6- Profitability Drivers (Source: CTC)
P aP ga eg e| |9 10
High Prices a drag on modest incomes

High prices for CTC products in Sri Lanka have reduced affordability, and we feel that future income
growth will not exceed growth in cigarette prices. The current price level is already high in
comparison to regional and global peers, comprising a large specific quantity tax that accounts for a
large wallet share of users’ disposable income. Lower-income individuals make up the majority of
smokers who spend a greater proportion of their income on tobacco and are therefore most
afflicted by price increases. The premium segment targeted at higher income groups – Dunhill – only
accounts for 2% of volumes (less than 800 million sticks a year).
On both absolute retail price (USD) and a PPP adjusted basis, Sri Lanka has one of the world’s highest
cigarette prices and the highest amongst its South and South-East Asian neighbors (Figure 7). This is
also reflected in the low current cigarette smoking prevalence of 12% and daily smoking prevalence
of 9% (approximately 2.5 million ‘current’ cigarette smokers).
Sri Lanka has high prices and low pervalence compared to peers...
USD Retail Price International Dollar PPP Price Prevalence of Daily Smokers
9 35
Price per pack of most sold cigarette brand
8
30
7
25
6
Prevalence (%)
5 20
4 15
3
10
2
5
1
0 0
Bangladesh India Indonesia Maldives Japan China Sri Lanka Thailand
Figure 7- Regional Cigarette Price and Prevalence comparison (Source: WHO Global Tobacco Epidemic 2013: Sri Lanka)
Therefore, CTC’s increasingly ‘expensive’ product portfolio is only regularly attainable for a relatively
small proportion of the population, particularly in rural areas where more than 80% of the
population resides. Sri Lanka’s estimated 1.75-1.90 million daily smokers consume an average of five
sticks per day, and volume declines are occurring primarily through existing smokers reducing
consumption and/or switching to alternate forms of tobacco use. We also believe that prevalence of
cigarette use will decline amongst the lower income rural and youth demographics in the future,
with a rise in smokeless tobacco use being witnessed.
P aPgaeg e| 10
| 11
Government Levies account for more than 70% of CTC’s

John Player Brand…
Thailand Thailand
Sri Lanka Sri Lanka
China China
Japan Japan
Maldives Maldives
Indonesia Indonesia
India India
Bangladesh Bangladesh
0 20 40 60 80 0.0 2.0 4.0 6.0 8.0

Total Tax % of Retail Price Total Tax Value (PPP adjusted Dollars)
Figure 8- Regional Tax Composition of most sold cigarette brand by Percentage and Value (Source: WHO Global Tobacco
Epidemic 2013: Sri Lanka)
The high cigarette retail prices in Sri Lanka incorporate taxes of above 70% due to the quantity excise
tax set at several times the manufacturing cost of a stick (Figure 8). Total tax revenue from cigarettes
is a crucial component of the government’s annual budget, accounting for 7.6% of state revenue in
2014. The tobacco tax code was simplified in November 2014 with the VAT and NBT ad-valorem
taxes combined into a more inclusive quantity excise tax, which is revised upwards every year. The
quantity excise tax on JPGL is currently LKR 21.60, 72% of the retail price of LKR 30.00.
The total tax contribution by the company amounted to LKR 76.5 billion in 2013 –7.4% higher than
2012 – but dropped for the first time in over two decades (YoY-4%) to LKR 73.6 billion in 2014.
Average Monthly Household Income by Quintile
Bottom % Middle % Top %
Year Overall % Change
20% Change 20% Change 20% Change
2013 10,245 30,944 121,368 45,878
25% 30% 23% 26%
2010 8,211 23,880 98,575 36,451
Figure 9- Income Distribution in Sri Lankan Households (Source: Household Income and Expenditure Survey 2010, 2013)
In between 2010-2013 the average price of a CTC stick increased by around 50%, but per capita
monthly income increased only 26% during this time (Figure 9).
A daily cigarette smoker in Sri Lanka is estimated to spend LKR 3,000 per month5 (about LKR 100 per
day) on CTC products, which is 7.4% of average household expenditure in Sri Lanka (LKR 41,444)6.
Considering that the bottom 50% of Sri Lankan households are estimated to earn less than LKR
30,400 per month and that many CTC customers belong in this category, it is clear that high prices of
cigarettes constitute an increasingly large proportion of their users’ wallet share.
A Survey by the Alcohol and Drug Information Center (ADIC) in July 2014 estimated that 71% of
cigarette smokers are daily users, indicating a significant strain on family resources when consumed
by the primary (male) bread-winner of the household.
5
ADIC Statistics/JBS Estimates
6
Department of Census and Statistics. 2013. Household Income and Expenditure Survey 2012/13
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| 12
Exports to grow steadily, but have lower margins

Ceylon Tobacco has successfully endeavored to improve its export performance in recent years,
although from a low base and at lower margins. Exports represented 1.7% of Net Revenue in 2014,
and 4.3% of Earnings. Total export earnings (LKR 369 Mn in 2014) have increased more than
sevenfold since 2011, and the current 230 million exported sticks represents 6.3% of total volume.
Exports are to the Maldives and Afghanistan, and an indication of more resources being diverted in
light of the slowing domestic market. Exports remain volatile and are limited in the long term by the
maximum 4.5 Billion annual stick handling capacity of CTC’s current production facilities, which in all
likelihood will not ever be increased.
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| 13
Threat of Substitutes – Mainly Beedi

It is our expectation that CTC stick prices will continue to rise, accelerating demand for cheaper,
unregulated tobacco substitutes. Home-made Beedi cigarettes are small (around 50mm), contain
less tobacco and no filter, but cost five times less than the cheapest CTC product. However, they
have largely been ignored by government regulators despite commanding similar total volumes to
Ceylon Tobacco. Beedi is differentiated by taste and sold an estimated 3.2 billion sticks in over 140
different brand names at informal retail outlets throughout the island; volumes are estimated to
have tripled in the last five years to around 3.2 billion sticks. Less discerning and price-sensitive
consumers are increasing consumption of Beedi and other local tobacco products, particularly
outside Colombo.
Figure 10- A Beedi Stick (bottom) alongside a John Player Gold Leaf Cigarette (Picture from JBS Research in March 2015)
Production of Beedi is labor intensive and provides valuable employment in rural areas, particularly
to female rollers. Despite containing four times less tobacco than Capstan (which is the only CTC
brand without a filter), Beedi gives the user a similar amount of puffs per stick due to the slower
combustion of its wrapping material. Beedi is wrapped in tendu leaf, currently its sole taxable
avenue (LKR 20 per kg) since tendu is sparse and usually imported from India - where Beedi
represents 85% of total tobacco consumption.
Beedi sticks sell for between LKR 2.00-3.00 and are currently estimated to account for 42% of total
smoking tobacco sticks in Sri Lanka7, but just 1% of industry tax revenue. Tendu taxes represent less
than 10% of Beedi prices, and the cottage industry is also exempt from the strict regulatory and
awareness measures applicable to CTC products. Similarly, the regulatory environment for un-taxed
chewing tobacco is essentially non-existent and awareness of health risks is low. While local tobacco
alternatives are historically popular in agricultural communities, they are now increasingly common
in cities and may pose greater health risks due to uncertain tobacco leaf quality and uncertain
assembly standards.
CTC is unable to compete with Beedi through its value for money (and lower-margin) products,
instead focusing on strengthening brand equity in the popular ‘Gold Leaf’ and premium ‘Dunhill’
brands through product differentiation. CTC reintroduced the mid-range ‘Bristol’ brand in 2012 and
sells for LKR 20 - an effort to secure a profitable brand in-between JPGL and Capstan brand which
account for 84% and 10% of volumes respectively. The firm’s value growth strategy is focused on
brand-loyal smokers but alienates the considerable number of smokers from price-sensitive tobacco
users of elderly, rural and youth communities in particular.
Beedi is outside the regulatory net of bodies such as NATA, meaning that it can continue to be sold
without health warning labels and product quality control. There are an estimated 800 manufactures
and importers within this industry, whose regulation is limited to a requirement to register with the
Excise Department.
7
JBS estimates, CTC management
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A potential demand suppresser for Beedi is a future regulation and specific taxation for Beedi
manufacturers, as is the case in India. The most recent Budget Speech in 2015 called for quality
production standards of Beedi sticks, but we feel that any technical regulation will be difficult to
implement and increases in the tendu tax will be the way forward to controlling consumption.
Illicit Market and E-cigarettes

The loss of volumes to cigarettes smuggled into the country is currently not a major concern for
Ceylon Tobacco, as in other countries where illicit markets dominate sales of regulated products.
CTC frequently commends the State Excise Department on its effectiveness in preventing smuggled
cigarettes and reported that 30 million illegal cigarettes (less than 1% of total CTC volumes) with a
market value of LKR 900 million were seized in the first nine months of 2014. The consumption of
smuggled cigarettes and ‘white cigarettes’ that are domestically produced are estimated to be 4-6%
of CTC volumes, but management is acutely aware that the failure to control unregulated markets,
as tax-evasion incentives continue to increase, would significantly hurt sales in the future.
Potential sales of e-cigarettes which have been developed by BAT international are unlikely to be a
significant revenue channel in Sri Lanka in the near future due to the dearth of a premium market.
While e-cigarettes have witnessed strong growth rates in developed countries, the majority of
substitution in Sri Lanka away from traditional combustible cigarettes will be to cheaper alternatives
such as Beedi instead. If CTC does expand its portfolio to include such products, volumes would not
be significant enough to materially change our view of the company’s value.
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Health, Social and Political Factors leading to declines in Prevalence AND

Persistence
Besides the price-related factors leading to a demand drop in CTC’s products, there are significant
socio-political reservations regarding tobacco use in the country. Negative cultural perceptions and
high related health costs has led to legislation aimed at dissuading potential and current smokers, as
well as protecting non-smokers from its debilitating effects. Legislation includes bans on advertising,
smoking in public and the recent imposition of health warnings on cigarette packets. State
sponsored educational programs, particularly in schools, have increased the awareness of the
dangers related to smoking and strengthened the cultural aversion to cigarettes. Since tobacco
consumption is strongly linked to low-income and low-education levels in the country, tax increases
and education initiatives are effective in reducing consumption from existing smokers and increasing
overall abstinence levels.
The various health issues related to cigarettes are from direct effects of tobacco smoke -on both the
smoker and the ‘passive’ smoker – as well as the addictive nature of the substance that often
competes with other priorities in a typical household. Tobacco related illness is a future burden that
is often not borne by the user himself, thereby straining current and future public health resources.
Public Health Initiatives implemented through NATA

Legislative measures in Sri Lanka are relatively stringent, and comparable to many developed
countries. The National Authority on Tobacco and Alcohol (NATA) was established in 2006, and is
responsible for implementing various controls on the tobacco industry. Measures include
prohibitions on all marketing activity related to tobacco products and bans on smoking in “enclosed
public areas,” which have reduced the incidence of tobacco use. Graphic health warnings on
cigarette packs have recently been implemented and will help to further dissuade prospective
smokers and decrease the loyalty and predominance of CTC’s products.
The persistence of smoking in Sri Lanka has declined due to the ban on smoking in public areas,
reducing the visibility and convenience of smoking. The legislation, introduced in 2006, is currently
limited to “enclosed public areas” such as office premises and restaurants. However, public areas
that are ‘not enclosed’ and ‘not restricted’ – such as bus stands – are seemingly not included in the
ban, and it is our expectation that these regulations will be extended in the near future to a more
inclusive definition of a “public place.” NATA has already proposed 14 further amendments to this
end, which have not been implemented due to political concerns over the possible deterring effects
on tourism.
The country has imposed comprehensive tobacco advertising, promotion and sponsorship bans since
2006, and is a party to the inaugural Framework Convention on Tobacco Control (FCTC) sponsored
by the WHO in 2005. Therefore, there already exists a strict regulatory environment in the country
which also adheres to the WHO recommendation of over 70% taxation of retail prices of cigarettes.
The appetite for legislation and advertising bans is now completed with the implementation of
Article 11 of the FCTC. From Jan 1, 2015, 60% health warning were enforced on all CTC cigarette
boxes, and this has now been increased to 80% after being approved by the newly appointed cabinet
of ministers. These warnings will however not have a significant effect on reducing prevalence
amongst existing smokers, since 95% of sticks are sold loose in the country. Nevertheless, it should
dissuade attracting new smokers and contribute to negative public sentiment regarding the firm’s
products.
Such initiatives, when combined with awareness programs in schools, agricultural and social
community groups serve as significant disincentives for the company’s products. Smoking
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increasingly carries a cultural taboo in Sri Lanka, and there is significantly less prevalence in the
youth segments outside of major cities.
Negative Externalities of Tobacco Consumption

A report published by the World Health Organization in 2013 estimated that tobacco use accounted
for 7% of all causes of mortality among Sri Lankan adults aged 30 years and older in 2004, with
almost all deaths occurring among males. The Health Ministry has indicated up to 65 people die
every day in the country as a result of tobacco-related illness, which has induced a sustained social
initiative against CTC’s products.
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Pricing Power Erosion

Future price increases may be unsustainable for it will be revenue negative for CTC. The current
sensitivity of volumes will prohibit the firm from increasing prices in addition to quantity excise taxes
– the main contributor to previous revenue and margin growth. The average price of a CTC cigarette
has increased at a 13% CAGR from 2010-2014 (Figure 11), also capturing the effect of higher-value
brands in the sales mix. Rapid retail price increases for cigarettes and the low average disposable
income of users have impacted volumes significantly and the previously price inelastic nature of
cigarette demand is becoming more elastic. Management if unwilling to significantly raise end
prices, the key JPGL brand will lack significant volume or value drivers in the future.
Price per stick Volumes dropped 11% in 2014, Stick Volume
(LKR) amid constant price increases... (Bn)
30.00 4.8
4.6
25.00
4.4
20.00 4.2
4.0
15.00
3.8
10.00 3.6
3.4
5.00
3.2
0.00 3.0
2008 2009 2010 2011 2012 2013 2014 2015 2016
CTC 'Net Price' per stick Tax Levies per Stick Stick Volumes
Figure 11- Gross Average Price Breakup-after retailer and distributor margins-vs. Total Number of Sticks Sold
(Source: CTC, JBS Estimates)
The only option for the firm to increase revenue in this environment is to rely on up-trading to
premium, higher-margin cigarettes such as Gold Leaf Special and its premium Dunhill brand.
Concerted investment in product differentiation and innovation will continue, but the effectiveness
of this strategy is proving to be limited. The data suggests that despite the addictive qualities of
products, many users are not loyal enough, or simply unable to bear the increased expenses of
smoking CTC cigarettes. While gains in disposable incomes may reduce the volume decline in the
short term, we feel that the longer term trend will be towards increased price-sensitivity of cigarette
users – especially after factoring in the increased regulation, negative public perception and rise of
sustainable unregulated markets.
Indeed, the current market for premium cigarettes is very small in Sri Lanka, with Dunhill
representing just 2% of volumes despite being introduced almost a decade ago. The inability to
advertise new or existing products and brands is a further limitation in efforts to improve the sales
mix.
Ceylon Tobacco’s flagship John Player Gold Leaf sticks remain the most popular brand amongst
smokers, but has lost almost 800 million in volumes in the last three years. The retail price of a JPGL
doubled in the last six years, and we are confident that future similar price increases will lead to an
even more dramatic drop in volumes. The increased responsiveness of JPGL customers is illustrated
(Figure 12) on the next page.
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JPGL under pressure…
Volume Declines (%) Price Increases (%)
2014 -10% 12%
2013 -6% 14%
2012
-5% 10%
-15% -10% -5% 0% 5% 10% 15%
Figure 12- YoY Percentage Change in JPGL Price and Volume (Source: JBS Estimates)
LKR Excise Taxes account for 72% of a

Gold Leaf Stick...
35.00
1.70
30.00
Retail and Distributor Margin (6%)
25.00
20.00
21.61
CTC ‘Net’ Price (22%)
15.00
10.00
5.00
6.69 Consolidated Excise Tax (72%)
0.00
Figure 13- Value Breakup for JPGL (March 2015) (Source: JBS Estimates)
The formula for setting cigarette prices, if one exists, is not disclosed by the government or CTC. The
firm’s products are not taxed uniformly8 - instead based on stick length – but total levies constitute
>70% of all brand retail prices. The current excise tax on JPGL is LKR 21.61 and once distributor (1%)
and retailer (5%) margins are deducted, the residual ‘Net Price’ accrues to CTC (Figure 13). This
metric increased 116% from 2008–13 compared with a 74% increase in government levies per stick
during this time – primarily due to increasing retail prices above mandatory excise tax hikes (Figure
14). During this entire period volumes fell just 10%, indicative of the previous pricing power that was
enjoyed. The effect on earnings was substantial as CTC limited per-stick production cost growth to
just 13% throughout the five year period.
8
See Appendix 2
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CTC has been increasing 'net' prices faster than excise tax increases
25% every year...
Net Revenue
20%
CTC Net Price/stick as % of Gross
Revenue
15%
Govt. Levies/stick
10%
5%
0%
2009 2010 2011 2012 2013 2014
Figure 14- Comparison between Net Price and Government Levy Increases (Source: CTC)
In 2014, volumes decreased 11% and per-stick production costs increased 19% YoY. Understanding
the developing trends in these key operational metrics illustrates the bleak long-term outlook we
have for CTC’s earnings.
CTC has focused on pushing its portfolio towards premium products (Figure 15) and increasing ‘net
prices’ in this manner. Investment in JPGL is at the forefront of preserving core volumes. Gold Leaf
Special was introduced at an Rs.1.00 premium in 2013, while the entire brand underwent a facelift
with the launch of a newly designed pack in 2014. The company has introduced innovative product
variants in the Dunhill brand: Dunhill Lights and Dunhill Switch (allowing users a one-off ‘switch’ to
menthol) which have proven popular among Dunhill users but has been inadequate in facilitating up-
trading from JPGL customers in recent years.
Sales mix has shifted gradually towards premium brands...

100%
22% 21% 19% 16% 17% 16% 15%
25%
80%
60%
40% 78% 79% 81% 84% 83% 84% 85%

75%
20%
0%
2007 2008 2009 2010 2011 2012 2013 2014
JPGL Other Brands
Figure 15- CTC Brand Mix Composition. Since 2010, Dunhill Volumes increased 60% while JPGL declined 20% and other
brands together declined 30% (Source: CTC, JBS Estimates)
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Dunhill sticks are levied with the same quantity tax as JPGL, despite retailing for a LKR 4 premium.
Innovative products like Dunhill Switch therefore have significantly lower taxes (61% vs 72% for
JPGL) which outweighs the increased direct material costs on company margins. Overall Dunhill
volumes remain low (2%) despite strong initial growth, and Dunhill Switch now comprises 65% of the
Dunhill brand - an insight into the future direction of CTC’s product portfolio. The company is
compelled to innovate in order to defend higher prices, but is unable to generate sufficient brand
equity to prevent consumption from falling amongst core customers. The low number of premium
users means that we forecast Dunhill volumes to reach 5% of volumes by 2018 which is not
significant enough to grow revenues at a pace that justifies the current market price.
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Operating Margins under Pressure

The lack of price and volume expansion will squeeze the operating margins for the company. CTC is
focused on shifting the production mix to higher priced sticks, but rising prices will instead force
customers to reduce consumption or down-trade to smaller, lower margin cigarettes. Cost
reductions through process efficiency improvements will not be sufficient to negate input price
increases and lower absorption of fixed costs due to declining volumes. Therefore, per stick costs will
outpace increases in the average price per stick received. We expect margins for distributors (1%)
and retailers (5%) to remain at near the current levels. Since quantity taxes are levied according to
stick length, the net stick price received captures the entirety of the premium from high value
brands, although this effect is diluted by increased costs of premium-blend tobacco and additional
higher-quality filter and packaging material for innovative products. We believe margins are also
vulnerable to a depreciating LKR, since almost all non-leaf material is currently imported.
The increase in margins (Figure 17) was primarily through higher prices that did not translate to
higher costs. During the period from 2009 – 2013 the net cigarette price received increased 78%
from LKR 3.01 to LKR 5.36, but volumes decreased just 1.6%. Therefore, per stick costs could be
effectively controlled and only increased by 24%, from LKR 1.42 to LKR 1.77 during this time. The one
year volume decline for 2014 was 11% and the per stick cost was LKR 2.1, escalated by higher factor
prices for leaf and packaging, and the large amount of fixed expenses (around 45%) that overwhelm
any savings associated with producing lower volumes. The detailed cost structure for 2013 is
illustrated (Figure 16), consisting predominantly of tobacco leaf, packaging material, labor and
factory overhead. A graphical illustration of CTC’s supply chain is included in Appendix- 4.
High fixed component will drive up Operating margins improved by 30%

per-stick costs… points from 2008-2013
Depreciation (4%) 25
Direct Materials (10%)
20
Labor (14%)
Other Direct Operating
15
Expenses (17%)
Indirect Operating 10
Expenses (27%)
5
Tobacco Leaf (28%)
37%
67%
0
2008 2009 2010 2011 2012 2013
Figure 16- Cost per Stick was LKR 1.76 in 2013 (Source: CTC) Figure 17- Operating Margin Contribution to Net Revenue
(Source: CTC)
While the company has been successful in continual productivity improvements, costs will be forced
up by higher factor input prices in the future. CTC has had to pay higher prices to tobacco farmers
recently and the price (per kg) of direct material used has increased 66% from 2011 – 2013. The
LKR’s devaluation and the higher quality materials required for premium cigarette sticks are the
drivers of this increase. Additional materials used in brands such as ‘Dunhill Switch’ increased the
total amount of material used marginally during this time (by 2%) as well. Accordingly, we expect
input price increases to overwhelm any further efficiency gains, which are close to being fully
exhausted and further pressured by lower handling volumes.
The company’s labor and factory overheads are largely fixed components of cost structure. Volume
declines are unlikely to be significant enough to materially change existing production processes.
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Lower energy prices and faster downsizing of the labor force may dampen some of the cost
increases.
Margins restricted by lower price-growth and falling volumes ...

70%
60%
50%
40%
30%
20%
10%
2007 2008 2009 2010 2011 2012 2013
EBIT Margin Net Margin Gross Margin
Figure 18- CTC Historical Gross, EBIT and Net Margin (Source: CTC)
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Valuation
Our per share fair value of CTC as of April 30, 2015 is LKR 623 per share, a 37.8% discount to the
current market value of 1,003 per share.
We have used discounted cash flow incorporating sensitivity analysis, and relative valuation using
historical dividend yields and the yield on long term government bonds to establish our view. The
five year forecast period is from 2015-2019.
DCF analysis alone has previously failed to capture the premium that investors were willing to pay
for CTC’s consistent dividend stream and high quality management and corporate governance. The
counter currently trades at 8.8x firm revenue, reflecting the added value from being the largest
corporate contributor to state revenues and the only legal manufacturer and distributor of
cigarettes. We have therefore combined our DCF value - using a weight of (65%) – with relative
analysis using a weight of (35%) to arrive at our fair value for CTC.
= (65% Implied DCF Value)*468 + (35% Implied Dividend Ratio Value)*912 = 623/share fair value
Our recommendation is based on a qualitative and quantitative assessment of the economics of the
tobacco industry and the future prospects of Ceylon Tobacco. We expect the dividend payout ratio
to remain high (~ 99%) due to the lack of a need for new capacity, reduced working capital
requirements, ample cash reserves and the lack of debt in the capital structure. The consistent cash-
return earned by investors will be of greater significance in the lower-growth environment going
forward.
Dividends this year will be affected by a one-time ‘Super Gain’ tax imposed on all corporates in Sri
Lanka with reported profits above LKR 2 Bn in FY 2014; the impact to CTC is estimated to be around
LKR 1.3 Bn. The net effect of the super-gain tax has been adjusted for in our valuation.
Discounted Cash Flow Analysis (DCF)

CTC’s business generates significant cash earnings every year that are usually fully paid to
shareholders. Additionally the lack of substantial future capital investment provides a consistency in
cash flows and dividends that lends itself well to a DCF model.
Assumptions
10 – Year Bond Rate 9.2%
Asset Beta 1.27
Cost of Equity 15%
Probability of Base Case 70%
Probability of Bull Case 15%
Probability of Bear Case 15%
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Base Case (70% probability)

Our base case scenario depicts the most probable future performance for CTC. Future price
increases will to be carefully managed to overcome volume declines, and therefore take place at a
slower rate in order to sustain revenues for CTC and the treasury.
The average receipt per stick (gross revenue/# of sticks) is estimated to grow at a 6.7% CAGR over
the forecast period compared to a CAGR of 13.3% from 2010-2014. The corresponding 3.0% CAGR
drop in volumes would lead to a Net Revenue CAGR of 4.8%.
Over our 2015-2019 forecast period, Gross margins are forecasted to improve by 120 basis points
due primarily to a premium bias sales mix, and EBIT margins are estimated to decline by 90 basis
points on account of higher value direct materials, slower growth in prices in comparison to factor
costs and higher per-stick employee and overhead expenses that offset cost declines from lower
handling volumes. Revenue from the export segment is expected to grow 20% annually.
Base Case Firm Value: LKR 85 Billion; Share Value: LKR 454
Bull Case (15%)
 Annual Volume growth: -1%
 Annual Price growth: +9.2%
 Annual Net Revenue growth: +10.7%
 Margins: Gross Margin increase by 320 basis points, Operating Margins increase by 400 basis
points
Favorable environment for CTC could result from better than expected up-trading to premium
products such as Dunhill Switch and Gold Leaf Special which boosts net per-stick prices as well as
gross and net margins. Higher future incomes and increased urbanization of the company’s
customers could make price less decisive in purchase behavior, leading to limited volume decline.
Local sourcing of direct materials would reduce factor cost inflation and currency risk.
Bull Case Firm Value: LKR 120.1 Billion; Share Value: LKR 642
Bear Case (15%)
 Annual Volume growth: -5%
 Annual Price growth: +5.15%
 Annual Net Revenue growth: +1%
 Margins: Gross Margin increase by 70 basis points, Operating Margins decrease by 160 basis
points.
Demand remains in the elastic zone, as public awareness and education levels rise. Any future price
increase fails to significantly increase revenues in this environment, but a higher portion of premium
sticks sold will incrementally improve gross margins. Operating margins increasingly squeezed due to
lower handling volumes, higher production costs of premium sticks, and a depreciating rupee.
Bear Case Firm Value: LKR 67.1 Billion; Share Value: LKR 358
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DCF Review
2019 Estimated Equity Value Share
Scenario Probability Earnings (LKR
(LKR Billion) Value
Billion)
Base Case 70% 27 85 454
Bear Case 15% 24 120 642
Bull Case 15% 36 67 358
Weighted Average DCF Value 88 468
(70%)*Base Case + (15%)*Bear Case + (15%)*Bull Case = DCF implied Share Value of LKR 468
Relative Valuation
Regional Peer Analysis
Tobacco companies can trade at very high multiples, but Sri Lanka’s limited growth opportunity in
comparison with these markets and lower long term bond rates means that CTC is underserving of
the current high premiums paid on its earnings.
Div Yield 10yr Govt Bond
Country P/E P/B EV/Sales
(%) (%)
BAT Kenya 16.9 8.9 3.4 3.6 11.8
BAT Bangladesh 29.7 16.3 5.2 2.2 10.7
BAT Sri Lanka 21.8 48.2 8.2 3.9 9.2
CTC as a Dividend Play

Ceylon Tobacco can also be evaluated on the basis of Dividend Yield, due to its historically high
payout ratio of earnings (currently >99%) which we expect to continue. Since 2010, CTC’s share price
has increased 205% compared with an 80% increase in per share dividends, therefore driving down
yields. Yields must also be evaluated in the appropriate interest rate environment, as 10-year
government bonds currently yield marginally above 9% compared with 12% in March 2010.
We feel that the lower future growth rate of dividends, limited price appreciation, and bottomed out
interest rates will prevent yields falling significantly. The placid growth environment indicates long
term dividend yields to trend higher.
TTM Dividend Yield9
5yr
Apr-11 Apr-12 Apr-13 Apr-14 Apr-15
Avg
Dividend Yield 7.5% 5.2% 5.4% 4.4% 4.8% 5.46%
Share Price on April 30 363.50 693.70 806.80 1,099.90 1,003.00 793.40
10 Year Bond Yield 9.6% 13.1% 11.9% 10.2% 9.2 % 10.8%
Div Yield/ 10Y Bond Yield 0.78 0.40 0.45 0.43 0.52 0.51
9
The current (Apr-2015) dividend yield is adjusted for the one-off ‘super gain tax’ in FY2014
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Using a 5-year average of the CTC Dividend Yield/Average 10 Year Government Bond Yield, we
estimated the fair value of CTC based on our forecast for 2015 dividends (LKR 9.3 Bn):
5–Year Average (Div Yield/10 Year Govt Bond Yield) 0.51
Current 10 Year Govt Bond Yield 9.2%
Implied Forward Dividend Yield 4.7%
Expected FY 2015 Dividend Per Share (LKR) 49.3
Imputed Share Price (Mar 2016) LKR 1049
The present value (Mar 2015) per share using the rationale outlined above is LKR 912 We assigned a
35% probability to this fair value calculated by relative analysis of historic dividend and bond yields.
Current High Dividend Yielding Public Companies in Sri Lanka (TTM)
 Ceylon Tobacco Company (CTC) : 4.4%
 Chevron Lubricants Lanka (LLUB) : 4.8%
 Nestle Lanka (NEST) : 3.1%
 Commercial Bank (COMB) : 2.5%
Valuation Summary – Fair Value as of Apr 30th 2015

(65%)* DCF Fair Value (LKR 88Bn) + (35%)* Relative Fair Value (LKR 171 Bn) = Firm Value: LKR 117 Bn
Total number of shares outstanding: 187,323,751; Per Share Value= LKR 623
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Appendix:
1- E-Cigarettes
Electronic cigarettes, vaporizers and other oral nicotine inhalers have emerged as a practical
alternative particularly in developed markets, and the $3.5 Billion a year industry is growing by
around 20% annually. Big Tobacco brands have invested heavily in developing innovative products in
this promising sector, but could struggle to match the customization and innovation offered by the
open-platform systems of smaller companies. The electronic market is split between e-cigarettes -
which combusts a nicotine filled liquid into vapor – and a variety of digital vaporizers, inhalers and
tanks which are usually smokeless, refillable and release no harmful chemicals due to the lack of any
real combustion taking place.
BAT became the first Big Tobacco Company to launch an e-cigarette brand with Vype in mid-2013,
and are looking to supplement their portfolio with other technologically proficient products. The
company recently announced the unprecedented achievement of securing a medicinal license in the
UK for its new ‘Voke Inhaler,’ a non-electronic product using ‘breath operated valve technology’ that
delivers a dose of nicotine without any electronics or combustion. ‘Vaping’ in particular is very
popular in the US, where sales of customizable mods are estimated to have already overtaken e-
cigarettes. These types of products are being recognized not only as a viable substitute to cigarettes,
but a stepping stone to smoking cessation.
The early promise of this new-wave of tobacco products, particularly amongst affluent smokers for
their convenience, innovative delivery style and healthier take on smoking has led to some industry
analysts claiming volumes could overtake traditional cigarettes in 10-15 years. BAT Sri Lanka has bid
to become one of the ‘key seed markets’ for its parents new product range but is unlikely to be a
significant revenue source for CTC the immediate future due to limited affordability for such
‘premium’ smoking products.
It remains to be seen whether the traditional ‘Big Tobacco’ brands will be as dominating in this
market, which will likely hinge on the degree of regulation introduced for the new products that
could drive out smaller manufacturers.
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2 - Historical Excise Tax Duties – Per Thousand Sticks

2009 2010 2010 2010 2011 2011 2012 2012 2013 2014 2014
Mar June Oct Nov Jan Oct Mar Oct Nov Oct Nov
Sticks <=
2,289 2,830 3,425 3,440 3,465 3,465 4,037 4,612 5,722 6,975
60mm
Sticks
between
5,706 6,246 6,893 6,922 6,973 7,540 8,112 9,258 10,355 12,675
60 -67
mm
Sticks
between
8,485 9,028 9,720 9,751 9,811 10,381 10,953 12,100 12,100 14,660
67 -72
mm
Sticks
between
10,715 11,260 11,988 12,030 12,108 13,243 13,815 14,963 16,510 17,746 21,610
72 – 84
mm
Sticks >
12,170 13,170 14,360 14,400 15,000 16,400 17,100 18,500 20,000 21,200 25,100
84 mm
3 - Comparison of Tobacco Alternatives in Sri Lanka

John Player Gold Leaf
Stick Type Beedi Capstan (CTC)
(CTC)
Stick Length (mm) 52mm 62mm 82mm
Tobacco Content (g) 0.15 0.6 0.7
Filter? (Y/N) N N Y
Price (LKR) 2.50 10.00 30.00
Tobacco Content/Price (g/rs) 0.06 0.06 0.02
4 - Ceylon Tobacco Company’s “Crop to Consumer” Supply Chain
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JB Securities Disclaimer
Rating Structure
JBS Research
Fair Value/Market
Investment Explanation
Value
Rating
Stock's price is at least 10%
Buy >1.1
lower than the JBS fair value
Stock's price falls between
Neutral 1.0 ± 10% 10% interval of JBS estimate of
fair value
Stock's price is at least 10%
Sell <0.9
higher than the JBS fair value
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The views expressed in this research report accurately reflect the personal views of the analyst(s) about the subject security(ies) and
subject company(ies); and no part of the compensation of the research analyst(s) was, is, or will be, directly or indirectly, related to the
specific recommendations or views expressed in the report.
General Disclaimer
This research is for our clients only.
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P aPgaeg e| 29
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Ceylon Tobacco Company
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Ceylon Tobacco Company Initiation Report

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Ceylon Tobacco Company INITIATING COVERAGE

Unremarkable Future Prospects at an FY (LKR Mn) 2012 2013 2014 2015E

Catalysts 900 -40%

Produced by: JB Securities Corporate Governance Score ★★★★★

Catalysts and possible downside to the valuation

Context for the Valuation

Local Tobacco Industry Overview

Size of the Market

Beedi Volumes have almost caught up to tradtional cigarettes...

Consumption – Demographics and Products

Year End Retail Prices (LKR)

Tax Revenue contributions have stagnated…

Tobacco Products in Sri Lanka – 2015

John Player Gold Leaf Special/Click 84 31.0/32.0

Benson & Hedges 84 33.0

Four Aces 67 20.0 0.47 (around

Alternative Tobacco Products in Sri Lanka

Betel Quid n/a 15.0 – 20.0

Market Price-Volume Dynamics

Figure 5- Revenue Breakup and Volume Trend 2007-2014 (Source: CTC)

25.00 Gross Revenue

Figure 6- Profitability Drivers (Source: CTC)

High Prices a drag on modest incomes

Government Levies account for more than 70% of CTC’s

0 20 40 60 80 0.0 2.0 4.0 6.0 8.0

Exports to grow steadily, but have lower margins

Threat of Substitutes – Mainly Beedi

Illicit Market and E-cigarettes

Health, Social and Political Factors leading to declines in Prevalence AND

Public Health Initiatives implemented through NATA

Negative Externalities of Tobacco Consumption

Pricing Power Erosion

JPGL under pressure…

Volume Declines (%) Price Increases (%)

2014 -10% 12%

2013 -6% 14%

-15% -10% -5% 0% 5% 10% 15%

LKR Excise Taxes account for 72% of a

Sales mix has shifted gradually towards premium brands...

40% 78% 79% 81% 84% 83% 84% 85%

Operating Margins under Pressure

High fixed component will drive up Operating margins improved by 30%

Margins restricted by lower price-growth and falling volumes ...

Discounted Cash Flow Analysis (DCF)

Base Case (70% probability)

CTC as a Dividend Play

Valuation Summary – Fair Value as of Apr 30th 2015

2 - Historical Excise Tax Duties – Per Thousand Sticks

3 - Comparison of Tobacco Alternatives in Sri Lanka

4 - Ceylon Tobacco Company’s “Crop to Consumer” Supply Chain

Other Important Disclosures

© 2015 Jefferies Group LLC

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