Sri Lanka’s Tobacco Industry

My current investment themes for Sri Lanka primarily involve growth stocks in the FMCG and healthcare sectors, including some conglomerates, with a specific emphasis on companies that have consistently had strong market shares in their respective areas of operation (over 20% market share is ideal).

Ceylon Tobacco Company(CTC), Sri Lanka’s 2nd largest company listed on its stock market, is another wide moat company to consider for investment amid Sri Lanka’s economic slowdown.  As the only legal manufacturer of tobacco in Sri Lanka, Ceylon Tobacco is the exclusive way to access this area of consumption, only facing indirect competition from other products such as beedi and betel nut.  CTC also has the support of The British American Tobacco Group(BAT), which has been listed on the Dow Jones Sustainability Index for the past 14 years and has a business model which focuses strongly on economic, social, and environmental impacts.  The company has faced some challenges due to new industry regulations but has nevertheless still delivered strong financial growth.  The company’s revenue grew by 21% during 2015, despite increased regulations and taxes. The company has around 70% market awareness with no advertising and a network of 16 exclusive distributors which are able to reach over 72,000 outlets in the country. Ceylon Tobacco is a necessary addition to any Sri Lanka focused portfolio, and a safe bet amid macroeconomic setbacks that may be ahead.

Industry Struggles

This industry is dominated by cigarettes, as well as bidis, a cheaper alternative to cigarettes that has been gaining a stronger market share.  Minor threats include illicit cigarettes and potentially even betel nut, a leaf product in Asia that sometimes contains tobacco as well.  Ceylon Tobacco has fared well amid many challenges this industry has faced, not only from Sri Lanka’s macroeconomic slowdown but challenges specific to this industry.

Excise Duty: Consumers are somewhat price sensitive to cigarettes, and the increased excise duties have presented a challenge for the industry.  Despite excise duties increasing by more than 250% over the past 10 years, CTC has still not been hindered by slowed growth.   The average tax composition in the price of a cigarette in Sri Lanka is now 80% compared to the global average of 55%.

Smuggled Cigarettes: Smuggled cigarettes are a notable problem in the country, and approximately 21.6 million illegal cigarettes were smuggled in 2015, a 29% reduction from the previous year.   Illicit products only hold a market share of approximately 2%, resulting in a somewhat negligent threat to CTC.

Beedi:  Consumers primarily switch to beedi, a cheaper alternative to cigarettes, which is also very commonly found in India.  This can be considered the strongest threat to the company’s financial performance.

Pictorial Health Warnings: CTC was also required to implement 80% pictorial health warnings for its products, based on new regulations in Sri Lanka.  This pictorial warning regulation was introduced for all products, including beedi, which accounts for approximately 43% of the total market.

Tobacco Products

Sri Lanka’s tobacco industry provides employment to over 66,000 individuals and indirectly supports over 261,000 livelihoods.  This is a significant portion of Sri Lanka’s population of approximately only 20 million.  The entire land used for Sri Lanka’s tobacco farming is less than 0.01% of the country’s arable land, and the water used for tobacco farming is 1/7 of the amount required for paddy.  For many, tobacco farming serves as an alternative source of income.

Country Smoking Prevalence(Male Population)
Bangladesh 44%
Cambodia 45%
China 49%
India 23%
Indonesia 72%
Japan 36%
Korea 52%
Laos 60%
Malaysia 45%
Mongolia 49%
Myanmar 35%
Nepal 39%
Pakistan 41%
Philippines 46%
Singapore 28%
Sri Lanka 29%
Thailand 42%
Vietnam 48%

Source:WorldBank

Approximately 29% of Sri Lanka’s population smokes cigarettes according to the WorldBank, and the average cigarette consumption is about 5-8 sticks in Sri Lanka, compared to 10-15 in Asia.  Singapore and India are two of the only countries below that have a lower smoking prevalence than Sri Lanka.  Smoking in Sri Lanka has declined at a rate 2.33 per capita since 1978, largely following the global trend.

Source: Asian Tribune

The new introduction of pictorial warnings for cigarette products in Sri Lanka(80% warning), presents another strain for the industry, although CTC has not been harmed financially so far.  These warnings have already been around in markets such as Thailand.

Beedi

Amid the sharp rise in cigarette prices, the price of beedi has remained the same, allowing this product to increase its market share from 20% in 2007 to its current market share of 43%.

Source: 2015/2016 Annual Report

 

CTC is viewed favorably for its large contribution to Sri Lanka’s government revenue.   While both cigarettes and beedi are known to pose health risks, beedi is notorious for the negative health impacts for the manufacturer. WHO observed that beedi rollers suffer from handling tobacco flakes and inhaling tobacco dust, resulting in potential issues such as tuberculosis, asthma, dizziness, and eye problems.  Most of this results from studies in India, as extensive studies in Sri Lanka have not been conducted.

Valuation Comparison

Company Country P/E
Ceylon Tobacco Sri Lanka 14.13
Karelia Tobacco Company Greece 11.53
Universal Corp. USA 16.30
Philip Morris CR Czech Republic 13.14
British American Tobacco Kenya Ltd. Kenya 16.21
Scandinavian Tobacco Group Scandinavia/USA 17.81
Hemas Holdings Sri Lanka 20.77

Source: Reuters

Despite its impressive financial performance amid industry struggles, CTC’s price has decreased by over 13% in the past year.  The company is consequently cheaper than other stocks in Sri Lanka, such as previously mentioned Hemas Holdings, and a safe pick given its strong, guaranteed market share.  On top of this, the company’s business is easier to understand, as compared to other conglomerates operating in Sri Lanka.  Ceylon Tobacco has already weathered the industry storm and is poised to benefit from the rise of Sri Lanka’s middle class moving forward, as consumers become less price sensitive to products.

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