Caltex Lubricants Lanka Limited (LLUB)

1st MARCH 2007 Reuters Code: LLUB.CM

EQUITY RESEARCH

PRICE LKR 91.25 No. of Shares 60,000,000 RECOMMENDATION LONG TERM BUY SUMMARY

COUNTRY EXCHANGE SECTOR

Sri Lanka Colombo Stock Exchange Manufacturing

Caltex Lanka Lubricants Ltd. (Caltex) is a subsidiary of the international energy giant Chevron Corporation. Caltex is the market leader in Lubricants in Sri Lanka with a market share in excess 80%. The company has maintained a solid dividend payment record, with anannual dividend payout of over 90% during each of the last two years. Caltex, which currently exports to Maldives and Bangladesh, has aspirations for further international expansion. The parent company, Chevron, is likely to be at an advantage due to United States Trade and Development Agencys (USTDA) funding of the oil and gas exploration programme in Sri Lanka.

FINANCIAL HIGHLIGHTS
2005
Turnover (Rs. Mn) Profit After Tax (Rs. Mn) Earnings Per Share (Rs.) P/E Ratio @ 91.25 (x)* Dividend Per Share (Rs) Price to Book @ 91.25 (x)* Net Asset Per Share (Rs.) 5,560 700 11.67 4.97 9.75 2.74 21.14

2006
7,694 807 13.45 6.32 9.50 3.39 25.09

2007 E
8,716 904 15.08 6.05 9.50 3.03 30.13

2008 E
9,873 1,025 17.08 5.34 9.75 2.49 36.71

(1USD=LKR 108.90) * The current price is used for forecasts only

PRICE MOVEMENTS
Caltex Price & Quantity in 2006
100.00 90.00 80.00 70.00 60.00 50.00 40.00 30.00 20.00 500,000 0 2,000,000 1,500,000 1,000,000
40.00 500.0 30.00 70.00

Caltex Price Vs ASPI in 2006

100.00 3,000.0

3,000,000
90.00 2,500.0

2,500,000

80.00 2,000.0

60.00

1,500.0

50.00 1,000.0

20.00

Price

Quantity

D ate

Caltex Price

ASPI

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SECTOR OVERVIEW
Key Players Ceylon Petroleum Corporation (CPC) had monopoly rights in importing, refining and distributing lubricants in Sri Lanka. The status quo changed in the 1990s with the re-constitution of CPC and in 1994, Lanka Lubricants Ltd. was incorporated to take over the lubricant division of the CPC. Lanka Lubricants Ltd, which later changed its name to Caltex Lanka Lubricants Ltd., enjoyed a monopoly in the following: a. Importing Lubricants until 1999, when the Government of Sri Lanka (GOSL) liberalised the import of lubricants. This saw companies such as ExxonMobil, Valvoline, Shell, British Petroleum and Lanka IOC introduce lubricant products into the domestic market; b. Operating a lubricant refining plant. This monopoly ended in 2006 when the GOSL permitted Lanka IOCL Ltd to operate a Lubricant plant in Trincomalee, in the East of Sri Lanka. Lanka IOC Limited (LIOC), a subsidiary of Indian Oil Corporation, is a relatively new player in the Sri Lankan market. It owns 100 filling stations and has franchised another 53, all of which sell only LIOC products (CPC owns around 260 of the countrys estimated 1100 filling stations, which exclusively sold Caltex products until 2004). LIOC is the key competitor to Caltex and enjoys around 12-13% market share. LIOC also enjoys a favourable tariff structure, which has enabled it to capture market share relatively fast by selling its SERVO brand lubricants below the prices of Caltex products. In July 2006, the Government of Sri Lanka called for bids from investors to blend lubricants locally or import and distribute them in Sri Lanka. Fourteen companies applied for a Distributor Licence, of which the government granted licences to five, while another three got provisional approval. Bharat Petroleum, Gulf Oil International, Motul, Total S.A. and Sinopec are the companies that are expected to join the fray during 2007 or early 2008. Laugfs, Toyota Tsushu Corporation and Waxpol International Industries were granted provisional licences, subject to meeting certain conditions. Caltex currently has a market share of around 80% while its closest competitor, Lanka IOC, has a market share of around 13%. The balance is shared by other players like ExxonMobil, Valvoline, Shell and British Petroleum. Market Size and Composition The Lubricants industry in Sri Lanka is estimated to be around 45,000 kilolitres with an annual growth of around 4% during the last 12 years. The local market is estimated to be in the range of Rs. 8-9 billion(USD 73-82 million). The local market is classified into two major segments: a. Retail Market: The vehicle owners buying their individual requirements dominate this segment. This segment, which consists of nearly 80% of the domestic market sales, has almost reached maturity with only 1-2% growth annually. b. Commercial /Industrial Market: Bulk of this segment consists of lubricants for plant and machinery of commercial establishments, such as power plants and rubber processing companies, and large government institutions like the Railway Department, Transport Board and Ports Authority. This segment has recorded a growth of around 15% per year.

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COMPANY OVERVIEW
Parent Company

Chevron Corporation (Chevron), formerly known as ChevronTexaco, is one of the worlds leading energy companies with over US $ 200 billion annual revenue. Chevron, its subsidiaries and affiliates operate in 180 countries worldwide. Chevron provides administrative, technical and financial management services to its subsidiaries and affiliates worldwide. The Companys three core business sectors: o Exploration and production of crude oil and natural gas and marketing natural gas. o Refining, marketing and transportation relate to the refining of crude oil into finished petroleum products. o Chemical operations, including the manufacture and marketing of commodity petrochemicals, plastics for industrial uses, and fuel and lubricant oil additives. Chevron owns 51% of Caltex. Core Business

The core business of Caltex is to import, refine and distribute petroleum-based lubricants. Strategies

Currently, Caltex enjoys market leadership position with a market share in excess of 80%. However, the company has lost its monopoly in refining and distributing lubricants due to the liberalisation of the market. With competition looming, the companys future strategy holds the key to maintaining it position as the market leader. Companys strategy to outperform rivals is to differentiate itself based on its Brand power and a reputation for delivering added value. The company enjoys Superbrand status and was awarded an A+ brand strength rating for 2006 by Brand Finance. The Company is focused on promoting its power brands Revtex and Havoline, both of which have resulted in volume growth. The brand strategy, in our opinion, will contribute substantially to the future success of Caltex. Caltex claims its Share of Voice i.e. its promotional expenses relative to its share of the market, as the highest. Caltex possesses a key advantage over its competitors through its parenting advantage. The Company is supported by the Parent Company, Chevron which, through its extensive R&D programme, ensures that it keeps abreast of the latest developments in the relevant industries. Caltex is likely to change its name to Chevron Lubricants Lanka Limited by mid May 2007, to align itself with the Chevron corporate brand. In the Retail segment, value addition is provided in the form of an experience rather than merely selling lubricants. This has led to investments in branded channels i.e. outlets like Star Lube Express Lube and Delo, which offer a full range of Caltex products in cosy ambience and added vehicle maintenance services, at a relatively faster pace than the common service stations. The Companys strategy for the Industrial segment, which contributed substantially to the increased revenue in 2006, has been the technical advantage over competitors and flexibility in meeting the segments demand with its professional approach. Caltex enjoys scale benefits in the industrial segment, as it is currently the only lubricant refiner in the country. This enables it to supply in bulk to the Industrial segment.

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Caltex has international aspirations. It currently runs a successful operation in Maldives and was exploring marketing operations in Bangladesh in 2006. The company has also re-launched products, such as coolants, to complement the current local product range. Key Risks

The Companys market share has eroded considerably during the last couple of years in favour of LIOC and the other lesser players, largely due to the loss of monopoly rights in distributing lubricants exclusively through CPC filling stations. With further liberalisation of the market and entry of foreign players from India, France, and China, competition is likely to intensify. The Company also has a disadvantage in terms of tariff rates, which places the prices of Caltex products higher than that of rivals. Caltex, which refine the lubricants locally, pays a higher tariff than its competitors who import and distribute lubricants. The escalating violence in North and East had a direct impact on the sales of Caltex as it was forced to withdraw from conflict areas. The revenue from these areas is estimated at around 4%5% of the total revenue. Lubricants contain mainly base oil (petroleum fractions) and additives. Base oil price, which constitute the major part of cost of sales, is prone to fluctuations with the oil prices.

PERFORMANCE ANALYSIS
Table 1: Key Ratios Financial year ended Profitability Gross Margin Operating Profit Margin Net profit Margin Liquidity / Solvency Current Ratio Quick Ratio Long Term Debt/ Equity (Book) Total Debt/ Equity(Book) Management Effectiveness Return on Equity (Book) Return on Assets Return on Investments(Book) 2004 28.98% 17.91% 14.23% 2005 26.47% 16.96% 12.60% 2006 23.87% 15.94% 10.48%

2.14 1.02 11.88% 75.79%

1.87 0.65 10.95% 97.77%

2.25 0.76 7.20% 69.17%

53.19% 30.25% 47.54%

55.22% 27.92% 49.77%

53.59% 31.68% 53.59%

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 Revenue The companys revenue has steadily increased during the past five years, with an average growth rate (CAGR) of around 18%. During 2006, the revenue showed a sharp 38% increase. Despite the volumes in retail segment being adversely affected by the loss of sales in conflict zones, the impressive growth of the industrial segment contributed largely to the revenue increase. High oil prices also resulted in an increase in the selling prices of Caltex products. Margins Intensive competition and the higher cost of base oil, has negatively impacted on the companys margins during the last five years. Gross margin during the last five years has dropped steeply from 39% in 2002 to 24% in 2006, while the Net Profit Margin (After Tax) for the same period dropped substantially from 21% in 2002 to 10% in 2006. Dividends The company has declared a dividend of over 90% during the last two years. Its payout, which was an extraordinary 315% in 2004, is around 70% in 2006. Table 2: Dividend Ratios Financial year ended Dividend Per Share Payout Ratio Dividend Growth Dividend Yield 2004 34.00 315% 196% 53% 2005 9.75 84% -71% 17% 2006 9.50 71% -3% 11%

Expenses Company has focused on the internal cost efficiencies to compensate for the fall in margins. The Administrative Expenses (6%) and the Distribution Expenses (7%) which were 13% of the revenue in 2002, dropped to 8% in 2006. This indicates the effort taken by the Company to run a lean operation whilst focussing on increasing its revenue streams.

FUTURE PROSPECTS
Grow with the economy Lubricants have a derived demand emanating from machinery and motor vehicles. With the growth of the economy, estimated at 7-8% , this demand is expected to rise steadily. This could result in some of the new entrants focussing on particular market niches, for instance, lubricants for ships. However, Caltex, with its First Mover Advantages, adopts a much wider approach, and caters to all of these segments. The company aspires to hold its dominant market position, with the impetus endowed by increased economic activity. Channel presence The increase in the number of branded channels during the next two years is expected to minimise the companys loss of market share in most rural areas. Especially since Caltexs main competitor, LIOC, currently has 70% of its outlets in rural areas. This, in our opinion, mitigates Caltexs risk of losing volumes in the urban sector, albeit in the short-term. However, LIOC plans to expand its distribution network and is likely to target outlets that vend an entire range of brands. Exporting overseas Caltex is focussed on developing the overseas operations in the region. It sees both Bangladesh and Maldives as potential markets. Further expansion is therefore expected. Currently, the revenue from overseas operation is estimated at about 10% of total revenue.

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 New Product Line Caltex has invested in a new filling line with a capacity of filling 1.2 million litres a year, to remove bottlenecks in producing coolants. Further additions/ improvements to existing product lines are also expected.

FORECASTS
Given the changing nature of the competitive forces, Caltex is focussed on consolidating and sustaining its past performances. Tariff Company sources suggest that the revised tariff rates, (Cess, Port and Airport Levy) applicable for 2007, will have a negative impact of around 195 million on the Profit After Tax for 2007. This has been factored in to our forecasts. Sales We have projected an increase in sales of around 10% annually over the next two years. This is less than the average growth in the past due largely to increased competition. Margins Margins could deteriorate further, with gross margin declining up to 20% by 2008, whereas net margin could fluctuate between 9-10%.

VALUATION
Free Cash Flow We have used Capital Asset Pricing Model (CAPM) in calculating the share value on the discounted cash flow basis. Based on the forecasts, the Free Cash Flow value is around Rs.95 per share. Price Earnings The stock is trading at 6x on its 2007 earnings and 5x its 2008 earnings. Price to Book Value Caltex is trading at 3x on its 2007 net book value and 2.5x on its 2008 net book value. Dividend Growth Based on a dividend growth model, the share value is in the range of Rs. 89 to 93.

Based on the above valuation we recommend a Long Term Buy

CONTACT US
Amna Securities Limited 550, R.A. De Mel Mawatha Colombo 03 Sri Lanka Telephone: 94 11 5552556/7 Fax: 94 11 5552553 Email info@asl.lk
This document is published by Amana Securities Limited (ASL) for the exclusive use of their clients. All information has been compiled from the available documentation and ASLs own research material. Whilst all reasonable care has been taken to ensure the accuracy of the contents of this issue, neither ASL, nor any Director, Officer or Employee, shall in any way be responsible for the contents.

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