th Capitalisation as at 4th September 2008 Company Ticker ... Valuation Report Sept2008 by...

JB Securities (Pvt) Ltd

Current Price : Rs. 111

Target Price : Rs. 116

Target (12 m) : Rs. 122

Dividend (12m) : Rs. 33

Recommendation : Buy/Hold

Chevron Lubricants Lanka Limited

Valuation Update - 2008

Company Ticker: LLUB.N0000

Industry : Manufacturing

Heading into Rough Seas!

Increased competition and escalating production cost will apply downward

pressure on volumes and margins, slowing down the growth in profits.

However the company will continue to retain its dominance in the lubricant

market and generate strong cash flows. Hence we believe the counter to

have potential to offer an attractive total return to investors.

Higher ROIC, despite intensifying competition: Intensifying competition will reduce

the pricing power of all industry incumbents, including Chevron. However we believe

that the company is in a position to maintain margins and achieve bottom line growth

albeit at a slow rate. However the company will continue to post high returns on invested

capital (ROIC) due to the low asset base required for operations.

Higher FCFE & dividends: Effective working capital management and declining capex

requirements contribute to higher FCFE and sustenance of higher dividends. We expect

the company to make a substantial dividend payment in the financial year 2008 & 2009

primarily from the cash generated in the 2007 financial year. The company will continue

to retain its capacity to maintain a high dividend payout in the future.

Financial Indicators

10th September 2006

Why read this report?

We value Chevron using

scenario based FCFE

valuation model.

We disclose our valuation

methodology in detail so

that an astute investor can

tailor the valuation in the

way he wants.

We highlight the possible

risks to Chevron.

Address:

JB Securities (Pvt) Limited

No:150, St Joseph’s Street,

Colombo 14

Sri Lanka

General: +94112490900

Web : www.jbs.lk

JBS Research

September 2008

JB Securities (Pvt) Ltd does and seeks to do business with companies covered in its research reports.

Investors should be aware that the firm may have a conflict of interest that could affect the objective of this

report. Investors should consider this report as only a single aid in making their investment decision.

0%

25%

50%

75%

100%

125%

150%

175%

200%

225%

Jan-05 Sep-05 May-06 Jan-07 Sep-07 May-08

ASPI

Chevron

Share performance relative to ASPI

Capitalisation as at 4th September 2008

52 w eek range, Rs.Market cap, Rs.Net debt, RsFree floatShares outstanding

Forecast/ValuationCurrent 2008F 2009F 2010F

EPS, Rs 17.97 19.87 22.10 21.36 DPS Rs. 13.00 16.00 33.00* 17.00 Price, Rs 111.25 - - - P/E 6.2 5.6 5.0 5.2 NAV, Rs 30.56 28.49 35.57 40.27 P/BV 3.6 3.9 3.1 2.8 GP Margins 26.4% 26.6% 26.6% 24.2%ROIC 50.9% 58.3% 58.2% 50.8%

Price & ASPI Performance1M 3M 12M

Chevron 9.4% 5.0% 34.1%

ASPI 1.7% -6.3% -2.7%

* Special dividend- From excess cash

81.75-113.256,780,000,000 (571,061,722)

49%60,000,000

Content

1. Why Read This Report 1

2. Industry Update 2

3. Key Factors to Consider for 2008 and beyond 3

4. Investment Thesis 10

5. Valuation Summary 12

6. Valuation Methodology in Detail 13

7. Scenario Analysis 14

7. Appendix – 1, Shareholder List 17

8. Glossary and Abbreviations 18

Why read this report

The effect of the following has been newly factored in to the Chevron Valuation Report

2008.

Macroeconomic Factors

Rising inflation caused by the higher commodity prices, expansionary budget of

GOSL, and its impact on the cost of capital and exchange rates

Industry Specific Factors

Commencement of operations by the following new entrants

1. Motul SA France – France

2. Bharat Petroleum Co. – India

3. Sinopec Co. – China

4. Gulf Oil Int. – UAE

5. Laugfs Holdings Ltd – Sri Lanka

Lanka IOC commencement of blending operations during the year

Reduction in price increases effected due to increase in competition

Valuation Assumptions

All scenarios have been modified to incorporate change in the competitive

intensity

1. Scenario 1: Base case - Sacrificing market share over the years with

reasonable negative pressure on margins

2. Scenario 2 : Base case with further market liberalization

3. Scenario 3 : Scenario 2 with increased capex and further competition

Cost of capital is adjusted to reflect the rising inflation

JB Securities (Pvt) Ltd Valuation Update 2008

JBS Research 1

Industry Update

Demand for lubricant slowed in 2009

The Sri Lankan lubricant market consumed approximately 55-56 million litres in

2007 in volume terms. Relative to 2006 volumes declined marginally by 1-2%.

Decrease in the use of automobiles, lengthening service intervals and the slowdown

in the growth of the vehicle stock resulted in a reduction in demand coming from

the automobile segment. Increase in thermal power generation and increased

demand from the defence forces helped to cushion the drag on total volumes.

The lubricant market is yet highly concentrated with Chevron dominating with a

market share of 84-86% followed by LIOC with 7-8%, Mobil, Shell, BP/Castrol,

and Valvoline account for the balance.

Laugfs Lubricants, Sinopec, Mac Lubricants, Gulf Oil and Motul commenced

operations during the year. We believe Laugfs to be an aggressive competitor than

the incumbent players. Laugfs will import its lubricants in bulk form and pack it

locally whilst the other players will import their volumes in packed form.

The Ceylon Petroleum Corporation (CPC) has also expressed its interest in re-

entering the lubricant market. We believe that CPC would have access to 9-10% of

the total industry volume via its network of fuel stations and preferential access to

key state sector accounts such as the Ceylon Transport Board.

LIOC commenced operation in its blending plant in November 2007. Players

blending lubricants locally still enjoy a tariff advantage of 8.7% albeit lower than

the previous 16.6%. LIOC is also in the process of intensifying its distribution

channels.

Given the expected slow growth in overall industry volumes, entry of new

competitors and existing players intensifying their operations will threaten the

market share of Chevron. Given that most of the new entrants will be pricing their

products very close to those charged by Chevron we believe that there is a strong

possibility of Chevron experiencing erosion in market share. The degree of erosion

will depend on how Chevron will react to competitors’ moves.

Market Size and

growth

Market Shares

New entrants

commenced operations

during the year

CPC has expressed its

interest in re-entering

the lubricant market

LIOC commenced

blending lubricants,

intensifies operations.

We expect Chevrons

market share to

reduce over time.


JBS Research 2

Key factors to consider for 2008 and beyond

Sustaining high margins key to maximising value to shareholders

Chevrons ability to maintain strong margins which drives the value of the company

will depend on whether the management will emphasis margin maintenance as

opposed to market share. Based on discussions we have had with the

management we strongly believe that the company will focus on the former

whilst modestly sacrificing volume and market share.

Chevron will be challenged on both the revenue and cost fronts in the coming years.

Increase in base oil prices and macro economic instability will drive costs up whilst

the entry of new players and the existing players such as Servo intensifying its

operations will hinder Chevrons ability to pass on these cost increases to the full

extent. Hence we expect current margins to be maintained in the short term whilst

experiencing marginal decreases in the medium to long term. However modest

declines in the gross margins will not hinder the company’s ability to generate

strong cash flows and maintain a strong return on invested capital given the

very limited needs for investments and low overhead costs.

Increase in overall cost of production driven by increase in base oil

prices

We expect cost of production to increase by 10-11% for the year 2008 recording an

increase of 20-21% over the second half as opposed to a decrease of 8% in the 1st

half, relative to 2007. This is due to base oil prices increasing by 45-50% in June,

relative to prices in December 2007. Chevron made a price revision effective from

June 2008 of 20%. This will enable Chevron to maintain its margins during the

current financial year.

Beyond 2008 we have factored in an increase of 20-27% in cost of production per

litre again mainly driven by base oil price increases. We expect base oil prices to

increase between 25-30% in rupee terms, with prices increasing by 20-25% in dollar

terms and a rupee depreciation of 5%.

Base oil prices settle after a series of price hikes

Base oil prices increased during the 1st half of 2008 in response to the rapid rise in

crude oil prices. Relative to prices recorded in December 2007 base oil prices are

now up by 45-50%.

We expect cost of

production to increase

by 20-21% in the

second half of 2008.

Increase in competition

will apply negative

pressure on both

margins as well as

volumes.

We believe Chevron’s

management to trade off

market share and volume

for margins, which

underpins its value.

Base oil prices

increased sharply with

rise in crude oil prices.

The recent declines in

Beyond 2008 we are

factoring in production

cost per litre to

increase by 20-27%.


JBS Research 3

The decline in crude oil prices over the past 4-5 weeks has helped to calm the base

oil markets, but these declines will not pass on to base oil since, despite the series of

price hikes made, many refiners are still faced with low margins. As reflected in the

following exhibit crude oil prices rose above the price of base oil during the first

quarter of 2008.

Exhibit 1- Movement of base and crude oil prices

0.2

0.25

0.3

0.35

0.4

0.45

0.5

0.55

0.6

0.65

0.7

0.4

0.5

0.6

0.7

0.8

0.9

1

1.1

1.2

1.3

1.4

Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul

US$/LitreUS$/Litre

Base oil

Crude oil

2006 2007 2008

Source: www.lubereport.com and JBS Research

The jury is still out on where crude oil prices could go but given the fundamental

problems of lack of growth in supply and the geo political risks surrounding many of

the oil producing nations, observers are of the view that the decrease recorded in the

recent past is only temporary and that crude oil could increase past the record high of

147.27$ per barrel posted in July. We have factored in a continuous increase in base

oil prices taking into consideration the uncertainty surrounding the direction of future

price changes.

Improvement in gross margins in 2007 and the 1st & 2nd quarter of 2008 was due to

Chevron acquiring base oil at lower price towards the end of the 3rd and 4th quarters

of 2007 as well as in January 2008. We estimate the average cost of a litre imported

during these periods to be approximately 2-3% lower relative to stocks purchased in

2006 and early 2007.

Exchange Rate Depreciation

Given that approximately 90% of the cost of production consists of imported

components the depreciation in the rupee will apply upward pressure on costs. We

have incorporated a 3% depreciation in the currency for the financial year 2008 and

expect it to increase to 5% in 2009 and beyond. Inflation levels, success on the battle

front and the emphasis on maintaining the competitiveness of exports will be key

factors driving the movement of the exchange rate.

We expect the rupee to

depreciate by 3% in

2008 and to depreciate

further by 5% in 2009

Given that the decline

in crude oil prices is

considered temporary

we could expect base

oil prices to increase

further in the future.

The recent declines in

crude oil prices

however, will not trickle

down to base oil.


JBS Research 4

http://www.lubereport.com/

Exhibit 2 – Exchange Rates and Forward Premiums

Forward Premium

Current 1 Month 2 Month 3 Month 6 Month

US$ 107.55 0.70 1.35 2.35 5.30

As at 08/08/2008

Source – JBS Research

As at May 2008 the rupee was overvalued by approximately 14-15%. Given the

current political scenario and the pressure to reduce inflation we believe that the

government will continue to intervene in the markets to ensure a certain degree of

stability in the rupee, at least for the next 3-6 months. However this would have to be

balanced out with the objective of maintaining the competitiveness of the country’s

exports as well. Hence we expect the government and the central bank to allow the

rupee to depreciate between by 2-3% during the year.

Exhibit 3 – Exchange Rates and Forward Premiums

Year Month REER Over/Under Valuation

2008

January 108.83 8.83%

February 111.69 11.69%

March 111.65 11.65%

April 112.49 12.49%

May 114.42 14.42%

Source – Central Bank of Sri Lanka

High inflation rates to continue

The rate of inflation has been rising since the later half of 2006, which is currently in

the range of 26-28%. Considering the expansionary budget of GOSL, the effect of

double digit inflation is expected to remain over the short to medium term.

Chevron will retain ability to pass on cost increases albiet at a slower

rate and maintain margins

The lubricant market is still highly concentrated with Chevron. We estimate their

market share to be between 82-86% at present. Strong market penetration and a well

oiled distribution channel enabled Chevron to pass on cost increases freely and

maintain strong gross margins historically. However the increasing competitive

intensity will limit Chevrons ability to pass on cost increases freely in the future.

Rupee overvalued by

14.4%, high inflation

and government

spending expected to

drive exchange rate

down

Increase in the

competitive intensity

will limit Chevron’s

ability to pass on cost

increase freely.

Inflation is rising due

to the expansionary

budget


JBS Research 5

Exhibit 4 – Increase in prices vs costs

2006 2007 To date

Price revisions made

Lanka Super DS 40 32.4% 10.4% 20.0%

Lanka Super Plus SAE 40 33.4% 10.1% 20.0%

Delo SAE 40 32.4% 6.0% 20.0%

Havoline SAE 40 32.4% 10.2% 20.0%

Increae in costs

Base oil prices 52.2% -1.4% 12.0%*

Overall cost of production 24.0% 9.6% -8.0%

* Change in average purchase price relative to December 2007


The entry of several new players and Servo increasing its distribution and marketing

activities coupled with slow industry growth could result in an erosion of market

share and also hinder Chevrons ability to completely pass on cost increases in the

future. However since we expect Chevron to continue to hold a large share in the

market, and given the effectiveness of its distribution channel, we strongly believe

that Chevron would be able to pass on cost increases to the extent needed to maintain

a high GP margin without an adverse impact on volumes. However modest decreases

in margins should be expected over the medium to long term as the competitive

intensity in the industry increases.

New players enter the market

Mac Lubricants, Gulf Oil, Sinopec, Total and Laughs received their licenses to

commence distribution and marketing of Lubricants in Sri Lanka in 2007 and all

players commenced operations during the first half of 2008.We believe Laughs to be

an aggressive player and would pose a greater threat to Chevron relative to the

incumbent players. The Ceylon Petroleum Corporation has also expressed its interest

in re-entering the lubricant market; their entry could pose a significant challenge to

Chevron (Refer ‘Understanding the Lubricant Industry’ report).

Servo commenced blending, Increased its Intensity in Operations

Servo commenced blending lubricants at its plant in Trincomalee in November 2007.

Further it has intensified its operations in the market by setting up 9 distributors

which currently account for approximately 1/3 of the volume sold whilst the balance

flows through LIOC sheds. Servo currently enjoys a market share between 7-8%.

The company has experienced a volume growth of approximately 20% relative to

last year.

Given that Chevron is

strongly entrenched in

the local market we

believe that the

company could pass

on a significant portion

of their cost increase

albeit at lower rate.

5 new players

commenced operations

in the first half or 2008.

We believe Laugfs to

be an aggressive

player. CPC also has

expressed its interest

in re-entering the

market.

LIOC has commenced

blending lubricant

locally and has also

take action to

strengthen its

distribution channel

and marketing efforts.


JBS Research 6

No change in the game plan of other players has been witnessed

We expect the other players such as Mobil and Shell to grow at a rate marginally

lower than the historical growth rates. We have not seen a major shift in their

strategy. Further given that their products target a cliental that is less sensitive to

increase in prices and inflation we do not believe that they will experience a larger

drop in volumes as well. Standing of each players in-terms of volumes and market

have been set out below.

Exhibit 5 – Market share and volumes of other players

2007 2003-2007

Player Volume Market share Growth

BP/Castrol 903,296 1.7% 17.7%

Shell 1,179,730 2.3% 18.6%

Mobil 1,031,039 2.0% 28.1%

Valvoline 515,789 1.0% 61.6%

Total 3,629,853 7.0% 24.2%

Source – JBS Research and Sri Lanka Customs

Shift in product mix towards high value and high margin products will

help to reduce pressure on margins

Chevron has taken action to shift customers away from low value products such as

Lanka Super Plus and Lanka Super DS towards high value items such as Delo and

Havoline. These products yield a higher value per litre, enabling Chevron to earn a

higher margin.

Further the company is also aggressively promoting speciality products such as

coolants to both the automotive segments and the industrial segment. Discussions

with management revealed that the thes products yeild a 4% higher margin than

conventional products. At present speciality products account for 10% of revenues

and the company hopes to increase this to 30% over the next 5 years.

Exhibit 6 – Shift to high value products

Diesel engine oils Petrol engine oils

Rs. per litre

328

445

Lanka Super DS SAE 40

Delo SAE 40

381

551

Lanka Super

Plus SAE 40

Havoline SAE 40


We have not witnessed

a significant change in

the game plan of the

incumbent players.

Change in sales mix

towards high value

products and speciality

products which

command high margins

would also facilitate

maintaining high

margins.


JBS Research 7

Industry growth will be low mainly driven by the slow growth in the

vehicle population

We expect industry volume growth to average between 1-2%, down from the

historical average of 5-6%. The key factor driving our lower expectation is the

slowdown in the expected demand from the autmobile segment of the market, whislt

we do not see a surge in demand coming from the industrial segment of the market

sufficient to offset this slowdown.

Demand for automobile lubricants will slowdown

The automobile segment of the market accounts for approximately 84-86% of the

total demand for lubricants. We believe the the following factors will negatively

impact the demand coming from the segment.

- Reduction in the number of services being performed

Rapid increase in fuel prices, increase in vehicle service costs, and general

inflation have driven up the costs of running a vehicle resulting in delaying of

the service intervals as well as reduced mileage.

- Slowdown in the growth in the vehicle population with current growth mainly

being driven by small engine vehicles

High tariffs and high interest rates prevailing in the country has resulted in

reduced demand for vehicles such as cars, motor lorries and buses. At present

the growth in the vehicle stock is primarily driven by motor cycles and three

wheelers.

- Ban on 2 stroke three wheeler imports

The Sri Lankan government imposed a ban on the importation of 2 stroke three

wheelers, effective from January 2008. Whilst the existing 2 stroke three

wheeler stock will be allowed to operate the government will also ban the

importation of spare parts from 2011 onwards. These actions collectively will

result in a decrease in the 2 stroke three wheeler population and the gradual

increase in 4 stroke three wheelers. Given that 4 stroke three wheelers consume

39% less lubricants relative to a 2 stroke engined three wheelers, we expect the

growth coming from this segment to slow down, and the abosolute consumption

levels to come down as well, in the long run. At present consumption from three

wheelers account for 7.4% of demand from the automobile segment.

We expect industry

growth to be in the

range of 1-2%.

Demand from the

automobile segment

will slowdown.


JBS Research 8

Industrial demand is assumed to be flat

We expect industrial demand which accounts for approximately 15-20% of the local

volume to also post marginal growth. Underlying this belief is the expected slow

growth/decline in thermal power generation which accounts for 35% of the lubricant

consumption in the industrial segment, whilst no major growth is expected from

other major industrial users. Although consumption from the forces increased by 13-

15% in 2007, a further increase in lubricant consumption from the defense forces

cannot be expected.

Heavy rain fall experienced during the 1st half of the year and the expected

commissioning of mini hydro power plants will reduce the growth in demand for

thermal power in 2008 and also 2009 provided that the current rainfall patterns

continue. We have factored in a growth rate of zero for thermal power generation for

2008 and 2009 and a marginal growth rate in the years beyond assuming that the

CEB would be able to commission new plants as planned. Delays in implementation

of many projects such as the Kerawalpitiya Combined Cycle Plant puts into question

the ability of the CEB to increase supply of electricity over the next 2-3 years.

However due to the prohibitive cost of operating diesel powered thermal power

plants, we cannot expect CEB to further increase the dependence on such plants.

Industrial demand will

also remain flat.

We do not expect the

installed base of diesel

based thermal power

generation to increase

given the sharp

increase in the cost of

diesel.


JBS Research 9

Investment Thesis

Business

Chevron will continue to generate strong returns on its capital and cash flows

Decrease in market share and decline in margins over the medium to long term will

not a have significant negative impact, and Chevron will continue to generate strong

returns on its capital. Our base case scenario indicates that the company could

generate a 49.5% return on invested capital (ROIC) on average for the next 5 years,

even in the face of declining margins and market share. This is higher than the

historical 5 year average RIOC of 46.3% due to the minimal need of capital to

support bottom line growth. Given the relatively low need for capital expenditure the

company will continue to generate strong cash flows to equity holders.

Chevron continues to retain its dominance

The key factors that differentiate Chevron in the industry, strong brand and

established distribution channel enable the company to maintain a strong presence in

the market. However we expect the company to lose market share albeit at a slower

pace.

Dominant position of Chevron will enable passing on cost increases

As explained before we expect cost of production to increase in the future driven by

increases in base oil prices. However given the strong market dominance of Chevron

and the nature of the product, we believe that the company will be able to pass on a

significant portion of the cost increases to the end consumer.

Our forecasted average gross margin (GP) and net margin (NP) for the next 5 years is

23.8% and 10.4%, which is lower than the historical 5 year average GP and NP

margins of 38.4% and 13.9% respectively in the base case scenario.

Valuation

Chevron’s fair value is Rs. 116 per share, target 12 month price is 122

Chevron is currently trading at PER of 6.1, whilst our fair value estimate points to a

justified PER of 6.4. Whilst a relatively slower growth profits could limit the

potential for large capital gains in the future, the high dividend payout rate

maintained by the company will enable investors to earn a relatively attractive total

return.

At the current price our fair value estimate offers a margin of safety of 1-2%. We

believe that estimates used by us to be fairly conservative and hence coupled with the

above margin of safety offers sufficient protection against deviations from the actual.

Chevron will continue

to generate strong

cash flow and high

returns on capital

despite the increase in

competition and rise in

costs.

Chevron will continue to

dominate the market, but

would lose market share

to a certain extent.

Chevron’s dominance

will enable the

company to pass on

bulk of the increases in

costs to the end

consumers.

Chevron has a fair

value of Rs. 116 per

share.


JBS Research 10

Risks

The major risks that should be considered are,

- The increase in the competitive intensity and changes in strategies adopted by

the exiting competition

- Possibility of further players entering the lubricant market

- Possibility of CPC not extending the lease on the land at Kolonnawa

Chevrons lubricant blending plant is located on a land belonging to the

Ceylon Petroleum Corporation(CPC). The lease agreement is expected to

end in July 2009. However it is not certain whether CPC would consider

extending the agreement since they are also considering entering the

lubricant market. It is too early to pass judgment on the issue. However in

the event an extension is not made Chevron’s management has stated that

they would be considering the following options

1. Blend their total demand abroad and import. If this option is pursued

the company would lose the tariff advantage it currently enjoys.

2. Relocation of the plant. The plant is fully owned by Chevron. Hence the

company could dismantle the plant, and move it to an alternate location.

However given that the plant has been up and running for more than 10

years, they will only move components that were recently installed

whilst purchasing components that have a limited future life.

There is a possibility of

Chevron loosing the

land on which the

blending plant is

located, which is under

lease from CPC.


JBS Research 11

Valuation Summary

Methodology

We use scenario based Free Cash Flow to Equity (FCFE) valuation model.

Dynamics of the lubricant industry necessitate a combination of multiple scenarios.

We have developed three scenarios.

Scenario 1; Base Case – Management focus on maintaining margins

whilst sacrificing market share

Scenario 2 – Base case with further players entering the market

Scenario 3 – Scenario 2 with additional players entering and increase in

capex

We have assigned probabilities to these scenarios depending on the likelihood of

their outcome.

Exhibit 7 – Summary performance

2005 2006 2007 F2008 F2009 F2010 F2011 F2012 F2013 F2014 F2015 F2016 F2017

EPS* 11.67 13.45 17.97 19.81 22.10 21.36 20.43 20.45 21.43 23.34 26.74 31.95 33.63

DPS* 9.75 9.50 12.50 16.00 33.00+ 17.00 15.00 14.00 15.00 17.00 20.00 22.00 22.00

NAV* 21.14 25.09 30.56 28.49 35.57 40.27 46.10 52.18 58.17 64.13 70.18 79.50 90.79

Current share price 111.25

P/E** 6.19 5.62 5.03 5.21 5.44 5.44 5.19 4.77 4.16 3.48 3.31

Dividend yield** 11.2% 14.4% 29.7% 15.3% 13.5% 12.6% 13.5% 15.3% 18.0% 19.8% 19.8%

P/B** 3.64 3.90 3.13 2.76 2.41 2.13 1.91 1.73 1.59 1.40 1.23

* Expected figure, weighted by probability of the realization of each scenario

** Based on closing price as at 4th September 2008

+ Special dividend from excess cash as at 30th June 2008 of Rs. 1,094,085,303


Exhibit 8 – Valuation of Chevron


Scenario 1 Scenario 2 Scenario 3

Value of equity during the explicit period 4,894,340,978 4,665,439,008 4,052,905,979

Value of equity during the continuing period 2,639,750,887 2,505,431,191 1,893,995,852

Value of equity 7,534,091,865 7,170,870,199 5,946,901,831

Number of shares outstanding 60,000,000 60,000,000 60,000,000

Per share 126 120 99

Probability 50% 20% 30%

Weighted price of Chevron 62.78 23.90 29.73

Weighted average price of Chevron 116


JBS Research 12

1st 5 years 2nd 5 years

Base oil cost 65.9% 26.8% 18.0%

Other direct material and overheads 34.1% 18.2% 12.8%

AverageComponent

Share of

production cost

Valuation Methodology in Detail

Principle Assumptions

The following basic assumptions will be kept unchanged in all three alternative

scenarios.

We have assumed total induatry demand to grow at an average rate of 1% and

3.4% for the 1st and 2nd 5 years respectively. This is lower than the historcial

CAGR of 5.7%, due to our expectation of slower industry growth.

A blending plant may operate at an optimal utilisation of 95% of its total capacity.

The volume produced in excess of the optimal utilisation will be produced in

extended work shifts.

We have incorporated the following increases in costs when forecasting cash

flows.

Exhibit 9 – Assumed increase in cost of production


Historical trend will continue.

Existing working capital policies will continue.

Deferred tax liability balance is assumed to remain constant.

Conforming to its past practice Chevron will continue to pay a dividend equal to it

FCFE.

Probabilities

Scenario 1: 50%

Scenario 2: 20%

Scenario 3: 30%

Industry growth is expected

to be slower than the

historical rate.

The optimal utilisation of a

blending plant is 95%

A future CAGR of 26.8% in

base oil prices have been

factored in.

Probabilities

Capital Structure

Working Capital

Deferred Tax

Dividend


JBS Research 13

Scenario Analysis

Scenario 01; Base Case – Management focus on maintaining margins

whilst sacrificing market share

This scenario is based on the assumption that the management will focus on

maintaining a sufficiently high margin and the resulting increase in prices will drive

their market share down. Based on the discussion we had with the management we

strongly believe that the company will pursue this objective.

The key assumptions underlying this scenario have been set out below.

Exhibit 10 – Key assumptions

F2008 F2009 F2010 F2011 F2012 F2013 F2014 F2015 F2016 F2017

Growth in prices 20.0% 19.5% 19.5% 19.5% 19.5% 19.0% 18.0% 17.0% 15.0% 13.0%

Growth in volumes -8.2% -3.4% -3.6% -4.9% -5.7% -6.6% -6.7% -6.3% -1.0% -0.2%

Gross margin 26.6% 26.6% 24.2% 21.6% 20.1% 19.4% 19.2% 19.7% 20.1% 19.2%

Net profit margin 12.4% 12.0% 10.4% 8.8% 7.7% 7.3% 7.1% 7.4% 7.7% 7.2%

ROIC 58.3% 58.2% 50.6% 41.6% 36.2% 33.5% 32.7% 33.8% 36.0% 33.7%

Market share 80.9% 77.4% 73.5% 68.8% 63.6% 58.3% 53.1% 48.3% 45.7% 43.5%


As set out above under this scenario we expect Chevron to maintain an average GP

margin of 23.8% in the first five years and 19.1% in the second 5 years. This is lower

than the historical GP margin of 28.1% .The reduction is mainly due to the rapid

increase in cost of production and the limited ability to pass on the cost increases as

competitors strengthen their position in the market. Maintaining the margins at above

levels would enable the company to maintain a high return on capital and strong cash

flows as well.

The key financial line items have been set out in the following table.

We strongly believe that

the management would

focus on maintaining a

higher margin whilst

sacrificing market share.


JBS Research 14

Exhibit 11 – Key financial line items

F2008 F2009 F2010 F2011 F2012 F2013 F2014 F2015 F2016 F2017

Income statement

Revenue 9,583 11,109 12,858 14,703 16,713 18,789 20,976 23,389 26,996 30,925

Gross profit 2,552 2,953 3,107 3,174 3,353 3,638 4,032 4,602 5,427 5,924

Operating profit 1,775 2,030 2,045 1,961 1,973 2,081 2,286 2,647 3,190 3,396

Net profit 1,188 1,330 1,341 1,287 1,295 1,366 1,499 1,734 2,087 2,221

Balance Sheet

Fixed assets 508 536 587 656 731 819 927 1,073 1,198 1,218

Working capital 1,641 1,923 2,299 2,718 3,152 3,576 4,001 4,438 5,093 5,898

Share holders equity 1,719 1,982 2,337 2,736 3,152 3,562 3,976 4,405 5,041 5,817

Liabilities 308 354 426 516 608 710 828 983 1,127 1,176

Cashflow statement

Gross CFO 1,261 1,428 1,440 1,388 1,401 1,477 1,617 1,861 2,224 2,360

Change in working cap 218 -250 -335 -374 -386 -377 -377 -388 -592 -727

Capex -75 -115 -138 -156 -163 -178 -201 -242 -225 -124

FCF from operations 1,404 1,062 967 859 852 922 1,040 1,231 1,407 1,509

Financing cash flow -28 5 19 29 27 33 45 74 43 -64

FCF to equity 1,377 1,067 986 888 879 955 1,085 1,305 1,450 1,445


The realization of this scenario will put the fair value of Chevron at Rs. 126 and the

target value at Rs. 131.

Scenario 02; Base case scenario with further liberalization of the

market

This scenario asses the impact a further liberalization of the market would have on

the cash flows and the value of Chevron. Hence the key difference between the base

case and this scenario is a lower market share for Chevron over time.



F2008 F2009 F2010 F2011 F2012 F2013 F2014 F2015 F2016 F2017

Growth in prices 20.0% 19.5% 19.5% 19.5% 19.5% 19.0% 18.0% 17.0% 15.0% 13.0%

Growth in volumes -7.7% -3.8% -3.3% -4.5% -5.2% -5.8% -5.7% -5.1% 0.0% 0.9%

Gross margin 31.4% 26.6% 24.1% 21.6% 20.0% 19.3% 19.2% 19.7% 20.1% 19.1%


ROIC 58.3% 57.8% 50.4% 41.3% 35.9% 33.2% 32.4% 33.4% 35.6% 33.2%

Market share 80.9% 76.7% 72.8% 68.0% 62.6% 57.2% 51.8% 46.9% 44.2% 41.8%


The average market share maintained by Chevron for the 10 years we have

considered decreased from 65.3% in the base case scenario to 60.1% in this scenario

due to our assumption of additional players entering the market. We have assumed

new entrants to commence operations in 2009, and despite the increase in

Scenario 2 assesses the

impact of a further

decrease in market

share, due to further

liberalization.


JBS Research 15

competition for the management of Chevron to continue to focus on maintaining

margins at high levels.



F2008 F2009 F2010 F2011 F2012 F2013 F2014 F2015 F2016 F2017

Income statement

Revenue 9,583 11,020 12,734 14,529 16,466 18,455 20,531 22,796 26,212 29,896

Gross profit 2,552 2,928 3,075 3,134 3,300 3,569 3,941 4,480 5,262 5,719


Net profit 1,188 1,317 1,325 1,267 1,270 1,333 1,457 1,676 2,009 2,126

Balance Sheet

Fixed assets 507 535 585 652 725 811 914 1,054 1,173 1,193

Working capital 1,641 1,908 2,277 2,687 3,107 3,514 3,918 4,328 4,949 5,706


Liabilities 299 352 423 510 600 697 810 958 1,094 1,140

Cashflow statement

Gross CFO 1,260 1,415 1,423 1,368 1,376 1,445 1,574 1,803 2,145 2,265


Capex -74 -115 -137 -154 -161 -176 -196 -237 -219 -124

FCF from operations 1,404 1,064 958 849 841 908 1,020 1,203 1,366 1,457


FCF to equity 1,369 1,075 976 877 867 938 1,062 1,273 1,405 1,395




Scenario 03 – Scenario 2 with increase in capital expenditure and the

entry CPC to the market

This scenario builds up on scenario 2 with the following additional assumptions,

1. The lease on the land on which the plant is located not being extended (See

‘Investment thesis, Risk’ above) and Chevron relocating its plant.

2. The entry of CPC



F2008 F2009 F2010 F2011 F2012 F2013 F2014 F2015 F2016 F2017

Growth in prices 20.0% 19.5% 19.5% 19.5% 19.5% 19.0% 18.0% 17.0% 15.0% 13.0%

Growth in volumes -7.7% -2.9% -8.9% -5.7% -6.8% -7.6% -7.9% -7.7% -2.4% -1.8%

Gross margin 31.4% 26.6% 24.1% 21.5% 19.9% 19.2% 19.1% 19.5% 19.9% 18.9%


ROIC 58.3% 51.7% 37.6% 33.2% 30.0% 28.5% 28.2% 29.4% 31.6% 29.4%

Market share 80.9% 77.5% 69.0% 63.5% 57.4% 51.3% 45.2% 39.6% 36.2% 33.0%


Impact of increased capex

and further decrease in

market share has been

considered.


JBS Research 16

We have assumed that CPC would enter the market in 2010, and as stated in the

lubricant industry report, would be able to capture a volume of 3-4 million litres

upon entry. We have further assumed that the plant relocation would cost between

Rs. 600-700 million, to be incurred in 2009.



F2008 F2009 F2010 F2011 F2012 F2013 F2014 F2015 F2016 F2017

Income statement

Revenue 9,583 11,123 12,111 13,642 15,194 16,715 18,170 19,619 22,011 24,436

Gross profit 2,552 2,957 2,914 2,929 3,028 3,212 3,462 3,823 4,380 4,630


Net profit 1,188 1,325 1,153 1,097 1,085 1,122 1,198 1,341 1,572 1,607

Balance Sheet

Fixed assets 508 1,085 1,002 962 949 960 996 1,071 1,131 1,131

Working capital 1,641 1,926 2,185 2,540 2,883 3,199 3,486 3,746 4,180 4,692


Liabilities 301 345 404 480 555 632 715 824 917 948

Cashflow statement

Gross CFO 1,260 1,422 1,379 1,295 1,265 1,289 1,358 1,497 1,729 1,761


Capex -75 -664 -132 -146 -150 -160 -174 -206 -187 -124

FCF from operations 1,403 505 1,021 834 812 852 935 1,066 1,155 1,179


FCF to equity 1,369 508 1,036 857 830 871 960 1,113 1,172 1,127





JBS Research 17

Appendix - 01

Top 10 Shareholders 22nd August 2008 Number of

Shares %

1 Chevron Ceylon Limited 30,600,000 51.0%

2 HSBC International Nominees Ltd - BPSS - LUX - Aberdeen Global -

Asian Smaller Fund 3,559,600 5.9%

3 Sri Lanka Insurance Ltd - Life Fund 3,546,300 5.9%

4 Stone, R.A. 1,870,000 3.1%

5 HSBC International Nominees Ltd - Aberdeen Asia Smaller companies

investment Trust XCB9 1,790,400 3.0%

6 Cargo Boat Development Company Limited 1,020,000 1.7%

7 The Gilpin Fund Limited 800,000 1.3%

8 Kamon, K.R. 731,500 1.2%

9 Renuka Hotels Limited 714,700 1.2%

10 Employee Trust Fund Board 660,000 1.1%

Total 45,292,500 75.5%

Parent Company (Chevron Ceylon Limited) Holding 30,600,000 51.0%

Free Float 29,400,000 49.0%

Issued Share Capital at Rs. 10 60,000,000 100%


JBS Research 18

Glossary & Abbreviations

1. Free Cash Flow to Equity (FCFE) - This is a measure of how much cash can be paid to the equity

shareholders of the company after all expenses, reinvestment and debt repayment.

Calculated as: FCFE = Net Income - Net Capital Expenditure - Change in Net Working Capital + New

Debt - Debt Repayment

2. Cost of Equity (Ke) - A firm's cost of equity represents the compensation that the market demands in

exchange for owning the asset and bearing the risk of ownership.

3. Net Operating Profit Less Adjusted Taxes (NOPLAT) - Total operating profits for a firm with

adjustments made for taxes.

4. Invested Capital – Capital/assets employed by a firm to run its operations

5. Return on Invested Capital (ROIC) - A calculation used to assess a company's potential to be a quality

investment by determining how well (i.e.. profitably) a company's management is able to allocate capital

into its operations. Comparing a company's ROIC with its cost of capital (WACC) reveals whether invested

capital was used effectively.

6. Earnings before Inters, Taxes, Depreciation & Amortisation (EBITDA) - EBITDA can be used to

analyze and compare profitability between companies and industries because it eliminates the effects of

financing and accounting decisions.

7. Maintenance CAPEX - Capital expenditure incurred to maintain the existing asset base.

8. Incremental CAPEX - Capital expenditure incurred in growth oriented activities.

9. CAPEX - Capital Expenditure

10. GP Margin - Gross Profit Margin

11. GOSL - Government of Sri Lanka

12. CEYPETCO- Ceylon Petroleum Corporation

13. Chevron - Chevron Lubricants Lanka Limited

14. Lanka IOC - Lanka IOC Limited

15. Mobil - Mc Larens Lubricant Limited

16. BP/Castrol - Associated Motorways Limited

17. Shell - N. M. Distributors (Pvt) Limited

18. Valvoline - United Motors Limited

19. H/ Avg - Historical Average


JBS Research 19

20. F’cast - Forecast

21. ASPI - All Share Price Index

22. CODO - Company Owned Dealer Operated

23. DODO - Dealer Owned Deal Operated

24. Net Debt - Debt minus Cash

25. NAV - Net Asset Value ,i.e., Equity divided by number of shares outstanding

26. REER - Real Effective Exchange Rate


JBS Research 20

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