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This article first appeared in The Edge Financial Daily on April 25, 2018

British American Tobacco (Malaysia) Bhd
(April 24, RM24)
Upgrade to buy with a target price of  (TP) RM34.72:
We believe British American Tobacco (Malaysia) Bhd (BAT) shares are undervalued at current levels, therefore upgrading our call from “hold” to “buy” with an unchanged TP of RM34.72 per share. Reasons for the upgrade are BAT shares are trading at a steep discount to a three-year historical trailing price-earnings ratio (PER) of 23 times and attractive dividend yield of more than 6%.

BAT’s share price has declined by 37.9% year to date (YTD), mainly due to: i) negative sentiment about the stock as the illicit cigarette market share continues to increase; and ii) earnings decline in financial year 2017 (FY17) by 28.4% year-on-year (y-o-y) to RM512.1 million. Currently, the illicit cigarette market share is standing at 58.3% (+5.6 percentage points [ppts] y-o-y).

In the face of the growing threat of illicit cigarettes, BAT has strategically maintained its leading market share within the tobacco domestic market over the past two years. Initiatives include: 1) restructuring of operations by closing down its manufacturing facilities and starting to import products from its sister company; 2) introduction of Rothmans brand to cater to the growing value-for-money segment; and 3) effective cost management across the organisation. In FY17, BAT’s market share within the legal domestic market increased by 1.4% y-o-y to 54.6%.  

As of last Friday, BAT’s share price closed at RM24.86 per share with a trailing PER of 14 times based on FY17 earnings per share. Note that the last time the counter reached this level was in the fourth quarter (4Q) of 1999, where the trailing PER was 32 times by then. Moreover, we find that the current share price is at a large discount to the historical three-year trailing PER mean of 23 times.

As such, we strongly believe the market has priced in all the relevant noises in the industry and the company, including: a) the growing illicit trade; b) dropped out of FBM KLCI; c) continuous selling pressure from institutional investors; and d) reducing earnings margins from change in portfolio mix. In fact, we believe the market has overplayed the risk factors and could possibility miss out BAT’s ability to maintain 80% dividend policy remains intact, and that the company is expected to benefit from the ringgit strengthening.

BAT has a dividend policy of 80% but the group’s dividend payout was at an average of 102% in the past three financial years. We believe the company is able to maintain the dividend policy as the corporate restructuring, that is plant shutdown and worker lay-off, has provided the group with much flexibility and agility. Prudently, we project BAT to declare a dividend payout of 94% (160 sen per share) in FY18 which translates into a dividend yield of 6.1%. This is attractive at 2.1ppts higher than 10-year Malaysian government bond.  

Besides its ability to maintain its dividend policy, we believe BAT would benefit from the ringgit strengthening given that products are now fully imported from Indonesia and Singapore. For 1QFY18, we project BAT to report quarterly profit of RM100 million to RM130 million, representing a y-o-y growth of 10%. This would be underpinned by higher revenue of an estimated RM900 million stemming from the ringgit strengthening, growing market share within the aspiring premium and value-for-money segments. We make no change in earnings forecasts.

Overall, we believe the risk-return trade-off is favourable to investors after the share price corrected by 37.9% YTD. As such, we upgrade our call from “hold” to “buy” with unchanged target price of RM34.72 per share based on discounted cash flow valuation (weighted average cost of capital: 6.7%; g: 2%). This implies a three-year forward PER average of 17 times to reflect 80% dividend policy, attractive dividend yield, and main beneficiary from strengthening in the ringgit against the US dollar. — TA Securities Research, April 23

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