This article first appeared in The Edge Malaysia Weekly on November 6, 2017 - November 12, 2017

BRITISH American Tobacco (M) Bhd’s (BAT) share price has been declining since the stock peaked at RM63.54 apiece on Dec 1, 2014. The question is, how much further will it drop.

A look at the tobacco company’s share price performance indicates that it has been through a rough year. Just last week, the counter shed 6.9% to close at RM37.70 on Nov 2, from RM40.50 on Oct 30. At RM37.70 apiece, it marked a five-year low for the counter, which is almost 70% off its peak price.

A look at BAT’s financial performance for its nine months ended Sept 30, 2017 (9MFY2017), does not paint a rosy picture.

For 9MFY2017, BAT reported a net profit of RM401.5 million, compared with RM432.95 million in the previous corresponding period — a year-on-year decline of 7.3%.

Earnings came in below consensus estimates, accounting for 67.3% of full-year forecasts, says Hong Leong Investment Bank Research analyst Sheikh Abdullah in an Oct 23 report.

“We cut our FY2017 to FY2019 forecasts by 5% to take into account a lower volume assumption and higher operating expenditure assumptions in anticipation of higher investments in its new brand, Rothmans.

“Despite showing signs of improvement, the market share of illicit cigarettes remains high at 56%, thus reinforcing our negative outlook for the sector,” he says.

While high excise duties and illicit cigarettes are the main contributors to BAT’s decline, the possibility of the stock being excluded from the benchmark FTSE Bursa Malaysia KLCI index coincides with the plunging share price.

On Oct 26, CIMB Investment Bank analyst Ivy Ng Lee Fang noted that the demerger of Sime Darby Bhd into Sime Darby Plantation Bhd and Sime Darby Property Bhd would alter the make-up of the 30-stock FBM KLCI.

“Our current break-up market valuations for Sime Darby are: (i) RM44.7 billion for Sime Darby Plantation; (ii) RM13 billion for Sime Darby Property; and (iii) RM10.4 billion for Sime Darby (post-demerger).

“Assuming these entities trade in line with our break-up value estimates upon listing, and applying the ground rules, Sime Darby Plantation and Sime Darby Property may be added into the FBM KLCI, and BAT or IJM Corp as well as Sime Darby could be deleted,” says Ng in the report.

This report was followed by an Oct 31 note by Phillip Wong of AmResearch, who says: “Apart from the potential capital market impact on BAT, we think perpetual regulatory hurdles and disruptive substitute tobacco products do not justify its lofty valuations (forward price-earnings ratio [PER] of 19.8 times versus a historical average of 17.7 times).”

At last Thursday’s closing price of RM37.70, BAT’s market capitalisation amounted to RM10.76 billion, making it the smallest stock by market capitalisation on the KLCI.

Meanwhile, BAT’s dividends, one of the main selling points for the stock, have been declining on a per share basis since FY2016 as net profit shrinks. Nevertheless, based on its present share price of RM37.70, dividend yield stands at 5.39% — still a handsome return compared with other stocks on the exchange. It should also be noted that the company has been consistent in its dividend payout ratio over the last few years, paying out more than 95% of earnings.

However, the pertinent question now is whether the dividends can be maintained considering the myriad challenges the tobacco industry faces — from illegal cigarettes to high excise duties.

When contacted, a BAT spokesperson tells The Edge that the company is committed to paying dividends above 90% of earnings.

To recap, in March last year, BAT announced that it was closing down its manufacturing operations in Malaysia and sourcing its tobacco products for the local market from other manufacturing facilities in the region.

“The restructuring is in line with the group’s efforts to realise a new and more sustainable business model, amid an increasingly challenging business environment,” it says in its 2016 annual report.

The land and building in Petaling Jaya was sold in November last year, with the proceeds from the sale going back to shareholders in the form of a special dividend at 46 sen per share in FY2016.

As at June 30, the company has successfully transitioned to importing its tobacco products and ceased domestic production of cigarettes.

The shift to fully importing its tobacco products seems to have paid off. Gross margins for its third quarter ended Sept 30, 2017 (3QFY2017), improved to 36.5% from 34.7% a year earlier.

BAT recently entered the value-for-money (VFM) segment with its new product, Rothmans. The price of the cigarettes, which retail at RM12 per pack, is below its Peter Stuyvesant and Pall Mall (RM15.50 each) brands and its premium brand, Dunhill (RM17 per pack).

Analysts are generally positive on BAT’s move into the VFM segment as it is the fastest-growing product segment.

“This allows BAT to compete with its peers in this segment, especially to capture customers with lower affordability and narrow the pricing difference between its products versus illicit cigarettes,” says a CIMB Research report.

Although the move to the VFM segment has been touted as necessary, some analysts say it could result in the cannibalisation of its premium Dunhill brand and consequently, the dilution of revenue growth and margins.

“We believe this will drag down its overall margins, given that VFM products have lower margins versus products in other segments. On top of that, we believe that this will also lead to the cannibalisation of market share of its higher margin product segments,” says CIMB Research.

For 3QFY2017, BAT’s net profit fell 32.7% to RM143.18 million from a year ago, while revenue shrank 18.8% to RM757.28 million. The weakness comes on the back of lower sales volume, higher operating cost from the expenses of a new product range and an elevated level of illegal cigarettes in the market.

As at August, BAT reported that illegal cigarettes stood at 56.1% of the market, a slight decline from 58.9% in April.

Nevertheless, BAT’s market share declined to 53.9% in 3QFY2017 from 54.5% in the second quarter. It is worth noting that BAT’s sales volume declined 1.7% quarter on quarter, even though the broader market grew 3%, highlights AmInvestment Research.

That said, many analysts believe that the proliferation of illegal cigarettes and the tight regulatory controls on the tobacco industry will continue to weigh down the company.

There are five “buy”, 10 “hold” and four “sell” calls on BAT, according to Bloomberg data, with an average target price of RM43.42. BAT is trading at a PER of 15.35 times.

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