British American Tobacco (M) Bhd
(Dec 29, RM42.78)
Reiterate hold at RM42.30, target price at RM42.50: The health ministry has set a minimum price of cigarettes at 32 sen per stick effective Jan 1, 2010 which will make the lowest legal price for a pack of 20s at RM6.40. The regulation also forbids retail price discounting and allows for tobacco manufacturers to adjust prices at a maximum of three times per year, at 5% or less.

Extremely low-priced cigarettes (ELPC) would be wiped out by the ruling, which in turn is a strong positive for BAT. The company’s cheapest value pack of 20s is already being sold at RM7.80, as such no price adjustment would be necessary in response to the floor price.

The ruling would reduce competition from ELPC, particularly in BAT’s value segment. Pall Mall, which is BAT’s leading value brand, saw a 0.6% decrease in retail audit market share in 9MFY09.

However, the minimum pricing does not help with illicit trade. The illicit segment accounts for 38.7% of all cigarettes sold in the country and presents the biggest threat to the “Big 3” tobacco players.

We expect BAT’s sales volume to contract by 10% in FY09 to 9.4 billion sticks resulting in a 1% decline in FY09 net profit to RM804.5 million.

The implementation of Afta (Asean Free Trade Area) is an added threat in 2010 that is likely to see an influx of cheaper imports. Moreover, BAT does not expect to benefit from cheaper leaf costs as it continues to support the local tobacco farming industry.

FY09 dividend yield of 6% is expected based on forecast net dividend per share (DPS) of RM2.53.

We reiterate hold recommendation with a target price of RM42.50 based on discounted cash flow (DCF) valuation with weighted average cost of capital of 6.3% and terminal growth rate of 2% (with risk-free rate of 3.9%, equity risk premium of 2.5% and beta of 0.4).

We expect a fairly weak 4QFY09 as trade loading activities in October are offset by lower sales volumes and a one-off VSS cost. — Kenanga Research, Dec 28

This article appeared in The Edge Financial Daily, December 30, 2009.