Tobacco sector
Maintain “neutral”: We maintain a “neutral” stance on the tobacco sub-sector due to a lack of positive catalysts, the challenging operating environment, and the ever present regulatory risks.

Following British American Tobacco (M) Bhd’s (BAT) 14% share-price drop since September 2014 when we downgraded the stock, its 2014 to 2016 dividend yield has increased to 5%.

We see limited downside on BAT, and hence, have a “hold” call on the stock with a RM63.40 target price (TP).

BAT announced that the market share of illicit cigarettes had fallen to 35.8% from the March to May 2014 period compared with 38.9% recorded from October to December 2013.

While the decline is positive news for the tobacco industry, it was the result of an aggressive government clampdown on the illegal cigarette market.

Lacking in visible follow through action from the government, we are doubtful that this reduction in illicit market share is sustainable, and hence retain a cautious view on the sector.

The recent floods in the East Coast of Peninsular Malaysia were particularly bad in comparison to previous years.

We had been concerned that this could pressure cigarette sales as distribution to the areas has been hampered.

Based on a recent media estimate that 150,000 people were affected, we are less worried because this represents only 0.5% of Malaysia’s population, and the floods are beginning to recede. Also, we believe that once life returns to normal there, dealers will restock.

With the weaker consumer spending environment and the impending goods and sales tax implementation, which could potentially raise cigarette prices further, we think that the tobacco industry’s sales volume will continue to see pressure.

Based on our recently updated recommendation definitions, we now have a “neutral” stance (“underweight”, under previous definitions) on the tobacco sub-sector and a “hold” rating (“reduce” previously) on BAT with an unchanged 12-month dividend discount model-derived TP of RM63.40.

While we do not see any signs of improvement in the tobacco industry over the next few years, given the lack of positive catalysts, we do not expect BAT’s share price to trend down any further as its dividend yield of 5% may provide some support.

Key risks to our view include stronger-than-expected sales volume growth, a successful curb in illegal cigarettes which would result in a shift back to the legitimate market trade and lower-than-expected operating expenses. — Affin Hwang Investment Bank Bhd, Jan 7.

This article first appeared in The Edge Financial Daily, on January 8, 2015.