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This article first appeared in The Edge Financial Daily on July 17, 2018

British American Tobacco (Malaysia) Bhd
(July 16, RM33.10)
Maintain add with a target price of RM38.66:
Since the reformist Pakatan Harapan (Pakatan) coalition took over Malaysia’s federal government in May 2018, the optimism for British American Tobacco (BAT)’s earnings recovery has propelled the stock by 45.7% from its 11-year low of RM22.23. Even with the post-election jolt, BAT’s 1-year forward price earnings (P/E) of 15.9 times is still below its five-year forward mean P/E of 19.2 times, and modest compared with other consumer stocks’ weighted average financial year ending Dec 31, 2019 forecasted (CY19F) P/E of 33 times.

According to media reports, the illicit cigarette trade has been costing the government around RM4 billion per annum in revenue. That is equivalent to around 11 billion cigarette sticks, or around RM8.5 billion in legal cigarettes’ market value. Given Pakatan’s pledge to eliminate corruption and restructure the public finances, we believe it will be aggressive in narrowing the illegal market’s share. BAT stands to benefit from this, as 58-63% cigarettes sold come from the black market. In the legal market, BAT is the leader with a 54.7% share as at 1QFY18.

We conducted a sensitivity analysis to calculate how much potential growth BAT can achieve if the illicit market contracts in FY18F. We found that every 1% point drop in illicit tobacco market share would translate into a 2.7% point increase in BAT’s FY18F net profit growth, or an earnings per share (EPS) increase of 4.8 sen. Our FY18F net profit estimate of RM556.6 million assumes a reduction of 3-4% points in the illicit market, which we believe is achievable in one calendar year. However, Rothmans’ nascent growth could hurt its FY18F margins.

Internally, BAT is diversifying its product portfolio to regrow its sales. Rothmans was launched in October 2017 under the value-for-money (VFM) segment, and in the span of six months made up nearly half of VFM cigarette sales, in our estimates. Although a margin-dilutive product, Rothmans can thrive on the volume game by attracting consumers of illicit tobacco. BAT has also been mulling to introduce tobacco heating products in the local market, should it receive the government’s approval.

We maintain our “add” call on BAT and retain our earnings forecasts, pending the group’s 2QFY18 results’ release on July 19, 2018. BAT’s CY19F P/E of 15.9 times has room to play catch-up with other consumer stocks, which are trading at an average 33x P/E. Plus, BAT comes with attractive dividend yields of 5.9-7.1% for FY18F-FY20F. — CGSCIMB Research, July 13

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