This article first appeared in The Edge Financial Daily on January 16, 2020
British American Tobacco (Malaysia) Bhd
(Jan 15, RM14.86)
Downgrade to sell with a lower target price of RM11.90: Amid our projection of persistent earnings erosion, we have increased our discount rate for British American Tobacco (Malaysia) Bhd (BAT) to 9.8% from 7.1%. As earnings growth is usually the key to an investor’s stock selection, we think few investors would have the appetite for BAT at this junction, thus providing little support to the share price.
Among the stocks under our consumer sector coverage, BAT represents the key laggard for 2019 with its share price being slashed by more than half (fell 58.2% in 2019; down 0.1% year to date). The sharp decline has resulted in a high financial year ending Dec 31, 2020 (FY20) prevailing dividend yield of 6.5% alongside market talk about it being a potential candidate for privatisation. However, in our opinion, it is neither a good dividend bet nor a privatisation candidate at any price above RM15 per share.
We believe privatisation may happen in the future but not at any price above RM15 per share. This is due to lack of incentives for its holding company to take BAT private.
Essentially, we believe privatisation of public companies is more likely to occur when companies are pursuing new goals, which require substantial market repositioning; the industry is growing; or companies’ assets are being heavily undervalued by the public. In the case of BAT, we do not see it as a strong fit to the aforementioned conditions for privatisation.
Firstly, we do not think that BAT has an aggressive goal repositioning in its cards as its current resources are expected to be utilised for defending its existing cigarette portfolio and developing its newly-launched tobacco heating product — Glo.
Secondly, the legal cigarette market is expected to remain challenging where legal cigarettes only represent a quarter of the total Malaysian market now. The level of illicit cigarettes has increased to a record level of 65% for the third quarter of FY19, while vapes make up 9%.
Moreover, plans for further internal reorganisation by BAT (about 20% of its workforce) and JT International Bhd (JTI Malaysia) (about 40% of its workforce) indicate that both managements acknowledge their industry is challenging and may continue to shrink.
In terms of valuation, BAT is trading at 15.3 times FY20 earnings per share and price-to-book ratio of 14.9 times, which is not excessively cheap in our opinion. Recall that JTI Malaysia was mostly trading at single digits or low teens price-earnings ratio (PER) valuation for a prolonged period prior to its privatisation decision.
The initial privatisation offer was RM7.80 per share (March 2014), which was subsequently revised to RM8.20 per share (May 2014), implying a forward PER. — TA Securities, Jan 15