Investment Highlights

• We think the selldown related to perceived negative prospects such as heat-not-burn products, a potential excise duty hike and the FBM KLCI exclusion on British American Tobacco (M) (BAT) is overdone. We maintain our FV of RM36.70/share (WACC: 7.2% terminal growth: - 1.0%) but upgrade our recommendation to BUY from SELL.

• BAT’s share price has slumped some 17% since it was determined it was to be excluded from the FBM KLCI in late November. Valuations are trading at a multi-year low. It is currently trading at a forward P/E of 15.4x, well below its -2SD of 17.6x (Exhibit 4). At these levels, the rewardto-risk appears attractive, especially when valuations eventually mean-revert. Apart from that, we like BAT’s more adaptable business model and capped downside risks.

• Heat-not-burn (HNB) tobacco devices appear to be catching on globally. The established tobacco companies, Philip Morris International (PMI), Britisth American Tobacco (BAT UK) and Japan Tobacco International (JTI) have come out their own versions of HNB products. However, it appears PMI has emerged at the forefront with its sleek iQOS device. This is reflected with iQOS’ refills which take up 11.9% market share of Japan’s tobacco market in 3Q17. However, we think regulatory hurdles, affordability and close substitution to conventional cigarettes may prove to be a deterrent to iQOS pickup rates.

• As of Aug 2017, the illicit market share stood at 56.1% of all cigarettes consumed in Malaysia, marginally lower at the all-time high of 58.9% (Exhibit 3). Proliferation of illicits previously trended around 30% to 40% prior to the excise duty hike in Nov 2015. Given the elevated saturation levels of illicits, we think there is little downside to earnings stemming from further proliferation of illicits.

• Malaysia’s longest absence of an excise duty hike was for 3 years, between 2010 and 2013 (Exhibit 2). We are approaching the 3-year period come Nov 2018. Therefore, we think there is a likelihood of an excise duty hike. But given that the amount of illicit cigarettes remain elevated, we are of the opinion a possible hike would not be excessive as it was back in Nov 2015.

• While regulatory risk in the form of excise duties hike is perceived negatively, it was only the more recent excise duty hike, which was excessive, dented earnings significantly (Exhibit 2). In fact, in the previous years preceding 2015, a reasonable excise duty hike resulted in higher earnings for BAT. This is attributed to cigarette consumption patterns typically exhibiting inelastic demand.

Source: AmInvest Research - 9 Feb 2018