- We reaffirm our HOLD recommendation on British American Tobacco (M) (BAT) with an unchanged DCF-based fair value of RM66.30/share.

- The press reported that BAT will raise the prices of all its cigarette brands by RM1.00/pack of 20s effective today. This translates into a hike of 8.3%-9.5%.

- Management said that it needed to raise prices to counter rising operating expenses (i.e. higher production and distribution costs), which resulted from inflationary pressures.

- Following this, the retail selling prices (RSP) of its premium brands (which includes its flagship brand, Dunhill) will be RM13.00/pack of 20s while its aspirational premium (VFM) brands, namely Pall Mall and Peter Stuyvesant, will be sold at RM11.50/pack.

- Based on previous price adjustments, we believe that the other manufacturers JT International (JTI) and Philip Morris International (PMI) will follow suit.

- We are surprised by this announcement as we had not anticipated another steep rise in cigarette prices this year. Recall that the RSP of cigarettes was raised by RM1.50/pack of 20s (+14% to +17%) in October last year in response to the government’s 14% (or 3sen/stick) hike in excise duty to 25sen/stick.

- We note that a rise in RSP is detrimental to the legitimate industry volume growth as it will only spur the sales of illicit sticks, specifically the illicit whites (FY13: 35.7%) and exacerbate the proliferation of cigarettes sold below the minimum price of RM7.00/pack.

- That said, we opine that the legitimate industry had been fairly resilient as the total legal industry’s 1H14 volumes had contracted by only 7.6% YoY as opposed to expectations of a double-digit decline. BAT had performed better vis-à-vis the industry, with its 1H14 volumes down by a lower 6.9%. This can be attributed to the higher levels of enforcement against illicit retailers by the authorities (Ops Outlet).

- In light of this announcement, we have revised our legitimate TIV growth assumption to -5% to -15% for FY14F-FY16F. Nonetheless, we believe the negative impact from a volume decline will be more than offset by the higher RSP and thus forecast EBIT margins to expand by 1-2ppts in FY14F-FY16F.

- These translate into a negligible (-1% to +1%) impact on BAT’s FY14F-FY16F earnings. Yields are still decent at 4.3%-4.6%.

Source: AmeSecurities