Highlights

• BAT has announced that it will be raising its cigarette prices in response to an excise duty hike, by up to RM3.20/20-stick pack for its premium and value-for-money (VFM) brands effective today.

• Post-price hike, new cigarette prices would be RM17.00 & RM15.50 for premium and VFM segment respectively.

• According to media sources, BAT MD Stefano Clini said the excise duty hike is to the quantum of 40%. If so, the base case for the new excise duty is circa RM392/kg from RM280/kg previously.

Comment

• Whilst we didn’t discount an off budget excise duty hike, we did not anticipate that the excise duty hike to be of this magnitude. The quantum of the increase in prices is magnanimous; premium brands will be raised by 23.2% (RM13.80 to RM17.00) while VFM brands will have a larger price hike impact of 26.1% (RM12.30 to RM15.50).

• Volume. We believe this development will decimate the legal industry volume, which as it stands is down 11% yoy in the month of September. We expect the volume to decline further against the challenging economic backdrop and diminishing consumer spending power. MIER’s lat est CSI index reading of 70.2pts is at a historical low. We anticipate Illicit and the vaping industry to benefit.

• IIllicits. We believe the market share of illicit cigarettes’ will benefit tremendously as the price gulf between illicits and duty paid cigarettes widen. The last reading indicated that illicits represent 32.8% of the market (the Wave 3, 2014).

• Vaping. In our recent tobacco industry report, we highlighted that the vaping phenomenon has induced smokers to switch between smoking and vaping, effectively diluting consumer’s nicotine consumption budget. We believe that with the cabinet deciding not to ban vaping, the pressures would be compounded further given that tobacco players now face two major competitors for nicotine consumption compared to one previously.

• Despite no similar announcement by JTI and PMI, we view that the two players would also follow suit.

Risks

• (1) Exceptionally higher excise duty hike; (2) Increase in illicit trade volume; (3) Weaker-than-expected TIV; and (4) Regulation tightening.(5) vaping

Forecasts

• We maintained our volume forecast for FY15 as we already imputed a 15% decline in volume. We extend our volume assumptions for FY16-17 to 20% vs.8-7% previously. We raised our WACC (7.2% vs 6.7% on higher risk premium) and lowered our Terminal Growth rate from 3.5% to 3% as we price in the heightened regulatory risk and to better reflect the headwinds BAT faces from price based substitution to illicit and vaping. FY16-17 EPS cut by 7-8%.

Rating

• We believe a SELL rating is warranted in view of the heightened regulatory risk and unprecedented magnitude of excise hike, coupled with an al ready declining industry volume and longer term risk from rapid growth of vape users.

Valuation

• Target price is decreased to RM53.30 based on DCF valuations. We downgrade our call to SELL.

Source: Hong Leong Investment Bank Research - 4 Nov 2015