With the Decline of BAT’s Share Price, Its Attractive Valuation Now Warrants a Relook. BAT’s Past 5-year Average PE Is 18.9x Compared to Current Forward PE of Just 10.6x Based on FY20 Earnings. At Current Price Levels, BAT Yields An Attractive 9.0% Based on a 95% Pay-out Ratio of FY20 Earnings. We Lower Our FY19/20/21 Forecasts by 6.0%/6.8%/3.9% to Factor in Down-trading From Premium Brand to VFM Brand. This Lowers Our DCF Based TP From RM15.28 to RM14.66. Still, Given the Decline in Share Price (-68% in the Past 1-year and -23% Since Our Last Report in Nov), We Think the Stock Is Worth a Shot and Upgrade From Hold to BUY.

Lower earnings expected in FY20. Going into FY20, we expect BAT to record lower earnings of RM309.3m (-3.7% YoY) from an expected RM321.2m in FY19. While we expect BAT’s volumes to remain stable, we anticipate down -trading from BAT’s premium brand Dunhill (shelf price: RM17.40/pack) to VFM brand Rothmans (RM12.40/pack). With regards to the illicit tobacco trade, we do not expect a significant change in terms of market share, as we understand the process of clamping down on illicit activity is proving rather challenging. Note that the illicit trade has stabilised at approximately 65% of the total market (Figure #1). While we do not dismiss the probability of a reduction in illicit tobacco trade, we feel it is more likely to remain at current levels in FY20.

Cost rationalisation. In light of declining sales volumes in FY19, BAT announced cost rationalisation plans which included a 20% reduction in head count (from 4Q19 onwards). Additionally, BAT shared they intend to moderate A&P spending going forward. While this should result in favourable margins for the group, we expect the down-trading mentioned above to offset the better margins.

New product offering ‘glo’. While we see “glo” as a viable product offering for Malaysian consumers, we understand that it will take a significant amount of time and marketing investment for it to have a meaningful impact on earnings. Furthermore, given the relatively high cost of refills (RM14.00 vs <RM5.00 for illicit tobacco), we do not see glo eating into the chronic illicit tobacco market share. Additionally, rising cost of living is fuelling the growth of VFM brand Rothman’s at the expense of premium brand Dunhill resulting in margin pressure. Since its launch in end-FY17, Rothmans has grown to 5.2% of the total legal market volumes (approximately 14% of BAT’s total volume). BAT’s 4Q19 earnings are expected to be announced on 20 Feb.

Forecast. We lower our FY19/20/21 forecasts by 6.0%/6.8%/3.9% to factor in down - trading from premium brand to VFM brand.

Upgrade to BUY, TP: RM14.66. Following the earnings cut, our DCF based TP (WACC: 9.5%, TG: 2.5%) is lowered from RM15.28 to RM14.66. While we acknowledge the challenging landscape of the tobacco industry, BAT’s battered share price (-68% in the past 1-year) and de-rated valuations prompts us to take a revisit. At current PE of 10.6x on FY20 earnings (vs 5-year mean of 18.9x) and projected FY20 dividend yield of 9.0%, we reckon that such valuations make it worth a shot. With the decline in share price (-23.3% since our last report on 20 Dec), we upgrade our call from Hold to BUY.

Source: Hong Leong Investment Bank Research - 6 Feb 2020