We attended BAT’s 1Q21 earnings briefing and came away feeling cautious on the group’s prospects going forward. Despite legal volumes seeming to recover in 1Q21, we expect this to be short lived as illicit players re-strategize their import operations to focus on smaller jetties and unofficial landing spots. We keep our forecasts unchanged. Our TP of RM11.75 based on a DCF valuation methodology (WACC: 9.5%, 2.5%) remains unchanged. Maintain SELL.

We attended BAT’s 1Q21 earnings briefing and came away feeling cautious on the group’s prospects going forward.

Industry volumes recovery in 1Q21 a false dawn? To recap, legal tobacco industry volumes in 1Q21 rose by 19% YoY. However, we partially attribute this to low base effect (note that 1Q20 industry volumes were the lowest in over 10 years due to MCO1.0) (Figure #1). While we are encouraged that the governments initiatives which included transhipment and import restrictions have already resulted an increased number of seizures of illicit volumes (76m cigarettes seized in 1Q21 vs. 34m cigarettes in the entirety of 2020), we note that illicit players are starting to shift their import strategies to utilise smaller jetties and unofficial landing spots as opposed to larger ports. As such, we reckon it is still too premature to tell if the legal volumes seen in 1Q21 can be sustained.

Mismatch in prices in legal vs. illicit still a boon. While the government’s efforts to limit the importation of illicit cigarettes are encouraging, the demand side of the equation remains unsolved. We opine that the high illicit market share in Malaysia is unlikely to decrease given the price differential between legal and illicit cigarettes. Note that legal cigarettes are generally priced between RM12 (VFM) to RM18 (premium) vs. illicit cigarettes of RM5-7 per pack. While we are encouraged by growth in BAT’s legal market share (1Q21: Premium: +3.8ppt, VFM +4.1ppt YoY), this came at the expense of higher marketing spend (opex increased by 7.4% in 1Q21). Going forward, we expect BAT to have to continue to incur marketing spend to move the needle.

Vape legalisation a potential wildcard. Legalising vape products would result in companies being able to provide smokers with a choice of reduce-risk products (note that vape products that are sold in the market now contain nicotine and are unregulated) and has the potential to add RM300m of tax revenue to the Government. We understand that should vape be legalised in Malaysia, this would greatly benefit BAT, as they already sell vape products in other markets, which they would be able to quickly bring to Malaysia. While we do not rule out the possibility of vaping being legalised in Malaysia, at this juncture, it is still unlikely, given MoH’s recent comments, calling vaping a ‘global epidemic’.

MCO update. The latest MCO rules will no doubt have an impact on BAT’s operations. However, BAT have shared that they are well prepared to deal with logistical hiccups, having ensured that their retailers are adequately supplied with sufficient inventory for the duration of MCO. BAT are holding 4 weeks of stock to manage uncertainties, with the inventory increasing by 7.5% in 1Q21 YoY.

Forecast. Unchanged.

Maintain SELL, TP: 11.75. We reckon BAT’s share price has risen to an unjustified level given the earnings uncertainty from (i) chronic high illicit market share (ii) growth in unregulated vape products (iii) consumers down trading to VFM brands. Our TP of RM11.75 based on a DCF valuation methodology (WACC: 9.5%, 2.5%) remains unchanged. Maintain SELL.

Source: Hong Leong Investment Bank Research - 9 Jun 2021