Smaller Packs, Greater Earnings?

Tobacco companies are proposing the reintroduction of smaller-pack cigarettes to narrow the pricing gap with illicit cigarettes and regain market share. We believe it is unlikely to be approved and we estimate the potential earnings impact on BAT to be somewhat neutral to slightly negative. We maintain our view that legal cigarette sales volumes should stabilize this year and BAT’s profit should improve on the back of sourcing tobacco regionally. We maintain our HOLD rating with an unchanged DDM-derived TP of RM43.50.

Tobacco Companies Push for Return of Smaller Packs

The Edge Financial Daily reported that tobacco companies have proposed reintroducing 10-stick packs to regain market share lost to the illicit market. We believe this will not have a material impact on improving sales volumes of legal cigarettes as the price per stick is still much higher and cost savings from illicit cigarettes can be up to RM300-500 per month for a smoker, depending on the daily consumption rate. More importantly, the proposal faces a lot of pushback from different parties, such as NGOs, Ministry of Health, and the public. Therefore, we think it is unlikely to be approved, given that the general election is approaching.

The Impact of Smaller Packs on BAT’s Earnings

While smaller packs may contribute marginally to top line growth, its impact on the bottom line is ambiguous due to the higher packaging cost. At the moment we are uncertain whether the proposal covers all cigarettes, i.e. all in packs of 10 sticks. Assuming the price/stick is unchanged and all of BAT’s cigarettes are in packs of 10 sticks, we estimate this will increase COGS by RM80-100m and BAT would need to sell at least an additional 260m cigarette sticks in order to break even or make additional profit.

Maintain HOLD With Unchanged 12M DDM-derived TP of RM43.50

We make no changes to our assumptions for BAT’s revenue and earnings. We have not factored in the impact of smaller packs as we believe the proposal is unlikely to be approved by the government. Barring any changes in the regulations, we expect the legal cigarette market to stabilize in 2017 and slowly regain market share. We maintain our HOLD rating with an unchanged DDM-derived TP of RM43.50. Dividend yields of 5% in FY17-19PE should support the share price. Key upside risks include stronger-than-expected sales volume growth and lower-than-expected operating expenses, whereas downside risks include excise duty hikes.

Source: Affin Hwang Research - 18 Sept 2017