Out of the Ashes

We reiterate our view of potentially more robust prospects for British American Tobacco (BAT) and raise our FY20E EPS by 11%. As we forecast a more bullish outlook beyond FY19E, we lift our multi-stage DDM-based target price from RM37.30 to RM43.10. Our conviction on BAT lies primarily on the industry’s game-changing factor, i.e., the commitment of the newly-elected government to declare war on cigarette smuggling. With an upside potential of 26% and the shares trading at -1SD relative to historical PER, we maintain our BUY rating on BAT. In our view, investors are still warming up to the change in prospects and we are the most bullish among peers to highlight its potential.

Pakatan’s War Against Rampant Cigarette-smuggling Activities

The rise of the illicit cigarette trade, from a steady 35% average of the entire market to an estimated 63% of the market in 1Q18, was the driving force behind legal tobacco companies, including BAT, to suffer from a sharp decline in earnings (FY17: -32% yoy). However, the industry’s prospects are changing. In the Pakatan Harapan government’s election manifesto, it has projected to recoup an additional RM2.6bn in cigarette excise duties by snuffing out the illicit trade, representing a crucial premise towards arriving at its estimated RM20bn in tax deficit following the abolishment of GST.

The Legal Tobacco Industry Is Expected to Regain 23% of Market Share

We believe that as BAT is set to gain back its market share from the illicit trade, its EPS is set to rise by 29% in FY19E and another 16% in FY20E. This is based on the assumption that the legal industry will be able to recoup an additional 7% of market share in 2019 and a further 7% in 2020. We have also employed the assumption that BAT’s market share in the industry will stay at 55% for FY19-21E.

Reaffirm BUY With a Higher DDM-derived Target Price of RM43.10

Drawing from studies of other countries, the war on the illicit cigarette trade could be won with dedicated resources and, as such, we believe that the Pakatan government will succeed with stricter enforcement. As we lift FY20E’s EPS by 11% and pencil-in a 15% growth in FY21E’s DPS, we derive a multi-stage DDM-based fair value of RM43.10 (vs. RM37.30 previously). We reiterate our BUY call on BAT. Downside risks: i) weak enforcement initiatives; and ii) further excise duty and sales tax hikes.

Riding on the Pakatan Administration

Lax Governance, Rather Than Price, Drives the Black Market

Since FY15, the rampant illicit cigarette trade has steadily worsened from a previously steady state of 35% towards an all-time high of 63% of the market in 1Q18, the highest in the world. While the tobacco companies’ malaise began in 2015/16 after a flurry of tax/duty hikes which caused cigarette prices to jump >60% from FY13-15, the hikes only provided further incentives to the smuggling network, in our view, and were not the enabling factor per se, as the illicit market remained stable during 2013-14, which also saw duty and retail price hikes, albeit to a lesser extent. Instead, we view the previous administration’s inadequate control measures and actions as the driver behind the alarming proliferation of the illicit cigarettes trade.

Enforcement Is the Key

Our emphasis on stricter enforcement rather than affordability is corroborated by the World Health Organization’s (WHO) study on the regional illicit cigarette trade, which showed that the illicit market is more prevalent in countries with lower perceived governmental control over corruption. Based on Malaysia’s past control of the corruption score, the local illicit market would hover within the 15-40% range, which is in line with the steady state of 35% recorded previously before 2016. The study also indicated that the smuggling of illicits is biased higher towards cheaper cigarette brands in terms of price and taxation, contrary to certain beliefs.

The Black Market Could Have Already Peaked Organically

We believe the illicit trade has already plateaued at 63% in 1Q18. In comparison with the substantial market-share losses suffered by the industry over 2015-16, we believe the demand for illicits has hit a saturation point at these levels, and should remain fairly stable for the rest of the year. In tandem with the industry’s volume loss since 2016, we have cause to believe that the illicits’ share gain above the 35% steady state is mainly comprised of premium cigarettes, which are predominantly Dunhill and Marlboro, the two most popular brands. All in all, the worst has already come to pass for the legal tobacco industry and BAT, in our view.

Win-win Endeavour for the Pakatan Government and BAT

In its election manifesto, the Pakatan government projects to recoup an additional RM2.6bn in cigarette excise duties by pledging to snuff out the illicit trade. This represented the largest indirect tax gain under Pakatan’s budget estimate, and is by design a critical assumption underlying the new administration’s fiscal reconciliation to arrive at its deficit measure of RM20bn in the wake of GST’s abolishment. Therefore, we believe the government’s interests are heavily aligned with that of the tobacco industry to plug the black-market leakages. In light of unchanged duty/tax structures and depressed volume growth, this necessitates a massive effort to clamp down on the illicit cigarette market.

War on Illicit Trade Is Likely to be Successful

We believe that given Pakatan’s political will against corruption as well as fiscal motivation, the government’s campaign against illicits will prove successful. Our study on enforcement outcomes from both developed and emerging markets – UK, Spain, Brazil, the Philippines, etc – have corroborated that the illicit trade is directly addressable with dedicated resources and execution. Although we note that the illicit situation differs across countries, we expect the authorities to have their work cut short by centering upon pertinent aspects of the supply chain, whereby illicits are mainly sourced from Indonesia, with premium illicits mostly comprised of Marlboro and Dunhill, and also on the local distribution network where minimarts and kiosks are the core points of sale. Nevertheless, the war on illicits will not be an overnight success, and we estimate the black market to only fall progressively from FY19E onwards to 40% by FY21E.

Valuation and Recommendation

Reaffirm BUY, Price Target at RM43.10

To account for BAT’s sustained earnings recovery as a result of the legal tobacco industry’s volume revival, we apply a two-stage DDM to reflect the strong earnings growth through to FY21E, with the assumption of a steadily improving legal market share from 37% (as at 1Q18) to 38%/45%/52%/60% in FY18/19/20/21E. Meanwhile, we maintain an assumption of BAT’s market share at 55% of the legal market. We reaffirm our BUY call on the stock with a higher CY19E TP of RM43.10 (Cost of equity: 8.3%; Terminal growth: 2.0%). The stock is trading attractively at -1SD to its historical PER of 22.5x and dividend yields of 4.5-6.8% FY18-20E. Risks to our call are weaker-thanexpected enforcement, further excise duty and sales tax hikes, as well as greater health awareness.

Source: Affin Hwang Research - 6 Jul 2018