Philip Morris International (PMI) has launched its flagship tobacco heat-not-burn (HNB) device, the iQos, in Malaysia. While it is too early to garner its initial reception, we believe the iQos could be a gamechanger for the local cigarette market, which previously was relatively insulated from smoking alternatives such as e-cigarettes amid regulatory uncertainty. Nevertheless, BAT is equipped to respond with its own array of competing products within the cigarette alternatives segment, and we maintain our BUY and TP of RM40.20.

Cannibalising the Conventional Cigarette Market

Based on the robust demand seen in Japan (16% tobacco market share in under three years), its maiden market, and Korea (7% over one year), we believe that PMI’s iQos could similarly receive a strong reception in Malaysia, based on its affordability (refills’ 20% discount) relative to premium cigarettes and alternatives such as vaping and e-cigarettes, as well as purportedly reduced health risks arising from lower harmful content emitted from heated tobacco. Consequently, we expect the introduction of heated tobacco products to cannibalise the traditional cigarette market.

Not Falling Behind Just Yet

BAT has yet to announce any plans for the introduction its own HNB brand, the ‘Glo’. However, with iQos typically taking at least 2 quarters to gain traction, BAT still has time to make up for PMI’s first-mover advantage, whilst possessing a wider portfolio of alternative products. On the other hand, the launch of HNB products should initially deflate BAT’s margins.

Culling of the Illicit Trade Would Still Drive Industry-wide Recovery

Meanwhile, we note positive actions taken by the authorities following Budget 2019’s announcement to curtail the illicit cigarette market. This supports our thesis for a broad earnings recovery for the legal tobacco players, particularly for BAT which commands the leading market share.

Maintain BUY

We hold on to our FY18-20E earnings forecasts. BAT is well-equipped to respond to the iQos competition with its brand of heated tobacco products, in our view, and we continue to expect a meaningful earnings recovery to materialise, underpinned by the envisaged decline in illicit trade. Reiterate our BUY call on BAT, with an unchanged 12-month DDM-derived TP of RM40.20. Downside risks: i) slower-than-expected enforcement activities; (ii) regulatory hurdles; iii) rising competition; and iv) excise duty shocks.

Source: Affin Hwang Research - 15 Jan 2019