BAT UK has recently pursued initiatives in the e-cigarette segment, andBAT Malaysia has adopted a wait-and-see approach pending clarity from the authorities. We lower our DCF-based TP to MYR54.90 (from MYR63.10, 11% downside) and downgrade the stock to SELL postearnings revision, in view of cannibalised sales and a slower recovery in consumer spending amid deteriorating macroeconomic headwinds.

BAT UK ventures into e-cigarettes. British American Tobacco UK (BAT UK) (BATS LN, NR) recently signed a conditional agreement to acquire an electronic cigarette (e-cigarette) business, CHIC Group, for an undisclosed sum. In addition, BAT UK has also formed an alliance with Reynolds American (RAI US, NR) to share e-cigarette technology up to Dec 2022. These agreements followed a study by UK Department of Health concluding that e-cigarettes, including vaping devices, are about 95% less harmful than tobacco cigarettes, while the Action on Smoking and Health (ASH) Organisation estimates that e-cigarettes have a penetration rate of 18% among current cigarette users (see Figure 1). However, there has been a mixed reaction by authorities incountries such as Singapore and Brazil, both of which have banned ecigarettes. The argument is largely on e-cigarettes’ nicotine addiction against traditional cigarettes’ debilitating effect of tobacco combustion.

On the local front. Local authorities have acknowledged the prominence of e-cigarettes, with the Ministry of Health due to release a finding on e-cigarette risks in Oct 2015. At BAT’s most recent analyst briefing in Jul 2015, management’s stance was to await official regulations from authorities on e-cigarettes before taking any measures.

Forecast. We trim our FY15F-17F earnings by 4-5% to account for: i)macroeconomic headwinds, as a recovery in consumer sentiment (the lowest in six years – see Figure 2) could take longer than expected, andii) cannabalised sales due to the proliferation of e-cigarettes.

Divestment case. In view of deteriorating macroeconomic headwinds, we adjust our assumptions by raising our WACC assumption to 7.5% from 6.7%. Coupled with our earnings adjustment, we downgrade BAT to SELL (from Neutral) as our TP drops to MYR54.90 (from MYR63.10) (WACC: 7.5%, TG: 1.5%). The implied dividend yield of 5-6% yield is also unappealing given the rising interest rate environment.

Source: RHB Research - 28 Sep 2015