BAT’s share price has corrected 12% since Sep 2015. We believe its current valuations has fairly priced in the steep excise duty price-led hike. We upgrade our call to NEUTRAL with an unchanged DCF-based MYR54.50 TP (2% upside). The estimated dividend yield of 5.7% for FY15-17 should be supportive of the company’s share price.

Balancing act going forward. We expect British American Tobacco’s (BAT) FY16 earnings to be dragged by lower cigarette volumes (-14% YoY), outweighing the MYR3.20/pack excise duty led-price hike. Yet, we believe the 12 sen/stick excise duty hike is unlikely to be implemented annually, but rather reverted back to 3 sen/stick (Figure 1) going forward. This is as authorities strike a balance between enforcing a clampdown on illicit cigarettes and revenue losses attributed to their proliferation. The Rakyat Post reported illegal cigarettes comprising ~45% of the cigarette trade in the weeks post the price-led hike, up from the yearly one-third average.

Vaping restrictions minimally positive. Restrictive policies on vaping implemented by various state governments have gathered momentum over the past few weeks. The prominence of vaping coincided with legal cigarette industry volume contracting 10% 9M15 YoY. However, historical price elasticity trends suggest the double price hikes in cigarettes (Nov 2014 and Jun 2015) would have accounted close to a 6% drop in volume. Correspondingly, the clampdown on vaping (with a 50% success rate) boosts industry cigarette volume by a mere 2%.

Key risks. While we leave our earnings estimates unchanged, key risks include: i) increased illicit cigarettes proliferation, ii) sales cannibalisationof e-cigarettes despite bans by some state governments, and iii) lowerthan-expected cigarette consumption arising from higher living costs.

Fairly priced in, upgrade to NEUTRAL (from Sell). We believe that current valuation of 17.3x FY16F P/E (less than -2SD of its historical 3-year mean) fairly reflects BAT’s flat earnings growth. Therefore we upgrade our call to NEUTRAL as we maintain our DCF-based TP of MYR54.50 (WACC 7.5%, TG: 1.5%). The company’s gearing of 52%(past 5-year average: 76%) allows for some flexibility in its capital management to maintain its DPS going forward. The estimated dividend yield of 5.7% for FY15-17 should be supportive of its share price.