Better upside seen for BAT on vape regulations, illicit trade clampdowns

British American Tobacco (Malaysia) Bhd
(Feb 21, RM14.34)
Maintain buy with an unchanged target price (TP) of RM18.80:British American Tobacco (Malaysia) Bhd’s (BAT) financial year ended Dec 31, 2019 (FY19) results beat expectations thanks to a stellar fourth quarter ended Dec 31, 2019 (4QFY19). A more effective engagement with the authorities may lead to increased intense clampdowns on the illicit trade. We also view the regulations on vaping as a significant upside catalyst for the stock. BAT is trading at depressed valuations, and offers attractive yields and return on equity. We believe the earnings downside risks will also be capped by cutbacks in operating expenditure (opex) and our base case assumption of no further gains by the illicit trade.

BAT reported FY19 core net profit of RM361.1 million (-19.6% year-on-year [y-o-y]), which beat expectations. The positive deviation could be attributed to higher-than-expected volumes for 4QFY19 on market share gains, while the cutback in opex was also more intense than expected. Post results, our forecasted financial years 2021 to 2022 (FY21F-22F) earnings are adjusted by less than 3%.

FY19 revenue fell 11.1% y-o-y to RM2.5 billion on a 10% decline in legal total industry volume. FY19 gross profit margin slipped 3.1 percentage points on consumers downtrading to lower-priced products. However, an 18% cutback in underlying opex partially mitigated the downfall.

4QFY19 revenue rose 13.3% to RM662.4 million due to seasonal consumer demand and effective marketing campaigns. Coupled with the moderated opex (-21.6% quarter-on-quarter), 4QFY19 core net profit jumped 36.1% to RM113.1 million.

The management indicated there has been more effective engagement with the related authorities of late in addressing the illicit trade issue, which we think could intensify clampdown efforts moving forward. We also understand there is positive traction with regard to vaping regulations — vaping currently accounts for 9-10% of total consumption. A positive outcome will pave the way for BAT to introduce its vaping products and grab a share of the sizeable and fast-growing market. This will be a significant near-term upside catalyst for the stock, in our view.

We kept our discounted cash flow-derived TP unchanged. It implies a 14.3 times FY20F price-earnings ratio, close to -1 standard deviation over the five-year mean and offers 10.5% yield. While we acknowledge the environment could remain challenging moving forward — due to high illicit trade incidences and unfair competition from vaping products — profits and dividend per share may not fall further. This takes into account the RM35 million savings per annum in opex from workforce downsizing and our base case assumption of no further gains by the illicit trade.

Risks to our recommendation include an unfavourable outcome in the government’s decision on vaping and weaker-than-expected sales pick-up for Glo. — RHB Research Institute, Feb 21