British American Tobacco : Valuations reflective of challenging outlook HOLD

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British American Tobacco : Valuations reflective of challenging outlook  HOLD

We reaffirm our HOLD recommendation on British American Tobacco (BAT) with a lower DCF-derived fair value of RM46.50/share (previously, RM51.10/share) as we revised our earnings downwards. In view of lower-than-expected volume sales, we reduce our FY17F-FY18F earnings by -4% and -13% respectively. Outlook remains challenging amid tighter purse strings. However, attractive dividend yields of 5.2-6.0% should support valuations at our implied PE of 18.0x or its 3-year mean. BAT ended its FY16 on a softer note with 4QFY16 core earnings of RM157.4mil (QoQ: -24.5%, YoY: -19.1%). BAT’s results key highlights included:-  (1) We caution on the likely structural decline of cigarette consumption as sales volume contracted -4.3% QoQ, for an unprecedented fifth consecutive quarter. Meanwhile, FY16 topline contraction of -18.0% was weighed by a 27.8% lower sales volume. (2) BAT’s market share declined 6.2 ppts to 54.3% as of 4QFY16 (vs. 4QFY15: 60.5%). Customers’ down-trading behavior persisted, with premium segment Dunhill impacted the most at 7.0ppts. (3) BAT’s FY16 EBIT margin slipped -3.8ppts YoY off the back of raised excise duties in Nov 2015.

Key takeaways from the analyst briefing included:- (1) Management did not rule out declaring an additional special dividend in regards to proceeds derived from the eventual sale of RM96.5mil or 33 sen/share worth of machinery. We think it is the most likely outcome given BAT’s healthy balance sheet and net cash generation. (2) We opine BATs earnings are likely to be more susceptible to forex swings as the group's outsourced purchases are denominated in USD amid the absence of its contract manufacturing as a natural hedge. (3) Cigarettes will be sourced from three separate BAT production facilities in the region i.e. Indonesia, Singapore and Korea. Despite the outsourcing, flavor profile of BAT cigarettes remains unchanged as materials employed to produce the cigarettes will be identical.

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