Deep-dive 2021-9: BAT Malaysia

British American Tobacco Malaysia (ROTH MK) is Malaysia’s largest tobacco company, selling cigarettes under the Dunhill, Rothmans, Pall Mall and Peter Stuyvesant brand names.

The company is a Malaysia-listed subsidiary of UK-listed tobacco giant British American Tobacco. The predecessor of the company was founded in 1912. The current corporate structure came into existence with the merger of Rothmans of Pall Mall (Malaysia) Berhad and Malaysian Tobacco Company Berhad in 1999.

The cigarette industry is highly profitable. Researchers say that nicotine is more challenging to quit than even heroin and alcohol. And consumers tend to be loyal to specific brands such as Dunhill. That puts the company in an enviable position with pricing power, should inflation surprise on the upside.

Up until 2015, the Malaysian cigarette market was growing at a steady pace. The country’s population is young and growing. Since alcohol is prohibited in the Koran, the Muslim population of Malaysia has turned to tobacco as a more acceptable sin. The overall market is not necessarily growing. But overall legal and illegal cigarette volumes are likely to be stable or decrease slightly over the next decade.

The problems started around 2015. Malaysian excise taxes on cigarettes doubled within a short period of time from 2013 to 2015. And lax border control caused the illegal cigarette industry to skyrocket from a market share of 35% up to 70% at the peak. That made Malaysia’s illegal industry cigarette the largest in the world. Since 2015, BAT Malaysia’s share price has dropped around 80%, despite flat overall cigarette consumption and a very strong balance sheet.

The current situation is not sustainable. From 2014 to 2019, tax revenue from cigarette excise taxes actually fell in absolute terms, despite higher excise taxes. Meanwhile, consumers switched to illegal cigarettes with no quality control, potentially damaging their health in the process.

The new government of Muhyiddin Yassin with finance minister Zafrul is finally taking steps to tackle the market for illegal cigarettes in order to raise government revenues. Zafrul was previously CEO of Malaysian bank CIMB and is seen as highly competent. His primary focus is on raising tax revenues. The 2021 budget was the first step in the right direction. The government raised minimum fines and introduced jail terms for those caught selling or smuggling illegal cigarettes. Trans-shipment of tobacco will be limited to just a few designated ports around the country. Meanwhile, cigarette excise taxes are not going to increase in the future. Crucially, Zafrul has said that:

“the government [has] set a target for excise duty collection from the tobacco industry”

Since excise duties are guided to be flat, that must mean that the government is targeting for legal cigarette volumes to increase.

Recent alt-data statistics provide positive signals. Reported quarterly sales volumes also suggest that the legal market has turned a corner. Assuming that the legal market reaches a 50% share - recovering half of the market share lost since 2015 - and a partial recovery in the operating margin to 23%, BAT Malaysia would then trade at a P/E ratio of 8.2x in 2024. The theoretical upside to intrinsic value would in that scenario be +112% in the share price. Coupled with additional 6.5% yearly dividends that would increase over time if the pay-out ratio is assumed to be constant.

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