Egypt: Eastern Tobacco – Raise TP 27% to EGP302 – BUY

123

renaissance-capital-logoThe introduction of Egypt’s new cigarette tax structure will allow Eastern Tobacco greater pricing flexibility, in our view. As a result, our ex-factory price forecasts for FY18-20 are 7% higher than before even though our retail cigarette price forecasts are 4% lower. Falling inventory has a mixed impact; it improves the cash cycle and in turn the net cash position in the short term, but puts pressure on raw material costs in the medium term. In this note, we also ease our wage inflation assumptions due to Egypt’s new civil service law. We reiterate our BUY rating and raise our TP 27% to EGP302.

New cigarette excise tax structure offers a major break

Egypt’s new cigarette tax structure (details on page 2) offers a major advantage over the old one by allowing for greater pricing flexibility. The old tax structure capped Cleopatra prices at EGP10/pack, above which the company would have had to move up to a higher tax bracket and raise retail prices by over 20% just to retain its ex-factory prices (a component of retail prices, and key revenue and value driver). With the tax threshold now raised to EGP13 from EGP10, the company managed to raise its blended retail price on 8 September 2016 by 22% while at the same time increase its average ex-factory price by 22% (to EGP2.33/pack in FY17E – as we forecasted previously). Our ex-factory price forecasts over FY18-20 now stand 7% higher on average, even though our retail cigarette price forecasts are 4% lower.

Falling inventory brings costs closer to spot FX levels

Eastern Tobacco’s raw material inventory is currently reportedly at just 0.5x the company’s standard level of 15 months (on our calculations) due to the FCY crunch. With global tobacco leaf prices being broadly stable according to World Bank forecasts, falling inventory levels imply that raw material costs over FY17-FY18 will come under pressure due to rolling currency movements coupled with the EGP2,900 /tonne in extra custom duties on imported raw tobacco since January 2016. On a more positive note, falling inventory levels improves working capital in the short term; we calculate that Eastern’s net cash position was up 1.4x by 30 June 2016 vs 31 December 2015. In this note, we raise our EGP/$ rate assumptions by 11% over FY17-18E and 5% onwards to a unified EGP11/$.

Cut wage bill inflation to 1.3x CPI by FY20E from 2.0x previously

We taper our wage bill inflation assumption to 1.3x CPI by FY20E from 2.0x in FY17E – down from a unified 2.0x CPI over FY17-20E due to: 1) Egypt’s new civil service law aims to curb wage inflation for public sector employees, and 2) the company’s run-rate has seemingly fallen to 1.0x CPI in 9M FY16.

Raise TP 27% to EGP302 and reiterate our BUY rating

We raise our TP 27% to EGP302 and reiterate our BUY rating. The key drivers to the net increase in our TP were: 1) higher ex-factory price forecasts, 2) more benign wage inflation, 3) larger net cash position, and 4) rolling our DCF model one year forward, more than offsetting 1) raw material cost pressure, and 2) higher WACC (to 16.5% from 15.6% on increased treasury yields).