We recently brought 11 fund managers and buy-side analysts to visit British American Tobacco (BAT)’s cigarette factory in Petaling Jaya, Selangor. Apart from catering to the domestic market, the factory – a Tier 1 cigarette producer –also exports to quality-conscious first world nations. The highly efficient factory is constantly seeking ways to cut wastage and localize raw materials. We are, however, maintaining our SELL and RM56.22 FV, not due to corporate governance issues, but on the stock’s stretched valuations and murky industry prospects.
Top-class manufacturer. The Malaysian factory is listed as a Tier 1 factory, which is a mark of its quality control being good enough to meet the high expectations of export markets such as Japan. Tier 2 and 3 factories such as the one in Bangladesh (not under BAT Malaysia) focus on keeping costs low (one way is via cheaper labour) and target the domestic market. Cigarette manufacturing largely involves two of BAT’s major departments in Malaysia, which in total employ about 160 people. The factory manufactures BAT’s key brands, including Dunhill, Pall Mall, Kent and Peter Stuyvesant.
Top-class manufacturer. The Malaysian factory is listed as a Tier 1 factory, which is a mark of its quality control being good enough to meet the high expectations of export markets such as Japan. Tier 2 and 3 factories such as the one in Bangladesh (not under BAT Malaysia) focus on keeping costs low (one way is via cheaper labour) and target the domestic market. Cigarette manufacturing largely involves two of BAT’s major departments in Malaysia, which in total employ about 160 people. The factory manufactures BAT’s key brands, including Dunhill, Pall Mall, Kent and Peter Stuyvesant.
Shipping across the Asia Pacific. The Malaysian factory, which can manufacture up to 20bn cigarette sticks annually, produces about 15.5bn sticks each year, of which 8.9bn are for domestic consumption. Some 3.5bn sticks a year are shipped to Japan, making the East Asian nation the biggest export destination for BAT. The group’s other export markets are South Korea, Hong Kong and Australia.
Save, save, save. One of the factory’s key foci (and any other factory, for that matter) is to improve efficiency, and accordingly, enhance profits. That is why the export market is important to the company, although the margins fetched are substantially lower than that from the domestic market. The factory’s high production volume enables it to spread out its fixed costs while at the same time enjoy favourable prices in sourcing its raw materials. Other ways to cut cost are to reduce wastage (currently at 2.4%) and localize certain raw materials. For example, the Malaysian factory only produces plain filters, whereas the charcoal and capsule filters are imported. It also imports relock packaging, commonly used in Dunhill. Efforts are underway to localize relock packaging production.
Maintain SELL. We value BAT at a FV of RM56.22, based on FCFF (WACC: 5.5%, terminal growth: 1.0%). Undeniably, the company is a shining example of good corporate governance and dominates market share on the local front. However, the industry’s growth prospects are clouded with regulatory risks that are likely to intensify after the impending general election.
FROM LEAF TO SMOKE
The making of a cigarette. Cigarette manufacturing is split between BAT’s Primary Manufacturing Department (PMD) and Secondary Manufacturing Department (SMD). PMD’s key task is to process the tobacco leaves while SMD produces the cigarettes and packages them for distribution.
Processing the leaves. The PMD process is pretty straightforward. Dry tobacco leaves, packed in boxes of 200kg each, first undergo the moisturizing process whereby the leaves are steamed to reach a 23% moisture level. This process facilitates cutting as dry leaves will crumble when shredded. Too much moisture, on the other hand, will cause sogginess. After the large leaves (see Figure 1) are cut into shreds, they are dried to a moisture level of 13%-14%. Moisture levels are kept at the higher 14% range when intended for consumption in warmer, more humid weather (eg. Malaysia) while moisture content is lowered to 13% if targeted for consumption in cooler temperatures (eg. Japan). Some edible ingredients, such as cocoa, sugar and fruit extract, may be blended with the leaves to create the characteristic taste of a certain brand. The leaf shreds are then sent to SMD for further value-add.
The making of a cigarette. Cigarette manufacturing is split between BAT’s Primary Manufacturing Department (PMD) and Secondary Manufacturing Department (SMD). PMD’s key task is to process the tobacco leaves while SMD produces the cigarettes and packages them for distribution.
Processing the leaves. The PMD process is pretty straightforward. Dry tobacco leaves, packed in boxes of 200kg each, first undergo the moisturizing process whereby the leaves are steamed to reach a 23% moisture level. This process facilitates cutting as dry leaves will crumble when shredded. Too much moisture, on the other hand, will cause sogginess. After the large leaves (see Figure 1) are cut into shreds, they are dried to a moisture level of 13%-14%. Moisture levels are kept at the higher 14% range when intended for consumption in warmer, more humid weather (eg. Malaysia) while moisture content is lowered to 13% if targeted for consumption in cooler temperatures (eg. Japan). Some edible ingredients, such as cocoa, sugar and fruit extract, may be blended with the leaves to create the characteristic taste of a certain brand. The leaf shreds are then sent to SMD for further value-add.
Local vs foreign. BAT has its own tobacco estates in Kelantan and Terengganu. There is currently a Government mandate requiring 70% of the company’s tobacco leaf used to be produced locally. While the factory manager finds Malaysian tobacco leaf to be as good as the imported ones, the local leaves are substantially more expensive. Furthermore, leaves produced within Malaysian shores are only of the Virginian variety, so the company has to import Burley, Oriental and some Virginia tobacco from the Americas and the Balkans. Different leaves from the same tobacco plant may have slightly differing flavour, with the younger leaves being of better quality.
Transforming leaf to stick. There are overhead tubes connecting PMD and SMD, where air suction is applied to transport the processed leaves through the tubes to SMD. One of SMD’s tasks is to produce 88mm-108mm filter rods, which are made of cotton-like materials known as cellulose acetate fibres. The filter rods are later sliced into four as each cigarette’s filter is 22mm-27mm in length. Various filters have different pressure drops, whereby a filter with a higher pressure drop will be harder to draw (i.e. harder to suck) and thus provide less ‘kick’. The cigarette is then made by wrapping the filter in paper and slotting the leaves from PMD into the tobacco rod.
Transforming leaf to stick. There are overhead tubes connecting PMD and SMD, where air suction is applied to transport the processed leaves through the tubes to SMD. One of SMD’s tasks is to produce 88mm-108mm filter rods, which are made of cotton-like materials known as cellulose acetate fibres. The filter rods are later sliced into four as each cigarette’s filter is 22mm-27mm in length. Various filters have different pressure drops, whereby a filter with a higher pressure drop will be harder to draw (i.e. harder to suck) and thus provide less ‘kick’. The cigarette is then made by wrapping the filter in paper and slotting the leaves from PMD into the tobacco rod.
The final package. BAT’s packaging line produces 400 packets per minute. A cigarette packet has four components: i) the tear tape, ii) polywrap, iii) paper packet (planks), and iv) foil. As the factory also produces cigarettes under a subcontract manufacturing agreement with the other BATs in the Asia Pacific region, we saw packaging targeted for the Japan and Hong Kong markets as well as the olive green plain packaging for Australia. Each packet contains 20 cigarette sticks.
Source: OSK
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