Investors’ key interests and concerns
During Huabao's NDR in Europe (23 -25 June 2014) a number of investors have been interested in e-cigarettes (e -cigs), which are gaining popularity in EU countries, but some investors had concerns over the company's plan to increase i nvestment s in a sunset industry.
Investing on future growth
The company believes that there is fast growing area in the no/low growth tobacco industry, and therefore plans HKD400m CAPEX for FY15 (c.9% of FY14 revenue) mainly on new e-cig, modified RTL and stem processing projects, of which it identified as the future growth drivers.
In particular, the company is optimistic of a rapid e - cig market development globally, partly as 1) it foresees unit cost of vaporizer to lower from USD2 now to USD0.29, making e - cig more competitive; and 2) leading tobacco companies are active in investing and promoting e -cig, thus accelerate market growth. Huabao plans to launch its own brand disposable e-cig for RMB20 (with dosage equivalent to one pack of cigare tte, which is mostly priced at c. RMB10/pack) in 3Q14 through 1) over 10,000 cigarette POSs in traditional channel; 2) convenience store chains; and 3) e-commerce. H uabao doesn't expect much profit fro m e - cig sales in the near term, but think it is a rare chance for H uabao to build its own brand. It is also looking to cooperate with leading C hinese tobacco companies to launch e-cig, and plans to sell tobacco oil to local and/or foreign e- cig brands/makers.
Separately, management said that its modified RTL technology, which minimizes water consumption, is ideal for tobacco production in Middle East.
Excessive cash for dividend and share buyback
Huabao held HKD2.6bn net cash as of Mar 2014, and will consider increasing di vidend payout ratio in future (FY14: 4 6%), provided no major M&A. It will also repurchase shares from time to time, in particular, to ease pressure on share price from short selling.
DB view
We hope to see Huabao increasing dividend payout ratio, but think it will take time to make e -cig Huabao’s future growth driver as the market as well as government regulation on e -cig is comparatively immature. We maintain a Buy rating on Huabao, which now trades at 6.6x FY15E PE and with a 6. 1% dividend yield. Our TP is HKD 5, which is derived by assigning a 40% discount to our DCF valuation (10.62% WACC and 1% TG), equivalent to 7.2x FY15E P/E and a 5.6% dividend yield. Key risks: input cost volatility, regulatory changes.