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See Appendix A-1 for Analyst Certification, Important Disclosures and non-US research analyst disclosures. Citi Research is a division of Citigroup Global Markets Inc. (the "Firm"), which does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Certain products (not inconsistent with the author's published research) are available only on Citi's portals.

28 Oct 2016 09:14:15 ET │ 15 pages Tobacco North America │ United States

Altria (MO) Alert: ABI’s 3Q EPS missed by 17%, showing the volatility of its earnings; ABI now ≈ 11% of MO’s earnings

 This morning ABI reported poor 3Q results – ABI’s beer volume was a little better than consensus and organic sales growth was close to consensus at +2.8%. However EBITDA missed consensus by 9% and EPS missed by a cool 17%. The EBITDA miss was driven partly by the U.S., but mainly by Brazil, where margins were down 14 percentage points, driving organic EBITDA there down -29%. The EPS miss was greater, mainly due to leverage, but the financials line, which is always volatile, was also a little worse than expected. The dividend was unchanged at €1.60, which is helpful as we had thought it might be cut. MO will receive its share (€315MM = $343MM) later this quarter.

 What it means for MO – For MO what really matters is (1) the dividend (which was fine), and (2) the EPS for 4Q and beyond, as it has owned ABI shares only since Oct 9. Our ABI analyst, Andrea Pistacchi, believes that consensus EPS for 4Q will inevitably fall now, and as a result there will be a lower base for 2017 earnings too. See ABI: Disappointing Q3, largely due to Brazil. ABI now contributes about 11% of MO’s earnings, as MO owns 10.2% of ABI, with earnings reported one quarter in arrears. Had MO owned its stake in ABI for the third quarter, this miss would have taken about 2% off MO’s 4Q results (=17% miss X 11% contribution, reported 1 quarter in arrears). The results also illustrate quite how volatile ABI’s earnings can be.

 MO’s own 3Q results – MO reported EPS yesterday, with all details close to expectations. (See: MO: EPS beat by 1¢ driven by non-core items) We left our EPS forecasts for 4Q16, and 2017 and beyond, unchanged, but lifted our 2016 EPS only to reflect the better than expected 3Q EPS.

 What does the bid for RAI mean for MO? – We expect BAT to be successful in its bid for RAI, and this means that MO will become the only large, high-yielding tobacco stock with no (or little) FX risk. We think this means it will become more attractive for many yield-seeking investors. We also share the view (expressed in many articles, eg on Bloomberg, Reuters and the WSJ, all Oct 21-22) that PM is now more likely to bid for MO, even if nothing is likely immediately, as a result of BAT’s offer for RAI. In fact we think that the more PM believes that its heat-not-burn technology can revolutionize the tobacco industry, the stronger the argument there is for PM to buy MO ahead of iQos’s introduction into the U.S. (which isn’t likely until 2018 at the earliest).

Adam Spielman AC +44-20-7986-4211 [email protected]

Andrea Pistacchi [email protected]

Jemima Benstead [email protected]

Ravi Sharma [email protected]

Buy 1 Price (27 Oct 16) US$64.43 Target price US$72.00 Expected share price return 11.7% Expected dividend yield 3.8% Expected total return 15.5% Market Cap US$125,887M

Price Performance (RIC: MO.N, BB: MO US)

Citi Research

Equities

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Figure 1. AB-InBev – 3Q16 P&L Summary vs. Citi & Consensus Estimates (USD in millions)

3Q16 3Q15 Actual Citi Vs. Citi Cons Vs. Cons Reported YoY Chg

Revenue 11,109 11,498 -3.4% 11,430 -2.8% 11,376 -2.3% Normalised EBITDA 4,032 4,447 -9% 4,432 -9% 4,406 -8% North America 1,741 1,734 +0% 1,764 -1% 1,734 +0% Mexico 419 508 -18% 490 -14% 513 -18% LatAm North 769 1,176 -35% 1,099 -30% 1,047 -27% LatAm South 335 298 +12% 294 +14% 351 -5% Europe 336 323 +4% 336 +0% 344 -2% APAC 463 462 +0% 449 +3% 410 +13% GEHC -33 (54) -39% 7 -571% 7 -571% Normalised EBIT 3,214 3,653 -12.0% 3,643 -11.8% 3,634 -11.6% Associates 3 4 -25% 4 -25% 4 -25% Net financial charges (1,226) (1,017) +21% (626) +96% (810) +51% Tax (225) (468) -52% (529) -57% (795) -72% Minorities (394) (380) +4% (389) +1% (397) -1% Normalised net profit 1,363 1,654 -18% 1,663 -18% 1,674 -19% EPS - Normalised, Basic 0.83 1.01 -17.6% 1.00 -17.0% 1.02 -18.7%

Source: Company Reports, Citi Research Estimates. Consensus is compiled by the company.

Figure 2. AB-InBev – 3Q16 Organic Growth Rates vs. Citi & Consensus Estimates

Actual 3Q16 Ests 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 Citi Cons

Volume North America -5.6% -0.9% +1.2% -2.9% -1.1% +0.4% -2.4% -2.3% -0.8% Mexico +2.1% +4.1% +11.5% +11.3% +13.0% +7.2% +9.6% +5.0% +4.9% Latam North +1.0% -6.5% +2.1% -2.6% -7.3% -4.6% -4.5% -4.6% -4.0% Latam South -3.0% +5.5% -3.3% -3.7% -5.3% -14.8% -1.7% -7.0% -5.0% Europe -5.9% -7.6% +1.4% +2.9% +1.8% -0.8% -3.2% -2.3% -1.0% APAC +4.8% -1.5% -1.5% +0.2% -0.5% -1.7% +1.2% +1.1% +1.0% GEHC +0% +9% +12% -1% +2% +1% +9.4% +0.0% +2.0% ABI Group -1.2% -2.2% +1.5% -0.7% -1.7% -1.7% -0.9% -1.7% -1.5% Revenue North America -3.8% +0.6% +2.8% -0.6% +0.3% +2.2% -0.3% -0.5% +1.1% Mexico +8.1% +7.9% +14.2% +13.9% +16.3% +9.5% +12.0% +8.7% +7.7% Latam North +11.8% +4.8% +11.6% +7.1% -1.9% +1.7% -5.3% +3.3% +3.1% Latam South +25.5% +42.1% +27.4% +24.1% +17.2% +4.1% +22.2% +9.7% +12.0% Europe +0.1% +0.5% +9.4% +8.9% +4.5% +4.6% +3.1% +1.6% +3.0% APAC +15.5% +2.5% +4.4% +11.0% +1.9% +4.1% +5.0% +6.2% +5.1% GEHC +15% -2% +1% +2% -1% +17% +10.4% +9.0% +6.0% ABI Group +6.2% +4.1% +7.9% +7.0% +3.1% +4.0% +2.8% +3.3% +3.3% Normalised EBITDA North America -5.2% -5.8% +3.2% -6.0% +2.1% +4.8% +0.9% -1.1% +2.2% Mexico +15.8% +14.4% +20.1% +22.6% +10.3% +6.6% +5.8% +11.3% +7.1% Latam North +20.2% +10.6% +10.9% +6.9% -3.4% -1.1% -28.7% +2.4% -0.1% Latam South +22.0% +56.1% +23.9% +18.7% +24.2% +11.1% +28.7% +14.8% +16.3% Europe -2.0% +5.1% +9.0% -7.4% -4.7% +0.1% +2.5% +0.0% +1.9% APAC +46.3% -2.0% +8.9% +186.8% +3.3% +20.0% +16.8% +14.4% +12.3% GEHC -133% -28% -8% +820% +330% +920% -6.1% -572% +9.0% ABI Group +11.1% +4.6% +9.6% +6.6% +2.5% +4.3% -2.0% +3.0% +4.4%

Source: Company Reports, Citi Research Estimates. Consensus is compiled by the company.

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Altria Valuation Our target price of $72 assumes that in 12 months’ time the stock trades at 20x forward P/E, but at that point it will be applied to 2018 EPS. Our target multiple is fractionally higher than MO currently trades at, but it is roughly in line with PM’s multiple. PM has historically traded at a premium, but we believe MO should close the gap because the very strong fundamentals in the US are likely to mean that investors come to see domestic tobacco as being a fundamentally a more attractive investment proposition than international. Risks The following risks could affect Altria’s share price:

 Market Risk – Tobacco stocks move up or down in large part due to sector rotation. This means the stock may rise above our target price, or fall below it, depending on whether the market rotates into or away from defensives.

 Taxation – While we think this is unlikely, several years of large increases in FET would be a negative. In California there is a proposition to increase the state tax by $2.00/pack (from $0.87), to be voted on in November.

 Regulation – At present the way the FDA regulates is relatively supportive for the tobacco majors, however this could change.

 Litigation – Although we are quite relaxed at present about US litigation, the threat could worsen, or get less bad.

 ABI – About 10% of earnings will come from ABI. MO could also suffer from large volatility in quarter-to-quarter EPS due to this stake.

If the impact of these risk factors is more negative or more positive than we currently expect, the share price may not reach our target price, or it may exceed it.

AB-InBev (ABI.BR; €112.10; 1)

Valuation Our €135 target price is set using a fair value on PE. ABI trades at about 22.5x 2- year forward PE (we use 2-year forward to take into a larger part of the deal benefits), a premium to global blue chip staples. We expect the premium to expand slightly over the next 12 months because: (1) of ABI’s better medium-term earnings growth outlook, (2) gradually improving ABI-standalone fundamentals, (3) mgt’s strong track record in driving shareholder value, and (4) the stock’s top-down qualities. In other words, we expect that in 12 months’ time (October 2017) ABI will be trading on a PE of about 24x on what will then be 2-year forward forecasts. Given our Oct-19 EPS of $6.29, this implies a fair value of €135.1 (at a 1.118 $/€ exchange rate) which we round to €135.

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Risks Compared with most industries, brewing is relatively predictable, but nonetheless brewers’ profits tend to be more volatile than tobacco or branded food companies. For ABI, in particular, we highlight the following risks to our target price:

US pricing: about 40% of ABI’s profit comes from the US. If its beer prices increase either faster or more slowly than we expect, profit margins are likely to rise above or fall below our forecasts.

Brazil: About 20% of ABI’s profit comes from Brazil. Given the macro, the Brazilian consumer is under pressure, weaker-than-expected volumes could affect profits there.

FX: About 40% of ABI’s profits are generated in dollars (ABI’s reporting currency) and less than 10% in euros. If the Brazilian real in particular is either stronger or weaker than expected, this will affect profit and cash flows, either for better or worse.

Input costs: All brewers depend on malting barley and glass and aluminium, and they are also exposed to the price of oil. If the price ABI pays is either higher or lower than we expect, profit is likely to be affected.

British American Tobacco PLC (BATS.L; £46.11; 1)

Valuation Our 12-month price target is £54. This represents our view of fair value, based on P/Es. Our fair value estimate assumes that in 12 months' time the shares will be trading at about 18x forward EPS, which is fractionally above the current level, as we assume the economic situation will be still be quite uncertain. However, in 12 months, this will be based on calendar 2018E earnings, not 2017E earnings. Risks There are several risks that may prevent BAT achieving our target price:

 BAT shares are likely to rise or fall, depending on sector rotation. If the market rotates away from defensives, tobacco will underperform.

 Foreign-exchange risk is significant for BAT. Recently the pound has moved dramatically and this has had a large effect on BAT’s share price. Also if some of its emerging market currencies fall, it may be subject to a worse-than-expected transactional squeeze. These currencies also may rise, helping BAT.

 Of all the European tobacco companies, BAT has the biggest risk from litigation, via its exposure to Canada as well as the US. Several Canadian provinces have passed legislation designed to help the provinces sue BAT for billions of dollars using reduced levels of proof.

 Plain packaging is spreading to other markets, beyond Australia, and this could cause downtrading, hurting profits materially.

 BAT could suffer from further large excise tax rises.

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 The proposed acquisition of Reynolds may destroy value in some way, possibly because investors decide BAT is overpaying. On the other hand, investor may come to believe it is a very attractive deal, potentially pushing the share price higher.

Conversely, if any of these factors proves to have less of an effect than we anticipate, the stock could materially outperform our target.

Reynolds American (RAI.N; US$54.26; 1)

Valuation Our price target for Reynolds is $57, based on P/Es. Its tobacco peers currently trade at about 19-20x forward earnings. We expect Reynolds to generate both the fastest EPS growth within the U.S. tobacco sector (albeit by a small margin), and the least volatile, so we believe it should trade at a small premium. We therefore assume that it will trade at 20.5x, slightly higher than where it is now, and a slight premium to its peers, but in 12 months’ time this will be based on 2018 EPS. Given our fractionally-above consensus estimates, this implies fair value of $57. Risks The following risks could affect RAI’s share price:

 Market Risk – Tobacco stocks move up or down in large part due to sector rotation. This means the stock may rise above our target price, or fall below it, depending on whether the market rotates into or away from defensives.

 Taxation – While we think this is unlikely, several years of large increases in FET would be a negative. In California there is a proposition to increase the state tax by $2.00/pack (from $0.87), to be voted on in November.

 Regulation – At present the way the FDA regulates is relatively supportive for the tobacco majors; however, this could change. If it decides to take more action on menthol for example, this would be particularly negative for Reynolds, as very roughly half its cigarette volumes are mentholated.

 Litigation – Although we are quite relaxed at present about US litigation, the threat could worsen, or get less bad. Reynolds has the greatest litigation risk among all tobacco stocks because the potential liability depends on historic volumes, and in the past the brands for which Reynolds is now responsible had a much larger share than they do now. Reynolds has also given indemnities for the brands it has sold to Imperial Brands.

 M&A – Currently BAT owns 42% of Reynolds. It is possible that BAT could bid for the rest of the company, potentially helping the shares materially, or even sell down the stake, hurting the shares.

If the impact of these risk factors is more negative or more positive than we currently expect, the share price may not reach our target price, or it may exceed it.

Philip Morris International (PM.N; US$95.78; 2)

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Valuation Our price target on PM is $106. This is based on the assumption that in 12 months’ time, PM will trade on about 20x forward P/E, which is roughly where it is trading on now, but EPS will be almost 10% higher. Risks There are several risks that may prevent PM achieving our target price:

 Market rotation – Tobacco stocks move up or down in large part due to sector rotation. This means the stock may rise above our target price, or fall below it, depending on whether the market rotates into or away from defensives.

 FX – All of PM’s earnings come from outside of the US. Therefore, if the dollar rises or falls, the earnings will rise or fall. (In our models, we assume spot rates will continue.) There is a risk therefore that our forecasts will turn out either too low or too high.

 Economic risk – If the GDP of PM’s main emerging markets falls sharply, it is likely to weaken PM’s performance. Better than expected GDP growth would be helpful for PM.

 Tax risk – The industry is very sensitive to tax increases, which are hard to predict. Outside the US, consumers usually trade down in response to tax increases, which hurts PMI, because it relies on Marlboro, which is a premium brand.

 Regulation – It is possible that tobacco control regulations tighten sufficiently to hurt profit. Plain packaging is already in Australia, and is spreading to other markets (UK, France, Canada), and there will be further bans on flavors and smaller pack sizes in the EU.

 Competition – It is possible that PM loses share in important markets and sectors as other companies innovate and market more effectively than PM.

 Litigation – PM has exposure to litigation in Canada. In the Blais-LeTourneau case C$3B of damages were awarded against PM’s Canadian unit, although this is being appealed. The Canadian provinces have passed legislation that allows the provincial governments to sue the tobacco majors for billions of dollars with reduced levels of proof. The industry is fighting all the way, however so far it has lost many more legal battles in Canada than it has won.

 Next Generation Products – PM is putting a lot of weight behind its portfolio of “Reduced Risk Products”. We currently don’t think that the existing data suggests that iQos and other RRPs will be able to achieve PM’s bullish targets, but that could change over the next 12 months. Equally, they could end up disappointing vs the current targets.

If the impact of these risk factors is more (or less) negative than we currently expect, the share price may not reach our target price, or it may exceed it.

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Appendix A-1 Analyst Certification The research analysts primarily responsible for the preparation and content of this research report are either (i) designated by “AC” in the author block or (ii) listed in bold alongside content which is attributable to that analyst. If multiple AC analysts are designated in the author block, each analyst is certifying with respect to the entire research report other than (a) content attributable to another AC certifying analyst listed in bold alongside the content and (b) views expressed solely with respect to a specific issuer which are attributable to another AC certifying analyst identified in the price charts or rating history tables for that issuer shown below. Each of these analysts certify, with respect to the sections of the report for which they are responsible: (1) that the views expressed therein accurately reflect their personal views about each issuer and security referenced and were prepared in an independent manner, including with respect to Citigroup Global Markets Inc. and its affiliates; and (2) no part of the research analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in this report.

IMPORTANT DISCLOSURES

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Due to Citi's involvement in the acquisition of Lorillard Inc by Reynolds American Inc also involving British American Tobacco Plc (the "Company") and Imperial Tobacco Plc, Citi Research restricted publication of new research reports, and suspended its rating and target price on 15th July 2014 (the "Suspension Date”). Please note that the Company price chart that appears in this report and available on Citi Research's disclosure website does not reflect that Citi Research did not have a rating or target price between the Suspension Date and 20 July 2015 when Citi Research resumed full coverage. A director of Citi serves on the board of Reynolds American Inc. Citigroup Global Markets Inc. owns a position of 1 million USD or more in the debt securities of Reynolds American Inc Citigroup Global Markets Inc. owns a position of 1 million USD or more in the debt securities of Philip Morris International Inc Citigroup Global Markets Inc. owns a position of 1 million USD or more in the debt securities of Altria Group Inc Within the past 12 months, Citigroup Global Markets Inc. or its affiliates has acted as manager or co-manager of an offering of securities of British American Tobacco PLC, Philip Morris International, Altria. Citigroup Global Markets Inc. or its affiliates has received compensation for investment banking services provided within the past 12 months from British American Tobacco PLC, Reynolds American, AB-InBev, Philip Morris International, Altria. Citigroup Global Markets Inc. or its affiliates expects to receive or intends to seek, within the next three months, compensation for investment banking services from AB-InBev. Citigroup Global Markets Inc. or an affiliate received compensation for products and services other than investment banking services from British American Tobacco PLC, Reynolds American, AB-InBev, Philip Morris International, Altria in the past 12 months. Citigroup Global Markets Inc. currently has, or had within the past 12 months, the following as investment banking client(s): British American Tobacco PLC, Reynolds American, AB-InBev, Philip Morris International, Altria. Citigroup Global Markets Inc. currently has, or had within the past 12 months, the following as clients, and the services provided were non-investment- banking, securities-related: British American Tobacco PLC, Reynolds American, AB-InBev, Philip Morris International, Altria. Citigroup Global Markets Inc. currently has, or had within the past 12 months, the following as clients, and the services provided were non-investment- banking, non-securities-related: British American Tobacco PLC, Reynolds American, AB-InBev, Philip Morris International, Altria. Citigroup Global Markets Inc. and/or its affiliates has a significant financial interest in relation to British American Tobacco PLC, Reynolds American, Philip Morris International, Altria. (For an explanation of the determination of significant financial interest, please refer to the policy for managing conflicts of interest which can be found at www.citiVelocity.com.) Disclosure for investors in the Republic of Turkey: Under Capital Markets Law of Turkey (Law No: 6362), the investment information, comments and advices given herein are not part of investment advisory activity. Investment advisory services are provided by authorized institutions to persons and entities privately by considering their risk and return preferences. Whereas the comments and advices included herein are of general nature. Therefore, they may not fit to your financial situation and risk and return preferences. For this reason, making an investment decision only by relying on the information given herein may not give rise to results that fit your expectations. Furthermore, Citi Research is a division of Citigroup Global Markets Inc. (the “Firm”), which does and seeks to do business with companies and/or trades on securities covered in this research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Analysts’ compensation is determined by Citi Research management and Citigroup’s senior management and is based upon activities and services intended to benefit the investor clients of Citigroup Global Markets Inc. and its affiliates (the “Firm”). Compensation is not linked to specific transactions or recommendations. Like all Firm employees, analysts receive compensation that is impacted by overall Firm profitability which includes investment banking, sales and trading, and principal trading revenues. One factor in equity research analyst compensation is arranging corporate access events between institutional clients and the management teams of covered companies. Typically, company management is more likely to participate when the analyst has a positive view of the company. For securities recommended in the Product in which the Firm is not a market maker, the Firm is a liquidity provider in the issuers' financial instruments and may act as principal in connection with such transactions. The Firm is a regular issuer of traded financial instruments linked to securities that may have been recommended in the Product. The Firm regularly trades in the securities of the issuer(s) discussed in the Product. The Firm may engage in securities

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transactions in a manner inconsistent with the Product and, with respect to securities covered by the Product, will buy or sell from customers on a principal basis. For important disclosures (including copies of historical disclosures) regarding the companies that are the subject of this Citi Research product ("the Product"), please contact Citi Research, 388 Greenwich Street, 28th Floor, New York, NY, 10013, Attention: Legal/Compliance [E6WYB6412478]. In addition, the same important disclosures, with the exception of the Valuation and Risk assessments and historical disclosures, are contained on the Firm's disclosure website at https://www.citivelocity.com/cvr/eppublic/citi_research_disclosures. Valuation and Risk assessments can be found in the text of the most recent research note/report regarding the subject company. Pursuant to the Market Abuse Regulation a history of all Citi Research recommendations published during the preceding 12-month period can be accessed via Citi Velocity (https://www.citivelocity.com/cv2) or your standard distribution portal. Historical disclosures (for up to the past three years) will be provided upon request. Citi Research Equity Ratings Distribution 12 Month Rating Catalyst Watch Data current as of 30 Sep 2016 Buy Hold Sell Buy Hold Sell Citi Research Global Fundamental Coverage 47% 39% 14% 0% 100% 0%

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The relative call may have highlighted a specific near-term catalyst or event impacting the company or the market that was anticipated to have a short-term price impact on the equity securities of the company. Absent any specific catalyst the analyst(s) may have indicated the most and least preferred stocks in the universe of stocks under consideration, explaining the basis for this short-term view. This three-month view may have been different from and did not affect a stock's fundamental equity rating, which reflected a longer-term total absolute return expectation. Catalyst Watch Upside/Downside calls: Citi Research may also include a Catalyst Watch Upside or Downside call to highlight specific near-term catalysts or events impacting the company or the market that are expected to influence the share price over a specified period of 30 or 90 days. A Catalyst Watch Upside (Downside) call indicates that the analyst expects the share price to rise (fall) in absolute terms over the specified period. A Catalyst Watch Upside/Downside call will automatically expire at the end of the specified 30/90 day period; the analyst may also close a Catalyst Watch call prior to the end of the specified period in a published research note. A Catalyst Watch Upside or Downside call may be different from and does not affect a stock’s fundamental equity rating, which reflects a longer-term total absolute return expectation. For purposes of FINRA ratings-distribution-disclosure rules, a Catalyst Watch Upside call corresponds to a buy recommendation and a Catalyst Watch Downside call corresponds to a sell recommendation. Any stock not assigned to a Catalyst Watch Upside or Catalyst Watch Downside call is considered Catalyst Watch Non-Rated (CWNR). For purposes of FINRA ratings-distribution-disclosure rules, we correspond CWNR to Hold in our ratings distribution table for our Catalyst Watch Upside/Downside rating system. However, we reiterate that we do not consider CWNR to be a recommendation. For all Catalyst Watch Upside/Downside calls, risk exists that the catalyst(s) and associated share-price movement will not materialize as expected. NON-US RESEARCH ANALYST DISCLOSURES Non-US research analysts who have prepared this report (i.e., all research analysts listed below other than those identified as employed by Citigroup Global Markets Inc.) are not registered/qualified as research analysts with FINRA. Such research analysts may not be associated persons of the member organization and therefore may not be subject to the FINRA Rule 2241 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account. The legal entities employing the authors of this report are listed below: Citigroup Global Markets Ltd Adam Spielman; Andrea Pistacchi; Jemima Benstead Citigroup Global Markets India Private Limited Ravi Sharma

OTHER DISCLOSURES Any price(s) of instruments mentioned in recommendations are as of the prior day’s market close on the primary market for the instrument, unless otherwise stated.

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