This article first appeared in The Edge Financial Daily on May 23, 2018

British American Tobacco (Malaysia) Bhd
(May 22, RM34.16)
Downgrade to market perform with a lower target price (TP) of RM31.70: British American Tobacco (Malaysia) Bhd’s (BAT Malaysia) net earnings for first quarter of financial year 2018 (1QFY18) of RM96.2 million (-20%) and interim dividend of 33 sen are below expectations, due to persistent drag from the growing illegal trade market. As there may be no immediate price adjustments with the “zero-rating” of goods and services tax (GST) in June 2018, we assume the group may benefit from better margins until an adjustment comes into effect.

1QFY18 net profit of RM96.2 million came below our and consensus estimates, making up 18% of both full-year expectations. The miss was owing to the continuing growth in illegal trades, which narrowed legal sales across the market. An interim dividend of 33 sen also missed our full-year estimate of 178 sen following the weaker results.

Year-on-year, 1QFY18 sales of RM637.6 million (-15%) came in weaker from the absence of export sales in 3QFY17, and declining sales volume due to market down trading towards illicit products (estimated 1QFY18 illegal market share of 63%, +3 percentage points). However, earnings before interest and tax declined by 18%, likely due to lower margin returns from the reintroduction of the value-for-money range of “Rothmans” products during 4QFY17. Core net earnings of RM96.2 million fell by 20%, which was also attributed to a one-off restructuring adjustment in 1QFY17 results. Quarter-on-quarter, 1QFY17 revenue decreased by 14% as legal trade transactions declined from the above-mentioned growth in illegal trades. However, better sales mix supported group margins while also retained market share. Core net profit, however, only fell by 7%, which could have been due to less marketing spend in lieu of the softer market.

Despite the introduction of more affordable offerings into the market, the proportion of illicit trade continued to grow and saw a new high of 63% during the quarter. With a new government administration, there could potentially be new approaches undertaken to resolve the issue, albeit requiring further proof of effectiveness. A “zero-rating” of GST was announced by the government to be effective from June 1. While this could translate into lower prices, management has described that the tobacco industry is restricted by health ministry’s regulations against decreasing prices without its formal evaluation and approval. Regardless, we believe the group may see some benefits either from better margins if prices remain, or better sales if prices become more affordable minus GST.

Post-results, we trim our FY18 and FY19 earnings estimates by 6.3% and 2.2% respectively for more conservative sales assumptions. However, we improve our margins assuming prices for the remainder of the year are constant, but without GST contributions. Our dividend assumptions are lowered to 167 sen/185 sen from 178 sen/195 sen.

Downgrade to “market perform” with a lower TP of RM31.70 (from RM33.85 previously). This is based on an unchanged 18 times FY18 price-earnings ratio eatimate (-2 standard deviation five-year mean) on a revised earnings per share. While capital upside appears limited, the stock may still be an avenue for dividend yield seeking investors with 5% and 5.5% expected in FY18 and FY19 respectively. — Kenanga Research, May 22