This article first appeared in The Edge Financial Daily on February 15, 2018

British American Tobacco (M) Bhd
(Feb 14, RM29.60)
Downgrade from buy to hold with a lower target price (TP) of RM34.72: British American Tobacco (M) Bhd’s (BAT) financial year 2017 (FY17) results came in below our and consensus estimates at 90% of full-year forecasts. The variance was mainly due to lower-than-expected revenue and higher-than-expected operating cost.

After excluding exceptional items of RM19.4 million, FY17 adjusted net profit declined by 29.6% year-on-year (y-o-y) to RM512.1 million. Revenue fell by 20.1% y-o-y to RM3 billion due to: lower domestic and duty-free volumes (-14.7% y-o-y to four billion sticks); cessation of contract manufacturing for exports; and high introductory costs of new products for the launch of the Rothmans brand in the fourth quarter of FY17 (4QFY17). This was partially offset by growth in lower-price-segment products.

Quarter-on-quarter (q-o-q), 4QFY17 adjusted net profit declined by 28.8% to RM102.2 million. Revenue was lower by 7.5% q-o-q to RM700.2 million due to decline in sales volume (-1.5 percentage points [ppts] q-o-q to one billion sticks). For this quarter, the total industry volume decreased by 3% due to illicit trades, while BAT’s sales volume declined by only 1.5%, indicating a win of market share by 0.3ppt q-o-q to 53.9%. BAT’s premium brand, Dunhill, recorded a market share of 37.7% (-0.7ppt q-o-q); the Aspiration premium segment maintained its leadership position in the market with a 10.7% market share and the new entrant, the value-for-money segment; Rothmans held a market share of 2.8% at end-FY17 (+1ppt since introduction in October 2017).

The board declared a final interim dividend of 43 sen per share (77 sen per share in 4QFY16), tax-exempt under the single-tier tax system for the quarter under review.

We reduce our earnings forecasts by 8.9% and 3.8% to RM487.7 million and RM482 million for FY18 and FY19 respectively, taking into consideration: growing threats of the illegal cigarette market and unfavourable declining sales of premium-segment products. We also introduce our FY20 earnings forecast and expect net profit to grow by 3.2% y-o-y to RM497.6 million.

In 4QFY17, BAT charged out a provision for impairment of prepaid excise duties of RM21 million (1.3% of total excise duties paid in FY17), pending a refund from the Royal Malaysian Customs (RMC). This refers to the unutilised tax stamp wastages from the manufacturing process. A decision on the refund for prepaid excise duties has yet to be approved by the RMC. We have considered this as part of our exceptional items together with other provisions, foreign exchange gains, and losses/gains on derivatives.

Management guided that the amount of marketing expenses for Rothmans in FY18 is expected to be the same as the amount spent in 4QFY17 for new product launches — RM10 million to RM15 million. Considering that BAT imports all its cigarettes, the strengthening ringgit is expected to support the group’s profit for FY18.

Illicit cigarette traders continued to be the main threat to the tobacco industry as it reached 59% of tobacco market share in Malaysia as of 4QFY17. With an estimated tax revenue loss of RM4 billion for FY17, the government is expected to enforce stricter enforcements to combat illicit cigarette traders. Management guided that reintroduction of small packs of cigarettes are still not off the table as the government has not come back with a decision.

We downgrade our call from “buy” to “hold”, with a lower TP of RM34.72 per share (previously RM52.08 per share). We increase our discount rate to 6.6% and reduce the growth rate to 2% based on discounted cash flow valuation. Our valuation has taken into account: continuing threat of illicit cigarette traders, declining sales volume across the premium brand; and continuous good dividend yield. — TA Securities, Feb 14