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

British American Tobacco (Malaysia) Bhd
(Oct 22, RM31)
Maintain underperform with a target price (TP) of RM28.25: We deem British American Tobacco (Malaysia) Bhd’s (BAT) first nine months of financial year 2018 (9MFY18) net profit of RM352.2 million to be broadly within our but below consensus estimates, making-up 78% and 76% of respective full-year expectations. A weaker fourth quarter (4Q) is anticipated from high forward purchases in 3QFY18 from the pending price increase per pack. An interim dividend of 40 sen (year to date [YTD]: 108.0 sen) is also within our full-year estimate of 150 sen.

Year-on-year, 9MFY18 revenue of RM2.05 billion (-8%) was dragged down by the unyielding illicit market which remained at its all-time high market share of 63% for the fourth consecutive quarter and a decline in industry volume by 4% YTD. Operating profit also saw a decline at RM474.1 million (-13%) as the operating margin was softened (-1.3 percentage points [ppts] from 24.4%) by a higher sales proportion of lower-yield value-for-money (VFM) products (introduced in October 2017). Core net profit closed at RM352.2 million (-16%) after adjustments from one-off restructuring expenses in 9MFY17. Quarter-on-quarter, 3QFY18 sales of RM735.5 million grew 8%. Operating profit rose to RM192.3 million (+27%) with an operating margin of 26.1% (+3.7ppts). Its 3QFY18 core net earnings were RM145.8 million (+32%) due to lower effective taxes.

The health ministry is expected to unveil the guidelines on the rate of increase in the coming weeks. Management has not discounted the possibility that the proposed hike could be greater than the earlier rise of 50 sen per pack. The group will absorb differences in taxes until the resolution of the matter. We believe the higher margin enjoyed during the three-month “tax holiday” could provide enough support to buffer potential losses from this tax for FY18. The industry may see distortion of monthly sales numbers with another round of forward buying in October at the expense of November and December sales. Illicit cigarettes levels will likely persist at current peak levels and further down-trading of VFM products could undermine future results.

We maintain our “underperform” call and TP of RM28.25 for BAT. This is based on an unchanged 18 times FY19 estimated price-earnings ratio (-1.5 standard deviation from the three-year mean). The dividend yield estimate of 4.7% for FY18 and FY19 may seem decent but is likely to be dampened by potential capital downsides. Risks to our call include: a faster-than-expected recovery in legal market share, lesser-than-expected conversion towards less premium brands and significant decreases in foreign exchange to improve cost of sales. — Kenanga Research, Oct 22