• BAT’s 3Q17 earnings were below the street’s expectations. We affirm our SELL call on British American Tobacco (M) (BAT) with an unchanged DCF-derived FV of RM36.70/share (WACC: 7.2% terminal growth: -1.0%). BAT is trading at a forward PE of 20.5x, well above its historical average of 17.7x. Aside from lofty valuations, we think that perpetual regulatory hurdles may undermine BAT going forward.
• BAT’s 3QFY17 core earnings were RM147.5mil (QoQ: - 2.7%, YoY: -29.3%). This brought its full-year core earnings to RM419.5mil (YoY: 19.0%), in line with ours but below consensus at 78% and 67% of estimates respectively.

• A third interim dividend amounting to 43 sen/share was declared, bringing its total dividends to 126 sen/share for 9M17 (9M16: 155 sen/share).

• Key takeaways from BAT’s results briefing were: i) BAT volume sales declined 1.7% QoQ despite the broader market growing a marginal 3.0%. We expect volume sales to trend sideways from current levels in the near future; ii) Proliferation of illegal cigarettes remains elevated at 56.1% of total industry volume (vs. a high of 58.9% in April 2017). iii)BAT saw market share slip, registering 53.9% for the quarter (2QFY17: 54.5%). However, BAT has launched its VFM brand, Rothmans in early Oct 2017 to stem the decline. We are neutral over the commercial strategy given it may cannibalise its premium Dunhill brand, resulting in a potential dilution to top-line growth and margins. iv) BAT alongside its peers are in discussion with authorities to legalise small pack cigarettes. Authorities are expected to come to a decision over the upcoming months ahead. v) Gross margins for the quarter continued to improve to 36.5% from 34.7% in 3Q16. This is on the back of the complete shift of importing as opposed to producing cigarettes domestically. vi) Operating expenses are expected to expand significantly in the subsequent quarter due to the A&P spend on the launch of its new Rothmans brand.

• We maintain our forecasts estimates as earnings were within our expectations. Key risks to our forecast include a delay in an excise duty hike and greater-than-expected cost savings related to its restructured operations.

• While we like BAT’s foresight and adaptability to transform its modus operandi into a trading model to negate high fixed cost, we think that regulatory hurdles and disruptive substitute tobacco products may prove too steep to overcome.

Source: AmInvest Research - 24 Oct 2017