Investment Highlights

• We downgrade our recommendation to HOLD from BUY on British American Tobacco (BAT). Current valuations appear to have priced in both the soft earnings and the potential clampdown on illicit cigarettes. We adjust our DCF-derived fair value to RM36.20/share (previously, RM36.00/share) in tandem with our new assumptions.

• BAT recorded 1Q18 core earnings of RM96mil (QoQ - 6.5%, YoY -20.0%) for the quarter against a revenue base of RM638mil (QoQ -8.9%, YoY -14.8%). Results came in below our and consensus expectations, at 17% and 18% of estimates respectively. The deviation was due to the dilutive impact arising from Rothmans.

• An interim dividend of 33 sen/share was declared. This was below our expectation of 48 sen/share.

• Key takeaways from BAT's results were: i. Total industry volume (TIV) contracted 4.2% YoY. This was due to further erosion by illicit cigarettes, gaining 3ppts to 63% YoY. It remains at an all-time high. Illicit incidences have almost doubled since the steep excise duty in late 2015 (Exhibit 3). ii. Illicit cigarettes remain a structural issue, both on the demand and supply side. However, it is coming off a high base and given the new government’s explicit intention to combat rampant illicit cigarettes, we have lower illicit assumptions of 51% in the long run (vs. 58% previously). iii. BAT gained a market share of 1.1ppts to 54.7%, primarily due to the successful launch of its Rothmans brand. The significantly lower priced value-for-money (VFM) brand alongside lower TIVs, dragged the topline down 14.8% YoY. iv. Gross margins contracted 1.0ppt to 29.9% due to the dilutive impact of VFM Rothmans. However, we expect margins to stabilize as the Rothmans brand has fully saturated the market. v. Operational expenses were 17.1% lower YoY with cost savings realized from the restructuring of BAT’s operations back in 2017. We these to be sustained going forward given the permanent nature of the restructuring.

• Factoring in variances to our forecast and new assumptions, we cut our FY18-19F earnings by 24%/9% but leave our FY20F unchanged. Key risks to our forecast include a steeper-than-expected excise duty hike and further proliferation of illicit cigarettes.

Source: AmInvest Research - 22 May 2018