BAT’s 9MFY18 core PAT of RM342.2m (-18.4% YoY) was below expectations due to choric rampant illicit market. The possibility of higher cigarette shelf prices (as mentioned by the Health Minister last week), further increases the risk of worsening the illicit trade problem. We reduce our FY18/19/20 forecasts by 8.9%/9.4%/7.2% to account for expected lower industry volumes going forward. We reduce our call from a BUY to a HOLD with a lower TP of RM32.80 (from RM37.00) based on DCF valuation methodology (WACC: 8.4%; TG: 3.0%)

Below expectations: 9M18 core PAT of RM342.2m was below ours and consensus expectations, accounting for 66.7% of ours and 73.5% of consensus expectations. We deem this below street’s expectations as we anticipate 4Q18 to be weaker due to absence of sales tax holiday, which predominantly occurred in 3Q18. The poor performance was due to chronic rampant illicit market share, which remained high at 63%.

Dividend. 40 sen per share going ex on 1 Nov 2018, bringing YTD dividend to 108 sen (9M17: 126 sen).

QoQ: Core PAT rose by 23.3% to RM135.8m. This was due to benefit from the removal of SST between June and August, volume growth, favourable sales mix (i.e. increased sales from higher margin premium brand Dunhill) and productivity savings.

YoY: Despite favourable sales mix, revenue was flat due to lower sales volume of 5.4%. Reduced top line was mainly due to higher illicit market share (3Q18: 63% vs 3Q17: 56.1%). This resulted in core PAT decline of 7.9%.

YTD: Core PAT declined by 18.4% to RM342.2m win tandem with top line decline of 8.9%. Revenue decline was due to lower sales volume of 5.8% due to the increase in illicit cigarette market share (Figure #2).

Prospects: BAT’s profitability ultimately remains at the mercy of illicit market volume. We expect the newly elected government to step up efforts to curb illicit trade to boost legal market volumes, in turn, resulting in higher excise duty tax collections. Despite this, we are reticent to factor in significant decrease of illicit market share as this endeavour has execution hurdles and will take time to bear fruit. Furthermore, should the government require cigarette players to raise shelf prices (as mentioned by the Health Minister last week), we expect legal market volumes to be crippled by the rampant illicit trade due to the already huge price differential (illicit: RM4-5/pack vs legal: RM17-17.20/pack of premium cigarettes)

Forecast. We reduce our FY18/19/20 forecasts by 8.9%/9.4%/7.2% to account for expected lower industry volumes from the chronic illicit market volumes.

Downgrade to HOLD, TP: RM32.80. We downgrade our call from a BUY to a HOLD with a lower DCF derived TP of RM32.80 (from RM37.00 previously) (WACC: 8.4% TG: 3.0%) After accounting for the high possibility of increase in shelf prices and unpredictability of illicit market volumes, we tweak our WACC higher to reflect these risks (previously, WACC: 8.2% TG: 3.0%).

Source: Hong Leong Investment Bank Research - 22 Oct 2018