1QFY19 core PAT of RM88.6m was below ours and consensus expectations, accounting for 19.3% and 18.2% of forecasts respectively. The poorer than expected earnings was mainly due to lower volumes and unfavourable product mix. BAT expects to launch their “heat-not-burn” device ‘glo’ as soon as they receive government approval. Cut FY19/20 earnings forecast by 1.8/1.7% to account for lower than expected industry volumes. After our earnings adjustment, our TP falls from RM24.50 to RM24.00 based on an unchanged DCF valuation methodology (WACC: 8.4%, TG: 3.0%). Our SELL call is maintained.

Below expectations. 1QFY19 core PAT of RM88.6m (QoQ: -8.7%, YoY: -7.9%) was below ours and consensus expectations, accounting for 19.3% and 18.2% of forecasts respectively. The poorer than expected earnings were mainly due to lower volumes and unfavourable product sales mix.

Dividend. 30 sen per share going ex on 13 Jun 2019. (1Q18: 33 sen)

QoQ. Decline in legal market volumes (-8.0%) were due to (1) Public Place Smoking (PPS) ban which came into effect in Jan 2019 and (2) growth in quasi legal cigarettes with fake tax stamps. Lower volumes were exacerbated by decline in aspirational brands (Pall Mall, Peter Stuyvesant; RM15.90/pack) at the expense of lower margin VFM brand ‘Rothmans’ (1Q19: 5.1% market share vs 4.6% in 4Q18) (RM12.40/pack). As a result, top line declined 19.4% to RM621.0m, in line with BAT’s volume decline of 15.5%. Core PAT was lower by 8.7% in tandem with lower sales.

YoY. Core PAT dropped -7.9% to RM88.6m for similar reasons mentioned above. Despite headline sales figure showing a -2.6% decline, after adjusting for SST pricing, the decline was -9.1% on a like for like basis. BAT volumes decline of -9.6% was more severe than the -6.0% drop in industry volumes due to the group’s relatively higher product mix of premium brands.

Prospects. Unexpectedly, lower reported illegal market share in 1Q19 (figure 2) did not lead to increase in legal volumes, which in fact declined. We suspect this is due to (1) growth in popularity of the PMI’s IQOS, (2) rebounding usage of vape products and (3) impact of the PPS ban. While headline illegal market share figures showed promise in 1Q19, we understand illicit players are becoming increasingly sophisticated at distribution illegal cigarettes, with increasing online selling and tracking of enforcement vehicles.

Glo. BAT have shared that they are fully ready to introduce their version of a “heat-not burn” device ‘glo’ (figure 7) to the market. We expect the device and refills to be priced similarly to PMI’s IQOS (Device: ~RM350, refills: RM14/pack of 20). Currently, BAT is still waiting for pricing approval for the refillables from the MoH before launching glo. While we expect BAT to launch glo by year end, we understand it will take time to grow market share given IQOS has already seized first mover advantage, which has shown to be crucial in other countries (figure 5,6).

Forecast. We reduce FY19/20 earnings forecast by 1.8/1.7% to account for lower than expected industry volumes and growth in VFM market segment at the expense of aspirational brands.

Maintain SELL, TP: RM24.00. After our earnings adjustment, our TP falls from RM24.50 to RM24.00 based on an unchanged DCF valuation methodology (WACC: 8.4%, TG: 3.0%). Our SELL call is maintained.

Source: Hong Leong Investment Bank Research - 29 May 2019