1H19 core PAT of RM164.9m accounted for just 36.6% and 37.4% of ours and consensus FY19 forecasts. The shortfall was mainly attributed to lower sales volumes and higher operating expenses from marketing activities. Despite BAT receiving approval from MoH to launch their HNB device Glo, we expect the group to face significant headwinds in grabbing market share due to the increasing popularity of IQOS and other vape products. We lower our FY19/20/21 forecasts by 8.7%/ 3.0%/ 1.1%. Maintain SELL with a lower TP of RM23.50 (from RM24.00) with WACC of 8.4% and TG of 3.0%.

Below expectations. Reported 2Q19 core PAT of RM76.3m (QoQ: -13.9%, YoY: 30.8%) brought 1H19 core PAT to RM164.9m (YoY: -20.1%). This accounted for just 36.6% and 37.4% of ours and consensus full year FY19 earnings. The shortfall was mainly attributed to lower sales volumes and higher operating expenses from marketing activities.

Dividend. Declared dividend of 26 sen per share (going ex on 8 Aug 2019), bringing 1H19 dividend to 56 sen (2Q18: 35 sen, 1H18: 68 sen) per share.

QoQ. Core PAT declined 13.9% mainly due to significantly higher operating expenses from marketing spend on new product variations of value for money (VFM) brand Rothmans. This was in spite of higher sales of 3.2% due to higher volumes from Rothmans.

YoY. Revenue declined 5.6% in tandem with total industry volume decline of 10.6% (Figure 3). Lower sales and higher operating expenses from reasons mentioned above resulted in core PAT declining by 30.8%.

YTD. Lower sales of -4.2% (-9.0% after adjusting for GST removal) was attributed to the growth of VFM brand ‘Rothmans’ (RM12.40 per pack) at the expense of aspirational brands (RM15.90 per pack) as well as lower overall legal industry volumes (-8.3%) cannibalized by IQOS and other vape products. Lower sales coupled with higher operating expenses (+19.3%) resulted in core PAT declining 20.1%.

Prospects. Alarmingly, lower reported illicit market share in 1H19 (Figure 2) did not lead to increase in legal volumes, which in fact declined. This was predominantly due to the growth in popularity of IQOS and other vape products. While BAT shared that they have received approval from the MoH to launch their “Heat not Burn” device, Glo (Figure 7), it is expected to only be launched in 4Q19. Furthermore, we expect the group to incur significant marketing expenses in order to claim market share for Glo, which proved to be challenging in other markets where they lagged behind IQOS (Figure 5-6), particularly given the high start-up cost to consumers purchasing the heating device, which we expect to be upwards of RM250. Despite media reports of increased clamp down on illicit trade, we expect BAT to continue to face volume decline as smokers continue to switch to IQOS or other vape options.

Forecast. We lower our FY19/20/21 forecasts by 8.7%/3.0%/1.1% to account for decline in legal market volumes from the growth of IQOS and vape alternatives.

Maintain SELL, TP: RM23.50. After rolling over our valuation year and factoring in lower earnings, our TP falls from RM24.00 to RM23.50 based on an unchanged DCF valuation methodology (WACC: 8.4%, TG: 3.0%). Our SELL call is maintained.

Source: Hong Leong Investment Bank Research - 26 Jul 2019