Reported 3Q19 core PAT of RM83.1m (QoQ: +9.0%, YoY: -49.6%) brought 9M19 core PAT to RM248.0m (YoY: -33.2%), accounting for just 60.3% and 66.0% of our and consensus full year earnings, respectively. We lower our FY19/20/21 forecasts by 16.9%/19.1%/20.1% to account for growth in illicit trade and vape in addition to consumers down trading. We tweak our DCF valuation requirements from (WACC: 8.4%, TG: 3.0%) to (WACC: 9.2%, TG: 2.5%) to reflect an uncertain earnings outlook. Our TP drops from RM23.50 to RM16.00. Maintain SELL call.

Below expectations. 3Q19 core PAT of RM83.1m (QoQ: +9.0%, YoY: -49.6%) brought 9M19 core PAT to RM248.0m (YoY: -33.2%). This accounted for just 60.3% and 66.0% of ours and consensus full year earnings, respectively. The shortfall was mainly attributed to lower sales volume due to growth in illicit trade volumes and competition from vape.

Dividend. Declared dividend of 29 sen (3Q18: 40 sen) per share (going ex on 13 Nov 2019) brought 9M19 dividend to 85 sen (9M18: 108 sen) per share.

QoQ. Revenue declined 8.8% of the back of volume decline of 8%. Despite this, core PAT grew 9.0% due to significantly lower marketing spend incurred in 3Q19.

YoY. Core PAT dived 49.6% in tandem with top line decline of 20.6%. This was led by volume decline (-13%) which resulted from (1) growth in illicit trade market share (Figure #2); (2) growth in unregulated vape; (3) introduction of IQOS by rival PMI; and (4) consumers down trading to VFM brand Rothmans.

YTD. Total legal industry volumes declined 11% vs SPLY due to SST-led pricing (tobacco companies raised shelf prices at the onset of SST implementation), rapid increase in vape market share and continued rampant illicit trade. Notably, VFM brands (brands with shelf prices under RM12.50) i.e. Rothmans (BAT), Chesterfield (PMI) etc. continue to grow market share in the legal market at the expense of aspirational and premium brands. Against the same period last year, Rothmans grew from 3.4% to 5.2% of the total legal market. Combination of legal volume decline and consumers down trading from premium and aspirational brands to VFM brand Rothmans resulted in revenue and core PAT declining 10.0% and 33.2%, respectively.

Prospects. Despite appearing to stabilise in preceding quarters, illicit tobacco market share has now risen to 65% vs 61% in 2Q19. Additionally, we understand that vape (9% of total market share) has claimed a significant portion of the smoking market, leaving BAT to contest a shrinking portion of the pie of just 25% market share currently (Figure #4). Despite this, we expect BAT to grow earnings with the introduction of their newly introduced tobacco heating product ‘glo’ (Figure #5). While we are positive on the introduction of glo, we expect the product to take significant marketing investment and time to have an impact on earnings. Note that tobacco heating devices currently make up just 1% of the total market (Figure #4).

Forecast. We lower our FY19/20/21 forecasts by 16.9%/19.1%/20.1% to account for growth in illicit trade and vape in addition to consumers down trading.

Maintain SELL, TP: RM16.00. Unfavourable macro factors mentioned above lead us to tweak our DCF valuation requirements from (WACC: 8.4%, TG: 3.0%) to (WACC: 9.2%, TG: 2.5%) to reflect a wildly uncertain earnings outlook. After incorporating our lower forecasts, our TP drops from RM23.50 to RM16.00. Maintain SELL call.

Source: Hong Leong Investment Bank Research - 1 Nov 2019