1Q20 core PAT of RM55.0m (QoQ: -51.4%, YoY: -37.9%) accounted for 17.4% of both ours and consensus full year earnings respectively. We lower our FY20/21 forecasts by 15.1%/23.5% to account for higher illicit market share going forward of between 68-70%. After adjusting for lower earnings, our DCF based TP (WACC: 9.5%, TG: 2.5%) is lowered from RM15.00 to RM10.60. We downgrade our call from a Buy to a SELL.

Below expectations. 1Q20 core PAT of RM55.0m (QoQ: -51.4%, YoY: -37.9%) accounted for 17.4% of both ours and consensus full year earnings respectively. The shortfall in earnings was due to lesser sales, as illicit market share rose to 69%, the highest it has even been. Core PAT figure was arrived at after adding back RM4.2m from severance payments for staff redundancies.

Dividend. Declared DPS of 17 sen goes ex on 5 Jun 2020 (1Q19: 30 sen).

QoQ. Revenue fell -27.4% to RM481.1m from lower sales volumes which was due to (i) growth in illicit trade and the expense of legal market share (Figures #2 & #3), (ii) absence of duty-free sales (which makes up approximately 4% of total sales) from travel restrictions and (iii) down trading from premium brand Dunhill (RM17.40/pack) to VFM brand Rothmans (RM12.40/pack). Core PAT approximately halved (-51.4%) due to weaker sales and down trading, which resulted in weaker margins.

YoY. Sales declined -22.5% due to similar reasons mentioned above. Core PAT decline was even steeper, at -37.9%, which was due to increased marketing spend in new products such as tobacco heating product (THP) glo and VFM brand Rothmans. This was in spite of head-count reductions in 4Q19 and 1Q20.

Outlook. Although BAT indicated that it was able to continue fulfilling orders during the MCO period, 2 factors emerged to hamper earnings: (i) higher illicit reading and (ii) consumer down trading. After approximately 2 years of illicit market share plateauing between 60-65%, we reckon that Covid-19/MCO has caused greater substitution from legal smokes to illicit as (i) consumers suffer from lower income and (ii) greater difficulty in getting legal cigarettes. In the absence of significant government clampdown on illicit trade, BAT continues to face a losing battle to reclaim smokers that have most likely gotten used to paying a lower price for illicit market cigarettes (~RM5/ pack) or smoking illegal vape which can be bought online. While BAT’s exact product mix sales breakdown during this quarter is unavailable due to Covid-19 disrupting data collection operations, we suspect that consumers are continuing to trade down from premium brand Dunhill (RM17.40/pack) to VFM brand Rothmans (RM12.40/pack) due to its cheaper shelf price. As the production cost for both brands are approximately the same, this is resulting in slimmer margins. We expect this trend to continue going forward. Note that Rothman’s market share has grown from 3.2% at the start of FY18 of the legal market to approximately 7.0% currently.

Forecast. We lower our FY20/21 forecasts by 15.1%/23.5% to account for higher illicit market share going forward of between 68-70% (from our assumed 65% previously) as well as quicker than expected down trading to VFM brand Rothmans.

Downgrade to SELL. After adjusting for lower earnings, our DCF based TP (WACC: 9.5%, TG: 2.5%) is lowered from RM15.00 to RM10.60. We downgrade our call from a Buy to a SELL.

Source: Hong Leong Investment Bank Research - 28 May 2020