1H20 core PAT of RM116.2m was below expectations, accounting for 43.3% and 44.3% of ours and consensus full year earnings respectively. The shortfall in earnings was due consumers down-trading to VFM brands from premium brands at a quicker rate than expected. We lower our FY20/21/22 earnings forecasts by 10.4%/15.2%/12.9% to account for quicker down-trading to VFM brands going forward. After adjusting for lower earnings, our DCF based TP (WACC: 9.5%, TG: 2.5%) is lowered from RM10.60 to RM9.00. Maintain SELL.

Below expectations. 2Q20 core PAT of RM61.2m (QoQ: +11.2%, YoY: -19.8%) brought 1H20 sum to RM116.2m (-29.5%). This accounted for 43.3% and 44.3% of ours and consensus full year earnings respectively. The shortfall in earnings was due to weaker-than-expected margins from consumers down-trading to VFM brands from premium brands at a quicker rate than envisaged. Core PAT figure was arrived at after adding back RM10.8m from restructuring expenses for staff redundancies.

Dividend. Declared DPS of 18 sen goes ex on 6 Aug 2020, bringing 1H20 amount to 35 sen (2Q19: 26 sen, 2H19: 56 sen).

QoQ. Revenue rose 13.6% due to sales volumes rising 12.0%. This was mainly due to disruption of illicit sales channels during the MCO period, which caused consumers to seek legal alternatives. Additionally, higher legal industry volumes were due to short - term spike in consumer spending due to Hari Raya celebrations as well as retailers restocking inventory after relaxation of MCO rules. Core PAT rose 11.2% in tandem with better sales.

YoY. Revenue declined -14.7% from volume decline of -16.0% mainly due to higher illicit market share as well as sales channels such as “mamak stalls” and duty free stores being shut during the MCO period. Core PAT declined by -19.8% from lower sales as well as unfavourable sales mix.

YTD. Revenue declined 18.5% due to (i) legal volumes decreasing from rampant illicit and vape market share (Figure #2&3) (ii) closure of legal sales channels during the MCO period (iii) consumers down-trading from Premium to VFM segment which have lower shelf prices (Figure #4). Core PAT decline (-29.5%) was even steeper than revenue decline, as down-trading resulted in weaker margins.

Prospects. Despite QoQ uptick in overall industry volumes, we do not expect this to continue as we reckon better legal volumes in 2Q20 was mainly due to consumers having difficulty procuring illicit products during the MCO period. In the absence of any significant government intervention we do not see legal volumes picking up any time soon. Furthermore, we expect consumers to continue to down -trade from premium brand Dunhill (RM17.40/pack) to VFM brands Rothmans (RM12.40/pack) or newly launched KYO (RM11.50/pack) (Figure #5) due to its cheaper shelf price. Note that VFM share of legal volumes have doubled to 14% in FY18 to 28% in 1H20 at the expense of premium and aspirational brands. As the production costs are approximately the same, this will result in slimmer margins going forward.

Forecast. We lower our FY20/21/22 earnings forecasts by 10.4%/15.2%/12.9% to account for quicker down-trading to VFM brands going forward.

Maintain SELL. After adjusting for lower earnings, our DCF based TP (WACC: 9.5%, TG: 2.5%) is lowered from RM10.60 to RM9.00. Maintain SELL.

Source: Hong Leong Investment Bank Research - 24 Jul 2020