Affordability Remains An Issue

9M17 core earnings fell by 19% yoy to RM420m, coming in below our and consensus expectations. BAT’s cigarette volumes declined marginally by 1.7% qoq; its premium brand Dunhill lost market share to the value-for-money (VFM) segment as affordability remains an issue that prompts smokers to switch. BAT entered the VFM segment with the launch of Rothmans. We cut our 2017-19E EPS by 10-12% as we assume a higher contribution from the VFM segment, which has a lower ASP and margin. Maintain HOLD with a lower TP of RM39.50.

3Q17 Earnings Below Our Expectations

3Q17 revenue declined by 18.8% yoy to RM757.3m as cigarette volume dropped c.15% yoy. Operating expenses rose 12.7% yoy due to marketing expenses on the launch of Rothman in October and will likely be extended into 4Q17. Hence, 3Q17 core net profit fell 30% yoy. 9M17 core net profit was RM420m, accounting for 63% and 67%, respectively, of our and consensus full-year estimates. We see the result as below expectations as the company continues to struggle vs. illicit cigarettes and in the VFM segment. BAT declared a 3rd interim DPS of 43 sen (vs. 3Q16: 55sen).

The Recovery in Legal Market Due to VFM Segment.

In 3Q17, the legal cigarette volume increased by 3% qoq driven by VFM, resulting in the legal’s market share to increase by 2ppts to 44%. However, BAT lost market share and its volume declined by 1.7% qoq. This is because affordability remains an issue that prompted smokers to switch to the VFM segment with lower ASP. Management also noted a new illegal cigarette dynamic, whereby certain local players sell cigarettes with fake tax stamps. As a result, BAT decided to increase its product portfolio and introduce Rothmans, a VFM segment with an ASP of RM12/pack, vs. its Dunhill brand’s selling price of RM17/pack.

Maintain HOLD Rating With Lower DDM-derived TP of RM39.50

We cut our 2017-19E EPS by 10-12% as we assume a higher contribution from the VFM segment, which cannibalizes Dunhill. While BAT’s new sourcing model has helped improve gross margin in 9M17, cost savings will likely be used to fund investment in the VFM segment, which has a lower ASP and profitability. We maintain our HOLD call with a lower DDMbased 12-month TP of RM39.50 (from RM43.50) given our weaker earnings base. Key upside risks: stronger-than-expected sales volume and lower-than-expected operating expenses. Key downside risk: excise hikes.

Source: Affin Hwang Research - 24 Oct 2017