The Worst May be Over

BAT’s 1Q18 core earnings fell 20% yoy to RM96.2m, falling below our and consensus expectations. This came amidst continued total market share loss to the illicit cigarettes market, despite cost efficiency gains as well as increased market share in the legal market (+1.1ppt yoy). Nevertheless, we revise our FY18E-20E EPS by - 15%/0%/7% to reflect an expected gradual recovery in total market share for BAT. Post-revision, we upgrade BAT to a BUY with a higher DDM-derived TP of RM37.30, after rolling forward to 2019 earnings.

Q1 Core Earnings Accounted for Only 19% of 2018 Estimates

1Q18 revenue decreased by 15% yoy to RM638m, as the Group recorded a volume decline amidst further legal market contraction, as well as the absence of sales from its winded-down manufacturing operations. Gross margins dropped to 29.9% (-1.4ppt) with a higher mix seen of its Rothman VFM brand. Meanwhile, the illicit market rose to an all-time high of 63% in 1Q18, gaining 3ppt at the expense of total legal industry volume (-4.2ppt yoy). Although illicits’ share has remained flat sequentially, the Group suffered an 8% qoq decline in volume. On a more positive note however, BAT’s legal market share rose 0.8ppt qoq to 54.7%, driven by stronger performance of its Dunhill brand (+0.5ppt qoq) as well as VFM segment (+1.2ppt qoq) which outpaced the cannibalisation of its Aspirational Premium brands. A first interim dividend of 33sen was declared.

Reliant on Positive Actions by the Newly-elected Government

Management opined that despite the zero-GST’s boost to consumers’ disposable income, a material recovery in its prospects is very much contingent upon favourable actions taken by the newly-elected government, primarily with: i) curbing the illicit trade; and ii) addressing the affordability issue posed by current legal cigarette prices. However, they have yet to receive a formal response by the authorities. Nevertheless, we are optimistic that the new government will step up its efforts on plugging-in leakages from excise duties and taxes to increase government revenues (Note: This Marks a Transfer of Analyst Coverage).

Upgrade to BUY With Higher DDM-derived TP of RM37.30

While we cut 2018E EPS by 15% to reflect the weak 1Q18 results, our 2020E EPS is raised by 7% to reflect our optimism in BAT’s market share gains. We assume the illicit market share to fall from 7ppts yoy to 55% in 2019E, driven by the government’s efforts to clamp down on illicit trade. We roll forward our valuation horizon to 2019E, lifting our TP to RM37.30.

Source: Affin Hwang Research - 22 May 2018