BAT reported a sequentially stronger set of results. 2Q18 earnings rose by 14.5% qoq, predominantly on higher volume sales while margins improved amidst normalised growth in the VFM segment, as well as materialised cost-down initiatives. Overall, the results were within our expectations but fell short of the market’s. We instead turn our attention to the Customs director-general’s recent comments on the fiscal necessity to plug the government’s tax leakages, of which the illicit cigarettes trade has been a key constituent, further supporting our view of a tougher wave of enforcement activity to follow soon. Reiterate BUY with an unchanged CY19E DDM-derived TP of RM43.10.

Results Broadly Within Expectations

On a yoy basis, BAT’s 1H18 net profit shrunk by 22.5% to RM206.4m, driven by a -3.5ppts decline in legal industry volume as the illicit cigarette market climbed 4ppts over 1H17 to an all-time high of 63%, despite the company recording +1.3ppt yoy growth in legal market share to 57.8% (restated figures from 2Q18 onwards). Overall, the results disappointed the street but came as no surprise to us, as we expected the illicit market to sustain at its all-time high level of 63% until the end of the year, as enforcement efforts will take time to materialise. A second interim dividend of 35 sen (2Q17: 43 sen) was announced for the year.

Fresh Positives From the Authorities

In a Star article published yesterday, the director-general of the Royal Malaysian Customs, Datuk Seri Subromaniam highlighted in talks on Tuesday the department’s priority of thwarting the corruption underlying the substantial tax leakages directly needed by the Pakatan government, subsequent to a meeting with Finance Minister Lim Guan Eng. The issue of strongly tackling the illicit cigarettes trade in order to recoup significant leaked revenues was also separately discussed during the same talks by the President of Transparency International Malaysia.

Maintain BUY With An Unchanged Target Price of RM43.10

The news came as a strong reassurance to our view that the war on the illicit trade will arrive in due course and subsequently revive BAT’s earnings prospects over the next few years, driven by the Pakatan-led government’s fiscal and administrative motivations. We hence maintain our earnings forecasts and reiterate our BUY call on BAT, with an unchanged CY19E DDM-derived TP of RM43.10. Downside risks: i) weak enforcement initiatives; and ii) further excise duty and sales tax hikes.

Source: Affin Hwang Research - 20 Jul 2018