BAT reported a disappointing set of results. Although the illicit cigarettes’ market share in 1H19 dropped 3ppts yoy, core earnings declined 20% yoy, whereby we were surprised by expenses incurred on: (i) campaign against the illicit trade; (ii) VFM marketing spend; and (iii) pre-launch investments in the newly-approved Glo. We believe BAT’s near-term outlook is now beset with more uncertainties, owing to the second wave of vape products alongside burgeoning presence of fake tax stamps in the market. Post-earnings revision, we downgrade the stock to a HOLD (from Buy) with a lower TP of RM30.

Below Expectations

1H19 core net profit of RM165m (-20% yoy) accounted for only 36%/37% of our and consensus’ full-year forecasts. Despite a sequential improvement in 2Q19 sales volume (+4% qoq) led by higher sales of value-for-money (VFM) Rothmans following a well-received marketing drive, margins declined 2.6ppts qoq due to A&P for the aforementioned, in addition to an upswing in investment spend on a public campaign against the illicit trade, timing difference in spending, as well as pre-launch costs for its heat-notburn (HNB) products, which have been approved for introduction in 4Q19.

While Smuggled Cigarettes Fell, Another Vice Rears Its Ugly Head…

BAT’s public campaign came about as the illicit trade remained stubbornly high at 60%, despite the authorities’ crackdown on cigarette smuggling activities which led to a 4ppts fall (vs. 4Q18) in smuggled cigarettes’ share. We understand that this was hampered by the rising prevalence of seemingly legal cigarettes sold under fake tax stamps. In addition, BAT’s survey indicated that two-thirds of illicit smokers, instead of switching back to legal cigarettes over the increased enforcement, contemplated converting to vape products. The resurgence in interest arose from the increasingly widespread availability of improved next-generation devices whose nicotine-based refills are prohibited, but are nonetheless still sold through online stores and in numerous vape shops at more affordable prices.

…which Throws a Wrench in the Works

In view of the above, our previously envisaged prospect of the authorities’ efforts to curtail cigarettes smuggling – gradually leading to a substantial recovery in BAT’s earnings – has turned less certain. We gather that the prevalence of fake tax stamps, coupled with the proliferating usage of nicotine vapes now account for approximately 3bn cigarette sticks per year lost from the legal market, alongside RM1.2bn in excise duty leakages.

Source: Affin Hwang Research - 26 Jul 2019