Downgrading: Illicit Trade Looking Intractable

BAT’s 9M19 results fell below both our and street’s expectations. Volume sales continued to decline qoq, while the apparent plunge in vape sales merely led to a resurgence in illicit cigarette sales. Amid the prevailing gloom, management has elected to undertake costcutting measures in a bid to stymie its earnings bleed. Post-earnings revision, we downgrade BAT to a HOLD, with a lower TP of RM19.20.

Below Expectations

Core net profit fell 30% yoy to RM248m in 9M19, as BAT’s volume sales declined 13% yoy (industry volumes -11% yoy) while gross margins progressively compressed due to downtrading towards value-for-money (VFM) cigarettes. Although illicit cigarette volumes also fell yoy in tandem with the overall market contraction, their market share rose to an all-time high of 65% in 3Q19 – reversing the cutback seen in 6M19, partially due to the significant qoq drop in vape sales. Overall, the results disappointed the street and us, accounting for 66% and 68% of full-year estimates respectively due to the worse-than-expected volume decline.

Resorting to Cost Rationalisation

As the increase in enforcement activities by authorities against the illicit trade failed to yield significant results, while the overhang of prohibited vape products’ prevalence remains unresolved, management has turned to cost cutting measures in lieu of growth-based endeavours. These include an internal reorganisation affecting 20% of its existing staff from 4Q19, in addition to moderated A&P budget going forward. Despite the introduction of its heat-not-burn product line (‘Glo’) which is priced competitively and yet offers higher margins due to much lower excise duty charges on its ‘Neo’ heat sticks, we do not expect the ensuing profit contribution to be enough to make up for declining sales of its traditional cigarettes over the near term.

Downgrade to HOLD

We cut 2019-21E EPS by 10-18%, reflecting our less optimistic stance on volume sales recovery in view of the unyielding illicit cigarettes and vape situation, while banking on cost cutting to prop up profits going forward. Post-revision, we downgrade BAT to a HOLD (from Buy) with a lower DDMderived TP of RM19.20 (from RM27.80). Yields of c.6% do not present enough appeal due to the elevated earnings uncertainty, in our view. Upside/downside risks: i) better/weaker-than-expected enforcement outcomes; ii) reversal/resumption of excise duty hikes; and (iii) abating/heightened competition from alternative products.

Source: Affin Hwang Research - 1 Nov 2019