BAT 1Q20’s core earnings contracted 37% yoy to RM55.4m, coming in below our and consensus expectations (19%/17% of full-year estimates). BAT’s domestic volume fell 21% in tandem with lower legal industry volume, coupled with reduced duty-free sales and market down-trading. We remain cautious as the tobacco industry continues to see high illicit cigarette trade, which is unlikely to abate much without a radical approach to enforcement activities. Post earnings cuts of 2-12% for FY20-22E, we downgrade BAT to SELL, albeit with a higher TP of RM9.50 after rolling forward our DDM valuation horizon.

Slightly Below Expectations

BAT’s 1Q20 revenue declined by 22.5% yoy to RM481.1m as domestic volume fell 21%, on the back of legal market contraction (-11%), reduced duty-free sales and market down-trading. Illicit incidence remains high at 69% (vs 68% in 4Q19), with 58% being FMC and 11% illegal vapes. In tandem with lower sales and higher value-for-money cigarette mix, EBITDA margin was down 3.2ppt. Excluding one-offs (mainly restructuring expenses), core net profit came in at RM55.4m (-36.9% yoy). We deem this below our and street expectations, accounting for 19% and 17% of respective forecasts. The variance to ours was partly on higher-than-expected opex.

Illicit Incidence Remains High

Sequentially, both revenue and core earnings declined -27% and -51%, owing to lower volume, stock in trade correction and seasonality factors. BAT announced an interim dividend of 17sen (1Q19: 30sen). In spite of Covid-19 business disruptions, the management indicated that they see little likelihood of adjusting down their payout policy of >90% of PAT. We gather that much of the group’s focus for 2020 would be to streamline its cost base while optimising investment to drive growth in its key brands.

Downgrade to SELL

In view of the results, we cut our earnings by 2-12% for FY20-22E, factoring in higher opex. We downgrade BAT to SELL (from HOLD), albeit with a higher DDM-derived TP of RM9.50, after rolling forward our valuation horizon. All in, we remain cautious on the operating environment challenged by Covid-19 disruptions and a stubbornly high level of illicit cigarette trade, which is unlikely to abate much without a radical approach to enforcement activities. Yields of c.6% may not present enough appeal to accumulate the stock given the risk of further earnings contraction, in our view.

Key Risks

Upside risks: i) better-than-expected enforcement outcomes; ii) reversal of excise duty hikes; and iii) abating competition from alternative products.

Source: Affin Hwang Research - 22 May 2020