Near-term outlook remains highly challenging for BAT, in our view - underpinned by a confluence of factors: i) stubbornly high illicit incidence, ii) dwindling corporate market share and iii) down-trading towards VFM segment. In our recent meeting with management, we gathered that active engagement with the relevant authorities is ongoing. Nevertheless, unless more radical action is taken, we maintain our stance that the illicit market will remain at elevated levels. We cut our 2022E earnings by 13%. In tandem, we lower our DDM-derived TP to RM9.20, from RM10.00. We reaffirm our SELL call.

Unabated Siege From Illegal Tobacco Market

Illegal cigarette trade remains rife, with illicit incidence hovering at an elevated 69%, including illegal vaping. During our recent meeting with management, we gathered that there’s been ongoing engagement with the relevant authorities in recent periods post the MCO. The authorities were said to be generally receptive towards seeking an effective solution to address the issue. That said, unless more radical enforcement is taken, we believe the illicit market is unlikely to abate sizably over the near term.

Continual Drop in Market Share

Notwithstanding an overall legal industry contraction, BAT’s volume is seen to have registered even sharper decline. This is particularly evident with BAT showing a stark volume decline in 1Q20 of 21% yoy against that of the industry which fell 11% yoy – potentially suggesting an increasingly competitive landscape, especially from the 2 other major tobacco players: Japan Tobacco International and Phillip Morris International likely owing to more effective marketing strategies and better brand appeal.

Down-trading Further Exerts Pressure on Margins

Elsewhere, the skew towards value-for-money (VFM) segment (Rothmans) at the expense of premium brand (Dunhill) will likely gain momentum going forward, given the increasing strain in affordability. We believe the lower margin VFM mix will likely exert further pressure on the group’s margins.

Maintain SELL

All in all, we remain doubtful of a sizable recovery in legal tobacco volume given the unyielding illicit tobacco trade. We cut our earnings forecasts by 1/13% for 2021/22E broadly factoring in dwindling legal FMC volumes and further market share losses. We reiterate our SELL rating with a lower DDMderived 12-month TP of RM9.20. Yield of c.7% may not be appealing as payouts have been shrinking amidst an extremely challenging operating environment. Upside risks: i) better-than-expected enforcement outcomes, ii) excise-duty hike reversal and iii) abating competition from alternative products

Source: Affin Hwang Research - 3 Jul 2020