BAT's  9MFY12  earnings were within  expectations, with  its  earnings  growing despite softer domestic volume as increased subcontract manufacturing volumes, greater  economies  of  scale  and  lower  compensation  provisions  boostedprofitability.  Despite  the  stronger industry performance, BAT's 3Q  volumes  were weaker y-o-y as it faced less trade speculation of an excise hike prior to the 2013 Budget  announcement.  We  are  downgrading  the  company  to  SELL  despite  its stellar  corporate  governance  and  commanding  market  share  as  industry prospects  are  weak  and  regulatory  risks  abound.  Dividend  yields  are  at  historic lows.  
 
Broadly  within  expectations.  BAT  saw  its  revenue  grow  to  RM1.2bn  in  3QFY12 (+5.0% y-o-y, +8.6% q-o-q) and RM3.3bn in 9MFY12 (+4.2% y-o-y) despite domestic net revenue declining by 1.4% YTD. The driver behind the rise is the firm's switch from toll manufacturing  revenue  recognition  previously  to  subcontract  manufacturing  revenue recognition in 2012.  Turnover  from  manufacturing  for its  affiliates  within  the  BAT  group will now include both raw material costs and a mark-up, from just a mark-up previously. Revenue  growth  from  the  change  in  revenue  recognition  methodology  will  be unsustainable  moving  into  next  year.  3Q  and  9M  earnings  clocked  in  at  RM185.7m (+5.3% y-o-y, -15.9% q-o-q) and RM601.0m (+11.5% y-o-y) respectively as higher cost efficiencies  from  greater  economies  of  scale  (production  volume,  including  subcontract manufacturing, grew 26% YTD), a one-time distribution restructuring charge of RM12m in  2011,  and  lower  employee  compensation  provisions  boosted  earnings.  The  9M bottomline reflects 78.0% and 77.0% of our and consensus full year forecasts.
 
Volumes weaker on lesser speculation. BAT's domestic cigarette shipments fell 4.9% y-o-y to 2.2bn sticks in 3QFY12 as trade speculation of an excise duty  hike prior to the 2013  Budget  announcement  were  lower  than  3QFY11. As a result, the company's 9M
shipments  declined  marginally  by  0.7%  despite  an  industry  growth  of  5.1%.  Industry volumes expanded 7.1% in 3Q as BAT's competitors piled up inventory and pushed out more stock to their distributors prior to the unveiling of the Budget.
 
Dunhill does it again. Market share remained steady q-o-q at 62.7% in 3Q, lifting YTD market share to 62.5% (+1.5ppt vs 2011). Dunhill was the only driver behind the market share increase, with nearly half of the legal cigarettes smoked in the country now being
Dunhill. The brand saw market share gain 2.4ppt to 47.1% YTD. BAT's other brands, in contrast, saw declining market shares. Illicit cigarettes have grown slightly over the past few months to account for 34.9% of total cigarette smoked (+0.2ppt q-o-q).

Government  forces  higher  taxes.  We  have  received  greater  clarity  regarding  the  higher  tobacco-related taxes, which resulted in a RM0.20 per pack price increase since 22 Oct. Although the Government has kept excise duties unchanged at RM0.22 per stick and ad-valorem taxes at 20% of ex-factory price, it has chosen to  impose  a  higher ex-factory price on cigarettes instead of performing a frequent review on the company's manufacturing  costs.  This  will  result  in  higher  ad-valorem  taxes,  persuading  BAT  to  raise  its  prices.  The company has marginally over-covered the higher taxes through its price increase (ie. the additional tax is less than RM0.20 per pack). Although the Government has spoken to all industry players,  the other players have yet to reveal the quantum of the ex-factory price increase. JTI and PMI have yet to raise their selling prices.
 
Downgrade to SELL. We are raising our FY12 earnings forecast by 3.5% despite potentially softer volumes in  4Q  as  operating  expenses  were  lower  than  expected. We  are  however  trimming  our  FY13  estimates  by 0.8%  on  expectations  of  minor  substitution  to  illicit  cigarettes  following  the  2.0%-2.4% rise in BAT's selling prices.  We  are  hence  downgrading  BAT  to  SELL,  with  our  FV  revised  down  to  RM56.22  (WACC:  5.5%, terminal  growth:  1.0%).  The  company  continues  to  be  one  with  stellar  corporate  governance  and  a commanding  market  share.  However,  industry  growth  prospects  are  weak,  with  regulatory  risks  likely  to further intensify after the general election. The firm's dividend yield of 4.1% is the lowest since the turn of the millennium,  1.3ppt  lower  than  the  last  three-year  average  of  5.4%.  The  additional  yield  above  that  of  the Malaysian  10-year  government  bond  has also  narrowed  to 0.7ppt  from  an  average of  1.6ppt.  The company has declared a quarterly dividend of RM0.65, bringing YTD dividend to RM1.95 per share.

Source: OSK