Period  2Q14 / 1H14

Actual vs. Expectations Net profit (NP) of RM473.5m for 1H14 came in within expectations; at 52.6% of our full-year forecast of RM899.9m and 54.5% of the consensus estimate of RM868.7m.

Dividends  A second interim dividend of 78 sen was declared as expected. Added to the first interim dividend, the total comes to 146 sen, or 47% of our FY14E NDPS forecast of 309 sen (representing a FY14 dividend yield of 4.5%).

Key Result Highlights QoQ, 2Q14 revenue rose by 6.2% on the back of higher domestic and duty-free volumes (+5.9% QoQ), and improved performance in contract manufacturing (+20% QoQ). This was largely attributable to the continuous efforts taken by the Royal Malaysia Customs (RMC) in tackling illicit cigarettes issue. The increased revenue coupled with lower operating expenses (-8.9% QoQ) in 2Q14, due to the timing of marketing expenditure, helped to lift the group’s NP by +10.1% QoQ to RM248.1m.

 YoY, 1H14 revenue improved modestly by 5.7% as the compound effect of pricing in June 2013 (30 sen/pack) and the excise-led price increase in Sept 2013 (RM1.50/pack) was more than enough to compensate for the declining volume in both the Domestic and Duty-Free Segment (-5.5% YoY) and the Contract Manufacturing segment (-18.4% YoY). Meanzhile, the group EBIT margin expanded by 2.5ppt to 27.3%, largely due to the better pricing strategy as mentioned above and a more favourable product mix with higher margin products. Consequently, this led to a 14.1% rise in 1H14 NP.

 YTD, BAT’s market share in Malaysia remained almost flat at 61.7% (-0.1 ppt YoY). However, the excise duty increase in Sept 2013, two years after the last hike, continued to put pressure on the company’s Premium brand portfolio.

Outlook  The tobacco sector is a sunset industry where the total industry volume has been on a declining trend. The higher revenue and NP were mainly supported by the higher cigarette price following the excise duty hike last year, but consumption volume has been shrinking. We believe that this trend of relying on higher price driver cannot be sustained over time. Consumption volume could be under another round of pressure from GST implementation next year, and also a possible further reduction in subsidies towards end-CY14.

 FY14 net dividend yield of 4.5% is now close to its 3-year average trough levels. This is unappealing vis-à-vis the 10-year MGS of c.4.0% or the REITs sector average yield of c.5.5%.

Change to Forecasts We maintain our FY14E-FY15E NPs of RM899.9m- RM922.1m, respectively.

Rating  We are maintaining our UNDERPERFORM rating as the risk-to-reward ratio is now leaning unfavourably given the reasons mentioned above which translate into flattish growth prospects.

Valuation  Our valuation of BAT remains unchanged at RM64.50, which is based on a targeted PER of 20x (+0.5SD above its 5-year mean average) on the FY15 EPS of 322.9 sen.

Risks to Our Call  Better RMC’s success in clampdown of illicit trade which would benefit the legal market TIV and BAT.

Source: Kenanga