Period  3Q14/9M14

Actual vs. Expectations 9M14 net profit of RM714.6m was within expectations; accounting for 79% and 79.4% of the consensus and our in-house forecast, respectively.

Dividends  DPS of 78 sen was declared in the quarter, bringing YTD DPS to 231 sen which is in line with our full-year DPS forecast of 308.9 sen.

Key Results Highlights YTD, revenue grew 4.9%, mainly backed by higher selling price due to the excise duty hike with sales volume recorded a 6.2% decline mainly due to the weak performance of its Pall Mall line-ups as well as downtrading in the market. Meanwhile, gross profit registered higher growth of 11.7% to RM1.27b as a result of higher efficiency level which led to gross margin expansion of 2.2 ppts to 35.3%. Besides, lower interest expense (-16.3%) was incurred following the repayment of Medium Term Note in August. As a result, net profit surged 12.6%.

 YoY, 3Q14 net profit was up 9.9% on the back of marginally higher revenue (3.3%), as the topline growth was limited by shrinking legal market volume (2.8%) during the period. The better net earnings can be attributed to the higher productivity level, as well as the  comparison against the lower net income last year which was dragged down by non-recurring leaf restructuring expense amounting to RM13m and settlement of dispute costing RM9m.

 QoQ, 3Q14 revenue was down by 1.3% following the short-term price hike in September (which lasted 2 weeks) by the Group which resulted in price disparity and thus adversely affected the competitiveness of BAT brand cigarettes, which subsequently induced the Group to reverse the price hike decision. Meanwhile, operating expenses were pushed higher by 13.2% due to recognition timing of its marketing expenses. As a result, net profit slid 2.8% vis-a-vis previous quarter.

Outlook  Legal volume showed continuous recovery for the third consecutive quarters after the low in 4Q13, thanks to the Ops Outlet operation which conducted intensive enforcement on the illegal cigarettes trade with the latest reading of illegal market share at 35.8%, down from a high of 38.9% previously. As a result, the YoY decline in legal volume has narrowed down to 7% as of 9M14 from 7.6% (1H14).

 For BAT, the Group has managed to grow its market share to 61.5% in 3Q14 (vs 2Q14:61.4%) after two consecutive quarters of sliding market share, due to the recovery in Dunhill sales after the launch of new variant and further aided by the overwhelming performance of its aspirational premium star, Peter Stuyvesant.

 Outlook was slightly boosted by the recovery of legal volume as well as consolidation of market share. However, the industry volume is still not expected to see significant turnaround following the last price hike as well as the higher cost of living environment, which encourages downtrading to cheaper illegal cigarettes. All in all, we remained negative on BAT despite the decent financial performance, which was driven by selling price hike rather than the industry volume growth.

Change to Forecasts  We have factored in lower decline in legal volume growth in FY14 to 6.6% from 7% previously but maintain the flattish 2% growth in FY15 following the effective outcome from the Ops Outlet operation. As a result, FY14E and FY15E net profit are tweaked higher by 2.7% and 1.7%, respectively.

Rating Maintain UNDERPERFORM

 Our Target Price is nudged higher to RM65.70 from RM64.50 following the earnings upgrade. Our TP offers potential upside of mere 2.9% (-1.5% capital loss and 4.4% dividend yield), which is still insufficient to warrant a rating upgrade; thus we maintain our call.

Valuation  No changes to our valuation parameters as we continue to peg our TP at 20x FY2015F PER, which implies +0.5SD over its 5-year mean.

Risks to Our Call  Better-than-expected recovery in legal volume  Better-than-expected efforts of Royal Malaysia Customs.

Source: Kenanga