Period

1Q16/3M16

Actual vs. Expectations

3M16 net profit of RM175.5m (-27.9% YoY) is below expectations, accounting for 18.5% of our in-house forecast and 19.8% of the consensus’ estimate. The negative deviation can be attributed to lower-thanexpected sales volume.

Dividends

As expected, first interim DPS was declared but the amount of 55.0 sen (vs. 1Q15: 78.0sen) was below expectations due to the weaker-than-expected profit.

Key Results Highlights

YoY, 3M16 revenue dipped 19.9% to RM1.0b following a 34.1% slump in sales volume. The legal industry volume shrank by 29.7% after the massive excise duty hike which led to price increase (23%-26%) in November 2015. Gross margin narrowed 1ppt to 34.6% as production utilization rate fell below 20%. As a result, net profit declined by 27.9%to RM175.5m.

QoQ, 1Q16 revenue fell 3.5% to reflect the full effect of price increase with volume shrinking 11.1% QoQ, higher than the industry volume decline of 5.3% as consumers down-trade to Aspirational Premium cigarettes, a segment that is not BAT’s forte. Earnings margins deteriorated due to the lower volume and thus net profit dropped 9.8% to RM175.5m.

Outlook

The negative reaction of volume to the price increase was worse than initially expected. The illicit market share strengthened to a staggering 45.6% in Dec 2015 as consumers were forced to down-trade with the affordability of legal cigarettes significantly dented by the price increase.

Furthermore, BAT has lost market share (by 2.3ppt to 58.7% in 1Q16 from 61.0% in FY15) as the Premium segment (75% of its product mix) fell prey to the downtrading behaviour in the legal industry due to the higher selling prices. As such, the Group has announced the cessation of its operations in Malaysia due to the low utilisation rates (refer overleaf for details).

In a nutshell, we have turned more pessimistic on the outlook of BAT as well as the whole legal tobacco industry as we do not foresee the volume to rebound significantly in the near term. We think that the downcycle is likely to persist as the affordability issue of cigarettes is not within the Group’s reach to address.

Change to Forecasts

We downgrade FY16E-FY17E net profit by 17.6% and 18.0% respectively after assuming lower sales volume (by 15.6%-17.6%) by revising down the industry volume and BAT’s market share.

Rating

Downgrade to Underperform (from Market Perform)

Valuation

We downgrade our Target Price to RM48.70 (from RM57.78) after the slash in earnings and rollover of valuation base year to FY17E. We continue to value BAT at -1.5SD over its 5-year mean (17.9x PER) to reflect the negative outlook.

Risks

Better-than-expected gain in market share.

Better-than-expected enforcement efforts.

Source: Kenanga Research - 27 Apr 2016