The 1H16 core net profit of RM309.1m (-32.6%) is deemed broadly as within our expectation despite only meeting 40% of forecasts as we foresee better 2H16 ahead. As expected, a 2nd interim DPS was declared, bringing 1H16 DPS to 100.0 sen. Hence, our earnings forecasts are maintained. We remain pessimistic on both the legal tobaccos industry and BAT in view of the weak volume trend which has yet to show any signs of recovery. Reiterate UNDERPERFORM with unchanged Target Price of RM48.70.

Broadly within expectations. 1H16 core net profit of RM309.1m (-32.6% YoY) accounted for 40% of both our in-house and consensus full-year estimates. However, we deem the result as broadly within expectations as we are foreseeing better numbers ahead in 2H16 on seasonality and sustained recovery momentum of key brand. 1H16 core net profit was derived after excluding RM85.7m of provision in expenses related to its restructuring exercise. The Group declared a second interim DPS of 45.0 sen, lifting 1H16 DPS to 100.0 sen (vs 1H15: 156sen).

YoY, 1H16 revenue dipped 16.0% to RM2.0b as selling volume slid by 32% following the decline in legal industry volume (-26%) coupled with the loss of BAT’s market share (-2.5 ppt to 58.5%). Gross profit fell by 21.5% to RM678.6m inline with the low utilisation rate of production as a result of low selling volume took a toll on the Group profitability, narrowing gross margin by 2.4ppt to 34.2%. As a result, 1H16 core net profit fell 32.6% to RM309.1m.

QoQ, 2Q16 revenue fell by 5.7% to RM926.6m as BAT selling volume declined 4.4% in line with the general weakness in the overall legal market (-4.0%). While we believe the fasting month played a part in the reduced consumption, the illicit market share might have climbed further (from latest reading of 45.6% in Dec 2015) as the dented affordability as a result of 23%-26% increase in selling price remained the key factor behind the subdued volume. The shrinking volume continued to put margin under pressure with gross margin further narrowed to 33.8% (1Q16:34.6%) and resulting in gross profit falling 8.1% to RM325.1m. Meanwhile, the difference in recognition timing of expenses caused a steeper decline in core net profit of 23.8% to RM133.6m.

Bearish outlook. We remain pessimistic on both the legal tobaccos industry and BAT in view of the weak volume trend which has yet to show any signs of recovery on the back of rampant illicit cigarettes trade encouraged by the huge price increase back in November 2015. However, on a brighter note, we believe appropriate enforcement efforts and the gradual adaptation by the consumers towards the new pricing would be the saving grace to stop volume going forward to deteriorate further from a weak base. Meanwhile for BAT, the performance of its key brand, Dunhill has shown recovery with market share of 43.8% in May 2016 as compared to the low of 43.1% recorded in Feb 2016 as we believe the strong brand name has helped to recapture demand following the negative reaction to the price increase.

Maintaining earnings forecasts. No changes to our earnings forecast.

Reiterate UNDERPERFORM with unchanged Target Price of RM48.70. We maintain our rating and TP, which is based on 17.9x PER FY17E. We continue to value the stock at -1.5 SD over its 5-year mean as we are still wary of the uncertainties over the new cost structure post-restructuring. We also opine that the prospect of special dividend following the disposal of its land and factory in June 2016 for RM218m or 76.0 sen/share as insufficient to compensate for the downside risk of gloomy industry outlook and the challenges to protect its market leader position.

Source: Kenanga Research - 27 Jul 2016