9M16 core net profit of RM517.7m (-27.7% YoY) was below our expectation (66%) but within the consensus’ (73%) as we were too hopeful for a normalization in sales volume. As expected, a 3rd interim DPS was declared, bringing 9M16 DPS to RM1.55. Hence, FY16E-FY17E profits are trimmed by 8%- 5%. 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 lower Target Price of RM46.40.

Below our expectation. 9M16 core net profit of RM517.7m (-27.7% YoY) accounted for 66% of our in-house, and 73% of street, full-year estimates. The result was within consensus expectation but below ours as we were too optimistic of a normalization in sales volume. A 3rd interim DPS of 55.0 sen was declared, bringing YTD DPS to RM1.55 which is also lower than what we initially forecasted due to the weaker-than-expected profit.

YoY, 9M16 revenue fell 17.2% to RM2.9b with sales volume contracting 32.3%, which is in line with the volume slump of 28.6% in legal industry as the illicit market share strengthened to an alarming rate of 50% in May 2016 (vs 2015: 37%). Meanwhile, 9M16 gross profit dipped 23.1% to RM1.0b as gross margin narrowed by 2.6ppt due to low production utilisation rate (>20%) dragged down by low sales volume. As a result, 9M16 core net profit slid 27.7% to RM517.7m.

QoQ, 3Q16 revenue fell marginally by 3.2% to RM932.2m with the downfall, attributable to the 34% fall in contract manufacturing volume due to the planned cessation of its manufacturing facilities. While 3Q16 gross profit of RM323.2m was flattish as compared to 2Q16, core PBT surged 20.8% to RM244.3m thanks to the swing in marketing expenses recognition in between the quarters. As a result, 3Q16 core net profit jumped 56.1% to RM208.6m, further aided by lower effective tax rate of 14.6% (vs 58.8%) as tax expenses were rectified following the overprovision in 2Q16.

Negative outlook. We remain pessimistic on both the legal tobaccos industry and BAT in view of the weak volume trend that has yet to show any signs of recovery on the back of rampant illicit cigarettes trade encouraged by the huge price increase (23%-26%) back in November 2015. Our earlier expectations of the enforcement efforts and the gradual adaptation by the consumers towards the new pricing to aid volume recovery did not come to fruition as the massive price increase eventually proved too much for the consumers to digest. Meanwhile, BAT was unable to improve its market share in the shrinking market as its Premium segment (75% of its product mix) fell prey to the down-trading behaviour in the legal industry due to the higher selling prices.

Trimming earnings forecasts. We trim FY16E-FY17E core net profits by 7.8%-4.6% after adjusting down the sales volume assumption by 4%-8% to factor in the weaker-than-expected legal industry volume.

Reiterate UNDERPERFORM with lower Target Price of RM46.40 (from RM48.70).Correspondingly, with the earnings cut, our TP is revised down to RM46.40, which is based on unchanged 17.9x PER FY17E. We continue to value the stock at -1.5 SD over its 5-year mean as we remain bearish on the industry outlook on the back of escalating illicit market share and BAT being the victim of down-trading in the industry due to its Premium segment oriented product mix.

Source: Kenanga Research - 25 Oct 2016