FY16 core net profit of RM675.1m (-26%) was below our/ consensus expectations due to lower sales volumes amidst the growing consumer down trading to the illicit trade market. Total 4Q16 dividend of 123.0 sen declared exceeded expectations. We continue to be bearish on the industry as there has yet to be any indication of improvements from the illegal trade situation and thus, trim our earnings by c.9%. Maintain UNDERPERFORM with a lower TP of RM43.14.

FY16 core earnings below expectations. FYF16 core net profit of RM675.1m were below expectations, making up 94%/90% of our/ consensus estimates. The negative deviation was a result of lower sales volumes amidst the shrinking legal market demand and expansion of the illicit trade market. A final interim 77.0 sen dividend and special dividend of 46.0 sen were declared for a full-year pay-out of 278.0 sen, which exceeded our full-year estimates of 252.0 sen as we did not anticipate a dividend pay-out of above 100%.

YoY, FY16 revenue of RM3.8b declined by 18% as sales volumes fell by c.28%, concurrent with the drop from legal sales volume by c.26%. The shrinking market size can be attributed to the higher excise duties further driving consumers to down trade for more affordable alternatives in the illicit market, which makes up of approximately 51-54% of total market volume. Operating profits fell by c.26% with a tighter margin at 24.5% (-2.6pts YoY) mainly due to poorer product mix arising from the decline from premium brands. Excluding the one-off restructuring gains of RM46.2m, the group recorded a core net profit of RM675.1m (-c.26% YoY).

QoQ, 4Q16 sales dipped by c.10% to RM840.6m due to the decline of contract manufacturing volumes by 33% amidst the closure of the group?s production facilities. Operating profits (less restructuring income) fell by c.26% arising from heavier production and marketing expenses incurred during the quarter. 4Q16 core net profit registered at RM157.4m (-c.25%).

Persistent threats from the illicit market. The pandemic of the illicit trade market continued to display growth arising from the spike in cigarette prices in the legal market from 23-26% in Nov 2015, which now commands more than 50% of the cigarette market in the country. While more aggressive efforts have been enforced by the authorities to curb illicit trades, we may yet have to hold our breath before we can see some meaningful recovery back towards the legal market. The existing conditions may continue to affect the group?s premium brands which are the most highly priced products while also being the largest contributor to the group?s product portfolio.

We trim our earnings for FY17E by c.9% to account for weaker sales volume assumptions. In addition, we introduce our FY18E numbers.

Maintain UNDERPERFORM with lower Target Price of RM43.14 (from RM46.40, previously). This is based on FY17E revised EPS of 241.0 sen against our unchanged targeted 17.9x PER. This is in line with the stock?s 5-year mean at -1.5SD as we remain pessimistic on the industry outlook arising from the rampant illicit trade market and its impact against BAT?s market share and product mix.

Source: Kenanga Research - 17 Feb 2017