1Q17 core NP of RM120.4m (-31% YoY) is below our and consensus expectations due to lower sales volumes amidst the growing consumer down trading to the illicit market. An interim dividend of 40.0 sen declared is also below expectations. We continue to be bearish on the industry in lieu of the rampant illegal trade situation with little signs of improvement. We cut our FY17E/FY18E earnings by 9%/3%. Maintain UNDERPERFORM with a lower TP of RM42.30.

1Q17 core earnings below expectations. 1Q17 core net profit of RM120.4m is below expectations, making up 18%/16% of our/consensus estimates. The negative deviation was a result of lower sales volumes as the illicit trade market expanded at the expense of the shrinking legal market. The interim 40.0 sen dividend declared was also below our 236.0 sen full-year estimate.

YoY, 1Q17 sales of RM770.7m fell by 25% owing to a decline in volume sales by c.23% attributed by higher illegal cigarettes demand. More expensive cigarettes prices arising from the excise hike in November 2015 as well as dampened consumer spending ability continued to be the culprits contributing to the weakness in the legal market. Operating profits decreased by 33% in addition to suppressed margins at 20.5% (-2.5 pts) despite cost streamlining efforts from the closure of factory operations, likely due to unfavourable product mixes from consumer down trading. Excluding one-off restructuring expenses, the group recorded a core net profit of RM120.4m (-31%).

QoQ, 1Q17 sales dropped by 8% due to higher illicit cigarette trading. Operating profits (less restructuring income and expenses) fell by 14% as down trading led to poorer sales volume from premium brands (i.e. Dunhill). 1Q17 core net profit registered at RM120.4m (-24%).

Persistent threats from the illicit market. The illicit trade market continued to display growth arising from the spike in cigarette prices in the legal market by 23-26% in Nov 2015, which possibly accounted for 57% of the entire cigarette market in the country. While more aggressive efforts had been enforced by the authorities to curb illicit trades, we may yet have to hold our breath before expecting any meaningful recovery in 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 cut our earnings for FY17E/FY18E by 9%/3% to account for weaker sales volume assumptions. Our estimated dividend payments are adjusted concurrently with our revision in earnings.

Maintain UNDERPERFORM with lower Target Price of RM42.30 (from RM43.44, previously). This is based on our unchanged 17.9x PER on a revised FY18E EPS of 235.0 sen. This is in line with the stocks 5-year mean at -2SD as we remain pessimistic on the industry outlook arising from the rampant illicit trade market and its impact on BAT’s market share and product mix.

Source: Kenanga Research - 21 Apr 2017