FY17 CNP of RM522.4m (-23%) and full-year dividend of 169.0 sen were below expectations. The growing illicit market share continued to undermine legal sales volumes. The reintroduction of the “Rothmans” brand to address affordability concerns may not lead to meaningful recovery in earnings. Post-results, we cut our FY18E earnings by 16.4% on lower sales estimates. Downgrade to MARKET PERFORM with a lower TP of RM33.85 (from RM40.50, previously).

FY17 core earnings disappointed. FY17 core net earnings of RM522.4m was below expectations, accounting for 92% of both our and consensus estimates. The negative deviation was due to the unyielding expansion in illicit market share, which was detrimental to legal sales volumes. Following the weaker results, an interim dividend of 43.0 sen was declared, making YTD dividend recorded at 169.0 sen, which is below our expected full-year pay-out of 192.0 sen.

YoY, FY17 sales of RM3.0b dropped by 20% mainly the result of a 14% decline in sales volumes with the rise of the illegal trades (est. 58.3% of market transactions, +5.8ppt). Group core EBIT declined by 22% after adjusting for restructuring expenses incurred during the cessation of its manufacturing plant. EBIT margin fell slightly to 22.7% (-0.5ppt) with lower contributions from premium brands and higher marketing expenses incurred with the re-launching of the value-for-money “Rothmans” brand in 4Q17. This translates to core net profit of RM522.4m (-23%).

QoQ, 4Q17 sales was weaker by 8% to RM700.2m, which we believe is driven by the down trading to less premium options and illicit products. This could have been further stimulated by the re-launching of the more affordable “Rothmans” brand to the market. Core EBIT plunged greater by 34% to RM127.2m due to marketing spend, registered margins of 18.2% (-7.1ppt) while 4Q17 core earnings of RM102.9m is 30% weaker.

No end to the illicit market situation. According to recent statistics, the share of illegal cigarette trade continued to widen despite tighter regulatory actions. The latest 4Q17 data recorded an illicit share of 59%, which is currently an all-time high. Management believes that affordability has always been the leading concern which kept the legal market share from recovering. So far, the reintroduction of the “Rothmans” brand has demonstrated encouraging reception in its attempts to regain BAT’s market share under the diminishing environment. While we view this approach favourably in lieu of the growing illicit market, we believe a more significant outcome could only be achieved by a meaningful reversal in the illicit market expansion. In addition, having a larger proportion of less premium products of total sales may dampen the group’s margins and returns.

Post-results, we slash our FY18E earnings by 16.4% on lower sales assumption. Our FY18E dividends is reduced to 178.0 sen from 192.0 sen, in line with the adjusted earnings at an estimated payout ratio of 95%. At the same time, we also introduce our FY19E earnings.

Downgrade to MARKET PERFORM with a lower Target Price of RM33.85 (from RM40.50, previously). This is based on an unchanged 18.0x FY18E PER (-2SD 5-year mean) on a revised FY18E EPS. While capital upside may appear limited, the stock may still be an avenue for dividend-seeking investors for yields of 5.4%/5.9% in FY18/FY19.

Risks to our call include: (i) slower-than-expected recovery of legal market share, (ii) larger-than-expected conversion towards less premium brands, and (iii) significant increase in forex undermining cost of sales.

Source: Kenanga Research - 14 Feb 2018