1Q8 net earnings of RM96.2m (-20%) and interim dividend of 33.0 sen are below expectations, due to persistent drag from the growing illegal trade market. As there may be no immediate price adjustments with the "zero-ing" of GST in June 2018, we assume the group may benefit from better margins until an adjustment comes into effect. Downgrade to MARKET PERFORM with a lower TP of RM31.70 (from RM33.85, previously) as we reduce earnings on lower sales.

1Q18 fell short. 1Q18 net profit of RM96.2m came below our and consensus estimates, making up 18% of both full-year expectations. The miss was owing to the continuing growth in illegal trades, which narrowed legal sales across the market. An interim dividend of 33.0 sen also missed our full-year estimate of 178.0 sen following the weaker results.

YoY, 3M18 sales of RM637.6m (-15%) came in weaker from: (i) the absence of export sales from 3M17, and (ii) declining sales volume due to market down trading towards illicit products (estimated 1Q18 illegal market share of 63%, +3.0ppt). However, EBIT declined by 18% likely due to lower margin returns from the reintroduction of the Value-forMoney range of “Rothmans” products during 4Q17. Core net earnings of RM96.2m fell by 20%, which is also attributed to one-off restructuring adjustments in 1Q17 results.

QoQ, 1Q17 revenue decreased by 7% as legal trade transactions declined from the abovementioned growth in illegal trade. However, better sales mix supported group margins while also retaining market share. Core net profit, however, only fell by 7%, which could have been due to less marketing spend in lieu of the softer market.

Curbing illegals a constant challenge. Despite the introduction of more affordable offerings into the market, the proportion of illicit trade continues to grow and saw a new high of 63% during the quarter. With a new government administration, there could potentially be new approaches undertaken to resolve the issue, albeit requiring further proof of effectiveness. A "zero-ing" of GST was announced by the government to be effective 1st June 2018. While this could translate into lower prices, management described that the tobacco industry is restricted by Ministry of Health regulations against decreasing prices without its formal evaluation and approval. Regardless, we believe the group may see some benefits either from: (i) better margins if prices remain, or (ii) better sales if prices become more affordable minus GST.

Post-results, we trim our FY18E/FY19E earnings by 6.3%/2.2% for more conservative sales assumptions. However, we improve our margins assuming prices for the remainder of the year are constant, but without GST contributions. Our dividend assumptions are lowered to 167.0 sen/ 185.0 sen from 178.0 sen/ 195.0 sen.

Downgrade to MARKET PERFORM with a lower Target Price of RM31.70 (from RM33.85, previously). This is based on an unchanged 18.0x FY18E PER (-2SD 5-year mean) on a revised EPS. While capital upside appears limited, the stock may still be an avenue for dividendyield seeking investors with 5.0%/5.5% expected 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 - 22 May 2018