1H18 core net profit of RM206.3m (-24%) and interim dividend of 35.0 sen are below expectations, owing to weaker sales volume and product mix. The group may benefit from better margins in 3Q18 but possibly at the expense of a SST-based price increase in Sept 2018 which could further expand the illicit market share. Maintain MARKET PERFORM with a lower TP of RM34.10 (from RM35.15, previously) as we reduce earnings on lower sales.

1H18 behind. 1H18 net profit of RM206.4m was below our/consensus estimates at 41%/42% of respective full-year expectations Persistently high illegal market share translated to lower industry volume and sales, hence the earnings miss. The interim dividend of 35.0 sen (YTD: 68 sen) also missed our full-year estimate of 167.0 sen owing to the weaker results.

YoY, 1H18 turnover of RM1.32b declined by 12% largely due to the expanding illegal market compromising the legal market share (estimated 2Q18 illegal market share of 63%, +4.0ppt). Operating profit, however, fell by 21% to RM281.8m as margins were affected by poorer profit contributions from VFM product ranges. This further translated to core net profit of RM206.3m (-24%), attributing to one-off restructuring expense adjustments in 1H17.

QoQ, 2Q18 sales improved by 7%. This was thanks to an expansion in total market consumption, possibly led by CNY festivities. However, a dip in sales proportion from the premium segment reflected that affordability is still an ongoing concern. Better operating profit (+17%) was backed by lower overheads attributed to cost transformation exercises. The “tax- holiday” enjoyed during the month of June should have also boosted margins as prices were left unchanged in a zero-rated GST environment. Net earnings increased by 14% from higher effective taxes.

Smoky prospects. In the near-term, the group could continue to benefit in a wider margin environment until the implementation of the new Sales and Services Taxes, earmarked to be implemented by 1st September 2018. The pending tax is likely to subsequently result in price increases reflective of the taxable quantum. Due to restrictions by the Ministry of Health, the group is required to pass down such taxes unless formal approval is obtained. In the meantime, illicit cigarette trade continues to ply undeterred and consistently maintained an all-time high proportion of 63% of total market volume for its third consecutive quarter. Asked on actions taken by the new government, management commented that evaluations could still be ongoing before any firm initiatives could be implemented. However, we suspect that if enforcement efforts remain status quo and a price increase from the above tax is effective, the illegal market share could surge above current levels. New SKUs were introduced by the group in hopes to regain consumer demand, particularly in the Value-for-Money segment.

Post-results, we cut our FY18E/FY19E earnings by 7.1%/3.0% for more conservative sales assumptions. Subsequently, our dividend assumptions are lowered to 147.0 sen/170.0 sen from 167.0 sen/185.0 sen.

Maintain MARKET PERFORM but with a lower Target Price of RM34.10 (from RM35.15, previously). This is based on an unchanged 18.0x FY19E PER (-1.5SD 3-year mean) on a revised EPS. While capital upside appears limited, the stock may still be an avenue for dividend-yield seeking investors with 4.4%/5.0% 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 - 20 Jul 2018