9M18 core earnings of RM352.2m (-16%) and interim dividend of 40.0sen are broadly within expectations. Illicit market share remains at its all-time high of 63% of market volume. Pending official guidelines on price increments from sales tax, the group will continue to sell at previous prices and will absorb the taxes until its resolution. Forward buying, especially on higher value products, is also anticipated during this time. Maintain UNDERPERFORM and TP of RM28.25.

9M18 broadly within. We deem 9M18’s net profit of RM352.2m to be broadly within our but below consensus estimates, making-up 78% and 76% of respective full-year expectations. A weaker 4Q18 is anticipated from high forward purchases in 3Q18 from the pending price increase per pack. The interim dividend of 40.0 sen (YTD: 108.0 sen) is also within our full-year estimate of 150.0 sen.

YoY, 9M18 revenue of RM2.05b (-8%) was dragged by the unyielding illicit market which remains at its all-time high market share of 63% for the fourth consecutive quarter and a decline in industry volume by 4% YTD. Operating profits also saw a decline at RM474.1m (-13%) as operating margin was softened (-1.3ppt from 24.4%) by a higher sales proportion of lower-yield VFM products (introduced in October 2017). Core net profits closed at RM352.2m (-16%) after adjustments from one-off restructuring expenses in 9M17.

QoQ, 3Q18 sales of RM735.5m grew by 8%, thanks to greater levels of forward buying in August on higher volume products in anticipation of sales tax-driven price hikes. Boosted from “tax-holiday” savings and non-reduction of prices, operating profits rose to RM192.3m (+27%) with operating margin of 26.1% (+3.7ppt). Subsequently, 3Q18 core net earnings registered at RM145.8m (+32%) which was also boosted by lower effective taxes.

Thicker smoke ahead. While the group and certain peers had retracted their sales tax-led price increases since 21 September 2018, it is expected that the Ministry of Health would unveil the official guidelines on the rate of increase in the coming weeks. Management does not discount the possibility that the proposed hike could be greater than the earlier rise of 50.0sen per pack. In the meantime, the group will absorb any differences in taxes until the resolution of the matter. We believe the higher margin enjoyed during the 3-months “tax holiday” could provide enough support to buffer the potential losses from this tax for the year. Regardless, it is possible that the industry may see another distortion to monthly sales number with another round of forward buying in October at the expense of November and December sales. It is likely the illicit cigarettes levels will persist at current peak levels and further down-trading to VFM products could undermine future results to come.

Post-results, we leave our assumptions unchanged for now, awaiting statements on the formalised price increase per pack.

Maintain UNDERPERFORM and Target Price of RM28.25. This is based on an unchanged 18.0x FY19E PER (-1.5SD from the 3-year mean), which could be reflective on the pessimistic outlook on the tobacco industry. Dividend yield of 4.7% for both FY18E/FY19E may seem decent but is likely to be dampened by potential capital downside.

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

Source: Kenanga Research - 22 Oct 2018