BAT’s 1QFY23 results missed expectations, following a significant uptick in illicit sales during the quarter. Its sales volume fell 24% as black market activities returned in strength, while margins were also hit as inflationary pressure resulted in down trading. Hence, we cut our FY23- FY24F earnings forecasts by 29% and 28%, respectively, reduce our TP  by 17% to RM10.00 (from RM12.00) but maintain our MARKET PERFORM call.

Below expectations. 1QFY23 results disappointed, accounting for only  14% of both our full-year forecast and the full-year consensus estimate.  We believe the variance against our forecast came largely from a sudden uptick in illicit sales during 1QFY23, resulting in a sharp drop in its sales volume. A dividend declared of 13.0 sen does not appear to be on track to meet our full-year forecast of 99.0 sen.

YoY. 1QFY23 revenue fell by 25% following a 24% decrease in sales volume, mostly attributable to renewed activity in the illicit market. Illicit market share jumped 2.4ppts to 57.2% during 1QFY23, resulting in lower sales across the legal segment. The group also partially attributes the drop in sales to increased sales of vapour products during 1QFY23. We believe this may be spurred by the government’s announced intention to regulate the vapour market resulting in consumers rushing purchases ahead of any taxes to be levied on such products. In terms of the group’s market share,  its premium market share remained relatively flat while mid-range and  value-for-money (VFM) segments grew 5% and 3%, respectively. The group also saw an uptick in down trading following the sustained inflationary pressure, resulting in gross margins falling to 22.3% from  24.8% previously.

Overall, net profit fell by 23% YoY as earnings were hit by the drop in sales volume.

QoQ. 1QFY23 revenue fell by 49% as the combination of the uptick in illicit sales, seasonally strong 4QFY22 and lower sales due to Ramadhan resulted in significantly weaker sales volume. The group’s market share across all its segments remained relatively flat, with its overall market share dropping by 0.1ppt following a minor contraction in its premium market share (-0.3ppt). Overall, earnings fell 35% QoQ, cushioned slightly by the absence of Cukai Makmur.

Outlook. Following the unexpected uptick in illicit activity, we remain wary of the group’s prospects looking forward. The black market remains the industry’s largest near-term headwind, with contrabands controlling a  major portion of the market. While illicit market share still remains below its peak during 2019-2020, recent performance has shown that even at current levels, contrabands pose a significant threat to legal sales volume. When coupled with the sustained inflationary pressure, we remain cautious as the group may see a further increase in down trading, even to the illicit market.

Looking to government regulation, the outlook still seems somewhat mixed. While the group is largely positive on the proposed measures in the revised Budget 2023, the implementation seems to be more challenging.  While the government has announced its intention to regulate vapour products, the extent and process behind the enforcement has yet to be revealed. While the group had previously commented that it would begin sales of its vapour products once the industry was fully regulated, the full roll-out of the regulations could take longer than initially expected. The government has also yet to re-table the generational ban on cigarettes.

Earnings forecasts. We lower our FY23-24F net profit forecasts by 29% and 28%, respectively, as we impute lower sales volume due to higher illicit incidence. We also take into account slightly lower margins following a minor uptick in down trading. We also reduce our FY23-24F dividend forecasts by the same magnitude to 69.3 sen and 71.0 sen, (from 99.0 sen and  RM1.00), respectively.

We continue to like BAT for: (i) relatively stable market demand in the medium term following the economic reopening, (ii) its leading position in the high-margin premium cigarette segment with its Dunhill brand, and (iii) its market position as the largest player within the legal tobacco market, holding 51.5% of the legal market share. However, we remain wary of the lack of catalysts for longer-term growth as well as rising health awareness dampening demand.

We decrease our DCF-derived TP (WACC: 8.1%; TG:-2%) by 17% to RM10.00 from RM12.00 previously. We also apply a  5% discount based on a 2-star ESG rating as appraised by us (see Page 3). Maintain MARKET PERFORM.

Risks to our call include: (i) regulatory risks including more restrictions on the sales of tobacco products and hikes in duties, (ii) illicit trade eating into the legal market, and (iii) rising risk premium as ESG investing gains more traction.

Source: Kenanga Research - 30 May 2023