• 4QFY16 earnings within expectations

• Low domestic volume and high illicit cigarettes continue to drag earnings

• Peter Stuyvesant lights on while Dunhill fizzled

• Post-restructuring of operations to contribute positively to earnings

• Declared a 77sen fourth interim dividend and a 46sen special dividend

• Upgrade to NEUTRAL with a revised TP of RM48.90 per share

Within expectations. British American Tobacco’s (BAT) 4QFY16 normalised net profit (excluding a one-off restructuring income of RM131.9m) came in at RM157.4m. This brings its full-year normalised earnings to RM675.1m which is within our and consensus estimates. Comparing against FY15, revenue and earnings dipped by -18% and - 25.8%yoy respectively while on a quarterly sequential basis, revenue declined by -9.8% and earnings slumped by -24.5%.

Lower domestic volume and high illicit cigarettes continues to drag earnings. The dip in BAT’s revenue and earnings year-over-year was mainly attributable to the lower domestic volume and contract manufacturing volume during the year. The domestic and duty free volumes slumped by -27.8%yoy, meanwhile, contract manufacturing volume declined by -46.2%yoy. The lower domestic volume was mainly driven by the legal market volume which contracted by -25.7% in FY16. Additionally, the price hike that took effect in November 2015 coupled with higher cost of living and high illicit cigarettes volume (c.51.2%) continues to put pressure on BAT’s earnings.

Peter Stuyvesant lights on while Dunhill fizzled. BAT’s total market share has declined from 60.9% in FY15 to 57.1% in FY16. The decline was mainly dragged down by contraction in volume of Dunhill which fell to 42.2% in FY16 from 46.1% in FY15. That said, we note that its other brand Peter Stuyvesant has been gaining traction. Its volume increased to 6.5% in FY16 vs 5.6% in FY15. We believe that this is due to its more affordable pricing. Meanwhile, Pall Mall’s volume has remained relatively stable at 4.5% in FY16 from 4.2% in FY15.

Declared 278sen dividend for FY16. BAT declared its fourth interim dividend of 77sen per share for 4QFY16. In addition, it also announced a special dividend of 46sen per share with respect to the proceeds from the sale of its land and building which was completed back in November 2016. This brings the total dividend declared for FY16 to 278sen or a payout ratio of 110%. This also translates to a yield of 5.7%. Excluding the special dividend, BAT’s dividend yield remains decent at 4.8%.

Post-restructuring. Post-restructuring of the business operations via the sale of land and building in Petaling Jaya, we are confident that the leaner and more efficient business operations will contribute positively to the company’s earning. Moving forward, we are expecting pretax margins to remain above 20% in light of the challenging market environment.

Revision in earnings. Post FY16 earnings announcement, we are revising our FY17 revenue earnings upwards by +18% as we factor in: (i) the gradual recovery in sales post its business restructuring, (ii) improvement in consumer sentiment and, (iii) better enforcement from the authorities with regards to the sales of illicit cigarettes and regulations on vape. Additionally, we are also introducing our FY18 numbers in this report.

Upgrade to NEUTRAL with revised TP of RM48.90. Despite the persistently challenging macro environment, we are expecting the abovementioned factors to assist in improving the demand for legal cigarettes in FY17 which in return would improve its revenue. Hence, we are upgrading our call to NEUTRAL (previously SELL) with a revised TP of RM48.90 (previously RM41.27 per share). Our valuation is derived from a dividend discount model valuation with a cost of equity of 6.5% and a long term expected dividend growth rate of 1.25%.

Source: MIDF Research - 17 Feb 2017