INVESTMENT HIGHLIGHTS

• 1QFY17 normalised earnings below expectations

• Low domestic volume and high illicit cigarettes remain a drag to earnings

• Peter Stuyvesant brand continues to gain market share

• Declared a 40sen first interim dividend

• Maintain NEUTRAL with a revised TP of RM48.60

Below expectations. British American Tobacco’s (BAT) 1QFY17 normalised net profit recorded RM120.4m. This is below our and consensus forecasts, making up only 16% of full year earnings estimates. Comparing against 1QFY16, revenue and normalised earnings dipped by - 24.5%yoy and -31.4%yoy respectively while on a quarterly sequential basis, revenue declined by -8.3% and earnings slumped by -23.5%.

Lower domestic volume and high illicit cigarettes bane to earnings. The dip in BAT’s revenue and earnings year-over-year is mainly attributable to the lower domestic volume and contract manufacturing volume during the year. The domestic and duty free volumes slumped by -23%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.57.1%) continues to apply pressure on BAT’s earnings.

Peter Stuyvesant continues to gain market share. BAT’s total market share year-to-date within the legal market continues to decline to 53.5%, versus 57.1% in FY16. The decline was mainly caused by contraction in volume of Dunhill, which fell to -37.3% year-to-date February 2017 vs 42.2% back in FY16. That said, we note that its other brand Peter Stuyvesant and Pall Mall have continued to gain traction with a combined market share of 12.1% and took leadership for the first time in the Aspiration Premium Brand segment. This was mainly driven by Peter Stuyvesant’s market share which experienced an increase to 7.7% from 6.5% in FY16. We believe this is due to its more affordable price.

Declared 40sen dividend for 1QFY17. In line with its lower earnings for the quarter, BAT declared an interim dividend of 40sen per share for 1QFY17 as opposed to 55sen during the same period last year. This is well below our initial dividend forecast of 236sen for the year. As such, we revise our dividend forecast to 219sen per share to better reflect our dividend expectations in view of the continued challenging operating environment.

Revision in earnings. Post earnings announcement, we are revising our FY17-18 earnings lower by -5.3% and - 3.6% respectively as we factor in: (i) slower recovery in sales due to high illicit cigarette trade as well as; (ii) continued weak consumer spending power.

Maintain NEUTRAL with a revised TP of RM48.60. Despite the persistently challenging macro environment, we take comfort in the fact that the government has recently announced that there will be no excise duty hike on tobacco products this year or any changes in terms of the minimum age allowed to purchase tobacco products. In addition, the tighter enforcement by the relevant authorities is expected to assist in clamping down the selling of illegal cigarettes in the market. Hence, we are maintaining our NEUTRAL recommendation with a revised TP of RM48.60 (previously RM48.90 per share) post earnings revision. 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 - 21 Apr 2017