INVESTMENT HIGHLIGHTS

• 3QFY17 normalised earnings below expectations

• Illicit cigarettes market slowed but challenges persist

• Peter Stuyvesant continues to gain traction

• Joining in the VFM bandwagon

• Declared a 43.0sen third interim dividend

• Maintain NEUTRAL with a revised TP of RM44.40 per share

Below expectations. British American Tobacco’s (BAT) 3QFY17 normalised net profit came in at RM145.5m. This is below our and consensus full-year estimates at 66.3%. Comparing against 3QFY16, revenue and normalised earnings dipped by -18.8% and -30.2%yoy respectively while on a quarterly sequential basis, both revenue and earnings declined marginally lower by -2.2% and -1.2% respectively.

Illicit cigarettes market slowed slightly but challenges persist. The dip in BAT’s revenue and earnings yoy was mainly attributable to the lower domestic volume and cessation of contract manufacturing during the year. The domestic and duty-free volumes slumped by -15.3%ytd. The lower domestic volume was mainly driven by the legal market volume which contracted by -10%ytd vs FY16. Additionally, a new illicit cigarettes dynamic has emerged in the market in the form of cigarettes sold with a false customs stamp. Therefore, despite the illegal cigarettes markets showing a decline from 58% in December 2016 to 56.1% in August 2017, concern remains that the improvement does not flow to the legal market.

Peter Stuyvesant continues to gain traction. BAT’s total market share year-to-date within the legal market is currently at 54% vs 57.1% in FY16. Despite its market share remains lower against last year but it is gradually improving throughout the year. Dunhill now registers a market share of 38.4% as of 3Q17, vs 37.1% in December 2016 and we expect further improvement in Dunhill’s market share as BAT is expecting to invest more in strengthening the Dunhill brand. That said, we note that its other brand Peter Stuyvesant and Pall Mall have continued to gain traction with a combined market share of 11.9% which continues its leadership in the Aspiration Premium Brand segment. This was mainly driven by Peter Stuyvesant’s market share which experienced an increase to 7.6% from 6.5% in FY16. We believe this is due to its more affordable price.

Joining in the VFM bandwagon. BAT has finally decided to jump into the value-for-money (VFM) bandwagon with its fellow industry players such as JTI with the launch of its VFM product called Rothmans (reintroduction of old brand). The brand which was launched earlier this month on the 9th of October is expected to appeal to the costsensitive consumer market and capturing some market share from the illegal cigarettes market. Having said that, the introduction of Rothmans which is priced at RM12 per pack, will have an impact on BAT’s overall margin as it commands lower margin compared to Dunhill. We estimate that BAT’s normalised margin would probably register in the tune of about 16% going forward with the introduction of Rothmans (from the current 18-19%) in the short term as we expect the improvement in Dunhill to offset the lower margin from Rothmans in the long run.

Declared 43sen dividend for 3QFY17. In-line with its lower earnings for the quarter, BAT declared a third interim dividend of 43sen per share for 3QFY17 as opposed to 55sen during the same period last year. This is well below our initial dividend forecast of 219sen for the year. As such, we revise our dividend forecast to 171sen 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 -22% and - 19.6% 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 RM44.40. Despite the persistently challenging macro environment, we take comfort in the fact that BAT has ventured into the VFM segment with launch of its new product Rothmans which will assist in sustaining its position as a market leader in legal cigarettes. 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 RM44.40 (previously RM48.60 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 - 24 Oct 2017