INVESTMENT HIGHLIGHTS

• 1QFY18 earnings below expectations

• Illicit cigarettes market at all time high of 63%

• Rothmans remains the fastest growing brand

• Declared a 33.0sen first interim dividend

• Maintain BUY with a revised TP of RM37.70 per share

Below expectations. British American Tobacco’s (BAT) 1QFY18 normalised net profit came in at RM96.2m which is below our and consensus’ full-year earnings estimates at 18.6% and 18.2% respectively. Comparing against 1QFY17, revenue and normalised earnings dipped by - 14.8% and -20%yoy respectively while on a quarterly sequential basis, revenue declined by -8.9% whilst earnings increased by +16.8% respectively.

Illicit cigarettes market at all time high of 63%. The dip in BAT’s revenue and earnings yoy was mainly attributable to the lower domestic and duty-free volumes which slumped by -6.0%yoy. The lower domestic volume was mainly driven by the legal market volume which contracted by -4.0%ytd vs 1QFY17. Additionally, the illicit cigarettes volume share continues to increase to a record high of 63% in 1QFY18 which consists of smuggled cigarettes at 59% and quasi legal cigarettes with fake tax stamps at 4%. This in return has impacted the group’s volume translating to a decline by -8%qoq in terms of the group’s overall volume sold.

Rothmans remains the fastest growing brand. BAT’s total market share year-to-date within the legal market grew by 0.8ppt to 54.7% in 1QFY18 from 53.9% in 4QFY17. In addition, Dunhill now registers a market share of 38.2% with a share growth of 0.5ppt vs 37.7% in 4QFY17; attributable to its ongoing initiative to reinforce the brand’s legacy. Furthermore, its Value For Money (VFM) segment, with the reintroduction of its previous brand Rothmans; remains the fastest growing brand within the VFM segment with a +1.2ppt growth in market share against last quarter’s 2.8%. The launch of Rothmans has also enabled the group to achieve a 30% market share in the VFM segment which is line with our expectations. However, the Aspirational Premium segment experienced a slight decline in market share due to the growth of the VFM segment. That said, the group managed to extend its leadership in the segment from 42% in FY17 to 44% in 1QFY18.

Declared 33sen dividend for 1QFY18. In-line with its lower earnings for the quarter, BAT declared a first interim dividend of 33sen per share for 1QFY18 which represents a 98% payout ratio. This is as opposed to 40sen declared during the same period last year. The 33sen dividend declared for the quarter under review is below our dividend forecast of 177sen for the year. As such, we are lowering our dividend forecast to 149sen per share for FY18F. Subsequently, we have also reduced our FY19F dividend assumption to 165sen from 182sen previously.

Revision in earnings. Post earnings announcement, we are revising our FY18-19F earnings lower by -15.4% and - 9.1% respectively as we factor in: (i) slow recovery in sales due to high illicit cigarette trade; (ii) continued weak consumer spending power as well as; (iii) growth in lower price segment (VFM) within the legal market.

Maintain BUY with a revised TP of RM37.70. Post earnings revision and rolling forward our valuation base year to FY19, we are maintaining our BUY recommendation on BAT with a lower target price of RM37.70 (from RM41.40 previously). 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%. We opine that while business environment will continue to remain challenging for BAT however, we are comforted by the fact that BAT VFM brand Rothmans in 4Q17 remains the fastest growing brand which we opine will assist in sustaining its position as a market leader in legal cigarettes. Although the reintroduction will come at the expense of lower expected earnings for the next 2-3years due to the lower pricing of Rothmans, we opine that this will nonetheless cushion the negative impact on earnings coming from the high illicit cigarettes. Furthermore, its dividend yield remains attractive at 5.0% FY19F.

Source: MIDF Research - 22 May 2018