INVESTMENT HIGHLIGHTS

• 2QFY19 earnings came in below expectations, attributable to the significant jumped in operating expenses

• Significant investment need to be poured in fighting illegal cigarettes and promoting value for money (VFM) brands

• Due to the strong performance of VFM brands, BAT’s market share remains stable at 54.8%

• Declared a 26.0sen first interim dividend

• Downgrade to NEUTRAL with a revised TP of RM28.80 per share

2QFY19 earnings below expectations. British American Tobacco (M) Bhd’s (BAT) 2QFY19 normalised net profit came in at RM76.3m. This brings its 1HFY19 earnings to RM164.9m which is below ours and consensus’ full-year FY19 earnings estimates at 36.2% and 38.1% respectively. Comparing on a quarterly sequential basis, 2QFY19 revenue staged an encouraging +3.2%qoq growth. Nonetheless, earnings declined by -13.9%qoq caused by a significant jumped in operating expenses.

Illicit cigarettes market remains stagnant at 60%. The dip in BAT’s 2QFY19 can mainly be attributed to the lower legal industry volume which contracted by -8.0%yoy. Additionally, the illicit cigarettes volume share remains stagnant at about 60.0% since 1QFY18. Furthermore, the challenging operating environment is further exacerbated by the launch of its competitor’s tobacco heated product and the switch from premium and aspiration brands to value for money (VFM) brands such as Rothmans which commands lower margin.

Investment into fighting illegal cigarettes. During the quarter, operating expenses rose by +19.5%qoq attributable to the higher marketing expenses in promoting VFM brands. Consequently, Rothmans continues its uptrend, registering a growth of +0.6%qoq. This signals a shift of trend from premium and aspirational premium to VFM brands. Thanks to Rothmans performance, BAT’s market share remains stable at 54.8% in the 2QFY19.

Declared 26sen dividend for 2QFY19. BAT declared an interim dividend of 26sen per share for 2QFY19 (vs 2QFY18 of 35sen). The dividend declared is below our dividend forecast of 143.6sen for the year. As such, we are revising our dividend forecast to 110.0sen.

Earnings estimates revised lower. We are revising our F19-20F earnings forecasts downward to RM344.7m and RM353.5m respectively as we factored in higher marketing expenses and lower contribution from premium brand in our earnings forecasts.

Downgrade to NEUTRAL. We are downgrading our recommendation to NEUTRAL (previously BUY) on BAT with a revised target price of RM28.80 (previously RM35.50). 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 business environment will continue to remain challenging for BAT in the near term. Nonetheless, we are comforted by the fact that BAT’s VFM brand Rothmans which was launched back in 4Q17 remains the fastest growing brand. We opine this will assist in sustaining its position as a market leader in the legal cigarettes’ domain especially with the switch from premium and aspiration brands to VFMs.

Source: MIDF Research - 26 Jul 2019