British  American  Tobacco’s  (BAT)  9M14  earnings  exceeded  our  and consensus expectations. Despite the decline in 9M14  sales volume, net profit grew 12.6% YoY on the back of a growth in revenue and its lowerthan-expectedopex.  We  raise  our  FY14F/15F  earnings  by  7%/4% respectively  after  updating  our  assumptions.  Maintain  SELL,  with  a revised DCF-based TP of MYR57.80 (from MYR56.00, 13.4% downside). 

Above  expectations. British American Tobacco’s (BAT)  9M14 earningsof  MYR714.6m  exceeded  expectations,  making  up  83.6%/79%  of our/consensus  full-year  estimates  respectively.  Despite  the  decline  in domestic  duty-free  sales  as well  as its  contract manufacturing  volume, BAT’s 9M14earnings grew 12.6% YoY  due to: i) a 4.9%  revenue  growth on  the  back  of  the  cumulative  effect  of  the  price  hikes  in  June  and September  last  year,  ii)  an  absence  of  non-recurring  leaf  restructuring expenses in 2013, and iii) cost savings from improved productivity.A third interim dividend per share of  78 sen was declared for the quarter under review. 

Outlook. Although it seems as if the industry has turned the corner, given the decline in illegal cigarette  incidences  and  the absence of a hike inexcise duty, we remain cautious on its longer-term outlook. This is  given the  continued  decline  in  legal  sales  from  the  stubbornly  high  level  of illegal cigarette trade, plusthe risk of an off-budget excise duty hike. 

Forecasts and risks. In view of the better-than-expected 9M14 earnings, we  lift  our  earnings  estimates  for  FY14  and  FY15  by  7.3%  and  3.9% respectively.  We  also  take  this  opportunity  to  introduce  our  FY16 projections.  Key risks to our forecasts include a  stronger sales volume and lower-than-expected raw material costs.

Investment  case. We  nudge  our  DCF-based  TP  higher  to  MYR57.80(from MYR56.00) (WACC:  7.2%, TG: 1.5%)  following  the revision to  our forecasts.With  its  unattractive  valuations  relative  to  its  earnings  growth as  well  as  unappealing  dividend  yield,  we  reiterate  our  SELL recommendation  on  the  stock.  The  stock  is  currently  trading  at  a 21.7xFY15 P/E (+1SD from its historical 5-year mean).

Briefing Highlights

Key  takeaways.  Key  takeaways  from  the  analyst  briefing  yesterday  include:  i)  its YTD  (August)  market share declined by a mere 0.4ppts to 61.5% vs  61.9% for the same  period  last  year,  ii)  Dunhill  faces  pressure  from  a  decline  in  its  full  flavor franchise but the launch of  Dunhill Taste  variants in Jul  2014 has contributed to the recent  market  share  recovery,  iii)  YTD  Aug  2014  market  share  in  the  aspirational premium  segment  remained  stable  at  35%,  as  the  better  performance  of  its  Peter Stuyvesant brand offset the underperformance of Pall Mall. 
Illegal  cigarettes  incidences  decreased.  Due  to  robust  enforcement  from  the launch  of  Ops  Outlet  in  March  this  year,  Wave  3  Illegal  CigaretteStudy  (which covered  Mar-May 2014)  recorded a 3.1ppt  decrease in illegal cigarettes incidence.On 10 Oct, The Starreported  that the Health Ministry said that  Ops Puntung,  a joint operation  to  combat  the  possession  and  sale  of  illegal  cigarettes,  will  be  made  a regular  activity  by  the  authorities.  The  joint  operations  will  be  carried  out  by enforcement  officers  from  the  Health  Ministry,  the  Customs  Department,  the Domestic Trade and Consumer Affairs Ministry and the police. While this is a positivedevelopment,  we remain cautious on  the  longer-term outlook  of the tobacco industry given the continued  decline in legal sales from  the still-high level of illegal cigarette trade, as well as the risk of an off-budget excise duty hike.

On the U-turn of its price hike.  To recap, BAT raised its cigarette prices by MYR1 per pack on 8 Sep  and  two weeks  later  on 22 Sep, it decided to  revise its  pricing back to the pre-8 Sep levels. We understand from management that in that two-week period, the decline in  market share and  sales  volume was rather significant.Hence, the reversal was necessary to maintain its competitiveness. 

Impact  of  theGoods  and  Services  Tax  (GST).  Upon  the  implementation  of  the GST, the current 5% sales tax will be replaced with a 6%  GST. However,  we  note that  under  the  GST,  businesses  are  entitled  to  claim  an  input  tax  incurred  for  its taxable supplies. As there is  a  lack of clarity on details of the  implementation  of the tax – given thatthe GST is a tax on the value added at each stage of the supply chain –  it  would  be  difficult  to  predict  its  impact.  However,  we  understand  from management that the impact of the GST on its earnings would be negligible. 
Forecasts.  We lift our FY14/15 earnings forecasts  by 7.3%/3.9% respectively afterupdating  our  sales  volume  and  cost  assumptions.  We  also  introduce  our  FY16 projections.  Key  risks  to  our  forecasts  include:  i)  stronger  sales  volume,  and  ii)  a lower-than-expected raw materials cost.

Source: RHB