A tough regulatory regime hurting BAT bottomline

Half Year results for BAT Kenya came in weak (EPS KES 19.48, -9.3% y/y) despite sustained efficiency gains (operating margin had an extra 160bps h/h to 32.9%) as sales continue to drag failing to catch up with the 24.0% increase in excise taxes last year. 

Positives:

1. Efficiency gains hinged on FY16 improvement in factory practices, sees operating margins tick to 32.9%, the highest in the past 3 half year periods. We expect to see continued efficiency gains from the factory reorganization exercise undertaken in 2H16, and with the company also looking at optimizing warehouse practices, operating margins look to sustain above the 5-Yr average operating margin of 31.4%.
2. Interim dividend held at KES 3.50/share (5.5% dividend yield) despite weakness in profitability. This reinforces the counter’s attractiveness to long-term dividend investors, having maintained an average 99% pay-out ratio in the last 5 years, which we see BATK maintain going forward.

Negatives:

1. Gross sales continued declining, (-9.6% y/y & -3.2% h/h) at KES 17.14Bn, on account of price adjustments due to increase in taxes in FY16. This affected domestic sales (mainly from down-trading to cheaper brands), which average about 52% of total sales.
2. Operations slackened in cash generation, -71.3% y/y (-71.9% h/h).This was driven by low sales during the period and challenges with realizing stock probably due to changing consumption patterns. We may see this remain a challenge in the short term, as the industry adjusts to higher price bands.

We see the tobacco industry sustaining low growth rates (global volume 5-Yr CAGR -4.3%) mainly from continued enforcement of strict anti-tobacco regulations, lobby groups and increased public awareness on smoking-related health problems.

Among the strict regulations brought about from the implementation of Tobacco Control Regulations 2014 are; gory pictorials on cigarette packages and controlled marketing of products. Noteworthy markets across Africa are increasingly adopting the World Health Organization (WHO) Framework Convention on Tobacco Control (FCTC) alongside country-specific legislation implementing similar measures to Kenya’s and developed economies. This will see a smaller tobacco industry and affecting BAT’s 48% export sales.

For the counter, we highlight notable efficiency gains, its high dividend pay-out and expectations of tobacco prices/value offsetting decline in volumes (global retail value grew by about 27% in a similar period volumes declined 4.3%). BATK currently trades at market (peer average) P/E of 19.5X and has an ideal dividend yield of 5.5%.

GENGHIS RESEARCH.