EUR 27.40 For Business Accounts Only

British American Tobacco Kenya (NSE: BAT) FY18 Earnings Note

BAT Kenya announced FY18 results, posting a 22.5% rise in EPS to KES 40.85. Gross revenue grew 5.9% y/y to KES 36.5Bn, driven primarily by growth in the export market on account of increased volume and revenue due to incremental pricing and distribution expansion initiatives. This was despite the subdued performance in the domestic market as a result of the slow business environment, coupled with the negative impact of illicit trade. A total dividend of KES 35.0 per share was declared (KES 3.5 interim, KES 31.5 final), a 34.6% increase from last year’s dividend. This represents a pay-out ratio of 85.7% (dividend yield of 5.5%), an improvement on last year’s pay-out of 77.9%. We are currently updating our valuation and recommendation on BAT Kenya.

Positives:

1. Growth in export markets, coupled with the domestic market (albeit subdued) drove gross revenue up 5.9% y/y, with net revenue showing a recovery. Profitability was driven by the growth in export volumes and revenue, with the domestic market witnessing subdued growth. The export market now accounts for approximately 48% of revenue, down from 49% in FY17. Further, the growth in cut rag sales resulted in USD 15Mn worth of export revenue, which enhanced profitability. We believe revenue growth was enhanced through product pricing and slight revenue mix changes as the company continues to cross sell its products. Despite this, operating margins were down 80bps y/y from FY17 on account of a 9.1% rise in operating costs.
2. Improved dividend pay-out and cash-flow position. The total dividend rose 34.6% to KES 35.0 per share on improved profitability and cash-flow position, representing a pay-out ratio of 85.7%. Management indicated the bulk of the increase in Capex (KES 479Mn) constituted a one-off investment on refurbishing their office complex, which should see cash flow improve in the next financial period (and quite possibly signal a sooner-than-expected return to near 100% pay-out). These restructuring costs appeared in the FY17 financials and form the basis for the 22.5% EPS growth in FY18. Stripping these costs out would result in a circa 10.0% rise in EPS in FY18. Finance costs were down 31.6%, indicative of reduced (possibly floating) interest rates on debt, as no debt was retired during the period. This also relieved cash-flow (KES 190Mn).

 

Key Risks and Considerations:

1. Excise duty revision. The company has not been able to fully recover from the 50.0% excise duty effected in 2015, as reflected in the negative net revenue performance over the last three years (3-year CAGR -2.3%). The tax proposal in Kenya’s FY18/19 fiscal budget that will see excise tax reviewed annually based on inflation, as opposed to the previous 2-year review is a key consideration. The proposal, which is under review, is expected to bring predictability and certainty in the tax environment, which could go a long way in creating a conducive environment, supportive of a stable growth industry.
2. Illicit trade undermining company operations. BAT Kenya noted that illicit trade was undermining its operations, estimating that prevalence rose to 14.1% of sold product in the market, compared to 12.4% in FY17. This had the impact of reducing sales volume in Kenya (9Bn sticks sold, a decline from FY17) and constrained profitability.
3. Regional risks. The company bears a number of risks in its export markets, some of which include (i) the possibility of a rise in excise tax in Uganda from 31% to a proposed 70% of the retail price, coupled with illicit trade at 22%, (ii) introduction of stringent tobacco control regulations in DRC, coupled with political tension, and (iii) introduction of plain packaging from June 2019 in Mauritius, which is expected to curb advertising and marketing initiatives by the firm.
4. Competition to subdue revenue? According to reports, Mastermind Kenya is in advanced talks to sell a majority stake to Philip Morris International (PMI). The entry of an established global giant is expected to rival BAT Kenya’s large scale model and could signal a tough competitive environment for the company, weighing down on profitability.

Our View:  The firm’s engagement with government agencies towards a more stable tax environment, coupled with curbing the growth of illicit trade that is weighing down on revenue in the local market, should see the business environment normalise. We believe a stable business environment will be vital for the company, which could see a recovery in growth in the Kenyan market and ultimately sustenance of the strong bottom line performance. This, coupled with the culmination of the one-off restructuring costs, should lead to a gradual increase in the pay-out ratio, back to historical levels (100.0%).