This article first appeared in The Edge Malaysia Weekly on September 17, 2018 - September 23, 2018

DESPITE the hurdles ahead for British American Tobacco (Malaysia) Bhd (BAT) — a price hike after the implementation of the Sales and Service sTax (SST), growing illicit market and general decline in its earnings — many analysts are still maintaining their “buy” rating on the stock.

According to Bloomberg, eight research houses (including Credit Suisse, RHB, Affin Hwang, CIMB and MIDF Research), have “buy” calls on BAT — double the number of “sell” calls (Kenanga, Macquarie, TA Securities and EVA Dimensions). Three analysts maintained a “hold”.

Most of the research houses with “buy” calls are banking on the Pakatan Harapan government’s promise of increased enforcement to combat the illicit trade.

Checks with various retail stores showed that brands under BAT — Dunhill, Kent, Peter Stuyvesant, Pall Mall and Rothmans — saw a 50 sen increase each in pricing per pack, or 3% to 4%.

Affin Hwang Capital Research analyst Lester Siew believes the legal tobacco industry could see an earnings recovery and notes that the market share of illicit cigarettes has stabilised at 63%.

“We believe the legal tobacco industry is primed for a revival in earnings under the PH-led administration, which is both fiscally and politically motivated to see through a massive clampdown on the illicit trade and recoup billions in tax leakages,” he says.

He adds that the price hike following the SST implementation should be manageable, based on an increase of 50 sen per pack, which is not expected to upset the consumer base.

Similarly, RHB Research Institute analyst Soong Wei Siang remarks that although the price hike could further dampen the share of the legal tobacco market — pointing out that the increase in excise duty in 2014 pushed the market share of illicit cigarettes from 35% to 60% — the government’s efforts could provide support for BAT.

“While the price hike could further pressure legal total industry volume (TIV), we believe more effective enforcement initiatives and commitment to address illegal cigarettes and corruption in the system, as stipulated in PH’s manifesto, will be sufficient catalysts to offset the downside risks.

“We gather that legal TIV has already experienced a recovery post GE14 as some illicit trade may have eased in anticipation of potential intensified clampdown efforts,” Soong says.

However, it remains to be seen how the government intends to address the problem as details remain scant.

In its election manifesto, PH had stated that it would direct enforcement agencies “to stop the smuggling of alcohol and cigarettes across the border, including tighter controls along the borders and heavier punishments of those convicted”.

Kenanga Investment analyst Clement Chua tells The Edge he will have to see how the government plans to deal with the issue before deciding on whether it will be positive for BAT.

“Even under the previous government, there were many news headlines about tackling the problem but the illicit market just kept growing. I think I would like to see some results first before we can actually comment on how effective this government will be on this matter,” Chua says.

In contrast to other analysts, he says the illicit trade could remain rampant and may continue to expand, undermining TIV and, in turn, affecting BAT’s sales.

After the implementation of SST, Chua downgraded BAT to “underperform”, with a target price of RM28.25, or a downside of 18% to the counter’s close of RM34.46 on Sept 12.

He says the quantum of increase is less than expected, but still sees illicit trade volumes increasing due to the significant price gap between legal and illegal products.

The RM12.50 selling price for a pack of value-for-money (VFM) cigarettes under BAT is more than triple that of illicit cigarettes, which are as low as RM3 to RM4 per pack.

“While we agree that more aggressive enforcement could be necessary to address the problem, we stay away from any positive expectations at the moment as delivering results has proven to be a challenge for the past regime,” he says.

Another analyst who declines to be named says the illicit trade is a challenging problem. The growth of the illicit market over the years shows there is huge demand and it cannot be addressed solely through greater enforcement, as the authorities are focusing on the supply, rather than the demand, aspect.

“Strengthening enforcement will only increase the premium to sneak in illicit products, making it more lucrative for smugglers and there will always be parties willing to take on the higher risk for a higher reward.

“I just don’t see how the illicit market will be dealt with effectively but we will have to wait and see how the government plans to deal with it,” the analyst adds.

Maybank Investment Bank Research analyst Liew Wei Han says the research house is awaiting further guidance on the government’s timeline and plans to address the illicit market.

He notes Singapore’s success in dealing with its illicit cigarette trade, with its share of the market plunging in just four years, from 35.5% in 2006 to 6.1% in 2009.

Between 2014 and 2017, the market share of illicit cigarettes was maintained below 4%, thanks to a multipronged approach, targeting smuggling syndicates at the supply, storage and distribution points, conducting raids and patrol activities, imposing a S$500 fine for each packet found and through public education and awareness.

“Taking a cue from the high illicit trade incidence in the second quarter of 2018, we understand that there has yet to be meaningful step-up in enforcement efforts. While we take note of Pakatan Harapan’s GE14 manifesto on better enforcement efforts, which should benefit BAT in the medium to long term, we await further guidance on timeline and action plans,” Liew says.

BAT’s shares have risen 55% from the year’s low of RM22.004 on May 7 this year to RM34.20 last Thursday, giving it a market capitalisation of RM9.7 billion. Meanwhile, BAT’s indicated dividend yield stood at 4.5%, according to Bloomberg.

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