No end in sight to smoky days


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This article first appeared in The Edge Financial Daily, on December 29, 2016.

 

KUALA LUMPUR: While local tobacco players have one less threat to deal with as the initial hype surrounding vaping subsides, the road ahead still seems far from clear, said analysts.

The declining cigarette consumption per capita, continued high illicit trades and regulatory risks suggest that the landscape for tobacco players will only get tougher next year, said AllianceDBS Investment Bank vice-president of equity Cheah King Yoong.

“We remain cautious about the growth prospects in the Malaysian tobacco sector for 2017. We believe that the sector landscape is getting increasingly difficult due to the declining cigarette consumption per capita as the population becomes more health-conscious, continued high illicit trades, regulatory risks and the emergence of alternative product offerings such as e-cigarettes,” he told The Edge Financial Daily via email.

Cheah said the legitimate industry volume is set to drop by 22% this year before stabilising in 2017.

“Nevertheless, we believe that regulatory challenges remain the key downside risk to our legitimate industry volume assumptions for 2016 and 2017,” he noted.

Cheah said while there was no announcement on an excise duty hike on tobacco products in Budget 2017, there is still the possibility of an off-budget increase.

“We continue to advise investors to exercise caution, as we do not rule out a post-budget excise duty hike for tobacco companies in the coming months. Besides that, we understand that the illegal cigarette trades remain higher at more than 40% (49.9% in May 2016), which could hinder the sector’s recovery,” he added.

In its strategy note dated Dec 21, CIMB Research viewed excise duty hikes as a major challenge affecting the sustainability of the tobacco industry. It has an “underweight” call on the sector.

“Excise duty hikes of 40% in November 2015 had led to a steep 28.6% decline in legal volumes, while illicit trade volumes currently stand at 49.9% of Malaysia’s total cigarette volumes,” it noted.

The local tobacco industry had to contend with three rounds of excise duty hikes between 2013 and 2016. Tobacco tax rose 14% in September 2013, 12% in November 2014 and 36% in November 2015.

In March this year, British American Tobacco (M) Bhd (BAT) — the only listed tobacco company in Malaysia — decided to shut down its plant in Malaysia, citing the high excise environment, which ultimately led to the sharp rise in illegal cigarettes and significantly lower legal sales volumes, and resulted in rising cigarette production costs.

Judging from the second quarter industry sales trend, UOB Kay Hian head of research for Malaysia Vincent Khoo said there are clear signs the decline in demand and consumer downtrading to cheaper brands are bottoming out. However, the research house has not seen any “meaningful recovery yet”.

But it’s not all bad for the tobacco industry. Khoo expects a less harsh regulatory environment in the New Year and does not foresee further excise duty hikes on tobacco products.

“The good thing is that we continue to expect a less harsh regulatory environment. For example, we do not foresee further punitive duty hikes on tobacco products as the last duty increase was counterproductive to the overall tax collection for the tobacco industry and led to [the] high level of illicit trade,” he told The Edge Financial Daily in an email reply.

Once dubbed a multimillion-ringgit industry, vaping no longer poses a threat to tobacco companies as “the earlier fad seems to have faded”, said Khoo.

“We believe that smoking would be stable from here on and substitute products would not have a wide appeal to smokers’ preference for taste and flavour,” he said.

In May, Malaysian E-Vaporizers and Tobacco Alternative Association (Mevta) founder and adviser Allan Foo was quoted as saying that the reduced adoption of vaping by Malaysians could be due to it being just a passing trend. The number of vapers and vape retail outlets nationwide has also dwindled.

Still, Cheah warns that the increasing popularity of other product offerings such as e-cigarettes pose a new challenge to the industry.

Meanwhile, BAT posted a 17% drop in net profit for the third quarter ended Sept 30, 2016 (3QFY16) to RM212.62 million from RM256.1 million a year ago. Revenue declined 19.6% to RM932.19 million in 3QFY16 from RM1.16 billion in 3QFY15.

For the nine-month period ended Sept 30, 2016 (9MFY16), its net profit fell 39.6% to RM432.95 million from RM717.18 million due to overall volume reduction and escalating cost pressures. Revenue fell 17% to RM2.92 billion from RM3.52 billion in 9MFY15.

“We are expecting a mid-single-digit earnings growth [in 2017], driven by cost-efficiency and modest volume recovery. We reckon that the consumption decline of duty-paid cigarettes has bottomed out in the second quarter of 2016,” said Khoo, who tracks BAT.

He pointed out that BAT’s prospective yield stands at 6.3%, after having fallen close to his target price of RM44.

“The current yield fairly reflects our outlook for extended sluggish consumption and earnings trends. We expect BAT to deliver only modest total shareholder returns at the current price,” he said.

Cheah is maintaining a “hold” call on BAT given the increasingly challenging industry outlook.

CIMB Research, which has a “reduce” call on the counter, said it expects BAT’s cigarette volumes to continue to decline due to weaker overall consumer sentiment and BAT’s more premium portfolio.

“BAT’s closure of its manufacturing facilities and outsourced production is positive, but benefits are only likely to materialise beginning 2018,” it added.

Year to date, BAT’s share price has declined by 23% to close at RM43.40 yesterday for a market capitalisation of RM12.39 billion.

According to Bloomberg, four of 18 analysts tracking the stock have a “buy” call on BAT, six a “hold” call and eight a “sell” call.