This article first appeared in The Edge Malaysia Weekly on September 4, 2017 - September 10, 2017

AT their wits’ end to improve their fortunes, which have been dented by the growing illicit cigarette market, tobacco companies are proposing the reintroduction of small packs of cigarettes — putting themselves squarely in the crosshairs of non-governmental organisations.

Over the last couple of months, British American Tobacco (M) Bhd (BAT), JT International Bhd (JTI) and Philip Morris (M) Sdn Bhd — which together control 95% of the legal tobacco market — have been engaging with the government to approve the sale of 10-stick cigarette packs.

The ultimate aim is to bridge the huge price gap between legal and illicit cigarettes caused by successive duty hikes in recent years. The magnitude of the latest excise duty hike — 40% in November 2015 — was reportedly the tipping point for the industry.

Currently, the retail price of legal cigarettes ranges from RM12 to RM17 per 20-stick pack. In contrast, illicit cigarettes are sold for RM3 to RM5.

“What we want to do is to breach the price gap between legal and illegal cigarette brands and offer something in between. (The 10-stick packs) are still not as cheap as illegal brands, but we can at least offer consumers an opportunity to step back into the legal market. From our studies, we do know that a lot of consumers would prefer to smoke legal brands but can’t afford to (at the current prices),” BAT managing director Erik Stoel tells The Edge in an interview.

JTI MD Guilherme Silva stresses that tobacco companies are not making legal cigarettes cheaper for consumers.

“We are still paying the same amount of excise tax and the same amount of ringgit per stick. We are just allowing consumers who have switched to cheap illegal products to consider switching back to legal products with the 10-stick packs,” he says.

“We believe consumers want to buy legal cigarettes. So, if we give them an option to come back to legal products, we believe they will because these cigarettes are of quality standard and the brands are well established. We are not saying 100% of the illegal smokers will come back to the legal industry, but we believe many consumers want to do the right thing.

“It (10-stick packs) is really tailored to tackle the problem. If we did not have the illegal tobacco problem, we would not be coming up with the 10-stick packs, honestly. For the industry, a 10-stick pack costs more. It brings complexity to the supply chain and erosion of margins,” Silva says.

According to Stoel, the reintroduction of smaller cigarette packs, together with enforcement efforts, can reduce the illicit trade in tobacco by 55% to around 25% of the legal market over the next three years, from a record high of 57.9% as at May this year.

“If we can bring down the level of illicit trade to around 25%, then from a pure enforcement perspective, it will be much more controllable,” he says.

The three local tobacco majors — BAT, JTI and Philip Morris — have seen yearly declines in earnings and revenue since 2015, amid a high tax environment that has led to higher cigarette prices, pushing smokers into the growing illicit market.

“As any legal company, we need to make a profit. We think we have a proposal on the table that if you logically think about it, will help reduce the overall consumption of tobacco and the illicit trade,” says Stoel.

He doesn’t expect BAT to return to the earnings growth seen in the financial year ended Dec 31, 2015 (FY2015), when it posted a net profit of RM913.31 million on revenue of RM4.58 billion, anytime soon. For FY2016, it registered a net profit of RM721 million on revenue of RM3.76 billion.

“No. It will not be. It (earnings) will probably improve a bit (if the proposal to reintroduce small packs goes through), but it will never come back to the good old days. Indeed, our profit at the moment is 50% of what it was before,” he says.

JTI’s Silva concurs, adding that the legal tobacco industry is less than half of what it was in 2015.

Vincent Khoo, head of research at UOB Kay Hian Malaysia, is of the view that the proposal for smaller packs will stimulate some demand in the duty-paid market as it raises the absolute affordability for smokers.

“Small cigarette packs (14-stick and 10-stick) used to account for almost 30% of the duty-paid sales mix,” he tells The Edge.

It was reported that the sale of packs of seven and 10 sticks was banned in 2006, followed by 14-stick cigarette packs in 2010.

“I would reckon that the reintroduction of smaller cigarette packs will have a substantial impact for BAT, given the high (more than 50%) share of the illicit market in cigarette consumption and the depressed duty-paid industry sales. However, it is difficult to quantify at this point,” Khoo says.

Rakuten Trade Sdn Bhd head of research Kenny Yee says he does not expect the move to be effective against the contraband as the pricing is still considered too high.

“Most contraband is now selling at a fraction of the existing (legal cigarette) price, hence the impact may not be great,” he says.

However, Yee believes that the reintroduction of smaller cigarette packs will allow tobacco companies to regain some of the market share lost to the illicit trade.

BAT saw its net profit improve 17.2% year on year to RM258.31 million for the six months ended June 30 (1HFY2017), driven by the recovery of market share coupled with the decline in illegal cigarettes.

Revenue for 1HFY2017, however, declined 22.1% to RM1.54 billion y-o-y due to volume decline and the cessation of contract manufacturing for exports as at Dec 31, 2016.

In a July 21 report, UOB Kay Hian’s Khoo says although the worst could be over for BAT, its valuations are not particularly compelling and its prospective dividend yields of 4.4% to 4.9% for 2017 to 2019 are unappealing, given the downside risks associated with the tobacco industry, which is frequently subject to excise duty hikes.

He has a “hold” call on BAT, with a target price of RM42.50.

In March last year, BAT became the first tobacco company in recent years to announce the closure of its manufacturing operations in Petaling Jaya, Selangor — due to falling sales. It affected 230 employees.

“To be honest, it was a decision we did not like to make. We have a decades-long history of manufacturing cigarettes here. So, it was a very hard choice to close down the factory,” says Stoel.

In May, JTI also announced the closure of its manufacturing plant in Shah Alam, Selangor, by the end of December, which will see about 270 employees made redundant.

“In our case, we will not see any cost savings by closing the factory in Malaysia. On the contrary, it becomes more expensive for the Malaysian operations because a big part of our production volume here was for the export market. We were producing for over 12 countries out of Malaysia.

“However, we decided to close down our manufacturing operations in Malaysia because the market here has become unattractive for producing cigarettes,” says Silva.

“It used to be that 50% to 60% of our production volume here was for the local market. But when less than 20% of our volume stayed in Malaysia, we started asking why do we still produce out of Malaysia? We needed to look at the global footprint of JTI Group and what makes sense for the group globally,” says Silva.

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