This article first appeared in The Edge Financial Daily, on December 23, 2015.

KUALA LUMPUR: The outlook for the tobacco sector next year is bleak as the increase in cigarette prices, illegal cigarette trade and preference for vaping are expected to cause decline in sales volume.

Analysts contacted by The Edge Financial Daily said the rise in cigarette prices was the result of a significant excise duty hike of more than 40% in November.

The industry has experienced many excise duty increases in the past and had somewhat recovered from them. However, this time around, analysts and industry players said the hike on Nov 3 was unprecedented.

Analysts, who initially expected growth in the industry for 2016, have trimmed their forecasts to take into account the decline in volume following the hike that will eventually affect the earnings of tobacco companies.

On top of that, the emerging vaping industry is expected to have an adverse impact on the tobacco sector, while the illegal cigarette trade remains a key challenge.

“Basically, we are negative [on the outlook], as pricing of cigarettes has gone above the ‘pain threshold’. So we expect significant volume drops that would nullify expansion in gross margin,” UOB Kay Hian head of research for Malaysia Vincent Khoo said in an email.

He expects smokers to cut consumption of duty-paid cigarettes or switch to cheaper duty-paid cigarettes, illicit cigarettes or electronic cigarettes.

He said the current situation is similar to what happened in the mid-1990s, when selling prices were significantly raised in response to duty hikes.

Kenanga research analyst Soong Wei Siang concurred with Khoo’s bearish view on the outlook for the industry, noting that the price increase will have a significant impact on sales volume growth.

“The massive price hike is near to killing the industry,” he said in a telephone interview.

He said the price hike affects the affordability of legal cigarettes, as the disposable income of consumers does not improve significantly.

“The industry is already experiencing a decline in volume. The volume will be very bad in the near term,” he added.

In his note dated Nov 4, he said that the legal tobacco industry had recorded a 10.9% decline in industry volume in the nine-month period ended Sept 30, 2015, on the back of weak consumer sentiment attributable to the goods and services tax (GST) implementation.

He expects a higher industry volume decline of 12% in 2015 from 7% previously, and a 5% decline in 2016 from a growth of 1% initially.

Meanwhile, both analysts, who closely track the tobacco sector, said the vaping trend does have some impact on tobacco players. Kenanga’s Soong said the vaping trend is definitely affecting the tobacco sector as more and more consumers are switching to vaping, which appears to be a cheaper alternative to smoking.

“It is not surprising that the vaping industry is gaining market share,” he added.

“As of now, there is no official statistics quantifying the market share of vape,” he noted.

Moving into 2016, Soong said there will be limited earnings growth for British American Tobacco (M) Bhd (BAT), the only tobacco company listed on Bursa Malaysia.

“We don’t see any investment merit in BAT,” he said. He has earlier given an “underperform” rating on BAT, with a target price (TP) of RM60.

UOB’s Khoo downgraded his rating on BAT to “sell” with a TP of RM55.50 after the hike in cigarette prices, according to his report dated Nov 4.

Meanwhile, according to BAT managing director Stefano Clini, legal volume continues to suffer as a consequence of the steep excise duty increases in September 2013 and November 2014, followed by the implementation of the 6% GST on April 1, which further constricted consumers’ disposable income.

The unprecedented massive increase in cigarette excise duty of more than 40% in November added insult to injury.

“This extreme hike in cigarette excise [duty] against the backdrop of both weakened economy and consumer sentiments will most likely fuel a higher level of illegal cigarettes, where one in three packs is illegal currently,” he told The Edge Financial Daily in an email response.

As such, he said the illegal cigarette trade in Malaysia will remain a key challenge, thus the outlook for 2016 “will very much depend on the recovery of the legal market and actions taken to address the illegal cigarette trade”.

Historically, he said tobacco companies have experienced a significant drop in sales volume after steep increases in excise duty, and recovered partially in the months that followed.

However, he described the recent massive increase in cigarette excise duty as “unprecedented” and expects this to further exacerbate illegal cigarette trade activity.

On the impact caused by vaping, Clini said the company is unable to determine its impact on the tobacco industry presently, given that the vaping industry is relatively new and there is no official statistics on the size and consumption of vaping in Malaysia.

BAT closed 14 sen or 0.26% higher at RM53.62 yesterday, with a market capitalisation of RM15.31 billion. Year to date, the counter has declined 17.63%.