This article first appeared in The Edge Financial Daily, on March 28, 2016.

KUALA LUMPUR: Higher taxes and rapid growth of illegal trade have weighed on tobacco manufacturers’ sales volume in the past three years. Now the situation has reached the crisis point.

Last Friday, the three major players in the tobacco industry put out a statement for the first time that the industry has reached a tipping point where it can’t afford another round of excise increase.

The statement was made against a backdrop of a 30% year-on-year decline in cigarette volume sales in Malaysia following the drastic excise increase of about 40% in November last year, as well as rising illegal tobacco trade, which constituted 45.6% of all tobacco consumed as of December 2015.

The Confederation of Malaysian Tobacco Manufacturers (CMTM) — comprising British American Tobacco (Malaysia) Bhd (BAT Malaysia), JT International Bhd (JTI) and Philip Morris (M) Sdn Bhd — also urged the government to address the illegal cigarettes situation as a matter of national priority.

The tough trading conditions have already claimed the first victim as BAT Malaysia, on March 17, announced it would wind down production of its factory in Petaling Jaya, Selangor by the second half of next year.

According to analysts covering the sector, another excise increase, which would encourage down trading to illicit cigarettes, could force more tobacco companies to pull the plug on their manufacturing activities in Malaysia and to operate purely as trading firms.

“The market for cigarettes is always there. But when tobacco players find that it no longer makes commercial sense to produce cigarettes here, they would turn to become trading companies similar to what BAT Malaysia is doing,” Hong Leong Investment Bank Research analyst Sia Ket Ee told The Edge Financial Daily.

In the announcement, BAT Malaysia said it will now source its tobacco products for the domestic market from other BAT Group factories regionally.

Sia noted that the closure of BAT Malaysia’s production plant shows even without another hike in excise duty, the current operating environment is already not conducive for local tobacco players.

“Other than the risk of a possible hike of excise duty this year, there is also vaping policy. We do not know yet how will it impact the industry, but there is always pros and cons for a policy.

“We can always argue that having a domestic production creates employment and brings businesses to the supply chain. But ultimately, it really depends on what the government wants,” he said. Sia has a “hold” call on BAT Malaysia, with a target price of RM54.47.

Currently, JTI has a manufacturing facility located in Shah Alam, Selangor, while Philip Morris operates a cast leaf plant in Seremban, Negeri Sembilan.

Last month, JTI general manager for Malaysia Guilherme Silva told The Edge Financial Daily in an interview that the group has no plans to close its local facility despite declining domestic sales volume.

“About 60% of our total production is exported, while the remaining 40% is for the domestic market. We have been exporting and this has kept our factory operations here fairly healthy,” he said.

In a note to clients dated March 18, Kenanga Research said while the operational restructuring is positive for BAT Malaysia to protect its interest, the exercise is also indirectly sending out a negative message that reaffirmed the research firm’s bearish and pessimistic view on the outlook of local tobacco sector, which has been severely dented by the high excise duty structure and significant illicit trade.

It is maintaining a “market perform” rating on BAT Malaysia, with a target price of RM57.78.

Meanwhile, analysts are of the view that there is a high possibility that the government would push forward another round of excise duty hike this year since Malaysia is a signatory of the World Health Organization’s Framework Convention on Tobacco Control (FCTC).

The FCTC recommended that the final consumer price of cigarettes should at least have 70% excise tax share.

At the current excise tax of 40 sen per stick, it translates to 47% of RM17 retail price of a 20-stick Dunhill pack by BAT Malaysia.

An analyst who declined to be named said in the past, tobacco players were able to mark up retail prices higher than the increment in tax to offset the potential losses in sales volume.

“That was in 2013 and 2014, when the annual increment in excise duty was just three sen each, but with this steep rise last year, I doubt that the retail prices that they marked up would be sufficient to cushion the decline in sales volume,” he told The Edge Financial Daily.

In a note to clients dated Nov 4, 2015, Maybank Investment Bank said it expects a larger contraction in the legal industry sales volume of 15% for financial year ending Dec 31, 2016.

“This would mean that the excise revenue collection would be considerably lower than it was before November 2015,” said CMTM.

“In the current operating environment where consumer sentiment is at a low, another round of excise increase will only produce a no-win situation for both the government and the legitimate industry as consumers will switch to cheap unregulated illegal alternatives,” it added.

The CMTM believed that high excise taxes are not discouraging smokers from quitting the habit, particularly with the availability of cheap illegal cigarettes selling at the price of RM3 per pack.

“These illegal cigarettes are significantly cheaper compared with legal cigarettes retailing at RM17 per pack,” it said.

“As a result of the steep excise increases against the backdrop of a challenging economic environment and weak consumer sentiment, illegal cigarettes escalated to 45.6% of the market in December 2015. This essentially means that almost one out of every two packs sold in Malaysia is illegal,” said CMTM.

It is anticipated that the illegal segment will soon overtake the legal segment in Malaysia.

While CMTM acknowledges the commitment of the Royal Malaysian Customs Department in curbing illegal cigarette trade over the past few years, it said the unprecedented excise increase had disrupted the significant progress that the government agency had made in its fight against illegal cigarettes.

Thus, CMTM is seeking the government to consider a moratorium on cigarette excise to allow the market to stabilise and for all law enforcement agencies to support the customs department in the fight against illegal cigarette trade.

The lone listed tobacco company on Bursa Malaysia, BAT Malaysia shares have lost RM3.3 billion in market value over the past year, from its peak of RM67.41 on March 25, 2015. It fell to a two-and-a-half-year low of RM53.10 on Dec 10 last year, but has since recovered slightly to close at RM55.10 last Friday, bringing a market value of RM15.73 billion.

According to Bloomberg’s data, only two out of 16 analysts covering BAT Malaysia have a “buy” or “outperform” call.