No breathing space for tobacco firms as illicit traders get innovative

This article first appeared in The Edge Malaysia Weekly, on April 13, 2020 - April 19, 2020.

Reed: Because of the supply restrictions on legitimate tobacco manufacturers, illegal operators have a virtual monopoly

O’Rourke: I am sure that a RM5 billion cash injection (from uncollected taxes) would be very welcome indeed

Photo by Sam Fong/The Edge

Naeem: Excessive restrictions on legal trading of any product will increase the chances of illegal transactions

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TOBACCO companies, which were already facing challenges with illicit cigarette sales before the Covid-19 pandemic, have had no respite as their illegal counterparts have come up with innovative ways to attract customers as the country remains under partial lockdown.

Illicit cigarettes are being sold online and food delivery providers are bringing them to the doorstep. This is expected to continue even after the pandemic comes to an end.

Like all other consumer goods sectors, tobacco companies have been impacted by the reduced economic activity during the Movement Control Order (MCO). They are not allowed to replenish their products as cigarettes are not considered essential goods.

In an April 8 report, CGS-CIMB Research cited a survey conducted by the Department of Statistics Malaysia that shows average household spending on alcohol and tobacco during the MCO period fell significantly, by 64.3% to RM35, compared with the pre-MCO period. While anti-smoking proponents may see this as an opportunity for people to quit smoking, the concern is that smokers are switching to illegal products.

British American Tobacco (Malaysia) Bhd (BAT Malaysia) managing director Jonathan Darlow Reed, tells The Edge that illegal tobacco traders are profiteering from a national health and economic crisis. “Because of the supply restrictions imposed upon legitimate tobacco manufacturers, illegal operators have a virtual monopoly. Consumers are being forced to turn to cheap, contraband cigarettes.”

Already losing RM5 billion per year in uncollected taxes because of illegal tobacco traders, Reed says the country simply cannot afford this when it needs every ringgit for the battle against Covid-19 and the subsequent recovery.

JT International Bhd (JTI Malaysia) MD Cormac O’Rourke concurs, saying the government should not lose sight of the issue of the illicit cigarette trade as it focuses on tackling the Covid-19 outbreak.

“As the government now turns its focus to the economy, jobs and the nation’s finances, I am sure that a RM5 billion cash injection (from uncollected taxes) would be very welcome indeed.

“Earlier this year, the Ministry of Finance had established a multi-agency task force to combat the illegal trade. We believe the new government should quickly adopt this as the primary vehicle to eradicate illicit cigarette trading in Malaysia once and for all.”

Malaysia is the largest consumer of illegal cigarettes in the world, making up 62.3% of the overall tobacco market last year, from 58.9% in 2018. This mean at least six in every 10 cigarettes consumed locally is illicit.

O’Rourke adds that the MCO has posed challenges for the company from an operational standpoint. “It is clear that supply chains will be tested during this period. From media reports, what we are now seeing is that illicit cigarettes are being sold online and even being delivered door to door by food delivery providers. This just goes to show the extent of the illicit cigarette trade in Malaysia. Of course, this compounds the problem for legitimate manufacturers, enforcement bodies and the government, which continues to be deprived of legitimate tax revenue.”

Malaysia’s Control of Tobacco Product Regulations 2004 prohibits the sale of tobacco products online.

“I am a firm believer that excessive restrictions on legal trading of any product will increase the chances of illegal transactions. We believe that both the government and people will understand the impact of illicit and unregulated sales of cigarettes post-MCO,” says Naeem Shahab Khan, who was appointed MD of Philip Morris (Malaysia) Sdn Bhd on Jan 1. “We are hopeful this will result in improved enforcement and higher compliance to avoid tax revenue leakage for the government, which is critical for the economy at this point.”

Naeem points to countries in Europe and New Zealand, where tobacco products are allowed to be distributed by manufacturers and distributors and sold by retailers during their lockdowns. “Here in Malaysia, it is not as clear. I hope that, together with the government, we can find a solution to prevent this from becoming a big problem.”

Heath Michael, MD of Retail and Trade Brand Advocacy (RTBA), a non-governmental organisation, says internal research shows that demand for illicit cigarettes has increased during the MCO as legitimate manufacturers are not allowed to distribute cigarettes.

“The syndicates have intensified their use of e-commerce and social media platforms along with e-hailing and courier services to meet the heightened demand. This trend is worrying as it defeats the national health agenda to encourage Malaysians to quit smoking during the MCO while extending the government’s loss of revenue,” he says in an April 8 statement.

 

Covid-19’s impact on the big three tobacco companies

Declining to provide guidance on 2020 earnings, Reed says BAT Malaysia is constantly monitoring and adjusting its plans as needed to ensure business continuity. “Like any business, we consistently review our cost base so our investments are in line with our business priorities. This is to ensure the sustainability of our business and shareholder returns.”

He highlights the group’s cost-cutting initiatives, which resulted in operating expenses falling 18% year on year in the financial year ended Dec 31, 2019 (FY2019).

BAT Malaysia, whose profits have been declining since FY2016, saw a 27% y-o-y drop in net profit to RM343.81 million on the back of an 11% y-o-y dip in revenue to RM2.51 billion in FY2019. It blamed the weak performance on legal market contraction and downtrading to cheaper options.

The group ended last year with cash and bank balances of RM20.39 million and total borrowings of RM421 million, leading to a net debt position of RM400.61 million.

Year to date, BAT Malaysia’s share price has fallen 29% to close at RM10.70 last Wednesday, for a market capitalisation of RM3.06 billion. It is currently trading on a forward 12-month price-earnings ratio of 9.71 times.

Bloomberg data shows that of the 17 analysts covering the stock, 14 call it a “buy” and three a “hold”.  

None recommend a “sell”. Analysts have an average 12-month target price of RM14.88 on BAT Malaysia.

The company is adjusting to operating within the MCO environment, says Reed, who assumed his current role on April 1. “Our first priority is to ensure the safety and security of our staff. Of bigger concern to us, is that illegal tobacco operators are taking advantage of the MCO supply restrictions on the legitimate industry to sell cheap contraband cigarettes.”

JTI Malaysia’s O’Rourke says it is too soon to gauge the overall impact of Covid-19 on its business. “While it remains too early to say what impact this will have on the tobacco category in the medium term, initial signs point towards continued downtrading to value brands. This is reflected in retail, where brands such as LD (which retails at RM11.90 for a 20-stick pack) are depleting at a faster rate than premium brands,” he says.

Describing consumer sentiment as “cautious” right now, O’Rourke tells The Edge JTI Malaysia is maintaining its 2020 outlook for now. “Our projection is for continued market contraction amid the widespread availability of illicit cigarettes.

“While much uncertainty remains regarding the immediate and longer-term impact of Covid-19 on the business, it is pretty clear that the industry will continue to see both volume and value declines with further pressure on margins. This has required us to remain focused on the investment side of our business and reflect the new industry reality accordingly. Only by restoring scale to the legitimate industry, by eradicating the illicit cigarette trade, will we see an improvement in the industry’s prospects.”

According to CTOS data, JTI Malaysia’s net profit and revenue fell 6% y-o-y to RM54.09 million and RM1.18 billion respectively in FY2018. Its latest set of accounts for FY2019 is unavailable.

O’Rourke believes now is the best time for the government to open a consultative process with private-sector employers to see how best to strike a balance between reducing the spread of Covid-19 and protecting Malaysian jobs and shoring up the economy. “This would surely be in the national interest and the contribution of the private sector in finding workable solutions should not be underestimated.”

Naeem says Philip Morris Malaysia has over the last few months implemented business continuity plans to ensure adequate inventories of its products, on average, across all markets. “Our focus is to look at ways to meet the demand of our customers who have moved away from smoking to reduced-risk products like IQOS.” The company launched IQOS, which heats tobacco rather than burning it, in November 2018.

“Once the situation is under control in Malaysia, we will continue with our mission of moving as many adult smokers who would otherwise continue to smoke away from cigarettes towards a better alternative such as heated tobacco products like IQOS,” he adds.

CTOS data shows Philip Morris Malaysia’s net profit was down 25% to RM1.27 million in FY2018, even though revenue grew by a marginal 1% to RM138.34 million.

Going forward, tobacco players may have to contend with more headwinds.

AllianceDBS Research analyst Abdul Azim Muhthar says in a March 25 report that the Malaysian tobacco industry’s landscape remains challenging due to declining cigarette consumption per capita given an increasingly health-conscious population, high illicit trade, regulatory risks and emergence of alternative offerings such as tobacco heating products.

 

 

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