Tobacco industry taxed to the precipice

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This article first appeared in Corporate, The Edge Malaysia Weekly, on August 29 - September 4, 2016.


ILLICIT cigarette volumes continued to rise this year, surging to unprecedented highs following the 40% hike in tobacco excise duties last year. Independent studies conducted earlier this year show that illicit products make up over 50% of all cigarettes consumed in the country.

In other words, about eight billion illicit cigarettes make their way into Malaysia each year. That works out to about 400 million packets, which would fill over 1,800 twenty-foot containers. If lined up end to end, the containers would stretch almost 11km.

As a result, the government will lose an estimated RM3.6 billion in tax revenue — not something the federal budget can afford with the decline in petroleum revenue this year.

Between higher taxes and a 26% drop in volume this year (see Chart 1), legal cigarette makers are also feeling the squeeze. It is a key reason British American Tobacco (M) Bhd (BAT) this year began shutting down its iconic plant in Petaling Jaya, which will cost 230 jobs.

“The tobacco industry is in critical condition. The share of illegal cigarettes in Malaysia has risen to among the highest in the world. It is not just an issue for the tobacco industry, it is a national issue,” JT International Bhd (JTI) managing director Guilherme Silva tells The Edge.

He points to Nielsen’s latest study, which looks at March to May, that shows the market share of illicit cigarettes rising to over 50% (see Chart 2).

These alarming developments have spurred the Royal Malaysian Customs Department into action, and to overhaul its strategy in combating the illicit trade. After all, its sheer volume underscores systemic weaknesses — such quantities are not making their way into the country by the boatload under the cover of darkness.

Leading the charge is Datuk Subromaniam Tholasy, who was appointed deputy director-general of Customs for enforcement and compliance in July this year.

“Tackling illicit cigarettes is at the top of our agenda,” he tells The Edge.

“We acknowledge that the volumes are a big concern as it is lost revenue for the government,” Subromaniam says, although he downplays the findings of the Neilsen study, citing weaknesses in the methodology. He says Customs is conducting its own study to assess the exact severity of the situation. But he will not wait for the findings to take action.

In order to stay one step ahead of the smugglers, he cannot disclose all of his plans. But they will involve a strategic shift from products to processes — going after the supply chain as opposed to confiscating from retailers.

“In the past, we have focused on confiscating illicit cigarettes from retailers. This is expensive, time-consuming and a big drain on resources,” Subromaniam says.

He points out that as at July this year, Customs had seized 505.62 million sticks worth about RM53.89 million — one of the largest hauls to date. In terms of taxes, these cigarettes would have cost the government RM279.24 million in taxes. But in the bigger scheme of things, such seizures barely make a dent in the illicit trade. Hence, Subromaniam’s change in tack.

“We need to secure the supply chain, and ensure we have effective manifest controls. Lots of these (illicit) goods are declared for transhipment or transit, but somehow make their way in. Previously, we did not monitor it so closely, but that will change,” he says.

Customs will be much stricter on freight forwarding companies, shipping agents and forwarding agents that are found to have manipulated documentation in relation to illicit cigarettes.

“There will not be any warning. If we find they have committed an offence, we will blacklist them and suspend their licences. We have the authority under Section 90 [of the Customs Act], but it has not previously been used in this manner. That is about to change,” Subromaniam says.

On the other side of the equation, smuggling is a multibillion-dollar business that involves highly organised and well-funded syndicates.

“This is not some side business for them. It is their main business. With these sorts of volumes, these syndicates could easily set up factories just to sell to Malaysia,” says one industry executive. “On top of that, there is a big concern about where the money is going and the kind of criminal or terrorist activities that it could be funding.”


How did it get so bad?

Coupled with weak enforcement, the large differential in price between legal and illegal cigarettes has been a key driver for the illicit trade.

The last tax hike bumped prices to RM15.50 and RM17 per pack for sub-premium and premium brands respectively. Previously, it was RM12 and RM13.50 a pack. In contrast, illicit cigarette prices have barely changed, ranging from RM3 to RM4 a pack.

In fact, buying in bulk can make it cheaper. A carton of 10 packets is estimated to cost between RM28 and RM35. In simple terms, illicit cigarettes are around 4.6 times cheaper than legal cigarettes.

The easy availability and growing acceptance of illicit cigarettes make matters worse.

“It used to be that people were less open about smoking illegal cigarettes. But these days, it has become mainstream. Almost half of smokers would be smoking illegal cigarettes. They smoke them openly and leave the packs on the table,” says Silva.

Ironically, but not unsurprisingly, average cigarette consumption has also been on an upward trend. The Ministry of Health declined to comment for this article, but the National Health and Morbidity Survey it conducted in 2015 shows an increase in smoking. Compared with the Global Adult Tobacco Survey in 2011, the number of smokers has increased from 4.28 million to 4.44 million. Average daily consumption also increased from 14 to 15 sticks a day.

This translated into an annual consumption of 24.3 billion sticks in 2015, up 11.5% from 2011. In contrast, excise duties on cigarettes have almost doubled from RM22 to RM40 per 100 sticks (see Chart 3).

In a nutshell, all key stakeholders have been the losers thus far. Customs is expected to collect less tax revenue from tobacco products this year, while MoH’s goal to reduce smoking has not been achieved. Meanwhile, legal manufacturers have seen their bottom lines fall, resulting in the loss of jobs as in the case of BAT.

At face value, Customs, MoH and the tobacco industry should now have similar objectives — to combat illicit cigarettes. But how can they go about it?

“There is very little that we [the tobacco industry] can do to combat illegal cigarettes. Because of regulation, we are not allowed to reduce prices or to absorb increases in excise duties,” says Silva.

Note that cigarette makers do increase their prices, on top of the tax increase, to compensate for lost volume. In recent times, however, they have been forced to sacrifice some profitability and some of their margins, or risk losing even more market share to illicits, says Silva.

Recall that BAT last month announced a 28.8% year-on-year decline in operating profit, in line with the 26.3% fall in legal industry volume. Including one-off costs from its ongoing restructuring, the group’s net profit declined 78% to RM47.7 million. BAT declined to comment for this story.

On a more positive note, Customs will be taking on a bigger and more proactive role on the front line. Previously, enforcement only acted as the last line of defence, Subromaniam explains.

“We have created a special squad to tackle cigarette smuggling. We are also looking to bring in new scanning machines to beef up our front-line capabilities. The smugglers’ days are numbered,” he says.

His determination to tackle the illicit trade is a step in the right direction, says Silva, giving the legal players a ray of hope.

“Looking at what Customs is doing, I am hopeful that things can improve. But until we see some change, it is hard to be positive or negative. Right now, we just want things to stabilise. We cannot afford for it to get worse,” he says.

However, with Budget 2017 around the corner, there is still some uncertainty for the industry, at least without a clear policy direction from the government. Sin industries tend to be easy scapegoats to raise revenue. But the evidence shows that an additional hike this year would do more harm than good to government coffers.

“We [the industry] cannot take another round of regulation [including tax hikes],” says Silva. He is hoping for a moratorium on tax hikes for at least three years to allow the industry to recover.

He points out that Malaysia already boasts the second highest cigarette tax in Asia, and has the third most expensive cigarettes in the world in terms of purchasing power.

Note that JTI’s plant manufactures 80% of its volume for export to 12 countries. Unlike BAT, it has reduced its exposure to the Malaysian market and is less likely to shut down its plant.

That said, Silva is wary of new regulations like plain packaging, something that MoH has talked about in the past.

“Plain packaging, simply put, is a branding ban. I do not want to get philosophical about it, but plain packaging would make the current problem with illegal cigarettes [in Malaysia] much worse,” he says.

“Without branding, cigarettes become commoditised. When cigarettes are commoditised, pricing becomes more important. Illegal cigarettes that do not have to comply with plain packaging become more attractive,” cautions Silva.

Moving forward, this uncertainty is going to undermine the once-defensive nature of tobacco stocks like BAT. Its share price has already fallen 14.29% over the past one year to RM50.38 last Friday. This is despite an expected RM139.9 million special dividend payout (48.9 sen per share) from the disposal of its factory and land later this year.

Customs will need to rein in illicit cigarettes before the outlook improves for BAT.