Smoking for a moderate tax increase

Tobacco sector
Maintain neutral: With the upcoming Budget 2011 set to be tabled on Oct 15, 2010, tobacco manufacturers are hopeful of a moderate excise duty increase this year. British American Tobacco (BAT) managing director William Toh said it would be worried if the Malaysian government were to impose an excise duty increase of more than 5% this year.

An excise duty increase of more than 5% represents a hike of more than one sen per stick. Tobacco manufacturers pay excise duty of 19 sen a stick currently. To recap, excise duty was raised by one sen/stick back in 2009, providing the industry a breather after a three sen/stick hike in 2007 and 2008, respectively.

Given that total legitimate industry volume (TIV) is positively correlated to pricing — a moderate hike in excise duties would benefit industry players with BAT and JT International (JTI) included.

As it stands, TIV has been on the decline since 2003, shrinking an alarming 11% year-on-year in 2009. Over the years, the industry was also subjected to challenging regulatory changes, namely the implementation of pictorial health warning (PHW) and a ban on the sale of cigarette packs of less than 20 sticks.

More importantly, depressed TIV growth was exacerbated further by the proliferation of illicit cigarettes.

Illicits currently stand at 37.5%, or the equivalent of every two-in-five sticks sold. Illicits are commonly sold for RM2 to RM3 per pack, with the top five brands comprising Gudang Garam, Luffman, LA Kretek, June Slims and League. Illicits are estimated to have cost the government circa RM2 billion in corporate taxes per annum.

We are of the view that the industry is more likely to be subjected to a minimum hike in excise duty, given the recently proposed cess tax of half a sen per stick by the National Kenaf and Tobacco Board last month.

Although implementation of the new cess tax remains a proposal at this juncture, such tax if it were to materialise, would be translated to higher selling prices. In short, consumers would have to pay at least 30 sen more for every pack of 20s, assuming the implementation of cess tax and a marginal hike of one sen/stick in excise duty is fully passed down to consumers.

We continue to be neutral on the sector. Despite attractive dividend payout policies (more than 90%) of tobacco companies under our coverage, the industry lacks positive catalyst for growth and continues to be fraught with regulatory uncertainties. Maintain hold on BAT with unchanged discounted cash flow-based fair value of RM42; and hold on JTI with fair value of RM5.80. — AmResearch Sdn Bhd, Sept 9, - Written by Kay