By Maybank IB Research
13 September 2012
Underweight Tobacco. Regulatory risk on tobacco sector rose when the plain cigarette-packaging rule took a quantum leap in Australia towards actual implementation. The industry also faces a greater threat
from the emerging mutatef illicit cigarettes despite a recovery in industry volumes in 1H12. Aside from the rising risk, the sector is losing its appeal on lofty valuations and dwindling dividend yields. Thus, we recommend an Underweight on the tobacco sector. BAT is downgraded to a SELL at an unchanged DCF-based TP of MYR55.00 while JTI remains a HOLD with an unchanged DCF-based TP of MYR6.70.
Plain packs attack! Anti-smoking bodies achieved a major breakthrough in materializing plain cigarette packaging when big tobacco companies lost their appeal against the plain packaging law in Australia recently. Although there are still several hurdles to clear before the rule is implemented, the judgment has created a domino effect as several other countries including New Zealand, Canada, the UK and India are planning to implement this. If implemented, tobacco players would lose one of their last two avenues of advertising, a major determinant of their pricing power. Without product differentiation, generic packs would also induce further downtrading to illicit cigarettes.
Rising illicit risk. A new variant of illicit cigarettes has surfaced in the market recently and quickly gained popularity for its low price and premium-like quality. However, the new illicit is not reflected in the declining illicit market share figures just yet as its packaging closely resembles the legal packaging, making it hard for the authorities to detect. The growing creativity of illicit manufacturers could have induced further downtrading from VFMs to illicits, since VFM‟s 1H12 market share contracted 0.8ppt YoY.
Downgrade BAT to SELL. Amidst the sector‟s gloomy outlook, BAT's lofty valuation and dividend yield at a 10-year low signifies rising downside risk to investors. Hence we downgrade BAT to a SELL at an unchanged DCF-based TP of MYR55.00, which translates into 18x FY13 PER. Meanwhile, JTI remains a HOLD as its share price is close our TP of MYR6.70 after its special dividend ex date in Jun 2012. Further share price downside would be limited by another generous special dividend payout expected in 2014 when its cash pile reaches MYR1/share, according to our estimates.
Plain packaging – plainly a threat
The first battle is fought… Plain cigarette packaging was first proposed in Canada in 1986 and followed by other countries such as New Zealand, the UK, France, Hong Kong and Brunei. However, all
past attempts to implement this had been futile, as tobacco companies have ferociously opposed generic packaging on the grounds that it violates trademark rights and free trade regulations. After 26 years of
ongoing battle, Australia‟s High Court had, on 25 Aug 2012, rejected the tobacco giants' appeal against plain packaging legislation, thereby setting a new global standard for anti-smoking policies.
…and, the war goes on. However, we think that the battle is far from being completely lost, as Australia still needs to face tough hurdles from the World Trade Organizations (WTO). Aside from three tobacco
growing nations – the Dominican Republic, Ukraine and Honduras –Hong Kong-based Philip Morris Asia also filed complaints with WTO premised on violation of global trade treaties. Nevertheless, the domino
effect from the judgment is apparent, as New Zealand and Canada will likely impose the rule soon whilst other countries including the UK, India, Brunei and Norway are reportedly considering the rule.
Domino effect on Malaysia? Malaysia has been part of the World Health Organisation (WHO) framework Convention on Tobacco Control since 2005. Malaysia's government is highly committed to tobacco control; in fact, Malaysia has a 9/10 compliance rating from the WHO. There is a comprehensive ban on tobacco advertising, promotion and sponsorship in Malaysia; tobacco advertising on national TV, radio and print media has been banned since 2004. We believe the Malaysian government would also implement the plain packaging rule,in time.
Last avenue of advertising gone? Due to restrictive tobacco advertising rules, packaging and retail display are the last two remaining pertinent marketing tools for tobacco companies. In fact, packaging is a major determinant of tobacco companies' pricing power.Under Australia's plain packaging rule, tobacco products will be packed in uniform drab dark-brown packs with brand names written in small generic font as shown in Figure 2. Cigarette suppliers will not be able to distinguish their brands under the law.
Plain packs – tobacco players’ worst nightmare. Studies on plain cigarette packaging show that generic packs have reduced attractiveness and are perceived to be of poorer quality. Companies would not be able to charge higher prices if they lose the perceived “premium-ness” of their products. Smokers would also be less attached to brands since plain packaging deters product differentiation. Thus, plain packaging could induce downtrading to cheaper alternatives like VFMs, sub-VFMs or even illicits. In addition, plain packs would increase the salience of health warnings and hence could be more effective in discouraging smoking.
Outbreak of new variant of illicitsImproved variant of illicit. An illicit brand in the country, namely “John” that is sold at MYR4 per 20-stick box, has been gnawing market share of legal cigarettes fast, according to industry players. This new
variant differs from previous illicit brands as its packaging closely resembles legal cigarettes packaging with the manufacturer‟s name and address, and health hazard pictorial warnings printed on the box. It also
has a security strip, which is only revealed upon close inspection of the unauthorised security ink and fake manufacturer details. It is therefore likely that the declining share of illicit and ELPC cigarettes have yet to
reflect the new variant‟s market share.
Threat to legal cigarette sales. Aside from the low price, the new variant's taste is also comparable to
that of premium brands, explaining the fast-growing popularity of this illicit brand. It was reported in Jun
2012 that a factory in Batam, Indonesia is producing thousands of illicit cigarettes daily under the “John” brand. The illicit cigarettes could be smuggled into Malaysia via land or sea with fake documents.
Downgrade BAT to SELL; Maintain HOLD on JTI. Our unchanged DCF-based TP of MYR55.00 translates into 18x FY13 PER. Meanwhile, JTI remains a HOLD as its share price is close to our DCF-based TP of MYR6.70 after its special dividend ex date in Jun 2012. Further share price downside would be limited by another generous special dividend payout expected in 2014.
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