Major tobacco firms like BAT getting burned by illegal trade

THERE is no doubt that these are challenging times for the tobacco industry in Malaysia.

The booming illicit market has put companies under intense pressure as consumers opt for cheaper contraband cigarettes, while globally, the growing environmental, social and governance trend (ESG) is moving investors away from the industry.

Many factors have contributed to the boom in Malaysia’s illicit cigarette market, which now stands at a staggering 58.3%.

The size of the illegal market grew significantly following a major tax increase in 2015, which pushed up the price of legal cigarettes. Prior to that was the ban on “kiddie packs”, or packs with 10 sticks in 2010 - which meant consumers no longer had the option of buying the smaller, cheaper packs.

Legal cigarettes became increasingly unaffordable, pushing more and more consumers to the much cheaper, and easily accessible, option of contraband cigarettes.

Tobacco players, including British American Tobacco (M) Bhd (BAT), which pay the government billions of ringgit in taxes each year, have found themselves competing within a shrinking legal market.

BAT pays about RM1.6bil in excise duties and another RM0.1bil in other taxes to the Malaysian government.

“While the legal market is contracting, Malaysia’s tobacco consumption is at an all-time high. And it is fully fuelled by the illegal trade,” says BAT managing director Erik Stoel.

In 2008, Malaysia’s illegal market comprised about 25% of the entire cigarette market, growing to 36% in 2010 with the ban on kiddie packs.

After the hike in taxes at end-2015, the price of legal cigarettes shot up further, widening the price gap between legal and illegal cigarettes.

Stoel estimates that illegal players are now selling 625 million packs a year in Malaysia, and pocketing profits of about RM1bil.

This is against BAT’s sales of 200 million packs, and a profit before tax of RM493mil.

Under the challenging conditions, BAT shut down its factory in Petaling Jaya last year, and let go of 230 workers.

Unaffordability, he says, is a major factor fuelling the country’s illegal trade, apart from weak enforcement.

“While the macroeconomic indicators of the country are looking better, the translation of that to the average person on the street is not happening yet,” he says.

Under pressure

BAT has seen its share price steadily decline from RM47.06 a year ago to its current level of about RM25.

Stoel says the decline is directly correlated to the growing size of the illicit market.

At a recent media briefing, he said despite being a “very healthy company”, its share price as well as its financial results were heavily influenced and directly correlated to the state of the tobacco market in Malaysia.

The impact on the company’s performance is evident, with BAT’s financial year 2017 (FY17) revenue falling 20% year-on-year to RM3bil from RM3.8bil.

Apart from the impact of the illicit market, the share price may also be feeling the impact of the global shift towards ESG investments.

Investors are increasingly looking to exclude companies that sell tobacco, alcohol, or deal with gambling and weapons, among others, from their investment portfolios in line with a growing trend of investments in assets deemed socially and environmentally responsible.

One of BAT’s major shareholders, the Employees Provident Fund (EPF), which has stated its intention to move towards ESG investments, has been paring down its stake in the group.

The EPF, which previously announced that it would be gradually decreasing its stake in the group, now holds about a 5% stake.

However, Stoel tells StarBizWeek that the ESG investment trend has not had a major impact on the share price.

“We don’t think that this has had any substantial impact on the share price.

“We haven’t experienced any change in significant shareholders, nor significant moves in shareholdings,” he says.

In essence, he says, the share price has suffered as a result of the thriving illegal market, which has in turn resulted in a shrinking revenue pool for legal industry players over the past two years.

“As we are the only public-listed tobacco company in Malaysia, that is therefore more transparent,” he says.

He adds that the announcement that the stock had been removed from the FBM KLCI component stocks list has also had a “compounding impact”, as it signalled that it was a higher-risk profile stock.

“Historically, BAT shares have always been a guaranteed option for good returns.

“The investor knows the issues in the legal industry and follows the progress the government is making to address this.

“In the absence of a noticeable reduction (in the size of the illegal market), it therefore negatively influences investor confidence,” he says.

Another reason investors are likely to shy away from the stock is the declining dividends paid out, in line with dwindling profits.

BAT, which has a dividend payout policy of 90% of its earnings, has seen its earnings slowly declining over the years, impacting the amount of dividends being paid out to its shareholders.

In its most recent quarter, the group announced a fourth interim dividend of 43 sen per share, bringing its total dividend payout for FY17 to RM1.23.

However, research houses have said that although capital upside appears limited, the stock could still be an avenue for dividend-seeking investors for yields of 5.4% and 5.9% in FY18 and FY19.

Despite the challenging conditions, BAT remains the market leader and even managed to strengthen its position in the legal market last year.

The group saw its legal market share increase to 54.6% in December 2017 from 53.2% in December 2016, driven by strong growth in flagship brand Dunhill, and an increased share of the premium segment from 59% to 62%. To address the issue of unaffordability, the group also ventured into the “value for money” (VFM) segment with the Rothmans brand, and quickly captured a 30% share in this segment.

“Our leading brands Dunhill and Peter Stuyvesant have performed very strongly and our portfolio has been strengthened with the introduction of Rothmans,” Stoel says.

Despite the tough operating conditions, Stoel says BAT is here to stay and is not looking to exit Malaysia. “We will continue to invest where it matters to strengthen our business performance in the legal market, whilst continuing to explore avenues for further cost efficiencies which do not undermine our growth,” he says.

The group’s operating expenses fell 4.7% to RM19mil last year, in line with overhead savings from the cost base transformation initiatives it undertook.