Total industry volume (TIV) on a YoY basis has performed better than expected in 1Q12 due to the absence of any tax hikes (much like a stand tide, where there are no changes in the tide's level) and an increased purchasing power, which has resulted in consumers switching from illicit and sub-value for money (sub-VFM) cigarettes to premium cigarettes. In addition, we are also expecting higher volumes in end-2Q and the 3Q, mainly driven by likely higher consumptions during the Olympic and EURO games. However, we still think that there is still a 50% chance of an increase in tax duties after the general election, say in the 4Q, and this will then likely pull back the volume growth.  As a result, although we have been seeing improvement in the legal industry in terms of both values and volumes in 1Q12, we are still maintaining our overall NEUTRAL view on the Tobacco sector. Challenges and obstacles that the industry face remain high with the key challenges being the continued uncertainties in future excise duty hikes and the continuing high level of illicit trades. Hence, we  continue to remain NEUTRAL on the sector and is reiterating our MARKET PERFORM call on BAT with a TP of RM55.10.

TIV improved better than expected. The 1Q12 TIV improved 8% YoY on the back of the absence of a tax hike in Budget 2012 last year. Further, the government's generous goodies distribution to the households since Budget 2012 also has had a positive spillover effect to the tobacco industry. We note that there has also been a big switch in the consumption behavior, with consumers moving from illicit and sub-VFM cigarettes to premium cigarettes, especially in the suburban areas after an increased in their purchasing powers. The TIV improvement is actually in line with our expectation as mentioned earlier in our report dated 28 March 2012, which we expected the TIV to improve slightly this year to 13.4b sticks from 13.3b sticks in 2011.

Greater volumes flowing into the legal industry. Given the backdrop of the absence of tax hikes and the decline in illicit trades, we are expecting higher volume sales, driven by the athletic games, to flow into the legal industry. As shown in Figure 1, we actually observe that the years with athletic games somehow do give a boost to either the legal industry or illicit trades volume. Thus, with the UEFA EURO and Olympic games in the current and coming months, the 2Q12 and 3Q12 TIV will likely continue to improve. 

All risks falling on next tax hike. Our main concern is the timing of the next tax hike that will kick in. In our view, there is still a 50/50 chance of a tax hike towards the end of this year and this will most likely be after the general election. If a tax hike is implemented in 4Q12, we believe the negative impact will likely be seen in 2013. Although 4Q12's TIV will potentially be affected, we remain positive on our forecast of a slight improvement in the overall TIV for the year if better volumes are successfully recorded for at least the current and next quarter.  

Although we have seen improvement in both BAT and JTI for their 1Q12 results, the challenges and obstacles that the tobacco industry face remain with the key challenges being the continued uncertainties of future excise duty hikes and the continuing high level of illicit trades after seven consecutive years of decline seen in the TIV. Thus, we continue to remain NEUTRAL on the tobacco industry and are maintaining our MARKET PERFORM call on BAT with a TP of RM55.10. Although we have not included JT International into our coverage yet, we believe that BAT will catch the most limelight among its peers as its market share is light years ahead of the rest especially in the premium segment.