While we see no exercise duty increase in the recent 2013 budget, which should be a piece of good news to tobacco players, we still maintain our NEUTRAL rating and our MARKET PERFORM call on BAT with a TP of RM58.70. The uncertainties over future potential excise duty hikes remains high especially after 13^th  GE and the continuing high level of illicit trades with the declining TIV since 2004. Also, given two consecutive years of zero tax hikes, we are not surprise to see the Government raising the tax in the coming one year ahead, with the quantum possibly ranging from 1 sen to 3 sen per stick. Should the Government imposes a higher tax of more than 10% on cigarettes (around 2 sen per stick), we reckon that the TIV will most likely be affected, hurting mostly the big players. 

In line with expectations. The 2Q12 and 1H12 TIV had improved by 0.6% and 4.0% YoY respectively. This is because 1Q12 saw a consumption increase after the absence of an excise hike in Budget 2012. In addition, 1Q11 consumption was low due to the off-budget increase of excise duty back then in Oct 2010. Further, the government's generous goodies distribution to the households in last year's Budget 2012 also has had a positive spillover effect to the legal tobacco industry. Together with the 7-13% increase in the civil servant salaries then, it led the consumers to move up from the illicit and sub-VFM to premium cigarettes, especially in the suburban areas. In summary, 1H12's TIV of 6.8b sticks was in line with our expected TIV sales of 13.4b sticks for the full year, making up 50.7% of the latter. Historically, 1H usually makes up slightly above 50% of the full-year volume, although an exception was noted last year in 1H11 as it was badly hit by the double-digit increase in excise duty in Oct 2010. This resulted in illicit trades surging 32.5% to 37.3% in 2Q11.      

Will history repeat itself? As seen in our analysis (see chart overleaf), there were only three years in the past 12 years (the first time in Budget 2003, 2012 and 2013) where the Government did not raise taxes on the industry. In  the first case, the subsequent year 2004 saw a continuation of the yearly increase in the excise duty by 20%. And worse, after the Government won comfortably in the 11^th  GE, it doubled up the increase to 40% for 2005. Tobacco shares prices like BAT then was still on an uptrend in line with the market, where the 2004 hike (announced in Sept 2003) did not deter its rising rally but the doubling-up in 2005 finally took the winds out of its rally, causing BAT's share price to plunge 28%. 

Could a similar situation recur going forward? With no excise duty hike for the last two consecutive Budgets, there is a high possibility hence (similar to the 2004 scenario) that there will be a hike after the upcoming 13^th  GE (we are expecting a quantum of around 1-3 sen, likely at the lower end, which should be bearable for the industry). However, the worry is what will happen should the Government win comfortably in the upcoming 13^th  GE like it did then in the 11^th  GE in 2004? We reckon it could be emboldened then to exert a heavier pressure on the industry, possibly through raising the excise duties significantly next year like what happened in 2004, either through wanting a higher revenue or to clamp down on the smoking habit. Whatever the reasons then, there could be a  repeat of history where the rally in the sector will end prematurely (like in 2004), especially given the high level of illicit trades now at 35% compared to just 14% then in 2004. If the Government imposes a higher tax of more than 10% on cigarettes after the GE, the TIV will most likely be affected, and it will hurt the big players the most.    

Thus, neutral at this juncture. Our main concern is the timing and the quantum of the next tax hike that will kick in. It is unlikely that the tax hike will be implemented in 4Q12. Thus, we remain positive on our forecast of a slight improvement in the overall TIV for 2012. However, the challenges and obstacles that the tobacco industry faces remain with the key challenges being the continued uncertainties of future excise  duty hikes especially after GE13 and the continuing high level of illicit trades compounding the negative effect of eight consecutive years of decline seen in the TIV. As a result, we continue to remain only NEUTRAL on the tobacco industry for now and are maintaining our MARKET PERFORM call on BAT with a TP of RM58.70. Although we have not included JT International into our coverage yet, we believe that BAT will continue to lead its peers as its market share is light-years ahead of the rest, especially in the premium segment.

Source: Kenanga