WITH THE STRONG MARKET rally from its low since March 2009, defensive stocks such as those in the tobacco sector have certainly not been in vogue. This was aggravated by the fact that tobacco players themselves are also seeing a challenging operating environment in the industry due to the rise of illicit cigarette trades and also a generally weaker consumer sentiment. According to local research house CIMB Research, Illicit trade has shot up to a staggering 38% of the total industry volume (TIV) and remains a key threat to the major tobacco players. It adds that the annual increases in excise duty and consequently higher selling prices for legal cigarettes will only worsen the situation if stricter penalties on smuggling activities are not enforced. Despite the weak economy, the tobacco industry is still facing government pressure, with the latter intending to lessen its subsidies on healthcare treatments such as government hospitals and medicines on smoker’s diseases. Such measures include not only the traditional taxes on cigarette products but increasingly, on restricting the sales and marketing of cigarettes.

For example, the government will be banning the sale of small cigarette packs of less than 20 sticks on June 1, 2010. With packs of 14s now accounting for close to 30% of the industry TIV and given that smaller packs generally command higher margins, analysts expect tobacco players’ earnings to take a hit from this move. The worry is that with the government’s strong stance against smoking, there could well be the possibility of more regulatory constraints on the consumption of cigarettes such as the extension of nonsmoking zones.

CIMB Research also believes that there will likely be an influx of foreign cigarettes into the country when the Asean Free Trade Area (Afta) comes into full force in 2010. While these cigarettes are expected to come in at the lower end of the market at the initial stage, competition will nonetheless intensify, the research house adds. Already, analysts are discouraged that persistent excise duty hikes will continue to cap tobacco players’ earnings growth potential in the future, giving them no room to rebound even if the economy recovers.