Saturday, November 12, 2011

My thoughts on cigarette operators

This is an amoral investment write up. If it bothers your conscience, please skip.

Tobacco industry is one the very controversial industries. Smoking can cause lung cancer and other related diseases. This sin industry is always targeted by the governments around the world on the premise it can kill people. However, this is also a big and profitable business. It’s almost a RM 10 billion industry in Malaysia. Whenever our government needs money, they will just go to these guys and shake the so called money trees.

There are several risks in investing in cigarette companies. If Malaysian government decided to get as tough as Singaporean government one of these days, it’s going to be a long day. In 1970, 42% of the Singapore’s men and 4.5% of its women smoked. Today, this number has shrunk to only 14%. The consolation is the players seem to be die-hard, Singapore still got double digits of people smoke. You may want to read this paper of what the Singaporean government had done go here

Look the price in Singapore, you will almost pengsan.

But don’t worry, it’s a different picture all together in Malaysia. Over the period of ten 10 years from 1996 to 2006, the number of smokers reduced merely by 3%. The cigarettes operators in Malaysia seem to be able to lobby our government to work with them in a friendly manner. Despite of more and more roadblocks are being put up. As you can see the below table, the freedom of promotion is as tight as Singapore but they seem to be surviving well.

The operators had done an excellent PR job demonstrating they have high standards of corporate governance. BAT for example won many awards from KPMG and Minority Shareholder Watchdog Group and enjoy endorsement from big fund like Aberdeen Asset Management. The cigarette operators were so proud of their success working with Malaysian government and often produce it as a case study in international conferences.

The real headache is the price difference between legal and contrabands. The price difference between legal and illegal is almost double. A pack of legal 20’s sticks cigarettes cost minimum of RM 7 vs. RM 3.5 for contrabands. I don’t care how efficient these legal cigarettes operators operate, there is no way they can close the price gap because a big chunk of them will go to tax. That drives the contrabands market share to record high of 38%. What it also means if the industry players behave irrationally to gain market share in the legal segment at the expense of others, profit margins can suffer.

IF, a big IF our custom officers will be as serious and effective comparing to their counter parts in Singapore, this industry suddenly will have big windfall. But you know the answer already-lah. Read here how aggressive the results shown by Singapore’s custom. These guys are talking about almost 40% reduction of contraband!

The major players are very similar internationally, dominated by the same multi-nationals. BAT has the highest market share of close to 60% and 15% JT International and 15% Philips Moris. Capital gains from BAT is fairly muted but JT International delivered a fantastic 50-75% share price appreciation.

The explanation is fairly simple, BAT revenue was flat while JT International delivered revenue growth year after year. If you already have a lion share of 60%, it’s very difficult to increase further. On the other hand, when your market share base is smaller, it’s much easier to grow. The big funds of course may have prejudice against JT International as a smaller player, despite both have about 5-6% yield. When I’m ready to place my chips again, I’ll park it at JT International.

If you happen to be able to invest in Indonesian stock market, Gudang Garam will be a far more attractive investment.

Disclosure: None