Tobacco shares may not go up in
Tuesday, August 05, 2008 (GST)
August 4, 2008: For a decade now, the Health ministry has been struggling to find ways of reducing the number of cigarette rs and curtail the recruitment of the youth into this dangerous habit. August 4, 2008: For a decade now, the Health ministry has been struggling to find ways of reducing the number of cigarette rs and curtail the recruitment of the youth into this dangerous habit. Though public education campaigns, ban on advertising of tobacco and restriction of smoking in public places have reduced demand for in Kenya — as evidenced by BAT Kenya’s sluggish domestic revenue growth — the real killer blow is expected to be the implementation of the Tobacco Control Act. The law upholds the ban on tobacco advertising, severely controls how, where and to who are sold and imposes huge fines on individuals violating the public smoking bans. If the new law meets the objective of significantly reducing the number of rs, it would be a major public health coup, but for investors, the big question is how this ban might affect the fortunes of BAT Kenya — a listed company on the Nairobi Stock Exchange (NSE). There is also concern over the fate of Mastermind Tobacco, retailers, farmers and the Treasury, which continues to be severely addicted to sin taxes to finance the national budget. Tobacco in Kenya is grown by more than 5,000 contracted farmers, another 5,000 shareholders have invested at the NSE and 42,000 small business owners are sellers. Overall, an estimated one million Kenyans depend on this industry for their livelihood. Treasury collected about Sh7 billion last year in excise duty, VAT and corporation tax from BAT Kenya, an increase from about Sh6 billion earned the previous year. Tobacco tax contributes 0.92 per cent of the Sh760 billion National Budget. Manufacturers have been given a six-month grace period up to January 1 to comply with the new regulations, which include selling in packs of a minimum of 10 sticks, and printing large font health warnings on all cigarette packs. Dangers of trading down The debate over the control of the consumption of tobacco and alcohol have over the years been shaped by moral and religious convictions, which have over the last two decades attracted government intervention because of rising public health costs and deaths associated with these products around the world. The Health ministry has been waging this battle for over a decade by shackling the ability of cigarette firms to make smoking attractive through marketing. The next shape that this fight has taken with the Tobacco Control Act 2007 is attempting an even ambitious use of economic sanctions (in terms of stiff fines and controlling production promotion and availability) to regulate consumer behaviour and morals by attaching a negative social sting to public smoking. According to experts, the harsh economic disincentives placed on public smoking and cigarette consumption through high taxes, court fines and jail fines could force a sizeable portion of the population to trade down from legitimate products sold by BAT Kenya and Mastermind to cheaper traditional alternatives and illicit products obtained through smuggling and other forms of tax evasion. This will produce a big underground movement of rs who fall below the radar of the ministry of health, but who continue to increase the public healthcare bill. According to Kestrel Capital, BAT Kenya, which commands 80 per cent market share for instance losses, an estimated 12 per cent of its Sh15 billion gross revenue to illicit trade. This will now grow. A similar down trading happens in the alcoholic beverage industry when governments try to force people from drinking too much by taxing the product heavily. Going by global trends in 168 countries that have heavily regulated tobacco consumption, the Kenyan ban will lead to a fall in the demand of in the short term, but the situation will stabilize over the long run into a profitable and cash rich business. This is what happened in Western Europe, Japan and particularly in the US when the George Bush senior government removed the spectre of bankruptcy that hang over the tobacco firms in the late 1990s after the industry was hit with a multibillion dollar class action suit and court judgment. President Bush supported a situation where tobacco firms would not be made to pay individuals the harmful costs resulting from tobacco smoking as was envisaged under the law of tort and product liability. Global trends In Kenya, this is the pattern that the management of BAT Kenya hopes will emerge after the harsh effects of the law. “In many parts of the world, our companies have continued to enjoy considerable success after the implementation of tobacco control laws,” says Keith Gretton, BAT Corporate and Regulatory Affairs Manager, Sub-Saharan Africa. BAT operates in 180 countries globally most of which have some form of tobacco regulation and is banking on emerging markets in Africa like Kenya to both contribute to future growth and offset the fall in revenue in the US and Europe. Currently 168 countries have signed and ratified the World Health Organisation’s Framework Convention for Tobacco Control (FCTC) policy. This means that these signatories are at various stages of tobacco regulation with some already having tobacco control laws in place while others are in the process of enacting control legislations within the next two years. Mr Gretton says that consumption generally falls by about two to three per cent initially in some of the countries at the time of imposition of smoking bans, after which it stabilizes. He however says that predicting the consumers’ reaction in Kenya may still be premature. “It is too early to make an assessment of the impact, if any, on our (sales) volumes. It is however perhaps worth noting that our volumes grew by 12 per cent last year despite the implementation of municipal smoking restrictions,” says Mr Gretton in reference to partial public smoking bans in major towns across the country mid last year. Mastermind Tobacco, declined to grant an interview on the grounds that the company has already filed a case in court seeking to challenge the new Act, introduced in October last year. BAT shares Perhaps, the biggest day that BAT Kenya’s management has been waiting for is when President Kibaki signed the Tobacco Control Act 2007 into law. However, four years ago, the company came to the realization that it would lose the legislative battle and started preparing for a dark future. Prior to that, a bad economy and an advertising ban had severely curtailed revenue growth, which remained stagnant in the Sh5 billion range between 1997 and 2005. Net profits too had dropped, before recovering and though the business was producing healthy profit margins as high as 30 per cent, the future did not look bright. In 2004, the company embarked on an expansion project costing Sh2 billion that would dramatically change the economics of the business over five years. Faced with the prospects of tobacco control in the 15 African markets that BAT operated, the firm decided to consolidate all its manufacturing in these countries into the Kenyan hub in one of the continent’s sophisticated supply chain operations remake to support contract manufacturing. The results have been dramatic as BAT Kenya’s revenue start to grow. Five years ago, the company’s revenue was mostly dominated by domestic sales with a small slice of export business. Today, as a result of contract marketing, domestic sales account for 57 per cent of revenue and Kestrel estimates that this will split evenly by 2010. However, what the business has gained in aggressive revenue growth has been lost to rising costs of operations. This impact is visible on the income statement given that operating costs in 2007 account for 77.62 per cent of revenues compared to 67.23 per cent in 2003. In terms of profits, it means the company is making less money from operations for every shilling generated in sales. Last year, the company was making 22.38 cents in operating profits for every shilling of revenue generated, compared to 32.77 cents in 2003. According to analysts, the company has been finding it harder to make money because of declining local sales, rising costs especially for electricity and transport (which is outsourced) and the fact that high volume contract manufacturing attracts lower profit margins. Kestrel Capital says that a combination of all these factors and the smoking ban have eroded BAT Kenya’s pricing power in the market, meaning that it cannot increase retail price to cover for the rising costs without losing customers to competition or illicit trade. Kestrel has assigned BAT shares a hold recommendation meaning that it is fairly priced and investor cannot expect to get major fluctuations in value at the current price. African Alliance noted this trend in its recent update of its research coverage of BAT Kenya noting that the new legislation and new printing and labelling costs would reduce profits margins and sales. Kestrel is currently advising its clients not to buy more or sell BAT Kenya shares because it is fairly valued with no opportunities for price gains. The stockbroking division of African Alliance advises clients in the current report to reduce their exposure to BAT shares in their portfolio. “We downgrade our recommendation to underweight and value BAT at Sh158…assuming a 10 per cent decline in domestic sales,” says the report, “We believe the domestic sales are likely to record negative growth as has been the trend since 2005, however, we maintain our estimated positive growth on export sales.” “We believe the tobacco industry in Kenya is in the stabilization and decline stage of the industry life cycle,” says an African Alliance analysis report dated July 22, after BAT released its half-year results up to June this year. “This is evidenced by declining profit margins, decelerating growth in domestic consumption.” BAT reported marginal growth of 4.6 per cent in pre-tax profits in the period to Sh1.1 billion. The company’s net sales grew by 7.9 per cent to Sh4.7 billion compared to 29 per cent growth in the half year period to June last year. Share performance Though BAT shares, priced at Sh160 last Friday has lost five per cent of its value over the last three months, it is still 15 per cent up on a year-to-date basis and 9.14 per cent down compared to last year. This could reflect on investors’ short-term expectations of how the tobacco ban will affect the performance of the company. For long-term investors, it has been a very rewarding share that has beaten market performance. A person who invested in the company in 1997 has seen the share grow by 327 per cent up to the current price, which beats the performance of NSE 20 share index (159 per cent) and Morgan Stanley Capital International Emerging Frontier Market (MSCIEF) index (248 per cent). The share is currently trading at a low price-to-earnings multiple of 11 compared to other blue chips stocks. One of the key drivers of this share has been the healthy profits margins and free cashflow the business produces and the generous dividend payout. BAT offers one of the best dividend yield of 7.3 per cent on the NSE and the highest dividend per share of Sh17. Such a generous payout signals that the business is in its maturity stage and it is attractive for investors looking for consistent and high dividend payouts. It means that given the investment outlook, shareholders are better off investing their cash on their own because the management does not have major projects (beyond expanding production capacity) that would generate better returns than what the markets are offering. Over the last five years, the directors has been so eager to return cash to shareholders such that the dividend payout has exceeded free cashflow and net profits, meaning that the company is now distributing retained earnings. This trend is expected to continue. BAT with its strong balance sheet and strong cashflows, however does not need to maintain a lot of cash because it can easily borrow and that is probably why it is giving all excess cash back to investors. Overall, the company is positive about the new legislation and it plans to use it to steal more business from illicit trade. “We see this as a reasonable piece of legislation if it is implemented in an orderly manner. As a company we support regulation of the Industry as it provides a level playing field for all players,” says Mr Gretton. BAT management says that it does not intend to scale down its operations in Kenya, and promises that there will be no staff layoffs. The company has 500 permanent staff and 1,000 contract employees in its Nairobi office, and employs up to a further 2,000 casual labourers in its Thika green leaf threshing factory during peak seasons. “BAT Kenya remains a worthy investment. Despite the post election challenges the company has registered a 16 per cent increase in gross turnover and a five per cent rise in profit before tax in the first half of the year compared to same period last year. Our share price remains stable at around Sh160, a clear indication that investors have confidence in the business.