CLSA Gudang Garam (GGRM IJ) update

Whats new?

According to the Director General of customs and excise at the Ministry of Finance, the government is contemplating a more than 5% increase in excise tax next year. The tax could take effect from Jan 1, 2010 and will vary depending on cigarette classification. The last increase in excise tax for cigarettes was in Feb 2009, which increased taxes for cigarettes by an average of 7% percent.

The customs and excise office expects to take in Rp 57 trillion in excise revenue in 2010 from taxes on cigarettes and alcohol, up from Rp 54.54 trillion this year. The cigarette tax contributes 98 percent.

The labor and transmigration departments opposed the proposed tax hike due to fears of job cuts if the industry suffers. The producers were also being consulted.

Comment: We have forecasted 5% increase in excise tax per stick for machine made cigarettes of Gudang Garam i.e. Gudang Garam Surya and Gudang Garam International. For handmade kreteks, we have forecasted a 7% excise tax increase per stick. We have forecasted only 2% price increase for handmade kreteks. While Gudang Garam believes that they will be able to pass all excise tax increases. We have been conservative in our forecasts as the turnaround is still in early stages. Therefore we do not think there is downside risk to our earnings if the excise tax increases goes through.

Longer run, excise tax increases will continue to happen, meaning cigarette prices will continue to go up. Increase in excise taxes will lead to industry wide price increases for cigarettes as seen in the past. Further like in the recent past, we expect increase in excise tax to be higher for handmade kreteks vs machine made kreteks. The government is trying to create a more level playing field which should benefit Gudang Garam. Increase in excise taxes can be positive for Gudang Garam as smokers switch to cheaper brands. HM Sampoerna cigarettes are the most expensive kreteks. Demand for cigarette is inelastic so increase in prices will not deter smoking but encourage brand switching.

We have also incorporated the new regulation which limits tax deductibility of advertising and promotion expenses. This regulation is not made applicable yet. If it is made applicable, it will be applied retrospectively from Jan 2009.

The cigarette industry supports 6-7m jobs and is a key contributor to government revenue. Therefore we do not expect a serious stance by the government to curb smoking. 5-7% gradual increase in excise taxes will continue and we have forecasted that in our model.

Reiterate our conviction buy on Gudang Garam (GGRM IJ) with 40% upside.