CLSA Gudang Garam and possibility of advertising

Whether a total ban on the advertising of tobacco products will happen? What will be the implications on cigarette companies?

We do not think it will happen any time soon. Millions of farmers depend on tobacco farming. Last week, thousands of farmers demonstrated in Central Java on regulation on tobacco. We have spoken to industry contacts who think this is just noise as Indonesia has lot of other problems to take care of before reducing employment opportunities in tobacco sector. Second cigarette contributes a lot to the government revenue. There are powerful lobbyists from the industry (cigarette, media companies etc) who will try to prevent this.

However we agree that regulation on cigarettes will get stricter over time. Then companies will find other ways to advertise products such as sponsoring club events etc. In other countries such as Malaysia when they introduced cigarette advertising ban in early 2000, it did not have much impact on volumes. It was the sharp increase in excise taxes (54%) in late 2004 which led to drop in volumes as cigarette prices increased by 25%.

Why we remove Gudang Garam from conviction buy?

The stock offers 18% upside to our price target now. So while we maintain a buy recommendation, we have removed the stock from a conviction buy.

Gudang Garam will spend a lot more than we forecast on advertising and promotions this year and there will also be a potential increase in expenses as Gudang Garam hires lot of new people, increases distribution network etc. So margins could contract in 1H10. So while the story remains intact the stock could trade range bound post 4Q09 results for sometime. So we maintain a positive recommendation given the stock is still cheap trading at 13x 10CL P/E and continue to like the bottom up story.

Implication on Gudang Garam if the ban is introduced earlier than expected? – Bear case scenario

We think there is low probability of this.

There is clear trend of a shift to the mild category. Gudang Garam currently has no presence in this category. It is investing a lot of resources to create a brand in the mild segment. If the ban is imposed early on, Gudang Garam will not be able to build this brand presence. For other categories, Gudang Garam will continue to face declining growth as it has been in the past as smokers are switching to mild cigarettes.

So while the cigarette ad ban will mean the industry slows down as a whole, for producers such as HM Sampoerna (owned by Phillip Morris) it will not be as bad as it is for Gudang Garam since HM Sampoerna is the leader in the mild category with 50% market share and it has been really hard for any other producer to challenge HM Sampoerna's presence.