Tougher Regulations Change Philippines Landscape

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Features

By Nathanael Lim, Research Analyst, Euromonitor International

Mighty Corp’s Acquisition by Japan Tobacco

In early 2017, the government found out that domestic player Mighty Corp put fake tax stamps on its products in a bid to evade government taxation, resulting in The Bureau of Internal Revenue filing three tax evasion cases against Mighty Corp. In its bid to settle the case, the domestic player was offered for sale to international tobacco companies. In August 2017, Japan Tobacco International acquired Mighty Corp for PHP47 billion, leading to the demise of the domestic company.

Japan Tobacco’s expansion in the Philippines is seen as important for its growth in Asia Pacific, considering the tough operating environment faced elsewhere, such as in Malaysia, where it closed its plant at the end of 2017. Back to its domestic turf in Japan, the company continues to observe a decline in sales of combustible cigarettes, coupled with increasing competition from Philip Morris’s innovation of IQOS in heated tobacco. With the Philippines generating the second highest retail cigarette volume in Southeast Asia after Indonesia, the acquisition enables the company to maintain its competitiveness in the market. As such, the company’s volume share in the Philippines has increased to more than a quarter, strengthening its position as the distant second behind Philip Morris Fortune Tobacco Corp, which accounts for approximately two-thirds of the market. This has changed the competitive landscape in the Philippines, with the stronger presence of international tobacco companies, as well as a level playing field in the industry, since Japan Tobacco is observed to adhere to government regulatory practices. Furthermore, the company’s stronger position enables it to increase its distribution and brand portfolio, using the Philippines as its regional hub. Meanwhile, the presence of domestic players will decline.

With Japan Tobacco’s acquisition, this will enable the company to penetrate into economy cigarettes, where it holds more than a third of the volume share in the segment. Moreover, the company’s active penetration in traditional stores such as sari-sari stores, accounting for approximately half of Philippine’s cigarette distribution, will enable it to expand its consumer base, appealing to low-income consumers.

At the same time, British American Tobacco has called it quits in the Philippines. As one of the early contenders seeking to purchase Mighty Corp, the loss of Mighty Corp to Japan Tobacco has made it challenging for British American Tobacco to compete in the Philippines. With Philip Morris International and Japan Tobacco International dominating the market, this has made it difficult for the company to maintain its competitiveness with its brands such as Lucky Strike, since it holds less than 1% of the cigarette market. As such, the company’s decision to exit the market in December 2017 meant that the cigarettes market is dominated by the two international players of Japan Tobacco and Philip Morris Fortune, where the latter continues to dominate the cigarettes market despite tougher government regulations. Since 2013, the implementation of the tax excise has impacted the price of cigarettes across all segments, resulting in a decline of the company’s sales. According to Philip Morris International, the company recorded market share decline in the third quarter of 2017 year-on-year. Despite the volume decline, the narrowing price gaps brought about by the annual tax increase has benefitted its premium brands as high-income consumers find it more worthwhile to upgrade. For instance, Marlboro recorded an increase in its market share due to its strong brand equity, while economy brands such as Fortune and Jackpot observed volume decline as they are unable to contain rising tax hikes, impacting low-income consumers. As a result, this reduces their consumption for economy brands as they turn towards illicit cigarettes to avoid paying the high taxation.

Intensification of Government Efforts to Reduce Smoking

Under the Duterte administration, the government has intensified efforts to reduce smoking nationwide. For instance, Executive Order 26 was implemented in mid-2017 to ban smoking nationwide except within designated smoking areas. Other government initiatives include campaigns such as Smoke-free Philippines’ Smoke-free Caravan as well as a Smoke-free Task Force, which seeks to implement strict policies including sales and advertisement restrictions for cigarettes. However, the most significant regulation for consumers and tobacco players would be the continual increase in taxation on cigarettes, which was passed under the Tax Reform for Acceleration and Inclusion (TRAIN) Bill in December 2017.

Table 1 highlights the tax excise increase over the next six years, rendering the competitive landscape tougher for tobacco players. Table 2 highlights the impact of the new tax excise on retail unit prices on several selected brands, comparing the price increase in March 2017 and January 2018 observed in sari-sari stores. For instance, economy brands such as Fortune observed a price increase of 10%, compared to premium brands like Marlboro, which recorded a higher increase of 31%. Although this is based on a January 2018 pulse storecheck, the higher price hike for premium brands might potentially lead to consumers trading down to affordable economy brands. At the same time, the lower price hike for economy brands seems to suggest that players are keeping prices competitive, appealing to low income consumers, which might boost volume shares of economy brands.

Given that economy cigarettes take up more than 50% of the Philippines cigarette market, it is vital for companies to maintain their focus on this segment to boost volume sales and maintain their price competitiveness, appealing to low income consumers. Furthermore, the new retail prices in January 2018 portray a widening price gap between premium and economy cigarettes, in an attempt by players to distinguish the low and high income consumer segments.

Outlook for the Cigarette Industry

Despite being one of the largest cigarette markets in Southeast Asia, the competitive landscape is expected to be more difficult over the next few years. Tougher government legislation is set to increase and policies observed in other Southeast Asian countries, such as increasing the legal age of smoking and point-of-sale display bans, could possibly be implemented by the government in its efforts to reduce smoking.

As such, the cigarettes market is expected to record continual decline in the Philippines. In fact, according to Philip Morris International, the Philippines recorded a high single digit decline in cigarette volume sales in the third quarter of 2017 year-on-year.

Meanwhile, in spite of Japan Tobacco acquiring Mighty Corp, resulting in strong volume gains especially in economy cigarette brands, it is unlikely that the company will record significant growth over the next few years. This is because the large proportion of consumers are low income and price sensitive to rising tax hikes. As such, economy cigarette brands are set to record declining volume sales as consumers either quit smoking or turn towards illicit trade. In addition, young adult smokers are expected to substitute towards vaping as an alternative to cigarettes. Moreover, the company’s heavy reliance on Mighty could potentially hinder the company’s value sales. This is because the company’s economy cigarettes account for about one fifth of the market, with its premium brand Mevius accounting for less than 1%. Furthermore, the recent tax hike in 2018 has led to players offering competitive prices for economy brands, and this could potentially limit its value sales. Hence, it will be critical for the company to balance its brand portfolio of economy Mighty cigarettes and premium Mevius cigarettes, ensuring strong value growth for the company.

All in all, tobacco players are set to continually boost their competitiveness, especially since it is not sustainable for players to maintain cost containment measures on cigarettes. Therefore, companies are set to look for various means to strengthen their values sales in the long haul, especially on non-price strategies. A potential area of growth would be to expand their distribution network, especially in sari-sari stores which account for more than half of the channel distribution in the Philippines. Other means could include companies targeting high income consumers with premium brands, through marketing efforts and new product innovations such as menthol or flavor capsules.