We remain UNDERWEIGHT on the consumer sector as we progress into 2016, amidst: i) consumers remaining cautious, underpinned bymacroeconomic headwinds, and ii) USD-led costs putting margins under pressure despite a possible respite from the PCAP Act. Wecannot rule out an excise duty hike for the brewers going forward. Our Top BUY is Berjaya Food.

• 3Q15 results in line. Broadly, the consumer companies under our coverage experienced more robust sales. Amidst heavier advertising & promotions (A&P) expenses though, margins remained under pressure. Despite this, earnings of the consumer companies under our coverage were largely intact. Notably, the retail sub-segment surprised on the upside while the food & beverage (F&B) sub-segment disappointed.
• Consumers treading carefully. The recovery in consumer spendingcould be more protracted vs what was observed in previous instances(typically 5-12 months). The prolonged recovery was due to the impact oflower oil prices on oil & gas investments, increased government fiscaldiscipline and domestic political uncertainties. All these factors may likelyconstrain the growth of private consumption, which the RHB EconomicsTeam expects to decelerate to 4.4% in 2016 from 5.7% for 2015 (2014:7%). This is amidst: i) consumer sentiment being at a 10-year low,surpassing that during the global financial crisis’ consumer sentiment index (CSI) score of 70.5 pts (Figure 11), and ii) household debt to GDP ratio was at 88.1%, as at August.
• Risks to upside: i) a faster-than-expected recovery in consumer spending, ii) strengthening of the MYR and iii) better-than-anticipated impact arising from Budget 2016 initiatives.
• Maintain UNDERWEIGHT. Our sector call is premised on: i) consumers remaining cautious on spending, and ii) USD-led higher input costs that may ultimately see companies risk continued margins compression or depressed sales. We cannot rule out a possible sin tax hike for the brewers following an unprecedented 43% excise duty hike on tobacco on 3 Nov. We like our Top BUY, Berjaya Food (BFD MK, TP: MYR3.00) for its more resilient customer base, robust expansion plan, and a venture into fast-moving consumer goods (FCMG). Our SELL calls are underpinned by the aforementioned deteriorating factors and compounded by company-specific challenges. The SELLs are: OldTown (OTB MK, TP: MYR1.20), British American Tobacco (BAT) (ROTH MK, TP: MYR54.50) and Aeon Co (M) (AEON) (AEON MK, TP: MYR2.40).

3Q15 results in line

Broadly, most of the consumer companies under our coverage experienced more robust sales. But amidst heavier A&P expenses, they recorded margins compressions. Despite this, earnings of these companies remained largely intact, with net profit of seven of the 11 consumer stocks coming within our estimates. Of the remaining four, two were above and below respectively

The retailers booked mixed results, but the sub-segment recorded numbers that were above expectations due to Padini (PAD MK, NEUTRAL, TP: MYR1.64), surprising on the upside with an impressive quarter fuelled by company-specific initiatives driving margins expansion. Higher than expected A&P costs dragged Esthetics International’s (Esthetics) (EIG MK, BUY, TP: MYR1.05) earnings. AEON’s earnings came in line as expected as the retail segment remains a drag on earnings. For the quarter, its retail business contracted 72% YoY, while contributions from the property management segment prevented a washout of a quarter. We believe heavy A&P expenses were incurred at its retail segment to sustain foot traffic in support of its property management segment. However, combined with other factors including a slowing economy and an ample supply of retail tenant space, its once-stellar property management segment is expected to face greater operational challenges in 2016. Reiterate SELL on AEON.

All the consumer staple companies booked results that were in line – BAT, QL Resources (QL) (QLG MK, NEUTRAL, TP: MYR4.10) and MSM Malaysia (MSM) (MSM MK, NEUTRAL, TP: MYR5.04). However, we downgraded MSM to NEUTRAL (from Buy) as we turn cautious on expectations of higher raw sugar prices impacting the company unfavourably next year. Meanwhile, Nestle (NESZ MK, NEUTRAL, TP: MYR68.60) is proving to be one of the bright spots of the consumer segment – but this has been largely priced in at this juncture.For the F&B segment, OldTown’s results came in line, with its export exposure proving a boon to the company. Domestically, its F&B segment continued to underperform.

Lastly, Guinness Anchor (Guinness) (GAB MK, NEUTRAL, TP: MYR14.70) and Carlsberg Brewery Malaysia (Carlsberg) (CAB MK, NEUTRAL, TP: MYR11.70) had mixed results. Guinness’ exceptional operational cost savings boosted earnings amidst quarterly revenue growth that was flattish at 3% YoY. Carlsberg fell by the same quantum, as its Singaporean operations propped up overall earnings, although its performance fell short of our expectations.

Recall how GST implementation impacted other countries

Based on the experience in other countries, recovery in retail sales has been observed within a few months after a goods and services tax (GST) was implemented. Our observation on three countries that have implemented GST – Japan, Singapore, and Australia – show that retail sales surged prior to the implementation of the tax, but the negative impact duration on retail sales variedbetween them. These countries subsequently recovered within 5-12 months. The historical trend between subsequent GDP growth and retail sales recovery suggests there is softening economic growth in the subsequent year protracts recovery in retail sales, as observed in Japan (1997), Singapore (1994) and Australia (2000). Malaysia’s softening economic growth to 4.5% for 2016F from 4.8% in 2015F would imply that a recovery in retail sales could have a similar impact.

Anticipating soft consumer spending

We believe consumer spending recovery could be protracted up to 12 months, in line with similar GST implementations abroad (typically 5-12 months). While consumers have greater clarity of the full impact of GST, the sluggish recovery is due to multiple factors. These are: i) the impact of lower oil prices on oil & gas investments, ii) lower government spending, and iii) domestic political uncertainties. All of these would likely constrain YoY private consumption growth to 4.4% from 5.7% for 2016F and 2015F respectively (2014: 7%). This is amidst domestic consumer sentiment being at a 10-year low CSI score of 70.2pts, surpassing the sentiment of 70.5 during the global financial crisis (Figure 11).

USD-led input costs partially cushioned by softer commodity prices

The USD has gained 21% YTD against the MYR (Figure 12). All the companies under our coverage have some exposure to the USD, be it the purchase of input costs or sales. The exposure varies but translates to consumers at least partially bearing the higher costs.

The stronger USD/MYR and its corresponding input costs are only partially mitigated by the softening of prices of commodities such as crude oil, coffee, milk, cocoa, malt, etc (Figure 13), as well as the export exposure or overseas operations that would benefit from a stronger USD/MYR.

Caught between a rock and a hard place In Jul 2016, the Price Control Anti-Profiteering Act (PCAP Act) lifts the restriction on the ability to reprice upwards that would result in an increased level of profitability. Initially to be implemented to protect consumers’ interest post GST implementation, it ought to arguably prevent costs being passed through for the duration of the enforcement. Businesses are expected to either reprice upwards or maintain their pricing. This would result in either falling demand or margins coming under pressure. Ultimately, businesses with higher bargaining power or commanding brand presence such as Guinness, Berjaya Food (ie Starbucks) and Nestle ought to have greater earnings resilience, as opposed to companies such as Padini and AEON.

Potential excise duty hike on the breweries Considering the unprecedented 43% excise duty hike on tobacco in early November, we cannot eliminate the possibility of a duty hike on the breweries. Recall the most recent implementation was an adjustment to the basis of excise duty to include A&P expenses back in Nov 2013. Beyond the minor adjustment, the last excise duty hike was implemented in 2005, amounting to MYR7.40 (from MYR6.00) or 23%, including adjustments to sales and an ad valorem tax. Alongside these factors, Guinness and Carlsberg’s aggregate earnings growing at a 5-year CAGR of 7.6% to 2015F form the basis for an excise duty hike. However should a reasonable excise duty materialise, we believe the existing price structure of alcoholic beverages, combined with relatively inelastic demand, may even positively impact earnings – with a buffer built in.

Key risks The upside risk to our UNDERWEIGHT stance on the consumer sector primarily includes a faster-than-expected recovery in consumer spending post GST implementation by end 2015. Also, the strengthening of the MYR should be a net positive to most companies in terms of improved consumer sentiment, as this would translate to enhanced sales and cheaper input costs. Lastly, a better-than-anticipated impact on consumer spending arising from Budget 2016 measures remain an upside risk. Specifically, the measures comprise the hike in the minimum wage to MYR1,000 (from MYR900), increased 1Malaysia People’s Aid (BR1M) payouts and benefits to civil servants, which include: i) a minimum wage of MYR1,200, and ii) a salary adjustment equivalent to one annual increment according to grade.

Maintain UNDERWEIGHT We remain UNDERWEIGHT on the consumer sector given that consumer spending is expected to be subdued. The consumer spending recovery could be more protracted than what was observed in previous instances (typically 6-9 months), while the lifting of the PCAP Act restriction in Jul 2016 could mitigate the fragile consumer sentiment. Imported inflation from the weak MYR is likely to put pressure on prices.

While we are bearish on the sector at large, there remains a pocket of opportunity with our top BUY for the sector, Berjaya Food. Its same-store sales growth (SSSG) contracted in 2Q despite achieving mid-teen growth for five consecutive years, but we are cautiously optimistic on its prospects for recovery going forward. The company offers long term structural growth with: i) its robust store expansion plan, and ii) a venture into FMCG in the pipeline. Meanwhile, its more affluent customer base is less susceptible to higher living costs and headwinds underpinning the broader consumer sector.

Our SELL calls for the sector are underpinned by the aforementioned deteriorating factors but are company-specific as well. OldTown, unlike Berjaya Food, is less resilient due to its lower income customer base. On the other hand, BAT’s nature of business faces some headwinds given the unprecedented 43% excise duty hike. The company is expected to see a close to 15% drop in sales volume, which would negatively impact earnings. Lastly, retailer AEON faces the brunt of a deteriorating macroeconomic outlook, as its retail segment reflects the heartbeat of Malaysia’s retail segment. This is because developing headwinds are expected to impact its once-stellar property management segment.