Comeback for tobacco titans

Has the tide finally turned for Pakistan’s tobacco majors? The illicit tobacco trade had become so pervasive in recent quarters that the cigarette volumes of Pakistan Tobacco Limited (PSX: PAKT) and Philip Morris (Pakistan) Limited (PSX: PMPK) were seen declining in double digits. (For a background, read “Tobacco in the budget,” published in this column June 2, 2017, and “On taxing tobacco,” published May 25, 2017).

For at least four successive quarters until 2QCY17, the gross turnover of both PAKT and PMPK saw massive slump on a year-on-year basis. The two companies attributed the gloom and doom to the duty-non-paid (DNP) brands, which were manufactured locally by unscrupulous firms. Especially in the volume-heavy value-for-money (VFM) segment, the DNP cigarettes naturally undercut legitimate sector volumes as they don’t have to pay all those taxes and duties.

PAKT had earlier estimated that illicit smokes had captured about 41 percent of the market by volume. This status quo would have made the federal government lose over Rs50 billion in taxes and duties from just PAKT and PMPK. Foreseeing massive potential tax loss, the federal government finally woke up to the alarm and announced a couple of fiscal measures in FY18 budget to undo the damage.

One step was to not materially raise the FED on the two tobacco tiers. This was to help the tobacco players maintain their competitiveness in the upper and medium price segments. The second measure was to introduce another tier at the bottom, where cigarettes retailing below Rs58 per pack would only carry an FED of Rs16 per pack. This third tier was supposed to help the legitimate players become competitive again in the VFM segment, where the DNP smokes were packing the hardest punch.

Apparently, the two measures have worked in the industry and the government’s favour. In the first quarter when the two measures went into effect, both PAKT and PMPK have staged massive top line recoveries. The 3QCY17 gross turnover grew for PAKT, the market leader, by 54 percent year-on-year, and for PMPK by 129 percent year-on-year.

It’s interesting what the two players have to say for this sharp turnaround. In the latest directors’ review, PAKT credits the top line turnaround mainly to “fiscal reforms and enforcement actions by the government to curb illicit trade”. Now, PAKT maintains that the illicit sector market share is down to 35.5 percent as of September 2017.

The latest directors’ review from PMPK also contains similar appreciation for the government. “After the implementation of third excise tax tier in 2017/18 federal budget and improved enforcement efforts to curb illicit trade, the Company saw a recovery of volumes which is evident in its results for the third quarter.”

As things stand, the duo may still end up closing CY17 on a somber note. In 9MCY17, gross turnover was down 21 percent for PAKT and 33 percent for PMPK; whereas net profits were down 18 percent for PAKT and 88 percent for PMPK. But momentum is the key. If the fourth quarter is anything like the third, PAKT would close the year on a note of profitable growth; as for PMPK, it should feel happy closing another year on a profitable note.

If 3QCY17 is any guide, thanks to the third tier, the tobacco players look set to recoup their market share – something that augurs well for the government revenues, too. The industry apparently loves the third tier. “(The) Company believes that in the long run, the third tier will provide a wider and more sustainable base for the growth of government revenues which would have seen a significant decline had the third tier not been introduced,” reads the same PMPK report.

Be that as it may, public health has received a setback. The third tier makes cheaper cigarettes available in the legitimate market. That decreases the entry-point or price-threshold such that more youth will be at risk to start smoking, besides making existing smokers smoke more. And the onus lies squarely on the government.

The policymakers never seriously cracked down on illicit tobacco trade. Over time, they were reduced into a corner where reliance on the sole fiscal measure – raising FED on tobacco sales – undercut the industry’s price competitiveness really hard. Eventually, the government had to relent on FED hike and to re-introduce the third tier, but that was an act of selfish interest: protecting tax revenues. Now, as corporate profits and tax revenues survive, the public health may be in even more jeopardy.