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Suddenly, it is not looking so good for the tobacco giant anymore. After posting record profits of over ten billion rupees in CY16, Pakistan Tobacco (PSX: PAKT) is off to a disastrous start in CY17. Owing mainly to a high double-digit top line slump, the firm’s operating profitability took a massive hit in the first quarter ended March 31, 2017.

A 34 percent decline in gross turnover clearly indicates that cigarette volumes continue to face severe pressure. This column has recently pointed out the possibility of duty-evasive illicit tobacco trade undercutting the sales volume of genuine players such as PAKT and Philip Morris Pakistan Limited, the second-ranked tobacco player in the organised sector. (For more on that, read ‘Turning on tobacco,’ published April 10).

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The number of cigarettes sold has been declining in recent years. For PAKT, from a high of 44 billion cigarette sticks sold in CY14, the volume had come down to 36 billion sticks in CY16 (see the illustration). At the same time, excise duties and sales taxes collected by the government had started to flat line last year. Now in 1QCY17, the two levies have gone down by a massive 32 percent to Rs14.7 billion. That’s a quarterly tax loss of nearly Rs7 billion from last year on just these two levies for one player.

The illicit trade is hurting the government now, but it is hurting PAKT even hard. This Jan-Mar quarter was the first time in recent years when PAKT’s gross turnover took a plunge. This should concern the firm because volumes once lost to the informal tobacco manufacturers and traders may not come back into the system as the market tilts towards price-conscious customers. Apparently the illicit brands are being sold at prices that are way cheaper than even the most economical of the formal sector brands.

Back at the firm, all three profit margins took a drubbing. PAKT’s gross margin went down by 49bps to 17.3 percent in 1QCY17, as the impact of a drastic top line fall couldn’t be overruled by a significant decline in cost of sales. Similarly, operating margin was down 390bps to 8.4 percent, despite respectable drops in selling/distribution expenses and administrative expenses. A more than 150 percent increase in ‘other operating expenses’ undid those savings.

In the end, PAKT closed the quarter with a hefty decline in net profits, as its net margin shed 161bps to come down to 6.9 percent. As pointed out earlier, with a receding top line, the management can only do so much with its cost management to cushion the margins from a hard fall.

There is still room for cost rationalization, but margins would come under renewed fire after potential cost savings are exhausted.

While it is plausible that folks may be cutting down on smoking, but the main threat seems to emanate from illicit cigarette trade. But there is nothing that PAKT and other formal sector players can do about it, except to lobby the government hard. Now confronting potentially tens of billions lower tax revenues from this sector, the government has an added incentive to crack down on the growing informal trade.

Copyright Business Recorder, 2017

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