Pakistan Tobacco Company

Pakistan Tobacco Company (PSX: PAKT), an affiliate of the British American Tobacco Company, is the oldest multinational in Pakistan. It was incorporated in 1947 as the first foreign investment in newly-born Pakistan, and succeeded the Imperial Tobacco Company of British India, which had been operating in South Asia since 1905. Pakistan Tobacco Company's parent company, British American Tobacco Company is the world's second-largest tobacco group by global market share, while PAKT is the largest cigarette manufacturer in Pakistan. About 94.3 percent of the company is owned British American Tobacco (Investments) Limited, while the rest is cut up between other stakeholders, such as investment companies, banks, insurance companies, mutual funds and employees. The firm's overall shareholding pattern is provided in the illustration.

Operations

PAKT operations across the country are marked by sustainable technologies. The company provides supply-chain facilitation to its farmers via agronomy support, which includes guidance on crop management, soil health, water management, and environmental-friendly practices. As PAKT is a major player, it has a role in Pakistan having one of the highest tobacco yields in the world.

The British American Tobacco Company owns about 200 cigarette brands worldwide, while PAKT sells brands such as Gold Leaf, Capstan, Dunhill, Benson & Hedges, Gold Flake and Embassy in Pakistan. PAKT, being the biggest player in the market, rakes more than 50 percent of the market share, followed by Philip Morris Pakistan Limited (PSX: PMPKL), which has between 15-20 percent share. Illicit cigarettes' sales volume is high in Pakistan, ranging above 20 percent, as per different estimates. Rest of the market is served by many small players in the organised sector, such as Khyber Tobacco (PSX: KHTC).

Tobacco majors are among the largest taxpayers in this country. In 2015 alone, the company documents shows that Pakistan Tobacco Company contributed over Rs 86 billion in taxes to the Government of Pakistan, in form of excise duty, sales tax, income tax and custom duties. The tobacco sector continues to contribute highly in tax revenue despite facing immense pressure from the illegal sector.

Recent financial performance

PAKT has turned a profit continuously in the recent years. Their gross profit has increased two-fold since 2011 and their earnings per share have risen from Rs 1.42 in 2011 to Rs 27.58 at the end of 2015. This success has been achieved not just by increasing sales, but also by achieving operational efficiency.

Cost of sales, for instance, have increased in absolute terms, but have decreased as a percentage of net turnovers. In CY11, cost of sales as a percentage of net turnover was 73 percent. It dropped to 57 percent by CY15, exhibiting huge improvement in operational efficiency over time. Likewise, PAKT's selling and distributional expenses have also decreased as a percentage of net turnovers, while the revenue consumption by administrative expenses has remained almost the same over these years.

As the federal government continues to hike taxes on tobacco products, companies such as PAKT who are working in the formal sector are forced to pass on the price hike to the consumer. This is detrimental to the formal sector as it drives consumers to the informal sector, further chipping away market share in an already saturated market.

However, despite the encroaching informal sector, PAKT has been producing solid double-digit growth in its net turnover. But that did not stop the firm from improving its operational efficiency. PAKT's focus on sustainable techniques, modernisation of tobacco-processing and steady consolidation of distribution channels over the years has led to increasing operational efficiency. That is manifested in the firm's savings on cost of sales and operating expenditures as a ratio of net turnover.

There is a steep increase in gross turnover in recent years, even as cigarette volumes have stagnated around 42 billion sticks per annum. That's because of the growing taxes and duties that are passed on to the customers. But unlike PMPKL, PAKT has been able to grow its profitability in recent years owing to greater popularity of their brands, and improvement in selling and distribution channels, despite a ban on over-the-counter advertising in the tobacco industry.

9MCY16 performance

PAKT's recent nine-month performance looks equally promising. Its net turnover had improved by 8 percent while the cost of sales had decreased 7 percent on a year-on-year basis in 9MCY16. There is notable amelioration in the three profit margins, and overall the picture looks very positive for the firm to close CY16 on a high note. PAKT is scheduled to announce its CY16 full-year financial results on Monday, February 20, 2017.

Stock performance

Between January and December 2016, PAKT's scrip hit a peak of Rs 1433 on December 30 and a low of Rs 975 on June 13. Despite PAKT's impressive financial scorecard, the stock has trailed the broader KSE-100 index for much of the last calendar year. With a beta of 0.65, PAKT counts as a low-volatility stock. That makes sense because tobacco itself is a defensive industry, with its leading stocks viewed as a good hold by investors who want to have a fallback for uncertain times.

However, in Pakistan's case, PAKT's low trading volumes on the local bourse perhaps better explain why the scrip has low volatility and resultantly weak movement with the broader index. The stock's average daily volume in CY16 was 2,285 shares, with an uncharacteristic peak of 338,000 on June 14, the day after hitting the intra-year low. PAKT shares had zero trading volume on 80 days, which is about a third of all trading days in CY16.

Outlook

PAKT has done well financially but it is operating in a market which faces pressure from increased taxes and illicit sector in an already saturated market. On the external front, decline in cigarette stick volumes will remain a concern for the firm and the broader organised sector. Part of the blame lands at the door of illicit tobacco trade, which includes smuggled products as well as counterfeit tobacco.

It remains to be seen whether the formal sector's lobbying on that front result in a sustained government crackdown on the illicit tobacco trade. Cracking down on illicit trade is in the government's own interest, too, for already, tax revenues from the tobacco industry are on a declining trend as cheaper, duty-evasive products smoke the formal sector brands.