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If the latest quarterly results are any guide, the formal tobacco industry is entering a period of contraction. In recent months, the two leading players had started showing displeasure with measures announced in recent federal budget. As per a notice sent to the bourse, Pakistan Tobacco Company (PSX: PAKT) had recorded a 26 percent drop in its top line (net turnover) for the quarter ended September 30, 2019.

If PAKT sneezes, the formal tobacco industry which it leads may catch a cold. One needs to wait for another quarter to pass judgment on the cold. But initial signs are not promising. Being the first reporting period after FY19 budget announcement, 3QCY19 gives a clue on how the government’s annulling of the erstwhile three-tier FED regime and higher FED rate for the bottom tier may be affecting formal industry.

Pakistan Tobacco: latest financials
Rs (mn) 3QCY19 3QCY18 Chg
Gross turnover 28,354 33,277 -15%
Excise duties 14,562 15,176 -4%
Sales tax 4,208 5,063 -17%
Net turnover 9,584 13,037 -26%
Cost of sales 4,650 6,598 -30%
Gross profit 4,934 6,439 -23%
Selling & dist. expenses 756 1,006 -25%
Administration expenses 441 507 -13%
Other expenses 314 335 -6%
Other income 582 13 4232%
Operating profit 4,005 4,604 -13%
Finance income 145 149 -3%
Finance cost 45 8 466%
Profit before taxation 4,105 4,745 -13%
Taxation 1,173 1,794 -35%
Profit of the year 2,932 2,951 -1%
EPS (Rs) 11.48 11.55 -1%
PSX announcement

Despite recent price hikes, gross turnover at PAKT declined by 15 percent year-on-year in the quarter. This suggests a sharp drop in number of cigarette sticks sold (volume). Official production data seems to confirm the possibility, as there is a significant yearly decline in cigarette production in the formal industry since February this year. (Read “Cigarettes: declining production,” published September 26, 2019).

A consequence of the latest budget was that it raised the effective FED rate on cigarette sales. (‘Effective FED’ rate is calculated as excise duties collected in terms of gross turnover). Computations based on PAKT’s quarterly financials show that the effective FED had jumped to 51 percent in 3QCY19, up from 46 percent in the year-ago period. This reduced PAKT’s cut in gross sales by over 5 percentage points.

The formal industry maintains that their legitimate sales are under threat from duty-evading informal sector. There is dispute on the market share of informal sector, but the tobacco industry claims that about a third of all cigarettes sold in Pakistan belong to manufacturers, who do not pay the applicable taxes and duties. Recent FED hikes have widened the price gap between formal and informal sector, they claim.

As the FED consumed 51 percent of PAKT’s gross sales and the GST sliced another 15 percent off, the company retained 34 percent of its gross turnover as net turnover (39% in 3QCY18). Down the income statement, the firm did well to minimize the harmful top line effects by controlling its core costs and operating expenditures, despite operating in an inflationary environment. However, what really saved the quarterly bottom line was an abnormal spike in ‘other income’.

In the end, the company closed the nine-month period with a slight increase in net profits, to Rs9.98 billion. Given the ways of the top line lately, it will be quite a feat for the management to close the ongoing calendar year with a healthy bottom line growth. There are indications that taxes are now declining, but don’t expect the government to act unless its tobacco billions go into a free-fall.