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December 7th, 2012:

Tobacco tax smokescreen evaporates

December 7, 2012 7:51 pm

Tobacco tax smokescreen evaporates

By Christopher Thompson

When the chancellor reached the end of his Autumn Statement on Wednesday without mentioning cigarette duty, smokers no doubt exhaled a sigh of relief. It meant a temporary reprieve from paying more than £8 for a packet of 20.

But another significant threshold has already been breached, which threatens tobacco companies’ ability to raise pack prices to offset falling volumes. According to research by Investec, it now takes more than half an hour of work, at average manufacturing wages, to afford a packet of cigarettes. In 1992, it took only 17 minutes.

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This affordability measure reveals a trend that many smokers may not have noticed: every time the government increases tobacco duty, tobacco companies put their prices up further.

“If tax goes up by 12p, they will increase the pack price by 13p, so operating margins go up too,” says Ed Salvesen, analyst at broker Brewin Dolphin. “The smoker believes it’s just the government. That’s why it’s rare to get price increases at any other time except after the Budget when it’s headline news.”

Using tax changes as a smokescreen for price rises has allowed tobacco companies to maintain their earnings as cigarette consumption in the UK and Europe has continued to fall.

One tobacco analyst, who asked not to be named, described the relationship between the tobacco companies and the government as “a cosy conspiracy”.

“When the tax goes up HMRC is happy, and the price goes up so the companies are happy,” the analyst said.

Tax is not solely a positive for tobacco companies, though. According to research group Euromonitor, it is also the main reason why the number of cigarettes smoked in the UK declined from 51bn in 2006 to 44.8bn in 2011.

However, over that five-year period, Imperial Tobacco – the biggest tobacco company in the UK by market share, with the JPS and Windsor Blue – managed to increase its UK operating margins from 62 per cent to 67 per cent. Similarly, Japan Tobacco International – the maker of Silk Cut and the second-largest tobacco company in the UK, increased its global margins more than 10 percentage points to 35 per cent.

But some industry watchers warn cigarette affordability is fast approaching a tipping point.

“People will stop smoking when prices go to a certain point, or lots of people will trade down,” Mr Salvesen says. “[Tobacco] shareholders are becoming increasingly concerned about where they will be in five years.”

Volumes are falling rapidly across western Europe. Euromonitor reports that the number of cigarettes consumed in western Europe fell 92bn units to 629bn between 2006 and 2011, led by steep declines in Spain and Portugal, as higher taxes combined with economic stagnation.

Imperial and JTI remain heavily exposed to these markets – with Imperial deriving more than half of its net revenues from the EU, and JTI booking 43 per cent of its 2012 earnings before interest, tax, depreciation and amortisation from the region.

By contrast, just 22 per cent of British American Tobacco’s adjusted profits in the last financial year came from western Europe.

Martin Deboo, an analyst at Investec, says: “In mature European markets, volumes are declining at about 3 per cent per annum, that’s unequivocally negative for the companies whose business is concentrated there.”

In response, Imperial is promoting fine-cut rolling tobacco, such as its Golden Virginia brand. Although roll-your-own cigarettes are generally less profitable than premium cigarettes, they still offer higher margins than value cigarette brands.

“There’s a lot of down trading from cigarettes to fine cut and we’re looking to capture as many as those consumers as we can,” says Alex Parsons, an Imperial spokesperson.

Innovation is another tactic the companies are using to convince recession-hit smokers to pay more for the same cigarettes.

In November last year, Imperial introduced a ‘glide-tec’ pack, which opens via a sliding mechanism, for its Lambert & Butler brand. The company has also introduced different price points within the same brand. For example, smokers of Fortuna in Spain can buy a cheaper soft pack instead of a more expensive hard-pack, giving them an alternative to trading down to a cheaper brand.

But some in the industry argue that there is a bigger threat than affordability: plain packaging for cigarettes, which is being considered in the UK and elsewhere in the EU.

Shane MacGuill, tobacco analyst at Euromonitor, says: “What’s key to tobacco companies’ earnings in Europe is the ability to innovate and ‘premiumise’ their products. Plain packages will remove that ability . . . the companies will no longer be able to communicate ‘premiumisation’ with their consumers.”

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