Taxing times for tobacco as smokers count the change

Marc Sidwell
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THERE were more bleak economic figures out of Spain yesterday, with its output in the last quarter of 2012 down 1.8 per cent year-on-year. That won’t have been much of a surprise for Imperial Tobacco, which produced an interim management statement for the last quarter of 2012 that announced its six month adjusted operating profit was likely to be down year-on-year and blamed the punishing effects of European market pressures. This follows Imperial writing down £1.2bn on its Spanish business in October last year. While the tobacco giant still expects its full-year results to be in line with expectations, thanks to cost-cutting, it is hardly a picture of booming growth, with the firm’s tobacco net revenue in the quarter up two per cent.

Part of the problem for Imperial is that, despite ongoing boom times in some emerging markets, it still generates most of its profits in Europe and America. In 2012, the UK accounted for 21 per cent of its adjusted operating profits, Germany another 15 per cent, Spain seven per cent, and the rest of the EU together a further 21 per cent. The rest of the world outside the Americas (including China, the biggest tobacco market in the world) brings in less than a third of its operating profit: 29 per cent.

Relying on smokers in developed markets is a tough call these days. Imperial estimates that the legal cigarette market size is down seven per cent in the EU. One obvious immediate challenge is the economic pressure from the Eurozone crisis. Imperial boasts of being a high margin company, maintaining tobacco operating margins at around 42 per cent. With smokers’ budgets increasingly constricted, they are looking for cheaper solutions, either trading down to non-premium brands, turning to rolling their own (Imperial saw nine per cent growth in its rolling tobacco in the last quarter of 2012) or simply turning to the black market to avoid the taxes which add so significantly to the legal products’ costs: 82.2 per cent of the retail price in the UK in 2012, rising to nearly 86 per cent for a pack of cigarettes in what HMRC's "ultra low" price category.

The result is pressure on tobacco firms’ profits, and also, perversely, on the tax-collectors. The Taxpayers’ Alliance reported last year that 16 per cent of the UK market in cigarettes was black market – and fully half of the market in rolling tobacco. As a result, the taxman lost out on a cool £12.2bn between the 2005/06 tax year and 2009/10 thanks to illicit cigarettes alone.

This is not just a challenge in Imperial’s most profitable market, the UK. Australia has moved to plain packaging of cigarettes. Russia floated a plan at the end of last year to increase tobacco taxes eightfold and is voting on a ban on smoking in enclosed public spaces. Russia is second only to China in tobacco consumption. Imperial has almost a 10 per cent share of the market.

Smoking is a costly habit, so consumers act to reduce those costs, by giving up or seeking cheaper products. With taxes and regulation pushing up costs, and hard times limiting income, fat margins will soon be going up in smoke.