Countries worldwide are increasing the taxation on cigarettes in a bid to curtail smoking in their respective nations. Taxes on cigarette companies are primarily in the form of excise duties and value added tax (VAT). In Europe, the effective tax rate on cigarette companies has skyrocketed to over 80% in some cases. Here we examine the impact of taxes on Philip Morris’s (NYSE:PM) operations in the EU.
Tax increases barely affect tobacco companies in terms of revenues per cigarette sold. The companies pass on the excess taxes to consumers through price increases. Faced with higher prices, consumers either quit or look for alternatives such as smokeless tobacco products, electronic cigarettes and smoking tobacco alternatives such as rolling tobacco and cigars.
Growing Cigarette Black Market Will Grab Market Share
One side effect of higher taxes, however, is the growth of the cigarette black market. These cigarettes are sold illegally, so are not taxed, and are priced far lower than their legally sold counterparts. As a result, a number of consumers choose to switch over to these cigarettes. As a result, higher taxes have actually caused the government in the continent to lose billions of Euros in tax revenues and have forced many consumers to switch over to more dangerous products.
The illicit tobacco industry is now a fierce competitor to tobacco companies in Europe. Contraband cigarettes have grabbed a substantial chunk of market share in a number of countries. According to a 2011 report by KPMG, one in ten cigarettes sold in the EU is contraband, which equates to 65 billion cigarettes.  We project Philip Morris’s market share in the EU to fall further as the cigarette black market continues to expand.
Tax Increase Causes Net Decrease in Number of Smokers and Unfavorable Mix
According to our estimates, countries in the EU had on average imposed excise duties of around 68% on tobacco companies in 2011. In Ireland, which is an extreme case, the price of a cigarette is on average €0.45 ($0.60), of which around 80% goes to the government in the form of excise duty and value added taxes.  Overall, Philip Morris (NYSE:PM) receives just $0.14 in revenue per cigarette sold in the EU.
Philip Morris’ operations in the EU generate around 40% of total revenues. Until recently, Europe used to be the largest source of revenues and profits for the company. This was because smoking was highly prevalent in the continent and there was a very favorable mix, with a larger percentage of smokers purchasing premium brands.
Going forward, however, we believe that the company will face declining growth in the EU. First, a larger number of smokers are quitting compared to the number of people initiating the habit, primarily due to increased awareness of the health effects and higher prices. This will cause a net decrease in the number of smokers in the region. Second, spending power is decreasing in the continent, leading to a less favorable mix as premium brand smokers switch to discount brands. Combined, this reduces the number of smokers as well as the proportion of premium brands in the mix, causing decreases in both revenues and margins.
We currently have a Trefis price estimate of $89 for Philip Morris, which is in line with the market price.Notes:
- Europe’s Smoking Problem, WSJ, July 2012 [↩]
- Puff, a magic answer to Irish trade crime: cigarettes at €4, Irish Times, September 2012 [↩]