Philip Morris (NYSE:PM) has a problem: the Philippines.
You see, even though Philip Morris is a leading tobacco company, it is coming under pressure from local competitors. In the case of the Philippines, it's specifically struggling with Mighty Corporation.
Now, Mighty has been underdeclaring its excise tax liability, which has allowed the company to undercut Philip Morris and sell more cigarettes. However, after several years of lobbying, Philip Morris managed to get the Philippines government to instigate excise tax reform.
Historically, the government placed an excise tax on cigarettes based on the net retail price per pack. Anything under 11.50 Philippine pesos (PHP) was taxed at 2.72 PHP per pack; any pack of cigarettes with a retail price above 11.50 was taxed at 12 PHP per pack. This was an unfair method of taxation.
The government is now hiking taxes to a standard 30 PHP per pack, although this is a slow increase and is not expected to take full effect until 2017.
How will tax reform help Philip Morris
To understand how this reform will help Philip Morris, we need to take a look at the Philippine tobacco market.
According to Nielsen baseline data, Mighty declared less than half the volume of cigarettes it sold during 2013. Underdeclaring allowed the company to maintain artificially low prices for its brands and keep its applied tax rate down. A flat rate of tax should ensure that Mighty has to pay a higher rate of tax and should level the playing field.
Philip Morris gave some detailed figures at the Goldman Sachs Global Staples Summit on May 13, detailing how the company's progress in the Philippines was coming along.
Unfortunately, Mighty continues to underreport its sales volumes, albeit at a slightly lower rate. The government is planning to introduce tax stamps in June, however, which should help to speed up Mighty's compliance.
What's more, Philip Morris has taken on Mighty in its own backyard, offing two discount cigarette types: Jackpot at PHP 1.25/stick and Champion at PHP 1.50/stick. This was done in order to compete with Mighty's own brand, priced at PHP 1.50/stick and Marvels at PHP 1.25/stick.
Philip Morris' Marlboro brand remained premium priced at 3 PHP/stick, but this was good news. The premium segment of the Philippines tobacco market ticked up to 21% of the market during the first quarter, from a low of 16% reported during the second quarter of last year. Furthermore, Philip Morris' market share rose to just under 84% of the total market, compared to 72% during the fourth quarter .
A negative side effect
Unfortunately, rising excise taxes within the Philippines is likely to have an unfortunate side effect: the growth of black market tobacco.
According to British American Tobacco (NYSEMKT:BTI), Philip Morris' slightly smaller peer, between 2007 and 2010 the size of the tobacco black market expanded within Australia from 6.4% of the market to just under 16% of the market. Oer the same period, the country's excise tax on cigarettes was hiked 25 %.
British American itself paid £33 billion to governments around the world in tax during 2013, eight times the company's net profit.
This is a trend that is unlikely to conclude anytime soon as high taxes on tobacco are just a way of life. They are impacting the bottom lines of big tobacco companies, however, and costing governments money as consumers switch to black market products.
The company is careful to point out that there is no evidence suggesting a connection. Still, with excise taxes on cigarettes jumping in the Philippines, the black market is likely to expand. This will impact sales.
Then again, it's just as likely that the benefits of reigning in Mighty's tax avoidance will offset black market growth.
All in all, the issue of tax avoidance by Mighty Corporation in the Philippines is being brought under control, though there is still some way to go. Trends are developing within the Philippine tobacco market which are likely to benefit Philip Morris, though, such as the growth of the premium cigarette sector. This should be a good growth market for Philip Morris during the next few years.
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Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.