Corporate and Legal Affairs Director Oleg Strekal interview re Ukrainian tobacco market tendecies

05.02.2016

Reduction of the legal cigarette market, traditional pre-year-end increase in excise duties on tobacco products, ongoing price wars between manufacturers – these and many other questions are answered by Mr. Oleg Strekal, Corporate and Legal Affairs Director at Imperial Tobacco Ukraine.

What is your assessment for 2015 in the tobacco industry?

In the past year, the worldwide trends towards reduction (albeit slow) of global tobacco market were confirmed in the Ukrainian market. Compared to 2014, the reduction of the domestic market amounted to about 5%, down to 66.5 billion pieces. For 2016 we forecast a drop to 62 billion pieces, although it is difficult to calculate for the year since it is not known how a factor of the illegal trade would show itself. After all, there are some factors that may trigger its sharp growth. As it has previously fallen from 10% (2013) to 1.4% (2015), it may rapidly revert this year to 10%, or even exceed this value. These factors include the excise policy of the state, its inability to properly control the markets and the border, and the lack of desire to do so.

What is the Ministry of Economy based on claiming that the market volume at the end of 2015 is 80 billion pieces?

We have not seen the statistics by the Ministry of Economy. We, Imperial Tobacco, counted each pack, as well as three other major manufacturers. Lviv Tobacco Factory manufactures relatively little, all for exports. I don't really know where the Ministry of Economy got such figures.

What are the main trends in the tobacco market of 2015 and those of this year?

We note down trading among the major trends in the market – people buy expensive cigarettes less and switch to cheaper options, that is associated with a reduction in the purchasing power of the population. The segment of expensive cigarettes declined by about 30%, and the cheap one increased by the same volume. The medium segment has remained in its stable state. Interestingly, consumers are now shifting to the cheapest legal, but have not yet switched to the cheap illegal segment on a large scale. This is due primarily to the fact that a very strong devaluation of the hryvnia has made smuggling to Ukraine uneconomic: the hryvnia depreciated by 3 times, and it turns out that the primary cost for the smuggler is higher than the price in Ukraine.

But there is another trend here – growth of transporting smuggled goods across the border of Ukraine. We cannot state exact figures, but unfortunately the scale is constantly growing. The impetus is huge – in Poland for legally manufactured Ukrainian cigarettes smuggled in one can gain 5 times more, and in Germany – even 10 times. At the same time, the liability is not that big. We know that there are criminal clans engaged in smuggling on a large scale, but often in the border regions, where unemployment rate is high, the population itself inevitably becomes a smuggler. Unfortunately, our country does not fight against this in any way; it makes some stink at the boundary from time to time, but it is ineffective.

Another problem is that not only Ukrainian cigarettes come to Europe, a lot of cigarettes come as transit smuggled goods through Ukraine. For example, a lot of products are imported to Odessa from the Emirates and China. The brought-in brands are not known in Ukraine at all. Due to corruption among officials covering all this mess, such products are unloaded at the port and then transported across the border; goods are not declared anywhere and are not displayed in the export structure. Unfortunately, Ukraine is not only a source of supply of illegal cigarettes to Europe, but also a kind of transit “silk way” for illegal products.

What countries are illegal products mainly come to from Ukraine and where do they come from to Ukraine?

From Ukraine they mainly go to Europe reaching the UK where they are sold even not in dollars but in pounds, therefore the UK is the most attractive market.

And illegal products come to Ukraine following a standard structure: about a third comes from Moldova, from Transnistria, 22-23% – from Belarus, plus Russia. Formerly, there have been domestic illegal products – counterfeit goods. This is a factory known to anybody called Hamadey which operated in Donetsk just for this purpose under the cover-up of criminal government. They forged a variety of brands and did not hesitate even to offer them on the Internet for sale. Now they are located in the temporarily occupied territory – a part of the production lines was moved to Russia and another part – to the occupied Crimea. It turns out that now they are fighting for market share with the Russian companies. The Russian manufacturer Donskoy Tabak comes to our occupied territory, but Hamadey keeps manufacturing probably because there are attempts from time to time to transport cigarettes to Ukraine.

Another trend, but it is more about our company, – there is relocation of production to Ukraine from other countries. Last year we imported cigarettes from Russia, but being aware of all the political and economic risks, we have gradually transferred production to Ukraine. Now we don't have any import from Russia. Everything is manufactured locally that is good for the Ukrainian budget and carries less risk for the company. In 2015, we paid into the state budget a little more than 5 billion UAH of excise duty, and all taxes totalled 6.2 billion UAH. We enter the top five of the largest taxpayers in the country, although it does not provide us with any privileges, on the contrary, we feel a lack of respect on the part of the authorities. The excise duties are raised for us on the last day before the New Year, although they should do so 6 months before. Final excise duty rates are the result of corrupt bidding rather than economic calculations. On the second day after lifting of the moratorium on audit of businesses the representatives of environmental and firefighting authorities came to us with audits  ... Where the changes are? Where the improving of the investment climate is? The President and the Prime Minister go to foreign countries and try to persuade investors to bring their investment to Ukraine, while taking no care of the existing investors. Who would take the politicians' bait of promises of unclouded future in such a situation?

Another trend of the tobacco market is a feast of corruption. It is unfortunate that the government, which in words follows the ideals of the Maydan, does not correspond to that method and those rules of doing business followed by us. Firstly, through all sorts of manipulation and falsification of decisions of the Parliamentary Committee for Tax and Customs Policy, the deputies finally adopted increase in excise duty rates which were lower than those proposed by the Ministry of Finance. In particular, the ad valorem component of excise duty has not been raised, although the Ministry of Finance proposed an increase by only three percentage points. The Parliamentary Committee voted for it, but then the information was published on the website of the Parliament that the Committee did not support the change. This means that, at a minimum, the deputies gave the tobacco companies about 500-600 million UAH. This is a direct evidence of rough back-room bidding. Unfortunately, the conductors of the procedure were the key people's deputies of the Block of Petro Poroshenko. “Thanks” to them, 500-600 million UAH will not get in the budget, they will be shared mostly by the two companies – Philip Morris and JTI because they have the premium segment from which the biggest ad valorem is paid.

Resigned Minister of Economy Aivaras Abromavicius told how he was pressed by the political lobbyists. But from the business side, we can also tell a lot about the activities of people's deputies who satisfy the interests of companies at the expense of the state budget “completely free”. And no arguments can influence them – since they were already targeted at a certain result, no objective figures can make them off the track.

Tell us please, what is the degree to which the amendments adopted to the Tax Code generally correspond to the European practice?

We originally have the excise duty in the Tax Code with the structure corresponding to the European one: there are minimum excise liabilities, specifics and ad valorem. However, the corruption component is behind the game of lowering ad valorem. In 2013, the ad valorem component of excise duty was reduced by half, thereby depriving the budget of some billions UAH of potential revenues – they have been retained by the same two companies. Now, with the help of deputies of the President's faction and back-room bidding with the Prime Minister they refused to increase it even just a little. When the average ad valorem in the European Union is 24% (because they already have both 1% and 55%), we have 12%. In the EU, we rank 4th from the end by the ad valorem rate. And there are no arguments (except corruption agreements) against its increase.

Fortunately, the deputies reviewed the base for accrual the ad valorem component, and brought it to the European standards (it is accrued on the full minimum retail price, including VAT, before it was net of VAT). This means an increase in ad valorem component at slightly more than 2 percentage points. If this was not voted for, the budget shortfall would be less than 1 billion UAH this year.

So, in fact, without this back-room bidding the Ministry of Finance would have been on the right way. It even managed to convince the Committee on Taxation and Customs Policy, but then the deputies “inclined for cooperation” somehow make the opposite position public. I would very much like to see such manipulations dealt with by the National Anti-corruption Bureau.

Which countries with adequate excise policy could be an example for Ukraine?

I believe, the criteria we take are the most important things in the excise policy. The rates may be different, but the most important is the stability and predictability, as well as compliance with the structure of each particular market. Because somewhere i50% ad valorem is working properly, and in some cases, in our country for instance, this will never work. Therefore, taking into account the market specifics is very important – the purchasing power of the population above all, as well as inflation and economic development.

I would hold Germany up as an example. It takes into account different level of population's incomes. For example, a lot of people there smoke the so-called roll-ups. Because they tax cut tobacco at a lower rate than manufactured cigarettes. And the share of roll-ups in the market reaches 15-17%. It is known that there are poor people which they pay no attention to in our country, especially the government which says that “rich people will pay more”, and in fact increases the excise duty on non-filter cigarettes (relatively speaking, cigarettes for the needy) immediately to 126 %, and thus the price increases by 70%. So the government takes into account the situation and needs of the population.

What should, in your opinion, an ideal excise duty be in Ukraine?

I think that by the structure and considering changes in the recalculation of ad valorem accrual we fully correspond to the European practice. Because the minimum excise duty guarantees public revenues, VAT is also included in the base, number of manufactured cigarettes is taxed at a specific rate and ad valorem part takes off the premium margin from those consumers who, roughly speaking, have the money and who can afford it. If, due to increased ad valorem, excise duty on a pack of cigarettes which costs 25 UAH increases by 1 UAH – it is not particularly noticeable, but if a price of a pack which costs 12 UAH increases by 1 UAH, then the increase is pronounced. In the low price segment the step of sensitivity to price increases is 50 copecks.

Please tell us what's going on with the approval of minimum retail prices for cigarettes by the Cabinet. If it has already been decided to introduce these prices, why there is still no government resolution?

The introduction of minimum prices is another example of prosperous corruption in the tobacco market. Starting from the moment of introduction of this provision in the Tax Code (Rada Committee on Taxation and Customs Policy has not even discussed this issue, but the Parliament was presented the minimum prices as the Committee's proposal) and finishing with the manipulations of the State Fiscal Service of Ukraine with the formula for calculating the minimum price in pursuing a clear goal to “lift up” the level of these prices to the maximum possible extent.

According to the marketing concepts, what is happening now is the price promotion. You reduce the price thus increasing the number of cigarettes sold. This campaign has been launched by Philip Morris since October 1, 2015 by reducing the price of Bond cigarettes immediately by 2 UAH, without any economic justification of the fact. Gradually, over 3 months, they dropped the price from 15 to 10 UAH, and still sell Bond for 10 UAH per pack. This is a significant loss to the budget, as Bond takes approximately 7% of the domestic market.

That is the company moves Bond from the middle price segment to the cheapest which starts to compete with the cheaper brands, and then through the mechanism of minimum retail prices returns Bond cigarettes to the previous level of prices while pulling up all the low-price segment with it to the level of Bond. The company benefits because cigarettes of the low-price segment lose a competition with Bond having appeared in the same price category with it. Economically, the primary cost of low-price segment cigarettes is below that of Bond, and manufacturing companies would leave them at the same price level, but the mechanism of minimum retail prices no longer allows it.

From the economic point of view, it is outrageous breach of all limits. This mechanism is banned in the EU by the European Court for 6 countries. There were also those “willing to outwit everybody”, but the European Court cut them down to size quickly. But we have none to do so. Unfortunately, all of the arguments that the mechanism of minimum prices is unlawful both according to Ukrainian legislation and international obligations of our country have been ignored even at the meeting of the manufacturers with the Prime Minister on January 18, where the issue was discussed.

At this meeting, we have provided the calculations based on the financial statements of the company on costs and production volumes, and calculated economically sound minimum retail prices for the case if a decision is made to introduce them. We obtained 13 UAH per pack of non-filter cigarettes and 15 UAH – per pack of filter cigarettes. This price level has satisfied all the attendant parties, and the relevant draft resolution was sent to various authorities – the Ministry of Economy, Antimonopoly Committee of Ukraine, Regulatory Service. But until now, the document has not been enacted, obviously because of the lack of opinion letters of the competent authorities.

Meanwhile, the State Fiscal Service of Ukraine assures that the economically sound prices are 14.50 and 16.50 UAH/pack, respectively, which is much higher than previously agreed by all parties to the negotiations. Thus, the tax authorities make their manipulations even on official statements.

In our company it was decided that if they continue to manipulate we will resort to the courts, in particular, the Resolution of the Cabinet of Ministers can be challenged in the Administrative Court. But we will apply not only against a mythical entity – the Cabinet of Ministers, but against particular officials providing evidence of manipulation. Because there are objective values, and there are their calculations. Everything is documented. Therefore, we are determined to be very principled. We have already filed a complaint with the EU representative office in Kiev having explained that the Cabinet of Ministers has to return to the path of eurointegration, not eurodemagogy, and now we're waiting for the response of the European officials. In parallel, our headquarters sends a relevant complaint to Brussels. We do believe that this is the issue of principle: if Ukraine has assumed international obligations it must comply with them, but should not make obsequious gestures towards individual manufacturers at the level of the Prime Minister.

How do the competitors justify these steps?

By budget losses. Allegedly, the prices fell to 9-10 UAH. But they led themselves there; 5% levy, VAT and partially excise duty fell accordingly. Of course, the budget does not get enough public revenues. But at a meeting with the Prime Minister they did not say that they led to this trouble themselves to share out the market.

Arguing the need for the introduction of minimum retail prices for cigarettes, the State Fiscal Service of Ukraine grounds it by 1.5 billion of additional revenue. But none calculates the risks. While they are grave. The sharp rise in price of cigarettes (from the current price of 9-10 UAH to the expected 16.50) will boost the shadow market. Moreover, some manufacturers, such as Lviv Tobacco Factory, might curtail production, it will not stand this level of prices. According to our estimates, the budget may lose up to 2.5 billion UAH. Let's not forget about the corruption component: minimum prices will be determined by the official who can be “inclined for cooperation” in the making decisions beneficial to individual manufacturers. The market should not be regulated by non-economic methods, it is a crime.

Could you please explain another scandal in the market – the situation with the company-distributor of cigarettes Megapolis-Ukraine? First it is accused of abusing its monopoly position, then in relations with the Russian owners.

As far as I remember the speech of the Head of the Antimonopoly Committee of Ukraine, the Committee is now conducting an investigation that began in October 2014 and plans to deliver the verdict at the beginning of February about whether there is any abuse of monopoly position. Because the Ukrainian legislation does not see any evil in the very concept of monopoly, it sees the evil in the abuse of monopoly position. And it is the Antimonopoly Committee of Ukraine that draws the borderline.

We were made an inquiries, and we provides the whole box of documents to the ACU – statistics, information on concluded contracts, the terms of these contracts. We're not addressed questions any more. We were the first of all manufacturers to fulfil the requirements of the ACU to develop and publish the criteria for the selection of distributors of cigarettes. We are holding consultations with the Committee on how to improve them, so that we do not violate antimonopoly laws. And now we are waiting for the decision.

 

What are the basic requirements for distributors?

There are 8 pages of the requirements, but the most important thing which they are based on is the same objective approach to all while providing a real business plan and guaranteeing certain volumes. The company must show that it has the resources to distribute and distribution geography. Why is geography important for us? Because many companies prefer to work in big cities (it's easier), but not everyone is willing to go in the villages, especially distant ones. The specificity of our products is that we sell more in the villages. And it is more difficult to get there, the costs are higher.

When selecting a distributor the official financial statements, possibility of providing a bank guarantee should also be considered. We provide products and either take an advance payment or require a bank guarantee to avoid a situation that the company has taken products for sale and disappeared. And the guaranteeing bank should be half a way to bankruptcy. Thus, the distributor shall do a fair business, have no criminal stories, including stories with tax evasion.

How long have you been working with Megapolis?

Since 2012. As a business model for manufacturers (if we ignore the whole policy), it is very effective. We are satisfied with the quality of services, the availability of the goods at the points of sale, do not have any problems with payments for delivered products and no problems with the commitments assumed by the company.

The most interesting is that after the publication of our selection criteria, we have not received any offers from other commercial distribution companies. Our competitors may have received the offers, but we haven't. Because it is one thing to shout and complain, and the very other thing is to really provide distribution services.

Could you please describe the last year's operations of Imperial Tobacco and tell us about the major plans for 2016.

Due to the artificial lowering of prices it is now difficult to speak about the market share, because the information has become biased. For 2015, we have reached the share of 25% by shipment of products to the distributor. We believe that this is a good result, previously we had a lower figure. This information, in our opinion, is the most objective, it displays the sales structure. Nilsen Company states a smaller share: compared to 2014, they argue that in 2015 our share rose from 21.4% to 22%. This is excluding the temporarily occupied territories of Crimea and Donbass.

Production volumes also rose due to relocation – from 15.5 billion pieces in 2014 to 16.7 billion pieces in 2015. The production grew despite the market breakdown, so we managed to keep our market share, even to increase it with no imports from Russia.

To what extent are the production facilities in Ukraine loaded?

At a rate of 60-70 percent. We have room to grow. We are looking for product markets. In the past year we delivered products to Iraq, Moldova, Mongolia, the United Arab Emirates, Burkina Faso, Ivory Coast, Egypt, Uzbekistan, Cambodia, Senegal. In 2015, our export totalled 1.25 billion pcs, we want to reach 1.5 billion in 2016.

Theoretically, we are interested in the EU market, especially in connection with the free trade area, but there is a quota of 2.5 thousand tons exported from Ukraine for the year – a little more than 1 billion pieces for each manufacturer. But there is a catch in it. This quota is allocated to the country, and when you have a contract for the supply, you never know what is the extent to which it is taken out is. We never know the volume of deliveries of our competitors in the EU. The quota may be taken out even by one manufacturer. Can you imagine the situation: we found a product market, planned production, ordered labels for a particular country, manufactured the products, but it turned out that the quota has already been taken out.

Is there is any unified register? Can the State Fiscal Service of Ukraine provide any information?

No, there is no registry. And the State Fiscal Service of Ukraine does not disclose any information referring to commercial secrecy. In addition, the European consumer does not have enough trust in products where the label says “Made somewhere...” but not in the EU. They have certain biases. Although they buy with enthusiasm legal products made in Ukraine and smuggled to the West at a price 2 times below the one existing in their market.

How much did your company invest in the production facilities in Ukraine last year, and what are your plans for 2016?

We opened a modern warehouse within the area of the factory, the investment was about 250 million UAH. And in general, we invested about 8.9 million pounds in relocation of production and in equipment. I think it's no bad in terms of the ongoing war and the market breakdown. It's difficult now to make forecasts for 2016, but we will definitely invest in certain cigarette formats.

What brands are your most successful?

It depends upon a segment. We have a brand Parker&Simpson in the segment of value for money (price/quality), it grew rapidly from scratch to more than 1 billion annual sales. Stolichnye are in demand, especially in a big box format (25 pcs in a pack). They are also produced in the segment of value for money. The premium segment of the market is falling, our Davidoff is growing, albeit slowly but steadily, due to the correct pricing and proper selection of tobacco varieties. And of course our classics, Prima, has always been sold well. The main secret is that we buy tobacco from suppliers directly. Our competitors buy it from their parent structures through intermediaries, they get the agent's margin in this case. This is a question of transfer pricing and withdrawing currency abroad, but none cares about it in Ukraine.

We purchase about 70 varieties of tobacco in various price categories and of any quality in more than 20 countries, including Iraq, India, Pakistan. We have logistics centers around the world – due to the scale they are able to compete. Our Group of Companies has a severe selection of suppliers, including research of fields and control over the lack of child labour.

How do you assess the initiatives of deputies to bind Ukrainian manufacturers to use domestic tobacco?

This is nothing more than populism. Unfortunately, Ukraine does not fit the requirements of our Group neither in terms of volume or quality of raw materials. We are neither the tropics, nor Pakistan, nor India. Tobacco does not reach the qualities required in our production. Importing tobacco we develop Ukrainian production – we employ Ukrainians, we pay taxes to the Ukrainian budget. This is not a farmer economy, we are part of the global economy. Therefore, parochialism of the deputies seems strange.

But these are not the most senseless laws. The Draft Law No. 2430 “On the Amendments to Some Laws of Ukraine on Bringing the Legislation in Conformity with the Requirements of the European Parliament / European Union Directive 2014/40” (revoked, but there are two alternatives) was previously registered in the Verkhovna Rada which provided that since May 18 this year a number of new requirements for packaging and labelling of cigarettes, which are introduced in parallel in the EU, as well as new requirements for quality control, would be introduced in Ukraine.

No transitional periods are provided there. It turns out that the EU itself has discussed the possibility of transition to these requirements over some 7 years, and Ukraine wanted to make this transition at once. We calculated that about 8 million pounds of additional investment in packaging and in equipment is required to upgrade to new standards. For now, there is no company even to place an order for new equipment to, because EU countries transfer to the same standards. Not all the requirements of the Directive are clear to the Europeans themselves. For example, they have a definition of a “characterising flavour”, but none can explain how to identify and measure it up. There is a lot of such things. And our guys have not only translated the Directive, but took quotes out of it. For example, they simply omitted the Article on the monitoring system, because is it introduced in the EU since 2019, they thought that there is still time. Thus, Ukraine implements not a EU Directive, but a collection of not related quotes.

Our industry has prepared a supplement to this Draft Law at 50 pages. We insist on the fact that the transitional period should be at least 2 years. We need to understand what final requirements will be adopted by our Parliament, make investment plan, order the equipment. If it is adopted without a transition period, the tobacco industry will halt production for 6 months. And the tobacco industry provides annually more than 20 billion UAH of excise duties.

Well, the opposite party has considered our views and agreed to review the Draft Law. We hope common sense prevails.