THE hefty impact of the special consumption tax (SCT) on cigarettes on volumes at Carreras Ltd, distributor of premium brands such as Matterhorn and Craven “A”, might lead one to think that Jamaicans can no longer afford the vice. Over the last three years, Carreras has seen a 38 per cent decline in volume, after a 100 per cent hike in the SCT on cigarettes in 2008, another 42 per cent increase in May 2009 and a further 23 per cent increase in January 2010.

However, though Carreras’s volumes have been steadily declining, recent studies indicate that tobacco consumption has not. A survey by the Rural Agricultural Development Authority (RADA), found a marked increase in demand for tobacco over the last two years. Data further indicates that just under 600 tobacco farmers are reaping the benefits of the lucrative cash crop. During a recent visit to the company, we were shown a video which illustrated the vibrancy of tobacco farming island wide.

Given that Carreras is one of the two authorised distributors of cigarettes in Jamaica, and claims to control as much as 98 per cent of legal sales, it follows that the “black market” for tobacco products is rapidly expanding. Some surmise that the emergence of an informal market was motivated by the cessation of Carreras’s local production. However, it was not until after a string of excise-led price increases that the illicit trade evolved into what it is today a heightening threat to the long-term growth of the formal industry.

As shareholders worry about the future sustainability of the company, management is focusing on positioning it for continued profitability. Managing Director Richard Pandohie said Carreras is exploring every angle to improve its results. It is looking to introduce new products and has begun placing greater emphasis on its marketing initiatives and distribution capabilities to boost sales. It is also implementing measures to reduce costs, which have been hurting its bottom-line.

Carreras is anticipating the ban by the World Health Organisation (WHO) on public smoking by ensuring that cigarette smoking is done responsibly. The company is working with restaurant and bar owners to build designated outdoor smoking areas and to sensitise the public to the new laws.

With regards to perhaps its biggest challenge — the illicit trade — the company has been working to raise public awareness of the consequences of the trade.

The illegitimate market, estimated to represent 40 per cent of the industry, consists of both “grabba” — unprocessed, dried tobacco leaves packaged and sold locally, and imported counterfeits of legitimate brands. These products are smuggled into Jamaican, thus evading taxes, including customs duties and the SCT. Undoubtedly, this puts Carreras in a weak position in terms of price competitiveness.

The development is an example of an economic theory called the Laffer curve, which states that increasing tax rates beyond a certain point will produce lower revenues. The emergence of a vibrant market in illicit cigarettes has cut not only volumes at Carreras but also income for the Government.

Even though the Government did not include another excise-led price increase in its 2011/12 budget, Carreras continues to be hit by the effects of past hikes. For its first quarter ended June 30, 2011, Carreras reported a 13.6 per cent year-on-year (yoy) reduction in operating income to $2.58 billion as its volume was significantly lower. Consequently, the company’s net income fell 22.34 per cent to $523.43 million. This contrasts with the first quarter ended June 30, 2010, when the company posted a 30 per cent yoy rise in net income to $673.9 million on a 58 per cent surge in gross operating revenue to $2.99 billion as it benefitted from the excise-led price increases.

Carreras, well-known not only for its brands, but also for its history of payouts, had less cash reserves to distribute to its shareholders. The company recently declared an interim dividend of $1.30 per share to be paid on December 8, 2011. This compares to $1.50 for the corresponding quarter last year. However, the company remains one of the best dividend paying companies on the Jamaica Stock Exchange (JSE) with a current dividend yield of nine per cent. Investor demand continues to be strong for the stock, which has appreciated 21.5 per cent since the start of the year to $64.50 on Monday.

As Carreras focuses on the strategic reorganisation of its business to promote growth and sustainability, it is management’s opinion that investors appear confident in its commitment to maintaining shareholder value. The company continues to sustain a consistent dividend and though long in coming, it is widely expected to pay a special dividend when it eventually recovers $1.73 billion in taxes from the Government.

Moreover, with the company’s drive to expand its product line and boost revenues, SSL expects the stock to outperform the JSE main index over the next 12 months.

— Deirdre Witter is an Investment Analyst at Stocks & Securities Ltd. You may contact her at dwitter@sslinvest.com.