Exclusive interview with Michalis Alexandrakis, the Managing director of Philip Morris Ukraine.

 

- How much has the total cigarette market in Ukraine decreased in the first half of 2019? What has impacted on this? What are the forecasts for 2019 and for the upcoming 2020?

Legal cigarette market volumes have been declining by about 10% from year to year over the last 3 years. If we compare 2016 with 2019, the decrease is about 27%. This is largely due to the introduction of high taxes by the government on cigarettes and the increase of the illegal cigarette market share, accordingly. From October 2018 to October 2019, we observed a 14% decrease in the volume of the legal cigarette market. We predict the continuation of this trend as a result of another 20% excise tax increase in 2020. It is difficult for legitimate business, which pays all taxes, to compete with illegitimate business. If this trend continues, then in 2020 the legal market decrease could be 10% and by 2025 we predict that the legal market will be about 25 billion cigarettes. I would like to highlight, that in 2016 the industry produced 73 billion cigarettes for internal market. This year, we forecast production of around 52 billion cigarettes for the domestic market.

 

- What is the share of PMI on the Ukrainian tobacco market, is it stable?

Yes, our market share has been quite stable for many years. According to our estimations, it is approximately 30%. We hope this tendency will continue in 2020. Due to a sharp increase in illegal trade, the market share is not the only indicator to focus on. Manufacturers who have most of their products in the lower value segment of the market have difficulties competing with illegal products because of their lower prices. Our company is losing 10% of our volumes annually, and producing almost 2 billion less cigarettes a year. This is a problem for us, but also for the government - despite the increase in taxes, budget revenues are not growing at the expected proportion. According to Kantar estimates, the amount of lost tax revenues in the budget of Ukraine due to the illegal trade of cigarettes in 2019 amounted about UAH 5.1 billion.

 

- How many cigarettes have PMI produced this year in Ukraine?

Our factory in Kharkov has a production capacity of about 40 billion cigarettes per year. Unfortunately, due to the situation on the domestic market and the exporting problems we face, we cannot unleash the full potential of the facility. So, this year we’ll produce about 28 billion cigarettes, which is 2-3 billion less than in 2018. And if things continue in the same way, then in 2020 and the following years we will reduce our production. In order to avoid this, we expect the government will introduce clear and transparent “rules of the game”. This would allow the industry and the government to unleash the potential of our industry and the country. The government must create a competitive business environment, which would keep investments in the country and,  equally important,  would increasw investment attractiveness of Ukraine in comparison with  neighboring countries.

Today, on a global level, tobacco companies are consolidating production, and factories are closing in countries with high production costs or an unpredictable business environment. Despite the highly unpredictable and non-transparent environment in Ukraine, we are still managing to keep our factory running and to remain very competitive, thanks to the commitment and passion of our employees to always deliver  the best possible quality in whatever they do.

 

- Are you currently considering the possibility of reorienting the Kharkov factory for export? 

The primary reason for our factory in Ukraine is to serve the domestic market. Of course, due to the reduction in the volume of the legal domestic market, we are interested in increasing exports, so that our factory and all its employees may continue delivering the best quality products not only for Ukraine, but for more than 20 countries around the world. Our strategy is to bring more exports to Ukraine, if possible. Our Ukrainian factory is competing with PMI factories in Romania, Poland, Greece, Turkey and many other countries around the world in things like export efficiency and costs.  

Currently, our factory is making products for export to more than 20 countries, as I mentioned. From year to year, the export share has fluctuated at  40-50% of the total production volume. Unfortunately, due to the country’s unstable business environment, we predict that export volumes will continue to decrease next year. We can increase our exports up to 20%-30% in 2020, but first we need to know that government authorities will not make ungrounded accusations against us, and will impartially take into consideration our arguments and position. Over the past 2.5 years, we  underwent a transfer pricing audit, during which tax inspectors made, in our opinion, illogical and unsubstantiated claims that our Company was setting low prices for export. With the very clear aim of  accusing our Company of wrongdoing, the tax authorities ignored significant differences between production for the domestic Ukrainian market and production for export. They try to compare our company with a small Scandinavian manufacturer with one single employee (which is absurd), or to a state-run Chinese monopoly (which is fundamentally wrong, since a state monopoly can set prices and does not have free market application economy principles). We have started the process of challenging the claims of the tax authorities, but it requires a lot of time, effort and cost. This situation and this ungrounded approach do not help us increase our production volumes and attract more investments into the country; on the contrary, we must fight even to keep what we currently have.

 

- How does the proportion of the market by segments look  in Ukraine at the moment, and how has it changed?

In Ukraine, the premium segment is quite stable,  close to 14%. I’ve been here for three years, and we have more than doubled the price of a cigarette pack during this time. This is due to the high increase of excise tax rates every year. I have never seen anything like this in my career. Although the prices of  products have doubled,  I do not think, unfortunately, that the purchasing power of Ukrainians has doubled over the past three years. The more the government raises taxes, the more we see adult smokers switching to cheaper or illegal cigarettes, because consumers cannot afford to follow high price increases. Therefore, the medium-price segment in Ukraine is under pressure. If in 2013 it was about 20%, now it is close to 13-14%. The low-price segment is increasing at the expense of the middle segment, so it is now estimated at 70% (and if we consider illegal trade, it is even higher), against 60-62% in 2013. When taxes rise sharply, illegal trade grows. And this is happening all over the world. For example, in the UK, when taxes were increased, illegal trade grew to 27%. In Greece, my native country, the same thing happened. When taxes were increased due to the austerity measures that we have had for the last ten years, people who had no money started buying cigarettes on the illegal market. So, it is very important, in my opinion, for the government to find the right balance between increasing taxes without thereby stimulating criminal activities in the country.

 

- The Antimonopoly Committee of Ukraine fined the distributor Tedis Ukraine and four tobacco giants with factories in Ukraine, including your Company,  UAH 6.5 billion. What is your position on this?

We received the decision of the AMCU in late October, and we are studying it. We are convinced that the Committee's allegations are unfounded. Philip Morris Ukraine works exclusively within the law. We compete in good faith to try to offer the best products to adult smokers. The Company has been and remains committed to the principles of corporate social responsibility and high ethical standards of doing business. We are convinced that we are in the right, and will protect our interests and business reputation in the ways that the law allows us.

 

- Will you defend your position in Ukrainian courts? How long could this take?

We will appeal and defend our position in local courts. But we also do not exclude the possibility of taking the matter to the international level. From the moment we receive the decision, we have 60 days when we can challenge it in the court, and this is what we are going to do. But I don't know how the judicial system will work in this case. This can take from six months to several years. We would like to believe that our arguments will be heard, analyzed, and the decision will comply with Ukrainian law. I hope that one day we will see the judicial system in Ukraine  transform and work exclusively in the legal field, characterized by high professionalism and independence. Such a situation would generate much more confidence, and more investments would flow into the country. I am convinced that the new government and the new president are working in this direction.

 

- Already after the signing of a settlement agreement between PMI and Ukraine, according to which tax notifications were canceled by the SFS on UAH 635.3 million, there was information about searches and the seizure of documents in this case. Now everything is calm, and the case closed?

The agreement was signed in the first half of the year, and this case is closed for us. The case of signing the Settlement Agreement is an excellent example of the improving  investment climate in the country. In 2015, we obtained a production permit under the customs processing regime, and started production for export. And after one year, when the permit was about to end, the tax authorities came to us with an audit, questioning the permit they had issued earlier. The result was an act that we challenged in the courts. The signing and implementation of the settlement agreement, which was carried out in strict accordance with Ukrainian and international law, in my opinion, was an acceptable solution for both the Philip Morris Company and the government.

 

- According to what scheme does PMI distribution work today, what is the percentage of direct contracts, how much goes through Tedis Ukraine? Will it be a problem for you to reorient to other distributors if that is the decision of the Antimonopoly Committee of Ukraine?

The Company does not independently distribute its products to points of sale. Our business model involves cooperation with large distributors. Today, our main distribution company is Tedis Ukraine, which now accounts for approximately 70% of sales on average. The remaining 30% goes directly from PMI to other clients, primarily to national retail chains.

We are ready to cooperate with other large distributors, who are characterized by high quality service, financial stability, predictability of long-term cooperation, and who carry out their activities in accordance with applicable law.

 

- Are you going to change your distribution model after the recommendations of the Antimonopoly Committee of Ukraine? 

The latest recommendations of the AMCU do not change our current business model. Our business model involves cooperation with distributors. We have always been and remain open to cooperation. The decrease in the number of distributors on the market and, what some refer to as “the monopoly position of Tedis today”, is the result of the absorption of other distributors by Tedis through concentration and concerted action, approved in due time by the Antimonopoly Committee of Ukraine.

 

- Tobacco companies also had a meeting on draft laws No. 1210 and No. 1049. What positions have you reached agreement on?

Yes, we also had a separate meeting with the Prime Minister, where we discussed draft law No. 1049 on trade margins. We believe that the Prime Minister shares our position— the draft law should be changed, the tobacco amendment must be called off.

The amendment was made in violation of the rules of the Rada, and in no way connected with the essence of the draft law on the implementation of a single account for tax payments. As the amendment's initiators noted, its essence is to remove the monopoly in the cigarette distribution market. However, after detailed analysis, it turns out that the norm provides a double increase of the trading margin for wholesalers and retailers. As a result, adult smokers will be forced to pay an additional 7 UAH per pack, and UAH 15 billion in total in 2020, which we believe is unfair to them, and  will add an additional burden to the industry.

We also discussed draft law No. 1210. We have explained our position: the industry is changing, and is no longer the same one it used to be for the last 150 years; it is moving dynamically towards the introduction of innovative nicotine consumption technologies. Draft law No. 1210 proposes to equalize tax rates electrically heated tobacco systems, Reduced Risk Products, with cigarette tax rates. This means a four-fold tax increase for such products. In other words, a pack of HEETS, the consumables for the IQOS system, could potentially increase from 50 to 70 UAH per pack, overnight.

Such a policy would be unfair to the more than 500,000 Ukrainians, whoaccording to our estimations have chosen more balanced life by switching to a better alternative vs smoking cigarettes. It would stimulate adult smokers to go back to smoking because they wouldn’t be able to afford reduced-risk products. This policy also does not consider the further development of the industry. For example, tomorrow nicotine chewing gum might appear on the market, or nicotine sprays, or e-cigarettes, which are  already on the market as an alternative to smoking; equalizing them to cigarettes would be illogical or even impossible. We hear the argument from some  government officials that the taxes should be equal because all the people who are using IQOS today used to smoke. This is exactly what the government needs to understand:  all these people who use IQOS today, quit smoking -- this is a fact. Like the people who drive electric cars today, who used to drive petrol cars; and like the people who use Bio Diesel today, who used normal diesel. And yet electric cars and bio diesel have a different tax treatment. PMI is clear in its message to adult smokers: the best choice is to quit tobacco and all nicotine-containing products. But the reality is, many adult smokers in Ukraine – and the world at large – have not and will not quit. We believe that  governments around the world should help adult smokers, who will otherwise  continue smoking, to switch to better and less harmful alternatives.

 

- Which distribution model, in your opinion, would be the best for Ukraine? How do you feel about state monopoly on implementation? Are there any plans to join the distribution company in Ukraine, by analogy with Megapolis?

Today the business model in Ukraine involves cooperation mainly with large distributors. We are open to consider any potential effective distribution model, if there is appropriate support from the government to create a stable, transparent and predictable environment on the market.

 

After three years working in Ukraine, I can assert that the government needs to tighten control over turnover of tobacco products on the market. The number of tax collection points in the distribution chain must be reduced, because the more there are, the more difficult it is to control them. It is necessary to get rid of all the "gaps" in the legislation which make it possible to implement different schemes of tax evasion. For example, the 5% retail sales tax on tobacco products in almost half of the cases is not paid by the end-seller of cigarettes; there are VAT non-payment schemes, and so on.

 

- In 2020, British American Tobacco is moving its regional center office from Kiev to Bucharest. Have you thought about this?

We do not have such plans now, but this largely depends on further actions of the government. We are fighting fiercely for our business on this market. This means battling against administrative pressure, doing business in  an unpredictable and non-transparent environment. Today, Philip Morris Ukraine is responsible for the markets of Ukraine, Georgia, Armenia and Moldova. I have to say that we might move our regional activities if  unreasonable issues continue to put pressure on our investment in the country. But, as I said before, we are here to stay and to continue growing our business.

 

- What is your estimate of the volume of the illegal cigarette market in Ukraine? What trends do you predict soon?

During the three years of my work here, the illegal cigarette market in Ukraine according to Kantar has grown from 1.1% to 7%. There are tax evasion schemes  used by some companies on the market; we trust that the new government and the President will address this issue once for all. Because if the current trend continues, by 2025, according to our estimations, the legal market will reach 25 billion cigarettes, and the illegal market will be 26 billion, thereby exceeding the legal one. In that case, it would be a disaster for legitimate market players and for the state budget.

 

- The government says that the electronic excise stamp is one of the mechanisms for combating the illegal market. Do you support this initiative?

In a global sense, digitalization is a measure for fighting against corruption, and we see this in many countries around the world. In my opinion, this is an excellent initiative, but it must also be implemented correctly. A working group has been set up by the Ministry of Finance of Ukraine to draft a law on this issue. Unfortunately, representatives of the industry were not invited to participate in the working group; but recently we have seen a positive change in their approach.

There are systems being successfully applied in other countries. In this regard, the European Union has made the biggest progress, defining at the legislative level the criteria, standards, and requirements for tobacco-tracking systems. At the same time, there may be slight differences in the digital systems of different countries, but they are compatible with each other and make it possible to quickly monitor the movement of each pack throughout the supply chain.

 

 

- In Ukraine, there is no regulation of new products in the tobacco industry. In what form should Ukraine introduce it? How did this process go with neighboring countries?

Reduced risk products are the future of the industry. PMI introduced such products to the world six years ago, and today many other companies are following this path. By 2022, the World Customs Organization has decided to combine all similar products into one category and consider them as innovative products. Different countries have different approaches in regulating these products. In the United Kingdom, for instance, the  Ministry of Health considers reduced-risk products as one of the most important initiatives, which will help reduce the number of smokers by 25% till 2025. The Ministry of Health in our country is trying to encourage people to quit smoking, but is not considering any solutions to help those who cannot or do not want to quit. In this context, we need to do exactly what we discussed at the meeting with the Prime Minister. We need to get everyone together, form a working group, identify products which will be launched onto the market and which already exist, and discuss regulatory and taxation mechanisms for such products. They cannot simply be lumped into one category with cigarettes for one basic reason—that they are not cigarettes. They do not burn or produce smoke.

 

- What is the trend in the spread of alternatives to traditional smoking on the Ukrainian market, what is the forecast?

According to our estimates, and as I said before, today more than 500 thousand adult smokers have switched to IQOS. Approximately 275 thousand individuals are users of electronic cigarettes. According to our data, the total amount of innovative reduced-risk nicotine-containing products available in the country should be close to 7-8%. I believe in 3 years the market share of novel products should be close to 15%.

 

- How many PMI factories produce HEETS tobacco sticks for IQOS? Are you going to redesign factories for HEETS in Ukraine or any other country?

Today, we have five factories around the world that produce HEETS. Some produce both regular cigarettes and HEETS. For example, we redesigned our factory in Greece to produce only HEETS, but our factory in Romania produces both cigarettes and HEETS. We believe that currently we got enough capacity for the next 3–4 years; however, in the future, factories will produce either only HEETS or cigarettes and HEETS. These plans also apply to Ukraine. If we have a stable, transparent and predictable environment in the country, which should include the regulation and taxation of Reduced Risk Products, we will consider investing in redesigning our production facilities in Ukraine, bringing more investments and creating more jobs in the country.