Government to reinstate zero rating regime for dairy sector
The government has agreed to reinstate the “Zero Rating regime” on UHT milk and nutritional milk powder, which was previously abolished in the Federal Budget 2016-17.
Frieslandcampina Engro Pakistan Ltd (FCEPL PA)
Taxation tailwinds can unlock value
In addition, the government intends to keep the sales tax on other value-added dairy products at 10%, despite a proposed increase in the Federal Budget for 2021-22. The decision to reinstate zero-rating may have been prompted by conditions under the US $442mn loan extended by the World Bank for poverty alleviation.
If passed in Parliament, the impact of zero-rating alone will result in annual tax savings of c. PKR4bn for the formal dairy industry. Against this backdrop, we prefer FrieslandCampina Engro Pakistan Ltd. (FCEPL), which holds a leadership position in the UHT segment under its brand Olpers and Fauji Foods Limited (FFL), which has recently begun to deliver strong growth. Other beneficiaries include NESTLE, ICI, and ABOT. That said, we prudently await formal approval from Parliament before incorporating it into our estimates.
A Previous Regressive Tax Regime
To recall, UHT milk has remained under the “Exempt category” since its removal from the “Zero-rating regime” in the Federal Budget 2016-17 during the PML-N’s tenure. This was done in order to avoid payment of tax refunds to the dairy sector and, consequently, UHT milk players from claiming tax refunds on inputs in the future.
Additionally, it was proposed in the Federal Budget 2021-22 to raise GST from the existing 10% to 17% on dairy items sold under a brand name such as flavored milk, fat-filled milk (tea whiteners and fortified/nutritional powders), yogurt, cheese, butter, cream and milk/cream (containing added sugar).
Windfall savings can improve margins for UHT players
As per news reports, the dairy industry has promised a collective investment of PKR8bn for capacity expansion and BMR and agreed to not raise the prices of UHT milk. Consequently, UHT milk producers are unlikely to pass on the benefit of tax refunds (under the zero-rating regime) to the end consumers, in our view. The industry has historically paid a 17% sales tax on raw materials and packaging materials and c. 27% on freight and energy costs.
The annual refunds from the FBR have historically amounted to PKR5-8bn annually to the dairy industry. FCEPL’s gross margins are reflective of this – declining from 22.6% in CY16 (last year of the zero-rating regime) to 16.3% in the following year. Additionally, the Pakistan Dairy Association has claimed that c. 30% of the industry’s capacity remains unutilized and the restoration of the pre-2017 taxation status will help it enhance its business.
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To illustrate, FCEPL witnessed a sharp drop in Dairy & Beverages utilization levels post-2016 (from 65% to as low as 44% in 2018). While this is due in part to the weakness in the tea whitening segment, utilization of UHT should return to historical levels as retention and cost absorption capability improves.
To conclude, for FCEPL, we estimate a sharp improvement in cashflows and a conservative c. 30% rise in the Dec’21 TP to PKR100/sh (from PKR75/sh currently) in the event of blanket approval from Parliament.
Milk powder segment to benefit even further – Implementation appears tough.
Fortified and nutrition-based milk powder has been subject to a 10% sales tax since 2019. There is a proposal to convert to a zero-rating regime. The key beneficiaries in this instance would be NESTLE (Nido), FCEPL (Full cream milk powder and other upcoming nutrition brands), ICI (Morinaga), ABOT (Pediasure, Ensure, Glucerna), and SEARL (EnfaGrow, Aptamil).
While this move is likely to have a far-reaching impact when compared to the zero-rating status on UHT milk (according to channel checks), there appear to be technical limitations to enshrining this in law. Sales tax for other value-added dairy products (tea whitener, cheese, butter, cream, yogurt, flavored milk) is to remain status quo at 10% vs. a proposed increase in the Federal Budget for 2021-22.
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Pakistan Dairy companies traded at premium valuations during CY15-16 (P/E of c. 30x) and we expect the sector to retrace to those levels. While a valuation re-rating is on the cards, we err on the side of caution and await formal approval from Parliament before incorporating the same into our estimates.
This is a constructive move of the government, from the perspective of not only poverty alleviation but also promoting the use of packaged milk in Pakistan (still a paltry 8%).
