Pakistan governments’ decision to reinstate zero-rating for the dairy sector

As per channel checks, the government has agreed to reinstate “Zero Rating regime” on UHT milk and nutritional milk powder, which was previously abolished in the Federal Budget 2016-17. The government is also looking to maintain sales tax for other value added dairy products at 10% against a proposed increase in the Federal Budget 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 the Parliament, the impact of zero rating alone will result in annual tax savings of c. PKR4bn for the formal Dairy industry.

In this backdrop we prefer FrieslandCampina Engro Pakistan Ltd. (FCEPL) which holds 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 the Parliament before incorporating in our estimates.

A regressive tax regime previously

To recall, UHT milk has remained under the “Exempt category” since its removal from “Zero rated regime” in the Federal Budget 2016-17 during PML-N’s tenure. This was done in order to avoid payment of tax refunds to the dairy sector and consequently prohibited 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), yoghurt, 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 collective investment of PKR8bn for capacity expansion and BMR and agreed to not raise prices of UHT milk. Consequently, UHT milk producers are unlikely to pass on the benefit of tax refunds (under zero rated regime) to the end consumers, in our view. The industry has historically paid 17% sales tax on raw material and packaging materials and c. 27% on freight and energy costs. The annual refunds from 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 zero rated regime) to 16.3% in the following year. Additionally, Pakistan Dairy Association has claimed that c. 30% of the industry’s capacity remains unutilized and restoration of the pre-2017 taxation status will help it enhance business. 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 partially attributed to the weakness in tea whitener segment, utilization for UHT should revert to historic levels as better retention and cost absorption capability improves. To conclude, for FCEPL we estimate a sharp improvement in cashflows and a conservative c. 30% rise in 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. This segment is proposed to be moved to zero rated 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 vs. zero rating status on UHT milk, (as per channel checks) there appears to be technical limitations to framing this in the law. Sales tax for other value added dairy products (tea whitener, cheese, butter, cream, yoghurt, flavored milk) is to remain status quo at 10% vs. a proposed increase in the Federal Budget 2021-22.

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 the Parliament before incorporating the same in our estimates. We think this is a constructive move by the government, from the perspective of not only poverty alleviation but also promoting use of packaged milk in Pakistan (still a paltry 8%) and can be followed by a renewed focus on minimum pasteurization program, in our view.

Courtesy – Intermarket Securities Limited.

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