Inefficient, benign competition for example, in the food-services space is what is creating the Arbitrage opportunity.
By Rohit Chordia & Anand Shah
We do not have enough resources or data points at our disposal to comment on whether consumer product, retail or quick service restaurants (QSR) companies have engaged in ‘profiteering’ post GST implementation and/or after GST amendments. The noise on this begs an important question—are individual ‘relevant markets’ (a specific FMCG category, a foodservice vertical, etc.) competitive enough in India? If they were, any category-level benefit would be competed away. Our purist view is that GST implementation is an ‘exceptional circumstance’, businesses collect indirect taxes from the consumers on behalf of the exchequer, while some pricing flexibility around changes in indirect tax structure/rates in ‘normal circumstances’ is perhaps fine, there should be a simple and straight 100% ‘pass-through’ of GST-induced change in ‘net indirect tax incidence, taking into account changes in input tax credit availability’ for all products or services, especially in cases where the net tax incidence is reducing and, by extension, there should be no ‘portfolio-level’ flexibility on benefit-pass-through decisions. The more important question is: Is the Indian FMCG/QSR/retail sector competitive enough? A simple test of competitiveness to us is what an industry does when there is a common material benefit accruing to all players—does the benefit get passed on to the consumers? If yes, is it passed on wholly or only partly? The recent sharp jump in profitability of most companies in our coverage universe suggests less-than-perfect (fairly benign, in our view) competition to us. So does the sharp fall in overheads and associated jump in margins in 2QFY18 (the first quarter post GST). As we said, we do not have enough details to say whether this was on account of partly/fully retained ‘higher input tax credits’ or not.
With the foodservices companies (full-service and quick-service restaurants) being at the centre of the recent debates and discussions on anti-profiteering, we present an illustrative example of how a hypothetical restaurant’s financials (for a specific product) have likely shaped up in the past few months (through the two big GST-related changes). We note that our example is purely hypothetical and uses a number of assumptions. We have made the following assumptions regarding the hypothetical restaurant in our illustrative example: n Pre-GST menu price (excluding taxes) of Rs 100. n Pre-GST overall output tax incidence of 20% (14% VAT plus 6% service tax) We have rounded off the numbers for the purpose of our exercise. This leads to a with-tax consumer price of Rs 120.
Net cost of material (after setting off available input tax credit (ITC)) of `30 implying a gross profit of Rs 70.
Allocated employee expenses of Rs 20 with no indirect tax incidence.
Allocated rent, net of available ITC, of Rs 12.
Allocated overheads, again net of ITC, of Rs 30.
* Total costs = 30+20+12+30 = Rs 92, leading to an operating profit of Rs 8. Hence, OPM = 8%.
Now, here’s how the math changed on July 1, 2017; we assume no change to the menu price, a fair reflection of what actually happened in the market.
Net sales = 100 assuming no change in ex-tax menu price. Consumer spend = Rs 118, including the initial GST rate of 18%. So, the consumer did benefit marginally to the extent of saving Rs 2.
Cost of material, net of ITC, of Rs 29.1. The reduction here is on two counts—(1) higher ITC availability and (2) better terms from RM vendors as the restaurant seeks its share of higher ITC in the chain.
On similar line of argument as cost of material, rent and overheads go down to Rs 11.3 and Rs 28.6, respectively. Employee expenses, not impacted by GST, stay at Rs 20.
Overall costs now sum up to Rs 89 resulting in an operating profit of Rs 11 or OPM of 11%.
A 100% pass-through of all GST-related benefits to the consumer, i.e. an absolute-profit-neutral outcome for the restaurant would have needed a menu price cut of 3% per our math (a with-tax consumer spend of Rs 114.5 versus `120 pre-GST). (See the exhibit) Effective November 15, 2017, the government GST was reduced to 5% from 18% and there was to be no input tax credit.
This is where things became interesting; the restaurant in our example (with ex-tax prices on the menu), without ITC, could no longer not raise ‘menu prices’ even to get back to the pre-GST operating profit levels. With a sharp reduction in GST, the overall consumer spend would not go up, anyway.
Things were slightly better for players that had ‘with-tax prices’ on their menu. They did not even need to raise ‘menu prices’. They should have ideally cut menu prices, equally for all items, but that’s just the purist in us, the one you read on the first page of the note, talking.
It is difficult for us to assess the exact weighted-average quantum of price hikes this hypothetical restaurant may have taken on November 15. However, we believe this restaurant is perhaps now trying to protect the elevated Rs 11 of operating profit —this would need a 10.7% hike in menu price, per our math. The consumer pays Rs 116.2, including taxes, a further saving of Rs 1.8.
Status quo on starting point operating profit (Rs 8), however, would need only a 7.7% hike in menu price. Consumer, in this scenario, pays Rs 113.1, including taxes. This is the Rs 100% GST benefit pass-through’ price level. On a side note, ex-tax menu prices or net realisations are going up in the revised ‘without input tax credit’ structure; extent could be anywhere in the range of 8-12%, in our view. This would mean a massive uplift to the ‘same-store-growth’ numbers listed QSRs report for the next 4-5 quarters. Optical (and not underlying) as it may be (given that there is a corresponding increase in costs as input tax credits go way), we would not be surprised if the market cheers such ‘headline prints’.
Lastly, we emphasise what we are trying to highlight in this note—if the foodservices market were efficient and competitive enough, the Rs 3 additional operating profit post GST would not have happened in the first place. It is inefficient, benign, competition that creates the arbitrage opportunity. Does the exchequer need to step in with anti-profiteering laws and a stick approach is something we do not have a view on. As a consumer, your scribe would like to see a more competitive CPG/foodservices/retail marketplace; that, and not fear of law, is the ideal construct.
Edited excerpts from Kotak Institutional Equities’ November 20, 2017, note on Consumer Products