Lower taxes to fire up revenues, earnings for cigarette makers

After 5 years of decline, cigarette industry expected to post volume growth under GST framework

economy news: Shares of cigarette companies were among the biggest gainers on Monday after the central board of excise and customs last weekend clarified on the goods and services tax structure on cigarettes. The new tax structure is expected to be about 6 per cent lower at around 58 per cent vs 63-64 per cent earlier. While ITC (up 5.7 per cent), VST Industries (4 per cent) hit their 52-week highs, Godfrey Phillips India too was up 2 per cent. The key beneficiary though is seen as ITC, which commands an estimated 80 per cent market share in the duty-paid cigarette industry in the country.

There are twin triggers for the optimism around cigarette makers. The first is the boost to volumes given the expectation of lower cigarette prices. Cigarette prices are likely to decrease by 8-10 per cent primarily in the 64 mm category, which will lead to a 5-7 per cent volume growth annually over the next two years. For the past five years, the legal cigarette industry has seen a decline of 5-6 per cent in its sales volume, while illegal trade has gained.

Abneesh Roy of Edelweiss Securities believes if these (6-7 per cent gains) are passed on there is volume benefit estimated at 5 per cent for FY18 for ITC. Given ITC’s market share, pricing power and largely inelastic demand it will benefit the most among cigarette makers from the lower indirect taxes.

An ITC spokesperson told Business Standard that the company welcomes GST and is taking effective steps to pass on the benefits to the consumer wherever such benefits accrue due to the recently announced GST rates.

The other reason for the run up in stock prices, especially for ITC is due to lower relative valuations. Analysts at Credit Suisse had highlighted in a note today that the ITC stock trades at 32 per cent discount to Hindustan Unilever, which is the highest discount in nearly 10 years. Arnab Mitra and Rohit Kadam of Credit Suisse believe that there is significant scope for re-rating in ITC as the earnings momentum comes back to the high teens trajectory that ITC achieved prior to FY14. On the back of higher contribution from the cigarettes business, Edelweiss Securities estimates that there would be 15-18 per cent annual earnings growth for ITC over the next two years. While new launches in the FMCG business (non-cigarette) is expected to add to overall revenues, cigarettes will continue to be the main driver of sales and profit. Cigarette segment contributes about 58 per cent of ITC’s revenues and 87 per cent of profit.

The key gains for cigarette makers is expected in the entry level, 64mm category. Sameer Deshmukh of Reliance Securities agrees and says this category accounts for 25 per cent of ITC’s sales volume. The 69 mm category (50 per cent of ITC’s volumes), had stagnated over the past couple of years.

His reasoning is based on the projection that the budget brands like Gold Star Super Star, Capstan and others will be directly competing with the bidi and the illegal cigarette segment where chances of converting a bidi smoker to budget cigarette will be the easiest.

Richard Liu and Vicky Punjabi of JM Financial say that players such as VST Industries can price its 64mm offering at Rs 2.65 a stick and yet make the same realisation as it did earlier at Rs 3. They believe that a Rs 2.5 a stick pricing for 64mm would lay out a smooth ladder to facilitate bidis-to-cigarettes up-trading. Under the GST framework, tax on bidi has increased to 28 per cent with additional cess from the current tax level of 18-20 per cent. While the effective price on bidi will increase, cigarette prices will decline. (Read more )