The government has issued a notification clarifying that there will be no levy of any additional duty of excise on cigarettes: However, we still do not have clarity whether the current ‘National Calamity Contingent Duty’ (NCCD) will be levied in addition to the Goods and Services Tax (GST).
Impact on ITC
In the scenario that NCCD is levied at the existing rate, our calculations suggest ~4% reduction in cigarette taxes and ~2% price flexibility for ITC . However, in the event that NCCD is not applicable on cigarettes, we see a higher 7% reduction in cigarette taxes and ~3.5% price flexibility. We note that under GST, tax incidence on the supply chain will rise, which would mean that ITC will increase distributor margin by ~2 ppt (built into our estimates of price flexibility for ITC).
What would this imply?
We expect the stock to react positively to this development, even as clarity on NCCD is likely to emerge over the next few days. The debate on government tax policy on cigarettes has been turned on its head— investors expected the government to be particularly harsh on cigarette consumption, but it now appears that a spurt in illicit cigarette trade and a shift in favour of less tax-efficient forms of tobacco may have challenged the popular notion of a relatively easy increase in tax collection from the category—leading to a look beyond the obvious health concerns.
Valuation methodology and risks
We reach our price target of Rs 310 using sum of the parts, derived from a combination of our base case residual income values for all businesses except cigarettes, where we use a probability-weighted RI value. We see higher probability of upside risks to our base case cigarette volume and Ebit growth estimates. Even cigarette pricing growth may be higher than our base case estimates. This is captured by our 25% weight to the bull case value.
Our bear case probability of 5% factors in the risk of a sharp increase in taxes under GST from here.The values are: Cigarettes (Rs 230), Hotels (Rs 2), Agri (Rs 11), Paper and Packaging (Rs 11) and other FMCG (Rs 23), and cash (Rs 11). We assume a 12.2% cost of equity (6% market risk premium, 8% risk-free rate, and 0.7 beta). We assume terminal growth rates of 6% for all business except Cigarettes (5%).
Downside risks to our price target:
(i) Adverse policy on cigarette consumption;
(ii) ITC is unable to turn around the FMCG business; severe downturn in cyclical businesses, with hotels trading below book value.