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  1. Butt of budget, again

Butt of budget, again

Taxation nearly doubles in four years; cigarette sales to take a hit.

Updated: March 9, 2015 1:23 AM

The government has hiked cigarette excise duty by an average of 13%. The increase is 12% in the regular slabs and 22% in micro cigarettes (<65 mm sticks). This is the fourth consecutive year of steep hikes in cigarette taxation, a first in the past 20 years. The cumulative tax/stick increase of the past four years is about 90%, which is the highest for any four-year period. It is also coinciding with a relatively weaker macro environment in India.

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Carry forward impact of FY15 adds 6% to hike: The cigarette excise hike for FY15 happened in July as against February normally, because of regime change. Hence the 21% hike taken in excise duty last year will have a carry forward impact over the first four months of FY16. For the first four to five months of FY16, the hike in cigarette excise will be a summation of this 13% hike and the 21% hike taken last year, which is closer 33%. Averaged over the full year the excise hike for FY16 will be 19%.

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Irrational anti-cigarette stance: There were no rational grounds for the government to hike cigarette taxes this year. Neither tax revenue maximisation nor health grounds logically necessitated a double-digit tax hike this year. The fact that the government still took such a hike signals that it is taking an aggressive anti-cigarette stance.

Revenue maximisation would have come at 5%: Tax revenues from the cigarette industry would have been the highest if the excise hike was 5%. This is because after three consecutive years of steep hikes, the elasticity of demand has kicked in cigarettes and hence steep hikes will lead to equally steep falls in volumes, taking away any gains from hiking the rate of excise duty. A prime example is FY15 where the excise per stick has gone up by 18%. However cigarette volumes are down 15%, and consumers have also downtraded to micro cigarettes where the rate of tax is lower. Hence the total tax collected by the government from the cigarette industry has likely come down year-on-year in FY15. The same will repeat in FY16 now as another high tax increase has been taken. We expect government tax revenues from the cigarette industry to be flattish this year.

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Health arguments do not hold: Cigarettes remains as a very small part, 15%, of tobacco consumption in India. However, 75% of taxes paid by the tobacco industry is from cigarettes. Thus, a very steep increase in cigarette taxation does not really make an impact on tobacco consumption, while shifting consumption to illegal cigarettes and other forms of tobacco. Also, cigarette consumption is largely in the upper income groups, and the bigger health issues from tobacco usage is at the lower income groups.

Anti-cigarette stance could be a multi-year problem: The only conclusion one can draw is that the government has an aggressive anti-cigarette stance and is unwilling to look at the low share of tobacco consumption under cigarettes. This could thus be a multi-year headwind for ITC as it can manifest itself in higher tax increases going forward under this government, which has four more years in office.

This could also mean other adverse cigarette regulations may raise its head. Since the new government took over last year, there has been a lot of noise on new regulations on cigarettes. The three key proposals were (i) ban on sale of single sticks of cigarettes (which form 70% of volumes), (ii) raising the minimum age for smoking, and (iii) raising the fine of smoking in public places. These seem to have gone into cold storage as they have been put up for feedback from the public.

However, this budget signals that the government may be serious about lowering cigarette volumes and hence these may actually become a reality sometime this year. While our view remains that these do not materially impact ITC’s earnings due to its near impossible implementation, they will be further negative news flow for the stock.

Cigarette Ebit growth trajectory to come down: Cigarette demand has been largely inelastic to price hikes in the past ten years. Even years of 25%+ price hikes have seen marginal 3% volume declines. However, the past three years have seen consecutive price increases, cumulative increase in just three years has been 75% for regular filter cigarettes. This has also come at a time when India’s economy has slowed down, and consumer purchasing power has also not been rising as fast as the past few years.

As a result, we saw a huge dip in cigarette volumes in Q3 FY15, the first quarter when the last tax increase hit the consumer. ITC’s volumes declined double digits y-o-y in Q3, the industry decline would have been worse.

Likely FY16 volume decline of 8%: ITC’s cigarette Ebit (earnings before interest and taxes) has grown in a tight band of 15-20% over the past 10 years irrespective of the quantum of excise duty. There have been years of 0% hike in excise and years of 22% hike in excise, and yet ITC maintained its tight band. The key basis for this was the inelasticity of cigarette demand with price. But now price elasticity of demand has kicked in. We expect ITC’s cigarette Ebit growth band to slow down from 15-20% to 11-14%. For FY16 we expect 8% decline in volumes.

ITC likely to rationalise costs: ITC is likely to respond to this extremely adverse environment by belt tightening on costs, something it did in FY15 as well. Being a very dominant market leader controlling over 95% of the industry profit pool, ITC could drive a cut in trade margins, trade promotions and other marketing costs. This will help it deliver margin expansion even in this environment when volumes may see high single-digit decline and gross sales may grow only in mid-single digits.

No risk to ITC’s market leadership: The silver lining is that ITC’s dominant position in the cigarette market is unlikely to be challenged. Even though illegal cigarettes will gain share, the fragmented and tough distribution system for cigarettes in India makes it tough for illegal cigarettes to reach a wide number of small stores. Hence, as of now we do not see ITC’s market position coming under threat from illegal cigarettes.

Multiples can de-rate: ITC trades at 27x 1-year forward PE (price to earnings multiple) which is a 15% premium over its ten-year average and at a slight premium to its five year average PE. In times of regulatory and earnings stress in the early 2000s, ITC has even traded at multiples of below 15x.

We expect the stock to de-rate from current levels as the irrational tax increases could become a multi-year headwind for the company and the fear of other anti-cigarette regulations panning out. ITC does trade at a large relative discount to other consumer staple peers, having underperformed in the past one year. That may continue as earnings growth accelerates in other staples due to margin tailwinds while it slows down in ITC, and there are regulatory headwinds expected as well.

Downgrade to Underperform: We cut our FY16-17 earnings estimates by 8-11% to build in the higher-than-expected hike in cigarette excise duty this year. We have also raised our estimates for excise hike in FY17 to 10% from 5%. Volumes are likely to decline in high single digits, however, earnings will still grow at 12-13% as ITC is likely to aggressively cut costs. Our SOTP (sum-of-the-parts)-based target price comes down to R320; we lower our multiple for the cigarette business from 27x to 22x, which is still a 40% premium to global peers.

—Credit Suisse

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