The government made an announcement last week regarding a revision to cess rates for tobacco products. The new GST structure was slightly intriguing, as it lowered the total incidence of taxation on cigarettes significantly, leading to a windfall gain for cigarette companies in general, with ITC in particular standing to make significant gains. Our calculations suggested that companies would have needed to cut prices by an average 6% to pass on the benefit to consumers. This would have possibly been one of the steepest price reductions in cigarettes in more than a decade. The government on July 17 made an announcement that it would revise the cess to correct this anomaly and increased the fixed component of the cess by 27-30% across various stick lengths. However, the ad-valorem component of the cess has been left untouched at 5% for all stick lengths except King-sized, which has been increased to 36%.
Our assessment shows that this tax hike should be neutral to marginally negative. The intent of the government clearly seems to be to correct the anomaly rather than to penalise the sector. The pre-GST effective taxation on cigarettes was around 65% (including VAT, excise duty and cascading taxation), which has now been revised upwards by 10%. Our assessment is that an average 5% price hike would be required to offset the impact.
The long term benefits of GST remain intact
One of the biggest issues was value-added tax (VAT) levied by states. Not only was the rate of taxation different but so was the frequency of the changes. Some states such as UP and Rajasthan have made multiple changes in VAT rates in a single year, making pricing decisions and uniformity difficult. With GST now coming in and a single tax rate being levied, this issue has been resolved. In addition to VAT, some regions (such as Mumbai city) used to levy local taxes well; these are now subsumed under GST. Moreover, the current GST structure is beneficial to ITC, in our view, as the fixed duty per stick (differentiated on the basis of stick length) has been retained. This means that pricing leverage will continue and the company can continue to move volumes from larger cigarettes to the 64 mm segment to increase volumes and maintain margins at the same time.
Another key benefit, which will be relevant to almost all consumer companies, is that unlike earlier, ITC will now have a tax set-off for all the services it employs. This will be positive for margins, in our opinion. While the news is a negative for the company and will require some restrategising on the pricing front, we believe that the long-term story remains intact. We maintain our Buy rating and would advise investors to use the correction as an opportunity to add the stock to their portfolio. Our SOTP-based Rs 389 target price implies 20% potential upside. The shares currently trade at a P/E multiple of 26.7x on our FY19F EPS of Rs 12.19.