In contrast to its previous strategy, ITC has pushed through a 13% price hike only at the premium end of its portfolio in response to a 10% hike in excise duty by the central government and a 5-15% hike in VAT by a few state governments. This essentially translates into a weighted average price hike of 7.6%, the lowest in the last four years. With this move, we can expect a boost in volumes, which have been on a constant decline over the past two years. In this sort of scenario, we expect the company to register an Ebit (earnings before interest and taxes) growth of 9% in its cigarette business in FY17F and FY18F, assuming another price hike in FY17F. This translates into a three-year EPS CAGR of 10.3%.
However, cigarette industry continues to be in a structural decline
Excise duty increase for the fifth consecutive year, along with a possible increase in VAT rates by states over the next quarter, pose continuous challenges that the company will need to tackle every year. Larger pictorial warnings on packs and ban on sale of loose cigarettes in select states are further regulatory hurdles. The possible implementation of a 40% rate of GST continues to be an overhang.
ITC trades at 22.9x FY17F P/E vs. sector at 29x; upgrade to Neutral
At our FY17F EPS of R14.5, the stock is currently trading at 22.9x vs. the sector at 29x. This implies a discount of ~21%, compared to a historical average of 10%. We believe ITC deserves to trade at a discount to peers in the fast-moving consumer goods (FMCG) sector, given the risks on the regulatory and taxation front that the company needs to tackle annually. We believe that most of the risks are now factored into the valuations and, hence, we upgrade the stock to Neutral. Our top pick in the large-cap space remains Hindustan Unilever.
Cigarette industry on a downward spiral
Continuous increases in taxation
Taxes on cigarettes in India are levied at two levels. The central government levies an excise duty, which is usually fixed on a per stick basis and the state government then additionally levies a VAT, which is levied as a percentage of retail price. In the budget announced last month, the central government had announced an average of a 10% increase in the excise duty on cigarettes. This is the fifth consecutive hike at the central level. The past five years have been unprecedented for the cigarette industry with the government hiking excise duty at a CAGR of 10.6-24.1%, depending on the cigarette length.
States continue to hike VAT on cigarettes as well
Following governments have implemented an increase in VAT for 2016-17:
The Rajasthan government has imposed a 15% VAT increase on all types of cigarettes for the year, essentially implying a VAT rate of 60% on all these products.
The Maharashtra government has also increased VAT on cigarettes by 5% this month, after increasing VAT by 5% in October 2015.
WHO recommends a 70% tax on retail price
WHO, in its report, has toughened its stand against tobacco in general and cigarettes in particular. Some of the key recommendations are:
It recommends a minimum 70% tax, as a percentage of retail price.
It also recommends a minimum fixed ad-valorem tax on cigarettes.
It recommends a simple single rate tax structure on cigarettes rather than a complex layered structure.
However, despite aggressive excise duty hikes and imposition of VAT by the states, India is surprisingly nowhere close to being at the highest level as far as cigarette taxes are concerned. The global average currently stands at 61.7% and India, at 60.4%, is now quite close to the average as compared to being below average six years back.
Our view is that the government can continue to hike cigarette excise duty by an average of 10-12% annually for the next three years. This potential hike will hurt the industry and ITC in particular in the long term.
Implementation of GST another key overhang
In a step towards unified GST, a committee headed by the Chief Economic Advisor has recommended a three tiered tax structure, with a high rate of 40% for tobacco products. We believe this will be negative for companies such as ITC, as the current tax rate (~25%) might move up to 40%. However, we will have to wait to see whether these recommendations are implemented. Our economics team expects the implementation of GST to take place by Q3CY16.
Other regulations pose a challenge too
Ban on sale of loose sticks: Some states in the country have started to put in place a ban on sale of loose cigarettes, and we estimate that over time more states could follow their lead. Maharashtra and Chandigarh, two states accounting for ~10% of volumes for ITC, have put in place this ban. Over 70% of the cigarettes sold in India are loose and hence this move, when implemented, will be a major negative for the company.
Plain packaging norms
Currently, India mandates that all cigarette packs should display pictorial warnings which cover at least 40% of the front side of the pack. However, the WHO recommends this percentage to be 85%. This change in packaging norms can also have an impact on volume growth in the long term.
Impact #1: Consumer base doesn’t grow. While continuous price hikes to offset excise duty hikes make cigarettes unaffordable for existing consumers, banning the sale of loose cigarettes and tightening the norms on packaging dissuades new consumers from trying smoking. As cigarettes get more expensive, we expect consumers to move down the value chain.
Impact #2: Share of illicit brands are on the rise. High incidence of taxation and a discriminatory regulatory regime on cigarettes in India have over the years led to a significant shift in tobacco consumption to lightly taxed or tax-evaded tobacco products such as bidi, khaini, chewing tobacco, gutkha and illegal cigarettes which currently account for over 89% of total tobacco consumption in the country. Thus, the share of legal cigarettes in overall tobacco consumption has progressively declined from 21% in 1981-82 to 11% in 2014-15 even as overall tobacco consumption has increased in India.
According to Euromonitor, total illicit cigarette sales in India in 2013 are estimated to have reached 21.8bn sticks, accounting for about 17.8% of overall cigarette volume sales, up from 14.6% in 2008.
The popularity of non-branded cigarettes such as Baisha, Marboro, Lucin, Golden Elephant and Win is spreading fast amongst consumers, as they are less expensive than branded cigarettes from ITC or Godfrey Phillips. Apart from these non-branded cigarettes, Indonesian brands are also gaining popularity amongst consumers, including A Mild, Djarum Black and Gudang Garam.
Our channel checks reveal that there is a wide price differential between ITC’s products and the smuggled products available in the market.
The increase in this number poses a risk to cigarette companies such as ITC:
The company loses market share as consumers move towards cheaper-priced substitutes; and
The company does not gain any incremental market share from those consumers who upgrade from bidis to cigarettes, as they will probably turn to cheaper alternatives in the market.
ITC’s response so far…
WHO suggests pricing action is possible in India
Pricing in India is not the most aggressive in the world: On a global comparison, ITC does seem to be in a position to take further price hikes given that the price increase for the most popular brand in India (Gold Flake) has been just an average 11% CAGR as compared to the global average of 10%.
Cigarettes are not that expensive as compared to the world
According to the WHO, on a purchasing power parity basis, the price of the most popular brand (in this case Gold Flake – small) for a pack of 20 sticks stands at $4.5. This is lower than the global average of $5.4, leaving India’s rank at 14, out of a universe of 26 countries. The price stands higher on a PPP basis in countries such as Singapore, Sri Lanka, Malaysia, South Africa and Mexico. According to the WHO, India is one of four countries (including China and Indonesia) where cigarettes have become more affordable in the last six years.
ITC has taken aggressive price hikes and sacrificed volumes
ITC has responded to the successive excise duty hikes by passing on the effect to the consumer through aggressive price hikes. As a result, though profitability has improved, volume growth has taken a hit. As we look at the indexed pricing of a stick for ITC, it has seen a near 3x increase in the FY03-16F period.
We therefore infer that, given the continuous price hikes taken, prices are now at a level that has started hurting the company’s ability to maintain profitable growth. We now believe, and ITC’s recent strategy demonstrates, that incrementally it would be fairly difficult for the company to hike prices at the same pace as it has been doing for the last three-four years. We also believe cost controls cannot help drive Ebit margin improvement for the company on an ongoing basis.