Decline in cigarette volumes to weigh on ITC

Price hikes could lead to deterioration in product mix of the cigarette business

The ITC stock shed 2.4 per cent on Wednesday, on worries that the company’s cigarette volume had declined significantly over the past two months after price hikes. The downgrades by Macquarie and Jefferies came on the back of regulatory uncertainties and decline in volume, impacting earnings growth.

The company has taken price hikes to neutralise an increase in cess after implementation of the goods and services tax (GST). Price hikes in the overall cigarette portfolio over the past nine months have been about 14 per cent. Those at 20-23 per cent in the 69-millimetre and 84-millimetre segments are primarily responsible for the estimated decline.

Macquarie analysts said a significant part of the 64-millimetre (entry level) segment was now priced at or above ~5, also leading to volume pressure. This category now accounts for an estimated 35 per cent of ITC’s volumes compared with a negligible contribution five years ago.

Further, the cigarette mix is expected to deteriorate as analysts believe consumers might switch to the 64-millimetre segment from the premium categories.

Loss of business, given the rising price differential between ITC’s portfolio and bidis and illegal cigarettes, are adding to its worries. Given the price hikes, the Street will keenly watch for volumes and segment profits in the September quarter.

While ITC does not provide volume figures for the cigarette business, Macquarie has cut its volume estimates by four per cent in FY18, compared with a flat projection earlier. Therefore, the brokerage has also cut its FY18 and FY19 earnings estimates for ITC by two to five per cent. They expect a higher valuation discount to peers on account of lower earnings growth and have recommended their clients to switch to Hindustan Unilever.

While there are other large business segments for ITC, such as agriculture and non-cigarette fast moving consumer goods (FMCG), cigarettes contributed over 55 per cent of revenues and 87 per cent of its operating profit in the June quarter.

Analysts are also not excited about the returns from other segments. CLSA, in a recent note on the FMCG business, indicated that despite a 15-year presence in the segment, enviable brands and strong position in several categories, profit continues to be elusive. Despite ~2,600 crore gross sales in the June quarter, the FMCG business reported a segment profit of ~2 crore.

Analysts were even critical on the hotel business. “Hotels continued to destroy value, an eight-year trend; while management blamed the macro backdrop, we remain perplexed with investments in a fairly capitalintensive business,” they added.

Unless the company surprises on the volume front, indication of which will be available in the September quarter results, the stock could continue to underperform.