Lower taxes a boost for cigarette makers ITC: STRONG PROFIT GROWTH AHEAD

Industry expected to post volume growth under GST as revenues, earnings go up; ITC key beneficiary

Shares of cigarette companies were among the biggest gainers on Monday after the Central Board of Excise and Customs last weekend clarified on the goods and services tax (GST) structure on cigarettes. The new tax structure is expected to be about 6 per cent lower at around 58 per cent versus 63-64 per cent earlier. While ITC (up 5.7 per cent) and VST Industries (4 per cent) hit their 52-week highs, Godfrey Phillips India, too, was up 2 per cent. The key beneficiary, though, is seen as ITC, which commands an estimated 80 per cent market share in the duty-paid cigarette industry in the country.

There are twin triggers for the optimism around cigarette makers. The first is the boost to volumes given the expectation of lower cigarette prices. Cigarette prices are likely to decrease by 8-10 per cent primarily in the 64 mm category, which will lead to a 5-7 per cent volume growth annually over the next two years. For the past five years, the legal cigarette industry has seen a decline of 5-6 per cent in its sales volume, while illegal trade has gained.

Abneesh Roy of Edelweiss Securities said if these (6-7 per cent gains) are passed on, volume benefit was estimated at 5 per cent for FY18 for ITC. Given ITC’s market share, pricing power and largely inelastic demand, it will benefit the most among cigarette makers from the lower GST rates. An ITC spokesperson told Business Standard the company welcomed the GST and was taking effective steps to pass on the benefits to the consumer wherever such benefits accrue due to the recently announced GST rates. The other reason for the run-up in stock prices, especially for ITC, was due to lower relative valuations. Analysts at Credit Suisse highlighted in a note on Monday that the ITC stock trades at a 32 per cent discount to Hindustan Unilever, which was the highest discount in nearly 10 years. Arnab Mitra and Rohit Kadam of Credit Suisse said there was significant scope for re-rating in ITC FY17 FY18E Revenues FY19E Figures in (~ cr) Operating profit Net profit after the earnings momentum came back to the high teens trajectory that ITC achieved prior to FY14. On the back of higher contribution from the cigarettes business, Edelweiss Securities estimated there would be 15-18 per cent annual earnings growth for ITC over the next two years. While new launches in the FMCG business (non-cigarette) is expected to add to overall revenues, cigarettes will continue to be the main driver of sales and profit. The cigarette segment contributes about 58 per cent of ITC’s revenues and 87 per cent of profit.

The key gains for cigarette makers is expected at the entry level or 64mm category. Sameer Deshmukh of Reliance Securities agreed, saying this category accounted for 25 per cent of ITC’s sales volume. The 69 mm category (50 per cent of ITC’s volumes), had stagnated over the past couple of years.

His reasoning was based on the projection that budget brands such as Gold Flake Superstar, Capstan and others will be directly competing with the bidi and illegal cigarette segment where chances of converting a bidi smoker to budget cigarette will be the easiest.

Richard Liu and Vicky Punjabi of JM Financial said players such as VST Industries could price their 64mm offering at ~2.65 a stick and yet make the same realisation as it did earlier at ~3. They believed pricing of ~2.5 a stick for 64mm would lay out a smooth ladder to facilitate bidis-to-cigarettes up-trading. Under the GST framework, tax on bidis has increased to 28 per cent with additional cess from the current tax level of 18-20 per cent. While the effective price on bidis will increase, cigarette prices will decline.

Deshmukh projected the 64 mm segment to become ITC’s volume growth driver in the coming years as its current share of 25 per cent was expected to increase to 40 per cent of total sales volume.