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Lower taxes to fire up revenues, earnings for cigarette makers

After 5 years of decline, cigarette industry expected to post volume growth under GST framework

Avishek Rakshit & Ram Prasad Sahu  |  Kolkata & Mumbai 

Lower taxes to fire up revenues, earnings for cigarette makers

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 structure on cigarettes. The new tax structure is expected to be about 6 per cent lower at around 58 per cent vs 63-64 per cent earlier. While (up 5.7 per cent), 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 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 has seen a decline of 5-6 per cent in its sales volume, while illegal trade has gained.

Abneesh Roy of Edelweiss Securities believes if these (6-7 per cent gains) are passed on there is volume benefit estimated at 5 per cent for FY18 for Given ITC’s market share, pricing power and largely inelastic demand it will benefit the most among cigarette makers from the lower indirect  

An spokesperson told Business Standard that the company welcomes GST and is 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 is due to lower relative valuations. Analysts at Credit Suisse had highlighted in a note today that the stock trades at 32 per cent discount to Hindustan Unilever, which is the highest discount in nearly 10 years. Arnab Mitra and Rohit Kadam of Credit Suisse believe that there is significant scope for re-rating in as the earnings momentum comes back to the high teens trajectory that achieved prior to FY14. On the back of higher contribution from the cigarettes business, Edelweiss Securities estimates that there would be 15-18 per cent annual earnings growth for 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. 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 in the entry level, 64mm category. Sameer Deshmukh of Reliance Securities agrees and says this category accounts 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 is based on the projection that the budget brands like Gold Star Super Star, Capstan and others will be directly competing with the bidi and the 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 say that players such as VST Industries can price its 64mm offering at Rs 2.65 a stick and yet make the same realisation as it did earlier at Rs 3. They believe that a Rs 2.5 a stick pricing for 64mm would lay out a smooth ladder to facilitate bidis-to-cigarettes up-trading. Under the GST framework, tax on bidi has increased to 28 per cent with additional cess from the current tax level of 18-20 per cent. While the effective price on bidi will increase, cigarette prices will decline.

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

is the market leader in the segment and once they reduce prices, other companies will follow suit. As a result, the effective prices, particularly in the 64 mm will come down and help bag market share from bidi and illegal cigarettes. This will lead to the overall volume growth in the legal cigarette sector,” he says.

The big picture is that lower tax incidence will help curb the illicit cigarette trade, which has seen big gains in recent years.

An industry official says the duty-evaded illegal cigarette industry, over the past five years, had grown to command a 22 per cent market share from 15 per cent in 2010 and sub-5 per cent in 2007. 

Estimates by Board, USDA and industry sources show that the consumption of illegal cigarettes has steadily risen from 11.1 billion sticks in 2004 to 23.9 billion sticks in 2015.

Roy of Edelweiss Securities adds, “Demonetisation had wreaked havoc on the illegal cigarette trade, which is cash based and the strict compliance laws under GST will result in sellers sticking to legal cigarettes. The availability of illegal cigarettes will come down drastically.” He expects to post annual growth of 16-17 per cent in and 5-6 per cent in volume in the next two years.

Industry officials reasoned that the government, after years of imposing extremely high on the to curb consumption, is now rationalising the sector as a whole as well as reduce contraband consumption.

“The government doesn’t earn a penny from the illicit cigarette market. Over the last two years the government has realised this and thus we are seeing tax rationalisation on the cigarette sector”, the official added.

In the 2017-18 Union Budget, against expectations of a 10 per cent duty hike on cigarettes, the government hiked the duty by only six per cent – the lowest hike in the past six years, while excise duty on hand-made bidis rose by 33 per cent and on machine-made variant by a whopping 271 per cent.

While non-cigarette and illicit products account for 89 per cent of the entire market, they pay only 13 per cent of total share in taxation from while legal cigarettes, which account for 11 per cent of the market, pay 87 per cent of the tax.

ITC, cigarettes graph

First Published: Tue, July 04 2017. 00:56 IST