ITC: Limited impact of regulatory clamp

Implementing ban on sale of loose cigarettes in some states is a challenge but no immediate triggers for the stock

The ITC stock has fallen about six per cent in June so far, on negative developments. The government of Maharashtra announced a ban on sale of loose cigarettes on June 1. In January, Punjab (two to three per cent of ITC’s cigarette volumes) had done so. Single cigarette sticks are affordable for youngsters and the rural population; hence, the ban could hit demand.

In the wake of the Maggi noodles controversy, other noodle brands could be impacted, though there has been no regulatory action on the ITC ones. While the first development is a setback to ITC’s cigarette business, the second development could be a negative if any action is initiated by state governments.

Heightened taxes and duties on cigarettes impacted ITC’s cigarette volumes and growth in earnings before interest and taxes (Ebit) in the March quarter. This led to earnings downgrades by leading brokerages. Further, given the likelihood of further tightening of regulations on cigarette consumption, ITC’s volumes here are unlikely to recover soon, believe analysts.

Loose cigarettes form 65 per cent of ITC’s cigarette sales and Maharashtra accounted for 10-12 per cent of ITC’s volumes. The extent of the impact would depend on implementation, “a challenging task, given the widespread distribution network of small kiosks, difficult to monitor,” writes brokerage JPMorgan in a recent report.

There are an estimated 10 million cigarette stalls in India, making implementation of a ban difficult. Notably, ban on smoking in public places, introduced in 2012, was implemented poorly, with very few people fined for this offence. Further, analysts believe ITC can introduce smaller packs containing two cigarettes to reduce the impact of this ban.

In this backdrop, most analysts polled by Bloomberg since May remain positive on ITC. High entry barriers and leadership position in the cigarette business (79 per cent market share) are some reasons. Healthy growth in most of the fast moving consumer goods (FMCG) segment is another. The stock trades at attractive valuations of 22 times the FY16 estimated earnings.

However, the regulatory overhang will keep a check on the scrip in the near term. The government is also considering measures such as raising the minimum legal age to consume tobacco and increasing of fines, among others. Consistent improvement in financial performance, particularly cigarette volumes and Ebit growth, is a requisite for any rally in the stock, believe analysts. Improving profitability of the FMCG business could act as a catalyst for the scrip.