ITC's cigarette EBIT may halve in FY16

Tax regime a sustained headwind for the stock, double-digit price rise to result in volume contraction

The steep increase in excise duty is expected to hit cigarette consumption in the country. There is a perceptible shift in the government’s policy towards cigarette consumption, which is expected to hurt ITC’s earnings in the coming years.

The company’s shares are down 13 per cent since the Budget on earnings downgrades. Even though cigarettes constitute a very small portion of tobacco consumption (12 per cent of overall consumption), the government is focused on curbing it rather than viewing it as a revenue resource (cigarettes account for 85 per cent of excise duty on tobacco). The punitive tax regime is, therefore, now being viewed as a sustained headwind for listed cigarette makers like ITC rather than an event that occurs every few years. Abneesh Roy of Edelweiss Securities expects the overhang of steep excise hikes to continue for the next four years.

The sharp increase —duty hike of 25 per cent on 64 mm cigarettes and 15 per cent for others — is expected to hurt ITC the most, as the stock had run up ahead of the Budget on expectations of a 10 per cent increase in excise duty. The market is now readjusting to the new and higher tax regime for the sector, which implies that the volumes will contract and so will earnings. The Street expects ITC’s cigarette volumes to contract by eight-nine per cent in FY16.

Cigarette prices have gone up 75 per cent in the past three years and analysts believe consumers might not be able to absorb another price rise to the tune of 13-15 per cent this year. Credit Suisse believes price elasticity of demand has kicked in the December quarter of FY15, which saw ITC’s cigarette volume decline in double digits after prices were increased for the third consecutive year.

In the previous decade, ITC’s earnings from the cigarette business has largely remained immune to tax rises and has grown by 15-20 per cent. But in the new tax regime, ITC’s cigarette earnings could grow by 10-15 per cent believe analysts. Religare Institutional Equities has cut its FY16 and FY17 earnings estimates by 12 and 13 per cent, respectively. The brokerage expects cigarette EBIT CAGR of 10 per cent over FY14-FY17 from 19 per cent in the previous five years.

Not all analysts are negative on the stock though. While UBS Securities has cut its earnings estimates, it believes that the company's leadership position in cigarettes will help it to pass on  cost increase. And over time, the company’s FMCG business would compensate for declining profitability in the cigarette business. But such optimism is restricted to a few.