ITC tanks 13% as GST Council hikes cess on cigarettes. Should you sell?

Biggest intra-day fall in 25 years; Rs 50,000 cr goes up in smoke

Shares of India’s largest cigarette maker, ITC, plunged nearly 13 per cent on Tuesday, its single biggest intra-day fall since May 12, 1992, after the Goods and Services Tax (GST) Council on Monday increased cess on cigarettes. The stock had plunged 15 per cent in intra-day deals on Tuesday — the sharpest fall in a decade — to hit a low of Rs 276.4 on the National Stock Exchange (NSE).

Stock prices of other cigarette makers Godfrey Phillips and VST Industries, too, fell 6-8 per cent because of the hike, which came after market hours on Monday. While investors in ITC saw their wealth decline by about Rs 50,000 crore, the fall in ITC’s stock price was the single biggest reason for the S&P BSE Sensex shedding 364 points to close at 31,711.

The increase in cess, according to Finance Minister Arun Jaitley, was taken to “reduce profiteering by companies and harm to public health.” The finance ministry indicated that the total tax incidence in the GST regime had come down compared to the total tax in the pre-GST regime. 

After the recent hike in cess, the average effective tax has increased by 10-11 per cent, which will require an 8-9 per cent increase in retail prices to offset the effect. With the 6 per cent hike in the Union Budget 2017-18, the total increase in taxes amounts to 16-17 per cent for FY18, according to Edelweiss Securities. The recent hike means that total tax on cigarettes is higher than pre-GST levels. 

The Tobacco Institute of India (TII), which represents over 95 per cent of India’s cigarette industry, said the new revision of the compensation cess rates (CCR) in the GST framework is not ensuring revenue neutrality, as was projected by the GST Council.

“The government’s move to hike taxes to more than pre-GST levels brings to fore its negative stance on the sin sector. Even if this policy gets partially rolled back, uncertainty would still loom large over the taxation policy for cigarette companies,” said Abneesh Roy, an analyst tracking the company with Edelweiss Research.

For 84-mm-long cigarettes, the government increased the ad valorem rate to 36 per cent (5 per cent earlier), along with a 28 per cent GST rate. These cigarettes could see the maximum price hike, impacting volumes and margins, said analysts.

In the past (FY13-16), when the hike in tax was around 18 per cent on an average, ITC’s volumes declined by around 20 per cent over the period. The negative tax is likely to continue going ahead, with most analysts downgrading the company’s earnings, as well as the stock.

“The incremental cess will mean that earnings will be downgraded as we do not believe the company will roll out huge price hikes. For 84-mm-long cigarettes, the company will have to take some tax hikes to pass the impact which ITC can easily manage as the category is relatively small and inelastic,” said Naveen Kulkarni, co-head of research, PhillipCapital, in a note. 

Realisation for ITC is expected to increase by a modest 9 per cent year-on-year considering the company does not hike prices from here, he added. The cigarette segment is important for ITC as it contributed about 58 per cent of its revenues and 87 per cent of profit in the March quarter. 

Analysts at IIFL Institutional Equities believe that ITC will take 11 per cent price hike and volumes will decline 2 per cent resulting in a 5 per cent growth in earnings before interest and taxes in cigarettes division in FY18.

What has taken analysts by surprise is the sharp increase in cess as most had incorporated a volume uptick after the initial GST rate announcement.  A K Prabhakar, head of research at IDBI Capital, said the stock had rallied sharply after the GST rate announcement in the last quarter, as the incidence of tax was lower-than-expected and could have boosted volumes going ahead. However, the recent revision has come as a setback. Moderate taxes were also expected to curb the illegal trade in cigarettes, thereby boosting organised players like ITC.

According to a TII official, the CCR revision will be increasing the pressure on the duty-paid cigarette sector which is already reeling under huge tax burden on account of the continuous increase in excise duties on cigarettes, which have cumulatively gone up by 131 per cent over the last six years.

“The escalation in cigarette taxation will lead to a further increase in the already huge arbitrage opportunity and provide an enormous incentive to smuggling syndicates who often fund terror groups. Contraband trade undermines the legal cigarette industry and government’s revenue collections”, TII’s statement noted.

Prabhakar though remains positive on ITC stock. “I feel that the stock has seen a knee-jerk reaction. Investors who missed the earlier rally and can hold for a period of two-three years can invest at the current levels. The company, I feel, should be able to pass on any hike in tax to the consumers. Over a period of time, the FMCG business segment should also do well,” he added.

While the company could still take some price hikes, Kulkarni of PhillipCapital believes consensus expectations for FY18 earnings growth will be trimmed to around 10 per cent from the current expectations of 16-18 per cent growth. 

“Considering the tremendous pricing power of the category and relatively cheap valuations we continue to remain buyers. Our target price is Rs 345,” he said. CLSA, on the other hand, has downgraded the stock from buy to sell. In order to pass on the hike, CLSA believes, ITC will have to hike prices by around 4 per cent to 9 per cent across brands, with weighted average hike of around 5 per cent. 

“We note that further price hikes would have potentially negative impact on volumes, which would also impact agri and paperboard divisions. The outcome is clearly negative from the neutral stance that the government always mentioned.” The brokerage revised its target downwards to Rs 285 from Rs 417. With inputs from Avishek Rakshit and Ram Prasad Sahu.

 

Per stick analysis (Rs per Stick)	FY17	FY18 Pre GST	FY18 old GST rates	FY18 revised GST rates
MRP per stick (weighted average)	6.6	7.5	7.5	7.5
Channel Margins	0.5	0.6	0.6	0.6
Ad valorem tax	1.4	1.6	1.3	1.3
per unit tax	2.2	2.3	2.3	2.8
Net realisation for company	2.5	3	3.3	2.8
MRP hike		13%	13%	13%
Total tax growth		9%	1%	16%
Net realisation growth		19%	30%	9%
Source: PhillipCapital India research