Taxing times for ITC

The market remains divided on earnings and volume impact of higher excise duty

That the Union Budget would announce an increase in taxes on cigarettes was a given, but the expectation was in the range of a 10-15 per cent rise. This year, however, the finance minister has imposed an ad valorem levy of five per cent on the maximum retail price (MRP) of cigarettes over 65 mm length. Over the years, the market has learnt to discount the rise in excise duties as ITC tends to expand margins in the years when taxes are raised. In recent times, the company has also started hiking prices ahead of the central and state budgets to mitigate the impact.

Given that it’s not a simple rise, the market is divided on the effective increase in duty. Analysis by Goldman Sachs suggests the increase in excise is around 19 per cent for ITC’s largest brand, Gold Flake Regular, while it’s 15 per cent and 14 per cent, respectively, for other key brands like Wills Navy Cut and Classic.

Excise duty on cigarettes below 65 mm length has been left unchanged. According to both CLSA and Sharekhan, the weighted average increase in duty would be 15 per cent for ITC. Including VAT, it would be 17.5 per cent. The company needs to rise prices seven to nine per cent to offset the impact of the duty hike. A two per cent rise was already taken before the Budget.

Analysts say the hybrid system of taxation implies the variable proportion of taxes could go up, which would mean further price rises. The market believes, going by past experience, ITC has managed to increase its Ebit (earnings before interest and taxes) from cigarettes by 16 per cent a year over five years. However, analysts at Sharekhan believe if margins have to sustain at the current level, the company needs to increase prices by 10 per cent across its cigarette portfolio.

Analysts are divided on the impact on volumes. While most believe these would not be hit, others feel ITC’s cigarette volume growth could moderate in FY13. However, in case the company chooses to introduce cigarettes below 65 mm, it could lower the incidence of tax.