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Taxation on cigarette: Overweight rating on ITC shares, says HSBC

Union Budget raised cigarette excise duty, but not as much as suggested by the Health Minister.

ITC Ltd Rating: Overweight

Taxation on cigarette rises: The Union Budget raised the cigarette excise duty (ED) generally from 11-21%; the 64mm segment was the only outlier, with the duty having been raised by 72% (note that this segment had escaped duty increases over the last three years). There was a c21% increase in the price inelastic premium segment (KSFT); other cigarette segments saw hikes of c11% and c17%. See Table 1 for ED hikes across segments.

Click here for graph

We estimate a weighted duty increase of about c20% for the ITC portfolio. Although, the hike is significant against the backdrop of annualised average ED hikes of c10% over the previous five years and has occurred three years in a row, it is still well below the proposal (raising the duty by R1-3 per stick) made by the union health minister, which had been an overhang on ITC?s stock price. The tax increase is more negative for players having more exposure to the 64mm segment, while ITC, given the strength of its portfolio, is well positioned to absorb the price hike; in our view, it will still be able to deliver cigarette Ebit (earnings before interest and taxes) growth of c16% in FY15. (See sensitivity analysis on page 3.) As noted, the biggest hit was in the 64mm segment, which had escaped duty increases over the past three years and had been under scrutiny by the union over the past two years (when duties on other lengths increased 18-20% annually), with several product launches by all players. ITC has 8-10% volume in this segment, which, in our view, is a result of market share gains and cannibalisation of its own 69mm cigarettes. With this duty hike, the pricing gap between 64mm and 69mm lengths should narrow?not necessarily negative for ITC.

ITC can still deliver double-digit Ebit growth: The weighted excise duty (ED) hike for ITC?s portfolio is c20% (effective hike of 14-15% for FY15, given one quarter has elapsed). In our base case, we assume about a 3.5% cigarette volume decline in FY15e as ITC will have to take double-digit price hikes to maintain earnings growth momentum. We also assume a weighted average VAT rate from c24% to 25.5%. Given these assumptions, we estimate that ITC may require a c15% price hike to register c16% cigarette segment Ebit growth. This Ebit growth trajectory, in our view, is plausible under various scenarios of volume growth with modest incremental price hikes. The table below provides a sensitivity analysis of price hikes needed under various volume growth assumptions.

The excise duty overhang is over: ITC?s pricing strategy is likely to ensure continuation of double-digit cigarette Ebit growth while improving margins in the Other FMCG segment should continue to boost earnings in FY15. ITC also plans to launch several new products in the foods segment and in dairy in the next 12-18 months that should buttress the long-term investment case for ITC. While VAT increases by states is still a downside risk, VAT increases by some states (Uttar Pradesh and Punjab) have been counterproductive and have resulted in their reversal, owing to the proliferation of illegal cigarettes and a decline in tax collection by these states. We think any weakness in ITC?s stock price is an attractive opportunity to buy this structurally attractive name. We remain Overweight with a target price of Rs 400.

?HSBC

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First published on: 14-07-2014 at 08:32 IST
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