ITC - Price hikes to impact near-term volumes - BRICS

The government has raised the basic excise duty on cigarettes by 21% and overall excise duty by 18% in the central budget, marking a significant increase in excise duty on tobacco products for second consecutive year. In addition to this, many states have announced an increase in VAT on cigarettes. We believe that ITC will have to hike prices of 84mm cigarettes by10% and 69mm cigarettes by13%, to maintain EBIT margin of its cigarette business. However, this will negatively impact ITC's near-term volumes. Nevertheless, considering the business' sticky nature, we remain positive on ITC in the long run.

Central excise duty up by 18%: In the FY13-14 budget, the central excise duty on >65 mm cigarettes was increased by 18% (basic excise duty up by 21%), but was kept unchanged on <65 mm cigarettes. The government has targeted collection of additional central revenue from the cigarettes sector (up by22% in FY13 budget) for the second consecutive year.

States follow similar strategy: In line with the increase in central excise duty, Rajasthan, Bihar, Gujarat, Jammu & Kashmir, West Bengal, Assam and Maharashtra have announced an increase in VAT on cigarettes during their respective FY14 state budgets. Considering the government's stand to reduce the smoking population, VAT and excise duties on cigarettes will remain under the scanner in the coming years. However, the duty on <65 mm length cigarettes will remain low to maintain the gap between bidi and cigarettes.

Hikes yet to be passed on: Despite the significant increase in excise duty, ITC has not yet hiked its prices. However, distributors and retailers are charging customers higher prices. In Mumbai, a packet of Gold Flake Light with MRP of Rs58 (before the duty hike) is being sold for Rs60-65. We have also observed manufacturing dates of November and December 2012 on these cigarette packets, which we believe, could be due to higher stocking by dealers ahead of the budget.

Price hikes to follow soon: Our analysis reveals that in order to pass on the increase in excise duty, ITC will have to hike prices of 84 mm cigarettes (Gold Flake Light, Gold Flake Premium, etc) by10% and of 69 mm cigarettes (Gold Flake regular) by13%. This will help the company maintain EBIT margin of its cigarette business.

Volumes to be significantly impacted: Historically, an increase in duties on cigarettes always results in pressure on volumes for 1-2 quarters. Considering the increase of 18% in excise duty and increase in VAT by various states, ITC will soon hike its prices, which will negatively impact its cigarette sales volumes in the coming quarters. We expect ITC to witness a volume de-growth of 3-5% in the coming quarters.

Valuation: At a CMP of Rs305, ITC trades at 32x and 27x FY13 and FY14 consensus earnings estimates. Considering the past trends as well as the habitual nature of cigarette consumers, we believe that consumers will accept the price hikes over a period. Hence, we remain positive on ITC in the long run.

Source : Equity Bulls

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