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Has the cigarette industry lost its puff?

Mar 11, 2013

About the Industry

The cigarette industry in India is dominated by ITC, Godfrey Phillips India (GPI) and VST Industries. The three companies together accounts for more than 90% of the total market. ITC is the market leader with an 80% market share followed by Godfrey Phillips having share of 12.5%.

The entry barriers in the industry are high. New manufacturing licenses for cigarette are no longer issued by the government. This along with a ban on Foreign Direct Investment (FDI) shields the industry from any new competition. The cigarette industry is not constrained by capacities as utilization of the top four companies remains equal to or below 50%. Foreign cigarette companies have significant market shares in domestic companies. British American Tobacco (BAT) holds stakes of over 30% in each of ITC and VST Industries and Phillips Morris has a 25% shareholding in Godfrey Phillips.

Regulatory Regime

The cigarette industry faces discriminatory taxation. Though cigarettes account for only 15% of the total tobacco consumption (including non-smoking forms such as bidi, gutkha, khaini and zarda), it contributes over 74% in the form of tax revenues. Excise duty on cigarettes is more than 50% of its selling price. The cigarette industry is subject to frequent revision in excise duty as well as differential VAT rates in various states. A plethora of 29 different tax rates are applicable on cigarettes across states in India. This has compelled manufacturers to adopt state specific pricing. Multiple tax rates will continue until the Goods and Services Tax (GST) comes into force.

In the Union Budget 2012, the excise duty on cigarettes (< 65 mm length) was raised by 22% through an ad valorem duty of 10% on existing specific rates. As the ad valorem duty is chargeable on 50% of the retail sale price, it has reduced pricing flexibility of companies to some extent. In the Union Budget 2013, the specific excise duty was raised further by 18%.

There has been a shift towards a strict regulatory regime for cigarettes. Uttar Pradesh has raised VAT rates from 17.5% to 50%. And other states like Kerala and Karnataka have followed suit. In the wake of ban on chewing tobacco in 16 states, state governments may be forced to raise taxes further to make up for the revenue loss. This can indirectly impact the industry in the long run.

The cigarette industry is in the eye of a storm. In such a tough environment, are cigarette stocks still worth investing?

Among cigarette companies, ITC has a pan-India presence and sustainable pricing power. ITC's brands Navy Cut, Wills Classic and Gold Flake occupy the premium segment imparting it higher pricing power. On the other hand, GPI's cigarette brands namely Four Square, Red & White and Cavenders lie in the mid-price segment. GPI has a strong presence in the northern and western markets. The company has been striving to widen reach in the eastern and southern markets in the face of resistance from ITC. Thus GPI's pricing power remains limited.

ITC recorded a 21% jump in profits during 9mFY13. However, GPI saw its profits slump by the same magnitude. For ITC, the cigarettes division contributes around 70% to overall sales. This division posted a 20% rise in EBIT earnings as volumes grew in single-digits despite a 11% increase in price during 9mFY13. On the other hand, GPI's cigarette volumes were hit by a 30% hike in price. It is to be noted that GPI depends heavily on cigarettes with around 90% of its sales coming from this segment.

Apart from weak pricing power, GPI lags on the profitability front also. The company earns the lowest margin due to high advertisement & promotional spends. At 10%, GPI's profit margin is less than half of ITC and VST Industries. Going forward, promotional expenses are expected to remain high as the company continues to expand reach. Even depreciation charges will remain high due to commissioning of new capacities. Therefore judging by pricing power and profitability, ITC is much better placed to tide the tough environment.

Conclusion

The cigarette industry is facing headwinds on the regulatory front. The excise duty has been increased in the last two years. Even states are raising VAT rates on cigarettes. Companies are hiking cigarette prices to pass on the higher burden. While this may impact offtake of low priced cigarettes, the premium end is likely to remain unaffected as cigarettes are addictive by nature. Moreover, as more states ban chewing tobacco, the switchover is likely to benefit the entry level cigarette segment (< 65 mm).

As per markets however, they seem to be tilting more towards ITC. This is perhaps the right thing to do as it is always better to invest in the leader unless valuations for number two and three aren't very compelling. But this does not seem to be the case right now.

Madhu Gupta

Madhu Gupta (Research Analyst), ValuePro has a post graduate degree in both physics and finance. Having worked with India's leading economic research agency, she has a natural flair for numbers and analytics. She brings with her a near-decade long rich experience in the field of finance. A firm believer of the principles of value investing, she looks for robust businesses with durable competitive advantages.


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