Hefty excise duty on cigarettes may force ITC to separate its core tobacco business

Ever since the Union Budget levied hefty increase in excise duty on cigarettes, ITC's stocks have been hampered affecting its core tobacco business and thus the company is thinking of separating its main business from other businesses.
Hefty excise duty on cigarettes may force ITC to separate its core tobacco business

ITC’s main business, the tobacco business, is being threatened by regulatory pressures and therefore, the company is thinking of separating its cash-cow business from other non-core businesses.

The Union Govt’s move to levy a hefty increase in excise duty on cigarettes is said to be the reason for this decision.

The Company’s stocks have been affected majorly due to this dropping down to 13% and emerging as the worst performer in the 12-member BSE FMCG Index.

Since the Budget day onwards, there has been an over 30% decline in the analysts' buy recommendations on the stock.

There is continuous rise in negative sentiments among investors who are also expecting imminent decline in the number of cigarettes sold by the company in response to price rise.

According to a report of J P Morgan, ITC has initiated price increase over the past two weeks to pass on the around 13% increase in FY16 excise duty.

According to Economic Times, this is the fourth consecutive year of a steep increase in taxation on cigarettes and the resultant price hikes would further challenge demand inelasticity and encourage growth of illegal trade which is around 20% of industry volumes.

VAT increase by state governments is another challenge being faced by ITC. Analysts have estimated 5% to 10% decline in cigarette volume this year.

This negative outlook on volumes is likely to keep the valuation of the stock under pressure in the near term. Comparing ITC's position with its peers in other emerging markets, the JPMorgan report states that aggressive taxation on cigarettes in countries like Brazil, the Philippines, Korea and Sri Lanka has led to moderation in volume growth and de-rating of the valuation of the market leader as well as higher share of illicit cigarettes. 

The growth of lobbying against the cigarette businesses is also compelling countries across the globe to step up efforts to curb smoking. This is likely to reduce the investment appeal of the tobacco sector among investors. At a market cap of $41.2 billion, ITC is the sixth most valuable cigarette company stock globally after Philip Morris, British American Tobacco, Altria Group, Japan Tobacco and Imperial Tobacco.

ITC's cigarette business provides ample free cash flows, enabling the company to earn high margins (of over 35%) despite a decline in volumes and to give high dividend payouts (of around 60%). It also funds the company's investments in unrelated businesses, like FMCG, hotels, paper and IT.

Will this be a case point for ITC to divest its businesses into separate entities?

ITC has set an ambitious target of making the FMCG segment a Rs 1-lakh-crore business in the next 15 years.

Incidentally, cigarette companies globally have not been able to grow non-tobacco food businesses under the same entity. Even after a decade of investment, ITC's FMCG business is yet to be a money churner.

In FY14, the company invested nearly Rs 3,500 crore in its FMCG business, leading to a top line of over Rs 8,000 crore with profits of just Rs 22 crore. Its other businesses have also not been great value creators.

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