ITC - ‘Healthy Rollback’

In the Finance Bill amendment, the Government has proposed to withdraw the imposition of ad-valorem duty introduced in the Union Budget and instead increase specific excise duties by ~21-22% depending on the slab. ITC has already hiked blended cigarette prices by ~15-16% (~12% post budget), to partly mitigate the impact. With the revised specified rates, and assuming ~3% decline in cigarette volumes in FY13, we expect ITC to take further price hikes of ~4-5% to pass on the additional burden and maintain 15%+ cigarette EBIT growth. We believe the removal of the ad valorem excise duty on cigarettes will help ITC maintain its pricing power and ability to expand margins on a consistent basis.
 
Removal of ad valorem duty a long term positive
The imposition of ad valorem duty was a structural negative for the cigarettes industry as the leverage to increase margins through price hikes would have reduced (tax/stick would have increased with price hikes). The new structure is expected to result in ~21-22% increase in specific rates (earlier proposal impact ~14-15%). We believe the weighted average impact on ITC’s portfolio would be ~20%. ITC has already increased blended cigarette prices by ~15-16% and will require ~4-5% further price hikes to pass on the additional burden and maintain 15%+ cigarette EBIT growth. ITC has not yet hiked prices of brands like Capstan while in the king-size cigarettes, the price hikes have been comparatively lower. We believe this gives enough headroom for ITC to take further price hikes.
 
New excise slab offers opportunity to re-enter <65mm segment
The new slab of lower excise duty for cigarettes below 65mm in length provides opportunity for ITC to re-enter this segment. ITC had exited the Rs2-2.5/stick price point post the excise duty increase in FY11. In the FY13 Budget, the Government has introduced a new slab of <65mm cigarettes with a lower excise rate of Rs0.66/stick (ITC is present from 69mm). This slab will not attract ad valorem tax thus providing opportunity for ITC to re-enter this segment with a 64mm offering at Rs2-2.5/stick price point.
 
Margins to expand; earnings to witness ~17% CAGR
ITC remains one of our top picks in the sector given the strong resilience in its core cigarette business. ITC is gaining traction in non-cigarette businesses as well making it a well diversified growth company. We expect ITC to witness 14.3% and 17.2% CAGR in revenues and net profit respectively over FY12-14. At the current market price of Rs240, the stock is trading at 22.3x FY14E EPS of Rs10.8. We maintain Buy.
 
Financial summary