Budget 2015: Cigarettes get short end of the stick
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When a government hikes duties on a product group, the intention is to not kill the golden goose. Therefore, duty hikes are designed to raise revenue without crippling sales growth. In cigarettes, the intention seems to be otherwise. After three years of successive and steep excise duty hikes, FY16 has seen another sharp increase in cigarette duties.
The market leader ITC Ltd, which is hit the hardest by these hikes, usually responds by increasing prices to cover for the duty increase and to add to its margins. This continuous and compounded hike in prices hits volumes, leaving companies dependent on better margins for profit growth.
Indeed, volume growth has suffered. Edelweiss Research estimates that ITC’s volume growth in FY15 could decline by 9%. Dolat Capital estimates that the current duty hikes may cause a 5% drop in volumes in FY16, though Edelweiss estimates a higher 8% decline.
The government appears to be in sync with the World Health Organization’s (WHO) efforts to reduce tobacco consumption through both tax and non-tax measures. It mentions measures such as not having differential tax segments and maintaining duty hikes ahead of nominal gross domestic product growth.
The steeper hike in smaller cigarettes, at 25% compared with 15% for higher categories, indicates that the government wants to minimize any price-based targeting. Lower length cigarettes could typically target the mass market consumer or a new consumer to cigarettes. The government is already considering a harsh set of measures to curb tobacco sales, which may further affect consumption in the longer run.
While the current budget has not touched bidis, it has brought in higher duties on chewing tobacco which will make cigarette substitutes also expensive. While that may be some consolation, the writing on the wall seems to indicate a rough road ahead for cigarettes in forthcoming budgets.
But there is a silver lining in the cloud of smoke. A common Goods and Services Tax (GST) is set for implementation from 1 April 2016. Reports had indicated that tobacco products will be part of GST. That may eliminate distortions created by arbitrary state levies on cigarettes, by having a uniform tax. Also, ITC is likely to attain the same cost savings that other consumer companies are targeting, as a result. Its consumer products business, too, will benefit from GST implementation.
Secondly, a reduction in the corporate tax by 5 percentage points can be a big boost, as ITC’s effective tax rate hovers at the 30% level. If we apply a 25% rate to its December quarter profit before tax, the calculated profit after tax growth jumps to 19.5% from the actual figure of 10.5%, a substantial increase. Still, these measures could provide some temporary relief, but if the government’s resolve is to cut smoking by levying stiff taxes every year, then cigarette companies will continue to be at the receiving end of tax hikes.
The writer doesn’t own shares in the above-mentioned companies.