What are ITC’s investors smoking?
That the goods and services tax (GST) is good for ITC Ltd is well known. In fact, the GST Council had decided in its 17 March meeting to cap the cess on demerit goods, and said it wanted the tax burden to remain the same. Since then, the company’s share has risen by a fifth, and gained by 8.7% in the past week alone.
Why does ITC benefit? Rates can be changed only by the GST Council now, lessening the possibility of sharp annual increase in taxes on cigarettes. The need to raise revenues, and the presence of states dependent on tobacco in the council, will help keep cigarette tax hikes in check. Stable taxation gives investors predictability and should also help ITC become more competitive versus illegally sold cigarettes. It also levels the playing field in respect of other forms of tobacco consumption.
In brief, cigarettes will be taxed at 28% and a cess of 5%, and a cess in rupees per thousand sticks, which varies by length. The cess is to compensate states for revenue lost due to GST, which they are entitled to for five years. On paper, it means the cess is time-bound but that could change too.
Nothing has changed in the past week to explain the recent exuberance seen in the ITC share, suggesting the rise may be a bit overdone. Consider this: a week ago, a Nomura Research report had said ITC was its top pick in the consumer segment after GST, with a target price of Rs356 when the price was at Rs311; but the current stock price is Rs337 already.
The ITC share trades at a price-to-earnings ratio of 38 times its fiscal year 2017 (FY17) earnings per share (EPS) and is quoting at 34 times its FY18 EPS. In comparison, Hindustan Unilever Ltd, the company it is often compared to, trades at a valuation of 53 times and 48 times EPS, respectively. That gap may be seen as an opportunity by some.
Note that GST’s impact in the form of disruption in the near term will be visible on ITC’s business as well, especially its fast-moving consumer goods business. That may be the first reality check for investors. The valuation upside is being front-loaded but the benefits from GST may take time to show up. Second, the regulatory risk of tobacco control remains very much alive and should be watched out for. If the government takes strong measures to curb cigarette consumption, that may eat into some of the benefits that GST will eventually bring.