The Uttar Pradesh government’s decision to impose a sharp increase in state levies on tobacco products has spooked investors in ITC Ltd, the country’s largest cigarette maker, which has seen its shares lose 3.5% this week. The state government raised tax on tobacco products from 12.5% to 50% on Monday.

Despite having a 16% share of the country’s population, Uttar Pradesh accounts for only about 5-6% of ITC’s cigarette sales by value. Analysts believe that price hikes may drag sales volume by 1.8-2% in the coming quarter.

ITC has two choices. It can pass on higher taxes to consumers. But that will make its products in neighbouring states cheaper, opening the possibility of leakages. Or it could increase prices by a bit across the board to cushion the impact of higher taxes.

Investors’ bigger fears are that other states may follow with their own tax increases. Espirito Santo Securities India Pvt. Ltd said in a 5 July note, “We think the risk of tax increases on tobacco has heightened, and more states such as Maharashtra, West Bengal, Tamil Nadu and Andhra Pradesh, which contribute more than 40% to ITC’s volumes, may see tobacco taxation as an easy option.”

If ITC absorbs the complete tax increase, earnings per share in this fiscal year will be affected by 2%, said Kotak Institutional Equities in a 2 July report. To maintain margins, the company will have to hike prices by around 2%, say analysts.

ITC, meanwhile, is still grappling with the steep price hikes of 12-13% it announced in April. This was after the significant rise in excise duty in the national budget.

In 2007-08, Uttar Pradesh had levied a 33% trade tax, while most of the other states had 12.5% value-added tax. But this was reversed within a few months. It remains to be seen if the latest increase will remain.

ITC’s share is up 23% in the past six months. Some pressure on profitability and revenue growth in the coming quarter cannot be ruled out.

Graphic by Ahmed Raza Khan/Mint