Has ITC Ltd been done in by the sharp hike in taxes on cigarettes under the Goods and Services Tax (GST) Act? What seemed like a windfall for the company, in the form of a stable tax regime and a lower tax outgo under GST, went wrong after a sharp hike in the cess on cigarettes. Cess is worse than an increase in the basic tax rate, as taxes paid on inputs cannot be set off against cess, except if those inputs attracted cess too.

The sharp hike in tax liability as a result of the higher cess led to ITC increasing prices, and this led to a decline in volumes of 6% in the September quarter, according to an estimate by Edelweiss Securities (ITC does not provide volume figures). While net sales increased by 6.8%, its material costs increased by a much higher 18.7% over a year ago.

The company’s press statement did say that it faced an additional burden in the quarter due to the non-availability of additional duty surcharge credit on transition stocks and adverse impact on pipeline stocks due to an unanticipated revision in cess from 18 July.

This sharp increase in material costs is at odds with a 1% increase in employee costs and a 9.6% decline in other expenses. The net result was that its operating profit rose by only 3.6% over a year ago during the quarter. Its net profit did slightly better, rising by 5.6%.

Coming to the segment performance, sales are not comparable due to accounting differences between GST and excise. Profit is comparable and shows that cigarette profits rose by 2.3% over a year ago, while that from agri-business (trading/exports) fell by 13.7% over a year ago. The paper business did well.

A few anomalies are at play. One, some GST-related effects could be affecting sales and expenses, and is likely to taper off in the coming quarters. Secondly, a sharp drop in profits in the agri-business is what affected operating profit and not a decline in its core cigarettes business. Excluding the agri-business, ITC’s overall segment profit increased by 4.2%, compared with the reported 2.8% growth.

What could change the currently prevailing dismal outlook for ITC? One, if its cigarette margins improve, as one-off factors affecting it and the hike in prices begin to reflect in fatter margins. Secondly, while taxes are high, if they remain stable at these levels, eventually, sales growth will normalize. Remember, what affected volume growth in the previous years was years of successive, sharp hike in taxes. It can absorb one bad year.

Also, ITC’s FMCG business did quite well, to see comparable sales growth of 10%—on par with that of Hindustan Unilever Ltd. Growth in this business should pick up under GST, especially as it operates in a few segments where the unorganized segment has a significant presence.

While the headline numbers may induce despondency and indeed, its shares have hugged the bottom of the price chart since the cess announcement in mid-July, it may be a good idea to keep an eye out for an improvement in its results in subsequent quarters. The cigarettes business has the potential to lift its earnings up from these levels. The risk is if taxes are increased again, which seems unlikely, or if public health concerns lead to further harsh measures to curb cigarette smoking, which is unpredictable.