ITC :: Mid-year excise hike for cigarettes? JPMorgan

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 Mid - year excise hike for cigarettes? As per media reports (CNBC
TV18), government may consider increasing excise duty on cigarettes by
20-30%, sometime around next month as more clarity emerges on
government’s excise collections. As always quantum of increase in taxes
remains indeterminate. Just to highlight in FY12 government did not hike
excise rates on cigarettes. In order to neutralise the impact of such excise
hikes (if implemented), ITC would need to implement at least 10-15% price
hike across its cigarette portfolio.
 Learnings from the past. Sharp price increases in the past have impacted
volume growth, though cigarette industry has shown commendable
resilience in recent years given its habit forming nature and enhanced
affordability. For e.g. in FY08 when cigarette prices were raised ~24%,
volume declined ~1% and very recently in FY11 when price increases of
~18-20% were effected, volume decline was restricted to ~2.8%. Analysing
the historical trends, in case tax hikes happen, we believe ITC will resort to
aggressive pricing strategy and pass on the tax burden to consumers.
Interestingly ITC has mostly taken price hikes ahead of what is required to
neutralise the tax hikes in the past and hence its operating margins have
improved on a consistent basis. Importantly in years of aggressive tax hikes
(FY08, FY09 and FY11) cigarette EBIT growth has been 15-17%.
 Earnings impact. For FY12 we are currently building in 6% volume growth
and price/mix increase of 5.5% for FY12. Assuming there is 20-30% excise
hike, a price increase of 12-15% could lead to cigarette volume decline of 3-
4% in our view (as seen in FY11) and impact FY12/13E earnings by 3-5%.
 Potential overhang on stock performance. We believe uncertainty related
to mid year excise hike could potentially impact share price performance
over next 1-2 months until more clarity emerges on this front. Given ITC is
trading at higher end of its historical valuation range (26x FY12E and 23x
FY13E P/E), any incremental negative newsflow could be an overhang. We
however like ITC from medium term perspective (12-18 months)
considering it is probably the only Indian consumer business whose pricing
power is intact, given low competition, high entry barriers and strong brand
affinity along with lower susceptibility to input costs. We would use any
correction on the back of weak sentiment post any excise hike to buy the
stock.