Reduce ITC :: Kotak Sec,report

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The government has sought public opinion on several proposed changes to
the Cigarettes and Other Tobacco Products Act, including changes on sales
of loose cigarettes, raising minimum age for purchase of tobacco products.
This follows prior news-flow that indicated that the government would like
to have wider discussion and would not take the ordinance route for the
changes. However, the emergence of proposals is rather quick following the
assurance last month. Incrementally, the news-flow is negative for ITC; we
revert to a negative stance on ITC, as we cut our price target to Rs 373 (27X
FY16E PER, cut from Rs 387 earlier), on concerns of structural negatives for
the cigarette industry


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 The government has initiated proceedings on making amendments to the Cigarettes
and Other Tobacco Products Act, following recommendations made by a
panel of experts to the health ministry. The Health Ministry has put out changes
in the public domain, and sought public comments on the same.
 The proposed changes include: 1/ ban on sale of loose cigarettes, 2/ raising the
minimum age for consumption of tobacco products to 21 years (currently 18), 3/
raising fine on smoking in public places from Rs 200 to Rs 1000, 4/ removal of
designated smoking areas in hotels and restaurants, and other public places.
 The ministry has proposed that in due course of time, the minimum age for purchasing
tobacco products shall be raised, in a phased manner, to 25 years.
 We note that these changes, proposed by an internal panel, have been under
government consideration for about two months now. Last month, media had
reported that several key ministers had urged the Health Ministry to reconsider
the changes, given that the changes are likely to impact tobacco farmers in a
significant way. As per media reports, the government had said last month that
until tobacco farmers are not provided with an alternate crop for their sustenance,
the amendments proposed by the panel shall not be brought about. This
had prompted an upgrade of ITC stock from us in December, 2014; we had then
believed that there was likelihood that the proposed changes would be shelved.
 However, the fact that the government is moving ahead with proposing these
changes soon after indicates that the changes could come over the medium -
term (last date for providing comments on these is 15th of February, 2015).
 While we await clarity on whether and when these changes shall be implemented,
we continue to maintain that: 1/ given that loose cigarette sales account
for about 70% of total sales of cigarettes in India, a ban on sale of loose
cigarettes will be significant, with the extent depending on the minimum pack
size allowed for sale (as of now, the proposed bill makes no mention of the pack
size), 2/we think provisions for changes in the minimum age for buying tobacco
are a negative, given that a significant part of the cigarette smoking populace
acquires the habit in the 15-25 age group, 3/ we do not think these changes are
impossible to implement, and the implementation of these depends upon the
fines that can be levied, 4/ the removal of designated smoking areas shall likely
be the only aspect of the proposed bill that we think shall have negligible impact
on cigarette consumption.

 We are fearful of the changes as proposed and we believe that cigarette sales
are especially vulnerable to changes in laws pertaining to tobacco, since the
cigarette smokers are the most likely to be targets for seeking fines by implementing
authorities. Whether the bill can actually be implemented in practice
may be a question mark, but the bill is likely to create conditions where the cost
of smoking shall rise further (i.e. apart from tax measures taken by the government).
 In recent past, the ITC stock has seen significant volatility on news-flow relating
to provisions of the likely amended tobacco laws. ITC has significantly
underperformed consumer peers in recent weeks, given the company's high dependence
on cigarettes (for profits).
 ITC is likely to report weak growth in the coming quarter, on the back of 6%
decline in cigarette volumes. The stock currently trades at 26x PER FY16E, at a
significant discount to FMCG peers (32-35x PER FY16E for domestic peers, 40-
45x PER FY16E for MNC FMCG players), given that ITC's exposure to commodity
prices is lower. ITC stock remains vulnerable to further hikes in excise duties in
the upcoming budget.
 We would expect ITC's valuations to remain subdued in the near-term, given the
above. Incrementally, we think that the news reported yesterday is a negative
for the stock, and places limits on upsides. We downgrade ITC to REDUCE, as
we cut our price target to Rs 373 (Rs 387 earlier), on greater probability of
changes to the COTPA.

LINK
http://www.kotaksecurities.com/pdf/dmb/MorningInsight14012015bb.pdf