Cigarettes are not very cool. Or, at least, that’s what the world in general thinks. The recent salvo against smoking came from Australia a few weeks ago. It has decided to adopt plain packaging, which means that manufacturers will have to sell cigarettes in drab, olive green packets with graphic pictorial warnings. Trademark brand logos will be replaced by the name in a prescribed font, from December 1.
Anti-smoking lobbies believe that plain packaging will help curb consumption. A market research on plain packaging, done by the Public Health Foundation of India and Hriday, a health awareness NGO, showed that more than 80 per cent people felt that plain packaging of tobacco products would help reduce the attractiveness, appeal and promotional value of the tobacco pack.
The Australian decision, which is just one in a series of initiatives, should send the Indian Tobacco Company (ITC) — which gets 57 per cent of its revenues from cigarettes but 80 per cent of its profits — into a tizzy. After all, health ministry officials in India have been watching global events keenly and have said that initiatives like the one in Australia may well be adopted at home, a concern that IDFC mentioned in its report.
“We have turned bearish on ITC after years, partly due to reasons not of its own making,” says IDFC. “The global tobacco industry is staring at a ‘systemic risk’, with Australia, the UK, Canada and Russia taking stringent actions that can cap cigarette sales and dilute brand franchise (packs sans logos, 40 per cent per annum tax hike, etc). We believe that as regulatory concerns escalate, global majors will be de-rated and have a rub-off effect on ITC. Adding to the woes is an increasingly disruptive tax environment for cigarettes in India,” IDFC adds. The company downgraded ITC’s stock to underperformer and said that it had turned bearish on the company after years. (Click here for graphs)
Smoking performance
Yet, ITC puffs along, unfazed, making even more money. From 2011 to 2012, ITC’s average value added tax (VAT) rate for cigarettes has increased from 18 to 20 per cent, but data show that cigarette margins that measure profitability were undented. In fact, margins improved from 29.92 per cent in Q1FY12 to 31.34 per cent in Q1FY13, in the backdrop of one of the steepest taxations in history.
In the run-up to the first-quarter results, analysts across the board had forecast a two per cent drop in cigarette volumes, year-on-year, but, ITC bucked the trend and reported a one per cent growth, despite a 13 per cent price hike in the wake of steep taxation.
What makes ITC such an outstanding company in terms of performance? The relentless pursuit of excellence in building strong, world-class Indian brands, together with innovation in processes and investments in state-of-the art technologies have enabled ITC to improve its market standing in cigarettes, is what ITC Executive Director Kurush Grant says.
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Analysts sum it up more succinctly: it’s the market leader’s pricing power. A Prabhudas Lilladhar note after Q1 results said that cigarettes posted a strong 260 bps improvement in ebit margins driven by price hikes, better product mix, softer raw material costs and an eighth consecutive quarter of margin expansion, underscoring ITC’s pricing power.
Clearly, cigarettes underwrite the ITC story. This, of course, is despite the fact that ITC Chairman Y C Deveshwar wants to create other avenues of growth to de-risk a revenue model, largely dependent on a restrictive business like tobacco. Non-cigarettes FMCG or the ‘others’ in the FMCG category — comprising foods, lifestyle retailing, personal care, education & stationery, safety matches and agarbattis — is a diverse category all by itself. About a decade-old, (though the different segments within the category have made an entry at different points in time), the others category accounts for a significant share of ITC’s revenues, but not in terms of profits. ITC, however, has managed to halve its losses in the category and is looking to take on international giants by becoming the number one player over the next 10-15 years. But more than a decade later, cigarettes still call the shots, even as fresh regulatory concerns loom large.
War against cigarettes
Since 2004, when the government dropped a bombshell with the Cigarettes and other Tobacco Products (Prohibition of Advertisement and Regulation of Trade and Commerce, Production, Supply and Distribution) Act, 2003 to protect public health by imposing restrictions on advertising and banning sponsorships, cigarettes’ profit share for ITC has slid from 90 per cent to 80 per cent currently, while the revenue share during the same period has come down from 72 per cent to about 57 per cent.
ITC has weathered many other storms in addition to banning of advertisements and sponsorships, such as, a ban on smoking in public places in 2008, graphic health warnings in 2009, harsher ones in 2010 and one of the steepest taxation rates over the past year. Yet, ITC knows how to work its way around.
A case in point: There may be restrictions on advertising in cigarette packs, but ITC’s brands are the most visible among the point of sale displays, almost omnipresent. “The government effort to curb tobacco consumption may affect sentiments, but fundamentally, there will be no major impact on ITC. Irrespective of any such negatives, the company has always maintained ebit margins. But steep taxation leading to price hike has resulted in lower volumes quarter-on-quarter,” an analyst said.
Deveshwar, however, scoffs at these assertions. “Analysts know about volume drop only through clearances. As far as consumption is concerned, we will know only over a period of time,” he said at the annual ITC press conference.
ITC’s main headache
Taxation, however, has been one of ITC’s prime concerns. There are about 30 different effective tax rates across the country. ITC’s average VAT is at 20 per cent while the highest rate, in Uttar Pradesh and Rajasthan, is at 50 per cent.
“In India, unlike any other country in the world, cigarettes constitute less than 15 per cent of tobacco, the rest comprising chewing tobacco, beedis, etc. The discriminatory and high incidence of taxation of the cigarette form of tobacco has led to a continuous decline in the share of cigarettes in overall tobacco consumption. This has led to tobacco consumption shifting from cigarettes to other revenue inefficient forms of tobacco. As a result, overall consumption of tobacco has increased while the share of cigarettes in total tobacco consumption has declined. Cigarette consumption in India constitutes only 1.9 per cent of global consumption. Per capita consumption of cigarettes in India is the lowest in the world,” Grant explained.
Though non-cigarette segment accounts for about 75 per cent of ITC’s capital expenditure, investment in cigarettes is also underway. In the last Union budget, the government introduced a lower excise slab for cigarettes having length less than 65mm, which will enable ITC to enter the Rs 2 a stick segment and help add to volumes.
“We have been test marketing cigarettes in this new category under several brands. While it would be too premature to comment on the response, it appears that such segmented offerings have the potential to act as a barrier to the enormous proliferation of illegal cigarettes,” Grant said.
The illegal cigarette that Grant was referring to, however, is priced at Rs 1 a stick.
Deveshwar recently took on India Inc and said that India’s consumption story was still alive, but what was missing is the investment story. For ITC, however, both the stories appear to be alive and kicking.