GST worries for cigarette companies

Likelihood of higher tax rate hits sentiments

Stocks of cigarette makers such as ITC, VST Industries (VST) and Godfrey Phillips fell three to seven per cent on Monday, reacting to the likelihood of a 'sin tax' on cigarettes proposed under the goods and services tax (GST) regime. Domestic companies currently pay blended value added tax rate of 25 to 26 per cent, plus central excise duty. The market fears these products will be taxed around 40 per cent in the GST regime.

If excise duty paid by these companies continues under GST, ITC might have to increase cigarette prices by 13 per cent to offset the additional burden, estimates Richard Liu of JM Financial. He believes ITC would have to bear an additional Rs 3,800-crore of indirect tax liability in financial year 2017 or a fourth of its FY17 estimated cigarette Ebit (earnings before interest and tax). The other option will be to pass on costs to customers.

  If the latter, it will lead to further pressure on ITC's volumes, which analysts estimate has been falling (on a year-on-year basis) for the past 10 quarters. VST, too, has witnessed pressure on its cigarettes volume growth which fell seven per cent in FY15 and is estimated to fall another 11 per cent this financial year.

G Chokkalingam, founder, Equinomics Research & Advisory, says, “For the first time, price elasticity of demand is not in favour of the industry. This government is too aggressive on taxing cigarettes, indicating the sector's troubles are far from over.” The knock on sentiment is also because analysts were factoring in some improvement in these companies' volume growth in FY17. This could now get delayed after the implementation of GST.

There, however, is some uncertainty as the recommendations are not clear on whether it is the total composite rate for demerit goods (proposed at 40 per cent) or only the state GST component estimated at around 20 per cent that will apply.

“As the 40 per cent rate has both Centre and state components, application of this would be tantamount to the Centre levying taxes twice – once through excise and then through GST,” says Liu, adding that if only the state GST component applies, it could be positive for tobacco companies.

The other uncertainty is on when the GST regime could come into effect. If it is from April 1, 2017, then sales volumes of these companies should grow at a reasonable pace next financial year.

Overall, as VST only deals with cigarettes and ITC derives about 80 per cent of its profits from this segment, the prospects of these stocks are tied closely to the regulations governing cigarettes.