ITC Shares Tank On New Cigarette Policy Yet Analysts See Massive Upside; Here's Why
Earlier this week, the health ministry published its draft on the Cigarettes and Other Tobacco Products (Prohibition of Advertisement and Regulation of Trade and Commerce, Production, Supply and Distribution) (Amendment) Bill 2020 after three years of planning.
The changes proposed in the bill are expected to threaten ITC's revenue, a major player in India's cigarette industry, which has still hasn't reached its pre-covid highs.
Major changes proposed in new cigarette policy
One of the major amendments is the increase in the legal smoking age from 18 years to 21 years. Penalty for selling tobacco products to persons under the legal smoking age is also being increased from two years imprisonment and Rs 1,000 to seven years' imprisonment and up to Rs 1 lakh fine.
The government has also sought to ban the sale of loose cigarettes. A provision in the draft reads that "trade and commerce in cigarette or any other tobacco product shall be in sealed, intact and original packing."
It is also proposed to do away with smoking rooms at airports, restaurants and hotels, in addition to a ban on smoking in public. Fine for smoking in public is proposed to be increased from Rs 200 to Rs 2,000.
Analysts express mixed opinions
Edelweiss Securities Ltd's analysts, in a report dated 4 January said, "Overall, if this draft becomes a law, the cigarette industry would face further headwinds: difficulty in adding newer consumers due to the increase in the minimum age to buy cigarettes and tobacco products, and impact on cigarette volumes due to sale of only sealed and intact packs."
The brokerage added that the sale of loose cigarettes is still widely prevalent in states where this regulation has come into effect. "Hence, in our view, it would be difficult to monitor and implement this law."
"On the other hand, illicit cigarettes and tobacco products, which were thriving due to heavy taxes on legal cigarettes, will take a hit due to stricter punishments proposed in this latest draft," Edelweiss Securities added.
Meanwhile, Centrum Equity Research believes that long-run companies will reinvent their products to comply with the law.
The brokerage has a "buy" rating on ITC Ltd with a target price of Rs 353, an upside of 74% from the current market price.
"So on the face of it, this news will have negative sentiments for the entire cigarette industry including major like ITC, Godfrey and VST. However, as done in the past, in the long run companies will try to reinvent its business offering adhering to guidelines in our view. We suspect if the draft paper becomes a law it would add further woes to the sector," it said.
The brokerage believes that ITC's renewed focus on maintaining cigarette market share, tailwinds for FMCG foods business, strong FCF, high dividend yield and compelling valuations make it more attractive for long term investors.
The stock has fallen 13% in the last one year but soared 21% in the last three months.
Key risks and opportunities
Apart from the amendments, any sharp increase in taxation could hurt ITC.
As for health ministry's amendments as per WHO's guidelines, the government has implemented various measures to cut tobacco consumption since 2003, with the enactment of COTPA (cigarettes and other tobacco product act).
Pictorial warnings, ban in public smoking, restricting entry of shops within 500mt radius of schools & colleges, were introduced, apart from the sharp increase in tax in the last five years that have made cigarettes expensive for the younger generation.
However, the increase in restrictions and taxes have resulted in the growth of illicit cigarettes sales, causing the government to lose tax revenue.
The GATS-2 survey conducted by WHO in 2017 revealed that the smoking population has come down, however, there was no significant change in overall tobacco consumption in the country.
"In these circumstances, we believe the intention of the govt. is driven by WHO guidelines, yet implementation and execution could be a big challenge. To illustrate, recently Maharashtra govt. (in its renewed focus) said to ban sale of loose cigarettes within the state, whilst on ground connect with channel partners suggest the local authorities still grappling to implement strictly. Further, the trade informed us that they have no mechanism to verify the legal age of its consumer, neither they are equipped with any such data, hence it may not control selling loose cigarettes in our view," says Centrum Equity Research.
As for the ban on loose cigarette sales, the industry is already experimenting by offering packs with 5 cigarettes in select geographies, and we may see more of that across India after the law is implemented.