Government's focus on cutting down smoking has meant continuous fall in ITC's performance

While the Budget has typically been negative for cigarette major ITC given the government's intention to curb tobacco consumption by raising excise duty, this year's Budget will be the most impactful so far.

The stock has fallen by 13% in two trading sessions following the Budget announcement to increase excise duty on cigarettes by 15-25% — the fall is the sharpest in two decades. The excise duty on cigarettes has been increased by at least 15% for the fourth consecutive year.

It highlights the government's focus on cutting down smoking — even if it means lesser tax revenue due to drop in cigarette volumes. There has also been a change in the classification of cigarettes and tobacco products. For the first time in a Budget speech, the excise duty changes for cigarettes and tobacco products were shown under the sub-theme of promoting public health. The strategy seems to be working if one looks at the eroding sales volume of cigarettes.
This has also challenged the concept of inelasticity of smokers' demand. During the nine months ended December 2014, ITC's revenue from cigarettes rose 10.6% year on year, indicating a drop in volumes as the company passed on the tax burden to smokers.

As tax increases, ITC will have to either take a hit on profitability if it absorbs the higher tax incidence or forgo volumes if it passes on the tax burden to smokers. This has made analysts cautious about the company’s future prospects. ITC's loss on the bourses means HUL's gain.

In the past six months, while the HUL stock has gained 24.5%, ITC's has dropped 2.4%. Until its FMCG business gains traction, the subdued prospects of ITC's cigarettes business would keep the sentiment on the stock dull. This would further consolidate the position of the consumer goods sector bellwether HUL as the proxy for retail consumption in the broader market indices.

However, ITC cannot afford to let its cash cow business suffer since it earns over 80% of its profit and provides funding for the expansion of its non-tobacco segments. Emulating the global trend, ITC may have to consider increasing focus on tobacco-free nicotine products such as e-cigarettes and nicotine-based chewing gum to reduce the regulatory risk on its main business and to attract new health-conscious consumers.