Earlier this week, the Union health minister of India, Harsh Vardhan, indicated that he is likely to increase taxes on branded cigarettes across all cigarette lengths, and perhaps include unbranded cigarettes as well. If this move comes through in the Indian government's annual budget being announced on July 10, we do not anticipate a large negative impact on ITC Limited, the market leader of branded cigarettes in India. This is primarily for two reasons.
First, while volume growth of cigarettes sold may witness slight downward pressure, as has been the case over the past few years, we anticipate the overall growth in revenue will still be positive because of the ability of the manufacturer to pass on the tax hike to its consumers. As last year's experience suggests, the 19% increase in cigarette taxes did not deter ITC from increasing gross sales of cigarettes by 12% over fiscal 2014 (although slower than 17% seen in the prior year).
Second, we anticipate the differential taxation across various lengths of cigarettes produced in India will continue to allow manufacturers some flexibility in products they wish to push. As such, the taxes paid on gross sales for ITC have remained at the 44%-46% level in the past three years and may not change drastically going forward. In fact, overall cigarette margins have actually expanded for ITC, as has been the case in European and U.S. markets, where despite declining consumption trends, tobacco firms continue to be hugely profitable.
We believe the recent sell-off in tobacco manufacturers in India has left the ITC stock trading at an attractive price with price/2015 earnings of 25 times, enterprise value/EBITDA of 17 times, and a free cash flow yield of 3%. We believe this is an intriguing entry point for investors to put money into India's largest tobacco company, which generates free cash flow/sales of over 15%, and pays out 50% or more of earnings as dividends to shareholders each year.
To read our investment thesis on the stock, click here for a detailed analysis.
