Up in smoke? Tobacco stocks struggle as costs rise, tax jitters grow

“Tobacco prices have gone up 20% in the last seven months and competition has intensified in the industry lately. So, cigarette prices won’t rise drastically either and margins will remain subdued in Q4 (for ITC),” said Devarsh Vakil, head of prime research at HDFC Securities.

ITC, India’s largest cigarette maker, reported a 211 basis-point year-on-year decline in its cigarette Ebitda margin in the December quarter (Q3FY25), largely due to a 25-30% increase in tobacco leaf prices. 

Read this | Company Outsider: ITC’s pivot to FMCG giant has been a strategic tour de force

Since the company has already addressed most pricing and portfolio gaps through new product launches, there is little room for further margin expansion, according to an HDFC Securities report.

Not surprisingly, as broader market sentiment sours, tobacco stocks have taken a harsher beating than the fast-moving consumer goods (FMCG) sector, which has been grappling with demand and profitability pressures for the past three quarters (see charts).

Volume gains amid margin pressure

But even as profitability remains under stress, cigarette makers have sustained volume growth over the past few quarters, clawing back market share from the illicit segment. Contraband cigarettes—including smuggled imports and tax-evading domestic production—account for nearly 25% of India’s tobacco market, a Nuvama Institutional Equities report said.

A combination of stable taxation, enforcement actions against illegal trade, and a shift toward premium products has helped the legal cigarette market regain lost ground, according to a recent ICICI Securities report.

In fact, in the December quarter, both ITC and Godfrey Phillips surpassed market expectations on volume growth. 

ITC’s gross cigarette sales rose 8% year-on-year to ₹8,940 crore, while Godfrey Phillips, a pure-play tobacco major, posted a sharp 27% year-on-year increase in core revenue, reaching ₹1,896 crore. 

Marlboro has gained strong traction among younger smokers, and as a result, Godfrey Phillips likely captured market share from ITC and VST in the third quarter, HDFC Securities’ Vakil noted. “They (Godfrey) have marketed themselves better as a premium brand compared to ITC amid the ongoing trend of premiumisation.”

According to a recent Centrum Broking report, Marlboro has emerged as a significant competitor in the above- ₹10 price segment, which now accounts for approximately 40-45% of cigarette sales. This has allowed Godfrey Phillips to buck the industry-wide trend of margin contraction, with its operating profit margin improving by 440 basis points year-on-year to 22.6% in the December quarter.

Tax uncertainty clouds outlook

However, despite stable sales and premiumisation trends, speculation that the government may raise goods and services tax (GST) on cigarettes to 43% has rattled investors.

Read this | Seeking value in ITC and Godfrey Phillips? Tobacco stocks gain momentum in FMCG play

A steeper tax burden could once again drive consumers toward illicit cigarettes, reversing the volume recovery seen in recent quarters and further pressuring already shrinking profit margins.

But the market may be getting ahead of itself.

Any potential tax action is likely at least a year away, when the compensation cess ends in 2026. And if the overall effective tax burden remains unchanged after a GST hike and the cess phase-out, all that smoke might be just hot air.

At present, cigarettes are taxed at 28% GST, along with excise duty, the national calamity contingent duty (NCCD), and a compensation cess, bringing the total effective tax rate to around 53%. 

If the levy on cigarettes under excise law remains unchanged, an increase in GST to 40% would not significantly impact the industry, said Neha Shrivastava, associate partner of indirect tax at Forvis Mazars. However, if excise duties are also raised, companies could face pressure on both demand and margins, she added.

Given that the compensation cess, a substantial component of cigarette taxes, is scheduled to end next year, the government plans to increase GST to maintain its revenue stream.

“This will ensure that the government does not lose a significant revenue source especially when it has announced tax sops for the middle class in the Budget that will likely hit its coffers,” Shrivastava noted.

In fiscal year 2023, taxes from tobacco and tobacco products accounted for approximately 2.39% of the government’s gross tax receipts. The latest budget introduced no cigarette tax hikes, and last year’s NCCD increase was minimal, providing a period of relative stability for the industry.

For now, the tax landscape remains unchanged, and the industry’s recent gains are intact. However, sustained input cost inflation could keep margins under pressure in Q4FY25, limiting pricing power in the near term.

Also read | Q3 earnings: Profit growth holds, but cracks are showing

“Tobacco companies will only be able to raise prices gradually over a course of three to six months after the hike. But their volume troubles will be more immediate,” Vakil noted.