“I’ll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It’s addictive. And there’s fantastic brand loyalty.”
— Warren Buffett, ‘Barbarians at the Gate’ on RJR Nabisco

Cigarette company discussions often start and end on moral stands that investors take about tobacco usage. While we will leave the individual preferences to the respective investors to evaluate and act upon, we will discuss a bit about ITC which commands over 75% share in the legal Indian cigarette industry.

Cigarette businesses comes with investment characteristics that are highly desirable (leaving aside the moral question of public good or increasing the value of the ecosystem they operate in)

  •  Cost a penny and can be sold for a dollar
  • Great brand loyalty
  • Government restrictions on ads and regulations means it is legally very tough to take market share away from incumbent players
  • India still does not suffer from the punitive legal hurdles present in the western world

ITC however has been going through a different challenge. Over 85% of Indian tobacco consumption is not legal or not subject to regulation. This has meant that companies like ITC bear the burnt of the high excise taxes which are increasing every year and VAT as well. Smaller companies that operate outside the legal boundaries have a huge cost advantage over the ITC’s of the world. If the government does get serious about tobacco usage and curbs the usage of illegal tobacco, it might actually strengthen ITC’s business model. Though, the chances are slim and might take a few years at least.

Currently, ITC is suffering a huge volume decline on the back of the big tax hike in the last few years. The volume decline has accelerated in the last two quarters. There is a possibility that the demand is not as inelastic as we believe it to be.

2014 2015
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
-2% -4% -2% -3% -3% -4% -13% -13%

In the backdrop of this, the already weak shares of ITC might see further weakness of the next few quarters. While we are not predicting the short term stock movements, as long term holders, we are hoping for a sale in ITC stock.

There are two catalysts that we see in the long run

  •  The sustainability of the cigarette over the longer period of time and its robustness. You cannot kill this business model except by banning cigarettes in India.
  • The cash engine ten years from now will be from FMCG along with Cigarettes that will ensure that the sustainability of the model will continue for the future. This change while tough to evaluate from a cash flow perspective is rather easy to evaluate from a predictability perspective.

You have a good cash cow, a new growth engine (yet to see cash flows though), a terrific management and a solid business model with a fair amount of predictability. For a long term investor, who does not care about short term weakness, price declines and can be  contrarian, some pain might be in order but definitely commands a look.

Disclosure: Long ITC