Overview of the Cigarette Industry in India
This analysis of the Cigarette Industry in India is written with a limited aim of giving a brief overview of the factors affecting the Indian cigarette consumption from an equity valuation perspective.
When I was valuing VST Industries (a manufacturer of “value” Cigarettes), in order to project revenue growth I wanted an understanding of the drivers affecting Indian Cigarette consumption but could not find any comprehensive article or report.
Thus, I read equity research reports, filings of listed companies, WHO reports, several studies analyzing tobacco usage in India, etc and thereafter have attempted to present the relevant information in a coherent and succinct manner.
The article is by no means comprehensive and a Cigarette industry insider can accuse me of being “Captain Obvious”.
However, having come across many ITC/VST investors who have limited knowledge of the Cigarette Industry (as I did prior to commencing my research), it is my sincere hope that this article can increase their knowledge to at least a certain basic level in the shortest time possible.
Key factors to consider while evaluating Cigarette consumption in India:
1. Overall Tobacco usage in India is 28%, but Cigarettes are only 4%
As per the WHO, only around 11% of the Indian population use smoking tobacco (comprising of Cigarettes and Bidis) as compared to 25.2% in China, 28.7% in Europe, 21.9% in the US, etc.
However, can this fact be extrapolated to assume that the Indian Cigarette market has huge growth potential? Not by a long shot. This is because not only does the Indian consumer has several options to get his/her tobacco fix but also these alternate options are substantially cheaper than Cigarettes.
a) Type of Tobacco Use
Usage patterns of tobacco in India has been well documented by the Global Adult Tobacco Survey-2 (GAT-2) – a survey of 74,037 individuals (15 years & above) conducted across India by the Tata Institute of Social Sciences on behalf of the Ministry of Health, Govt of India.
The first round of GATS-1 was conducted in 2009-10 and the second round was conducted in 2016-2017.
As per GATS-2, 28.6% (266.8 million) of adults in India (aged 15 and above) currently use tobacco in some form. The use pattern of tobacco is as follows:
There are a few major insights from the GAT-2 data:
* Overall tobacco use in India is higher in India at 28.6% of the population as opposed to the global average of 20.7%
* However, tobacco usage in India is very different from other parts of the world. As per the WHO Report of Trends in Tobacco Smoking, Smoking tobacco accounts for 81% of the tobacco usage in Africa, 86% in Americas, 88% in Eastern Mediterranean, 99% in Western Europe, etc whereas in India, as can be calculated from the above chart, smoking tobacco for only around 37% in India
* Even within smoking tobacco, bidis are twice as popular as Cigarettes. Cigarettes are only 14% of the total tobacco consumption
One can argue that the aforementioned insights from GATS-2 are based on survey data and not actual market data.
However, given the huge difference between smokeless and smoking tobacco (and within smoking tobacco the huge difference between bidis and cigarettes), the general trend cannot be wrong.
b) Trends in the use of Smokeless tobacco & Smoking tobacco from 1987 until 2016
A study by Rizwan Suliankatchi Abdulkader et al analyzed data from nine cross-sectional surveys conducted between 1987 and 2016 to understand trends in tobacco consumption and also the impact of the WHO Framework Convention on Tobacco Control (FCTC).
The results are depicted in the chart below:
As per the study, between 1987 and 2016 smoked tobacco use showed a steeper decline compared to SLT use.
There has been a radical switch in the predominant type of tobacco product used after 1995, with chewers outnumbering the smokers.
After the implementation of FCTC provisions, all forms of tobacco use declined and India is on track to achieve the global tobacco control target by 2025 but with the constituent state at varying levels of achievement.
Thus, an assumption that the Indian cigarette industry has a long growth ahead, simply because of the lower percentage use of Cigarettes compared to other countries, cannot be sustained.
2. Other Tobacco products are a lot cheaper than Cigarettes
As per a study by Mark Goodchild et al, Cigarettes are around 3.5x price of bidis and around 11-12x price of Chewing Tobacco.
The vast difference in price is one of the main reasons why other tobacco options are more popular in India. The study calculated the nominal and real prices of tobacco products over the years:
a) Nominal Prices of Tobacco Products
This table shows the prices for tobacco products for a standard pack size in the Indian market: 25 bidis/packet, 10g of chewing tobacco, and 10 cigarettes/packet.
The above table clearly shows how expensive Cigarettes are compared to other Tobacco products despite the fact that the prices used for Cigarettes in the above table are for the cheaper variety.
Because of the sheer price difference between the tobacco products, switching to Cigarettes from Chewing Tobacco or Bid involves a huge monetary impact, and thus it’s not easy for a Cigarette company to “up-sell” and convert a bidi/tobacco user.
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The data also shows that over the course of the past 10 years, the prices have increased 11-12% on a yearly CAGR basis across all Tobacco categories. The benefit of increased prices is shared by the Government (in the form of increasing indirect tax revenue) and the Tobacco Companies.
b) REAL prices of Tobacco Products
The table above gives the same data as that in the previous table but in “real prices” (i.e. inflation-adjusted). This shows that even after adjusting for inflation, tobacco prices have increased between 4-5% on a yearly CAGR basis across all Tobacco categories.
c) Prices of Tobacco Products in terms of Tobacco content
One can argue that the tobacco content in these products is different and thus comparing cigarettes, bidis, and chewing tobacco is not correct.
This is because one bidi typically contains 0.33g of tobacco, one cigarette (of size <69mm) contains 0.65g of tobacco, and a 10g pouch of chewing tobacco contains 3.5g of tobacco.
If we were to adjust for the tobacco content and calculate the prices on a per 1000g of tobacco content, the conclusions remain the same in the case of bidis: Cigarettes are around 4.5x price of bidis.
In the case of chewing tobacco cigarettes will 5.5x the price of chewing tobacco (as compared to 11x on a non-adjusted basis).
All said and done, even after adjusting for tobacco content Cigarettes still are around 4.5x-5.5x the price of other tobacco options. One can also argue that the refinement of a Cigarette cannot be compared to a bidi (or the social nuisance of chewing tobacco) just the way you cannot compare a country liquor with a single malt whisky (even after adjusting for alcohol content).
This is a fair point.
However, the idea in this point and in the previous point no.1 is to show that the Indian consumer has several tobacco products (available at a variety of price points) to choose from and such variety in tobacco products is not so prevalent in most of the other countries and thereby projecting growth rates in cigarettes based on other countries and/or assuming that Cigarette companies can easily “up-sell” their Cigarettes is seriously flawed.
3. Can cigarettes be taxed higher?
Before this question can be answered, the following questions must be considered:
a) How much have Cigarette prices increased over the years?
The data presented in the above point already tells us that Real Cigarette prices (i.e. inflation-adjusted prices) have increased around 4.7% on a yearly CAGR basis from 2008 to 2018.
A study by G. Emmanuel Guindon et al examines the data from 2000 until 2018. Even this study tells us that cigarette and bidi real prices increased by about 3% and 3.70% respectively on a yearly CAGR basis from 2000 to 2018.
TII, the mouthpiece of the Indian Cigarette industry, informs us that the Affordability of Cigarettes (defined as the % of GDP/Capita required to purchase 2000 cigarettes of the most sold brand) is 13.49% in India compared to only 1% – 3% in Japan, US, Germany, China, Thailand, Australia, Pakistan (yes, Pakistan!), the UK, etc.
Thus, as per the TII, cigarettes in India are not so affordable when compared to other countries.
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When the above factors are looked into isolation then it appears that there could be a chance that the Government will reduce taxes.
However, the TII shows the affordability of Cigarettes on GDP/capita basis ONLY for the year 2018.
It does not show how this data has changed over the years. The following graphs, taken from the aforesaid Study by G. Emmanuel Guindon et al, plots the “real” prices of Cigarettes and Bidis and the “real” GDP/capita from 2000 to 2018:
The first graph shows that while real prices of cigarettes and bidis increased 3% and 3.70% respectively (on a yearly CAGR basis), GDP/capita increased much faster.
That means cigarettes and bidis take a smaller portion of our wallet now as compared to what they did in the year 2000.
The second graph clearly illustrates that cigarettes have actually become CHEAPER by 20% (and bidis by 30%) when compared to that in the year 2000!
b) What are the tax rates on Cigarettes in other countries?
The graph below made from WHO Report on Global Tobacco Epidemic 2019 shows total taxes on the most popular brand of Cigarettes for the year 2018. India has a tax rate of 56% for the year of 2018.
While there has been a further increase in taxes in India after 2018, it is still below that of many countries as depicted in the graph.
WHO recommends that the taxes should be at least 70% of the retail price. However, despite their inclusion in the GST demerit list of highest tax slab and even after accounting for the recent increases, taxes on tobacco products are still below the WHO recommendation.
Now, when the information presented in 3a and 3b are looked together, it is rather unlikely that taxes on a cigarette will reduce. On the contrary, there is every chance that it may increase further.
Unlike most investors, I hope that now, with this background in mind, you will not be surprised if & when the Government increases its taxes on Tobacco.
4. Tobacco use has been declining in India
a) The study referred to in Point 2b notes that over the past three decades, the prevalence of smoking has declined steeply and consistently. Smokeless Tobacco, after seeing an initial rise, has also declined but by a lesser magnitude.
Post-FCTC, the prevalence of all forms of tobacco use declined, setting India on track to achieve the global tobacco target of 30% reduction before 2025.
*The GATS-2 survey (conducted in 2016-17) shows a decline in tobacco use as compared to that prevalent during the GATS-1 survey (during 2009-10):
b) Furthermore, under the National Health Policy 2017, the Indian Government has set a target for a reduction of 30% (from 2010 levels) by the year 2025. Thus, it is highly unlikely that there will be relaxation in Government policies towards tobacco.
The aforesaid points talk about a percentage decrease in the number of tobacco users. However, it can be argued that the absolute volume of tobacco can still grow if the population growth outpaces the decline in the percentage of users.
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However, if the Government achieves its aggressive target then this will not be the case.
In regards to Cigarettes, it also can be argued that as the Indian population ages more and since older smokers consume more cigarettes per day than younger ones (as noted in the GATS-2 survey), the volume of cigarettes will increase.
While this argument is within the realm of possibility, such an increase has not happened in developed countries with older populations.
c) MARKET DATA: The combined Cigarette volumes of ITC Ltd (the largest cigarette manufacturer in India) and that of VST Industries Ltd (a manufacturer of “value” cigarettes) have not grown in the past decade. As per various equity research reports published by ICICI Direct and HDFC Securities, the volumes have marginally declined as can be seen below:
Note that the volume numbers in the chart above are approximate and had to be (rather frustratingly) compiled from various Equity Research reports as the companies (very conveniently) have stopped providing them. They may not extremely accurate but at the same time the general trend is unlikely to be incorrect
5. Price elasticity of Cigarettes
A research paper by Mark Goodchild et al gives a summary of the price elasticity of Cigarettes.
As per this paper: International evidence suggests that the price elasticity of demand for cigarettes in developing countries ranges between −0.2 and −0.8. The range of estimates for India is similar to ﬁnding an elasticity of −0.24 for cigarettes and ﬁnding elasticities of more than −0.5 for cigarettes and bidis.
A study, using India’s National Sample Survey (NSS), calculated a price elasticity of −0.34 for cigarettes. As per the above studies, a 1% increase in price can reduce demand between 0.24% to 0.5%
* E-Cigarettes had the potential to further reduce the Cigarette consumption especially in the higher end of the Cigarette market. However, in September 2019, the Government banned the import, manufacture, sale, advertisement, storage, and distribution of e-cigarettes in order “to ensure that e-cigarettes do not become an ‘epidemic’ among children and young adults” and thereby dashed the hopes of the likes of Juul and other US vendors.
Left unsaid is the fact that the Government also would not want to lose its lucrative tax revenue from Cigarettes and jeopardize the interests of the tobacco farmers.
Until the Government finds an effective way to tax e-cigarettes, it is likely that the ban will remain and by that time one can assume that the Indian Cigarette manufacturers will have a good vaping product of their own.
* Another point to consider is the “alleged” growing share of illegal cigarettes in India.
This point is routinely cited by TII and is also stated in Annual Reports and other filings. Investors sometimes provide this reasoning that if the illegal trade is controlled then the sale of legal cigarettes will increase.
When you look at the graph in the link above, you will see that illegal cigarettes have “purportedly” increased from 11.1 billion sticks in 2004 to 26.5 billion sticks in 2018. Now, if we take this data at face value, then the Cigarette industry with all its huge cash reserves and the Government with its interest to protect tax revenue have not been able to do anything about this “allegedly” huge illegal trade in 14 years then why should one assume that things will change anytime soon.
Moreover, take this argument of the Cigarette Industry with a pinch of salt as it is presented with a view to seeking lower taxes from the Government. Thus don’t build any great expectations of any gains on account of the conversion of illegal cigarettes into legal ones and instead, if & when it actually happens, take it as a positive surprise.
Based on the above, as of today, it is my view that the revenue growth in Cigarettes is very unlikely to come from any significant volume growth, and instead, the companies will have to primarily rely upon price increases for increasing revenue.
Price increases, as we have seen, can increase revenue but only up to a certain point as beyond that, the consumption will fall.
Furthermore, price increases have to be shared with the Government in the form of GST and cesses. Hence, one must extremely wary of making any strong revenue growth projections for Indian Cigarette companies. Is strong volume growth possible?
Sure, but the question to ask is how likely is it? It is my view that investing is a game of probabilities and therefore less likely outcomes should not be modeled while projecting revenues and instead should be left as positive surprises.
Needless to say that if the underlying factors change then my view will (and should!) change.
The sources of information are linked and referenced in this article so that you can form your own independent view.
Cover Image: Fortune