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ITC insights - Do regulations strengthen the cigarette business moat?

By now you've probably heard a fair bit about the non-cigarette FMCG business of ITC. We've covered it in a fair amount of detail on our Twitter thread here, and also covered how the firm is using a cash cow to grow a star here.

But cigarettes still remain the bread and butter of the company for now, driving more than 80% of the firm's operating income. So it is important to know how this segment will do. Clearly neither regulators nor the government are fans of the sector, trying to get people kick the habit using a combination of price hikes, gruesome graphics, and advertisement bans. But do these clear negatives strengthen the moats of the market leading firms?

Tobacco is an extremely attractive business to be in, generating a ROCE in excess of 30% for decades at end now. Every year the government raises some or the other cess on the space, cigarette firms pass that on to the customer, and things on with very limited disruption in volumes. Addiction may not be great for the end user, but its a phenomenal driver of steady demand. The average cigarette smoker spent close to 1200 INR/month on cigarettes in FY17, up from 670 INR less than a decade ago.

But one would assume that the high ROCEs would attract competition to the space that would eventually reduce the returns to a more normal level. This is what generally happens in most sectors in the lack of a strong moat. Not for cigarettes though. Legendary investor Terry Smith of FundSmith fame provides some interesting insight on why this might be.

First the regular increasing cess and government animosity keeps most new entrants out. One would not typically want to be in a space that the government actively wants to see shrink. If some brave soul does decide to enter, it is a very uphill journey - here too supported by regulations.

Cigarette packaging now requires 85% of the surface to be covered with gruesome warnings. Advertisements have been banned by a 2003 ruling, except (wait for it) on packaging - not a lot of space for that on the pack with 85% covered, and most people in India buying individual cigarettes, and at point of sales (where most incumbents have already put up there shop linked boards). Not a very attractive position to be in if you're entering the space as an entrant.

With neither of these likely to reverse anytime soon, one can be fairly certain, and thankful, for the durability of these government provided moats.

We cover the market leader in cigarettes, ITC, in quite a lot of detail under GSN Invest++. Do subscribe to read more on the moats, drivers, and financial metrics of the firm.


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