VST Industries:

Founded in 1916 by Vazir Sultan, Vazir Sultan Tobacco (VST) Company Limited, is a manufacturer and distributor of cigarettes.

Today, albeit the name ‘VST’, the company is controlled by the British American Tobacco (BAT) group. Coincidentally, the BAT group also has interests in India’s largest cigarette maker, ITC Ltd.

VST is lesser known across western India due to its operations traditionally being limited to southern and eastern India. In recent times it has begun expanding into the central and northern reaches of the country.

VST’s key brands:

I believe that most of us would not be familiar with these brands barring the older generation who may have had exposure to the ‘Charminar’ brand introduced years ago. Unlike ITC’s Gold Flake and Godfrey Phillips’s Marlboro which have been highly visible to the modern consumer, the brands of VST seem to slip under the radar. While the two have been battling it out in the mid-price and high-price segments of cigarettes, VST has quietly entrenched itself in the lower end of the price spectrum and has now marked a cautious entry into the mid-price segment.

The strategic decision of limiting itself primarily to the lower end of the price spectrum has helped in avoiding head-to-head competition with the larger competitors like ITC (This could also be due to BAT’s interests in both companies). This non-confrontational approach has allowed VST to maintain healthy operational metrics.

We will now talk about the key influencing factors for the tobacco industry.

Tax Influences, Sin Goods, and Livelihoods:

It is my belief that the business interests of the three largest tobacco manufacturers in India: ITC, VST Industries, and Godfrey Phillips, are more likely to be aligned in the same direction. The Tobacco Industry is one of the most regulated (unfortunately, there are failings that I will talk about) and heavily taxed industries and is considered to be a ‘sin’ good due to its detrimental effect on not just the smoker’s health but also on the bystanders (passive smoking). However, it also happens to be one of the most profitable and cash rich industries and is a significant source of tax revenue stream for the government.

The taxes on cigarettes (barring Bidis, I was unable to ascertain whether they have been added into the 28% GST Slab or not) looks something like this,

Total Tax = 28% GST + GST Cess + NCCD (National Calamity Contingent Duty) + BED (Basic Excise Duty)

[Taxes may vary from State to State]

Roughly 10% of India’s tobacco consumption occurs in the form of legal cigarettes. This meagre 10% contributes roughly 80% to the total tax paid by the tobacco industry. In developed countries, over 90% of the tobacco consumption comes from the legal cigarettes industry.

Bidis and Chew Tobacco (gutka) are primarily manufactured in the unorganized sector and hence tax collection is a lot harder, tax evasion is rampant, and regulatory structure is weak. Due to legal cigarettes bearing a major brunt of the high taxes, the illicit cigarettes industry has been on a steady rise. Today, this illicit cigarette industry contributes to over 25% of the cigarette industry and has been growing steadily.

The Indian tobacco industry is quite labor intensive and employs over 45 million people (direct and indirect). Most of them find employment under tobacco farmers as farm workers in Andhra Pradesh and Karnataka who harvest tobacco and sell it to tobacco processing and manufacturing companies. Generally, the manufacturing companies have contracts with the tobacco farmers. Beyond the farming aspect (farmer & farm worker), the rest of the industry provides indirect employment in the form of factory workers and retailers/traders. The illicit tobacco trade has a profound negative impact on the farmers and farm workers who supply only to the legal industry. Retailers/Traders generally benefit either ways.

Taking all of these into consideration, to truly control smoking and it’s detrimental health effects, it is paramount to strike a balance between the livelihoods of 45 million people, higher tax regimes, and a clampdown/disincentivizing of the illicit tobacco trade.

Hence, keeping in mind both health and wealth, the shift from unregulated tobacco industry to a uniformly well-regulated industry would be beneficial for most parties involved.

Regulations:

The government has been contemplating on whether 100% FDI should be permitted in Tobacco Cultivation & Manufacturing of value-added tobacco products. An approval along these lines could bring in new foreign competition for the existing cigarette manufacturers, while benefitting tobacco farmers. However, these new entrants would only be allowed to operate in SEZs and will be prohibited from selling in the domestic market (only export allowance will be granted).

The COTPA was enacted in 2003 which prohibits advertisements and marketing of tobacco products in all mediums.

The ban on e-cigarettes and vaping devices has arrested the growth of the vaping industry. A ban on these devices will probably push nicotine users back towards traditional tobacco products.

Thus, it seems like the regulations are an attempt to establish an equilibrium and create a well-regulated industry.

Valuation:

Market Analysis:

Cigarettes are the most expensive way of consuming tobacco in India. On the surface, tobacco companies seem to be doing well, defying odds many a times.

However, these numbers do hide some realities. The volume growth in the industry has been poor and is in the lower single digits. The revenue growth seen is due to the ability of the cigarette companies to pass on higher prices to the consumer year after year. Any tax raise is met by hiking the prices of cigarettes which these companies have been able to pass to the end consumer.

I do feel a bit melancholic saying this, but such is the strength of ‘habit formation’ which is the key economic moat of the industry.

In the future, regulations and rising awareness of tobacco’s harmful effects could dampen sales. On the flip side, cigarettes constitute roughly 10-14% of the Indian tobacco industry, hence rising affluency could shift users of other tobacco forms to cigarettes. VST Industries could benefit from this upward shift due to it occupying the lower (entry) end of the cigarette price range.

Revenue:

Year 1-5: Revenue Growth at 10% annually

Year 6-10: Revenue Growth tapers down towards 2% (below the risk free rate of 3.30%)

Margins:

Margins will decline towards 28.67% by Year 10.

Tax Rate:            

Company has been paying a tax rate of roughly 24.8% in the latest 3 quarters. I expect the company to pay a marginal tax rate of 25.17% throughout the valuation.

Reinvestment:

The company’s Sales to Capital lies between the 75th and 80th percentile of comparables. I believe that this is sustainable and hence I use a Sales to Capital ratio of 2.15 throughout my valuation.

Cost of Capital:

The company has a bottom-up beta of 0.482. However, going forward, I believe that the company’s business will become riskier due to regulations and contingencies. The beta will move towards 1 by the Terminal Year. The company will continue to maintain a debt ratio of 0%. I believe that India will become less risky as a country and hence the ERP for India will reduce.  The increase in the beta far outweighs the lower ERP in the future, and hence, the cost of capital moves upwards.

Terminal Year:

As a conservative estimate, I have allowed the company to grow at a pace lower than that of the risk free rate. The company will grow at a rate of 2% in perpetuity whilst earning its cost of capital of 10.05%.

The required reinvestment rate for this scenario would be 19.90%.

Since VST is a ‘sin’ goods company it will attract greater scrutiny from society and the government.

Hence, a discount on the intrinsic value of INR 3728.88 may be necessary. Coincidentally, since my intrinsic value happens to be a strong resistance on the chart, instead of taking an arbitrary discount, I decided to use an unconventional way of trying to estimate one using chart reading.

This chart is from 2016 to mid November 2019. Source: ChartAlert – http://www.chartalert.com/

I make use of the concept of channels and supports. The thick red line shows my intrinsic value. Although the blue line (INR 2479.3) is an extremely strong support, it has wick formations (showing potential overreaction to an event) and hence I do not use it in this situation. The red dotted lines show moderately strong supports and consolidation occurring at these price levels (INR 2844.16 & INR 3127.12).

I will use these red dotted line levels to calculate a discount that the market may be applying.

We get a discount of 16.13% (% difference of 3728.88 and 3127.12) and 23.73% (% difference of 3728.88 and 2844.16) from my intrinsic value. Both these discounts seem reasonable.

Melded Intrinsic Value with discount factors applied (I have chosen these weightages as per my preference, there is no complex logic involved),

= 50% * (3728.88) + 25% * (3127.12) + 25% * (2844.16) = INR 3357.26

The melded intrinsic value for VST is INR 3357.26

Relative Valuation:

I ran a regression across EV/EBIDTA multiple for 21 Tobacco companies while adjusting for differences. The R squared is 82.05% (this high R squared could be due to the small data set).

Using the predicted EV/EBIDTA of 10.16 I get a value per share of INR 3077.23

Conclusion:

Today, VST Industries trades at INR 3621.75 which is slightly below my intrinsic value of INR 3728.88, but above the melded intrinsic value of INR 3357.26

Hence, on an intrinsic basis, VST Industries is fairly valued. However, the discounts applied could vary wildly based on your margin of safety requirements.

On the relative front, VST Industries seems to be overvalued by 17.69%.  

VST Industries is an incredibly strong company with excellent free cash flow generation ability. However, at the end of the day, it manufactures ‘sin’ goods and hence may face increasing scrutiny in the coming years!

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