Why Analysts See ITC Living Up To Their Optimism, Finally

Cigarette-to-staples maker ITC Ltd. has been one of the worst performers among peers in the past one year. That’s despite highest consensus rating and the biggest upside potential in the Nifty FMCG Index, according to estimates tracked by Bloomberg. ITC underperformed after increase in taxes on cigarettes and a decline in consumer demand as India’s economy slowed down to worst pace in more than a decade.

Yet, India’s second-largest consumer goods maker has been able to maintain margins by cutting costs and is expected manage increase in levies better than other cigarette makers, brokerages said.

The government increased taxes on cigarettes in the previous two budgets. It imposed a National Calamity Contingent Duty of Rs 5 per 1,000 cigarette sticks in July 2019; and raised the overall excise duty to Rs 200-250 for every 1,000 sticks without filter and Rs 440-735 on cigarettes with filter, depending on the length, in February.

The tobacco business contributes 40 percent to the overall revenue of the maker of Gold Flake cigarettes.

According to a note by Investec, the recent hike in excise duty on cigarettes is comparatively lower at higher price points and more on shorter filter lengths. That impacts ITC’s competitors VST Industries Ltd. and Godfrey Phillips Ltd. more, the brokerage said retaining its ‘Buy’ rating on the company. “ITC could exploit the new structure to be more competitive.”

Non-Cigarette Cheer

ITC’s non-cigarette consumer goods business, including food and personal care, has also slowed over the last three quarters due to weak consumer sentiment in a slow economy. This segment, accounting for nearly 24 percent of the company’s gross revenues, grew 4.6 percent in nine months ended December.

But the segment’s operating margin rose to 6.8 percent in the first nine months of the 2019-20 compared with 5 percent a year ago, according to ICICI Direct. The company expects the margin to move into double digits by the end of the next fiscal.

While ITC doesn’t disclose Ebitda margin, the company’s Ebit margin has improve in the first nine months of the fiscal.

Moreover, its agriculture, hotels and paper businesses—which contribute nearly 36 percent to revenues—have been either steady or grown at a faster pace, the brokerage said. That has led to more room for upside at current valuations, said ICICI Direct which has a ‘Buy’ on the stock.

According to Anand Rathi, ITC continues to mitigate the impact of the slowdown by enhancing distribution and reaching retailers directly. The brokerage said the company is also introducing targeted offers for -seeking consumers, investing in fast-growing channels and extending credit judiciously to select trade partners.

Cheap Valuations

Shares of the cigarettes-to-hospitality conglomerate trade at 13 times its estimated earnings for FY20, according to Bloomberg data. That’s a 10-year low and a steep discount to peers.

Axis Capital said the valuations for ITC remain inexpensive as all the bad news has been priced in at this point. Investec also cited low valuations at a reason to retain its ‘Buy’ rating on the stock.

Key Risks

Still, taxes remain an overhang for ITC.

If the government is unable to meet its revenue targets through taxation, it may need to continue to lean on taxing “sin goods”, G Chokalingam, founder of research firm Equinomics, said in a note.

Any potential hike in taxes will hurt ITC’s volumes, said Emkay Global. “Given reduced affordability and demand slowdown, it could impact cigarette volume and profitability,” the brokerage said in a report. The impact could be higher for key brands moving out of popular price points, it said.

Rivals are also increasing capacity and JPMorgan sees that a challenge. VST Industries Ltd.—maker of Charminar cigarettes—is ramping up its 69-millimetre business, while Four Square-maker Godfrey Phillips India Ltd. is scaling up presence in the sub 64-mm segment.

And then there’s the big problem of counterfeiting. Illegal cigarette trade comprising international smuggled and locally manufactured tax-evaded cigarettes accounts for a fourth of the industry, according to the Tobacco Institute of India, and causes an estimated revenue loss of Rs 13,000 crore a year to the government.