Correction in ITC stock a good buying opportunity for investors

A sharp hike in tax on cigarettes could see post-Budget selling, but the company's long-term prospects are good and target prices suggest a significant upside

As the Budget approaches, investors start speculating on the likely changes in taxation and the ensuing impact on various sectors. ITC is always a subject of discussion since the fast moving consumer goods (FMCG) major’s key revenue centre is tobacco and that is a popular target for sin-taxes. 

 

The last three Budgets have not seen tax hikes, so the chances of the 2023-24 financial year (FY24) seeing a tax hike is quite significant. ITC could see growth in its other divisions, such as FMCG (ex-cigarettes) agro, paperboards, hotels, etc., but around 37 per cent of revenues, and a higher share of profits comes from cigarettes.

 

A factor to be considered is the smuggled component of the cigarette market. If ITC brands remain price-competitive, the company can hold to or gain market share. However, a big tax hike could lead to erosion of market share, given the easy availability of smuggled, tax-free, cigarettes in every price category. 

 

The share of legal cigarettes in total tobacco consumption has declined from 21 per cent in FY82 to around 10-11 per cent at present. Less than one-tenth of the tobacco consumed in the country consists of duty-paid cigarettes but that contributes over 80 per cent of the revenue generated from the tobacco sector.

 

According to one analysis, a tax hike beyond 12 per cent would have an adverse impact, with volumes shifting away from the legitimate market and perhaps, a cutback in consumption. History shows that during FY13 to FY17, duty on cigarettes increased sharply at a compound annual growth rate (CAGR) of 15.7 per cent but tax revenue from cigarettes grew at only 4.7 per cent CAGR. This sort of sensitivity analysis will have fairly high error values but that could go both ways. 
 

 

 

ITC's quarter 2 (Q2) FY23 sales and Ebitda (earnings before interest, tax, depreciation and amortisation) grew 27 per cent year-on-year (YoY) and Q3FY23 sales growth is expected to moderate to 7 per cent, while Ebitda growth could be 17 per cent YoY, given a stronger base. Margin expansion has been seen in Q2 and this could continue to some extent in the second half of FY23. 

 

The plus factors for the company include revival in cigarette demand as the economy pulls out of the pandemic, a marked improvement in the hotels sector (a classic unlock trade) where costs have been pared, revenues are rising, and lower input cost pressures versus the peers make ITC look attractive.

 

Rural recovery could drive both the cigarette business and its other FMCG lines (ex-cigarettes), given its excellent distribution network. The paper segment is also likely to see growth. 

 

The stock, though, is seeing some selling pressure. It’s up 48 per cent in the last 12 months but down by 4.7 per cent in the last month. It’s likely to see selling intensifying in the next fortnight as the Budget nears. If there is a tax hike on cigarettes, there will be post-Budget selling.

 

Given the long-term prospects, the excellent balance sheet, with high cash-flows and low debt, this is probably a buying opportunity. Target prices around Rs 400 suggest a significant upside.