ITC stock puffed up over stable tax regime, steady volume recovery

Better capital allocation and valuation make it a preferred choice amid a volatile environment

ITC, the country’s largest cigarette maker, has been a major outperformer since March on the returns front, besting its peer index BSE Fast Moving Cons­umer Goods and the benchmark Sensex.

While the consumer major delivered returns of 36 per cent, its peer index trail­ed with 16 per cent gains; the Sensex pos­ted losses of 4.4 per cent during the period under review. These gains were led by smart recovery across its key verticals over the past couple of quarters, an improved outlook for cigarettes — which remains the cash cow — and easing concerns related to the environmental, social and corporate governance or ESG framework.

The key investment argument for the company is its steady volumes and improving prospects for its      cigarettes business, which is its mainstay, accounting for over 81 per cent of the segment level operating profit. Analysts led by Abneesh Roy of Edelweiss Research say: “In FY23, we expect legal cigarette players to gain market share from illegal players (almost one–fourths of the market), given no tax hike for a second consecutive year. Also, relatively, cigarettes are affordable as most other forms of consumption have seen an inflation of 10–20 per cent.”

After a subdued showing over the past two years, volumes rebounded in the second half of FY22, surpassing pre-Covid levels. The company posted 9 per cent volume growth in the March quarter and analysts estimate this to be in the 11-28 per cent range in the June quarter. No change in taxes for the second consecutive year (or a stable tax regime) has given the market leader flexibility to calibrate price increases without disrupting demand. The Street will keep an eye out for tax changes in the Budget next year and a status quo should help ITC improve its volumes and earnings over the near to medium term.

The fast-moving consumer goods segment has been expanding its reach, with market and outlet reach up 1.1-1.4 times as compared to a year ago. The company which owns a slew of brands, including Aashirvaad, Sunfeast, Bingo!, and B Natural, has a presence across 7 million retail outlets and now reaches over 200 million households. The company launched 110 new products across categories last year.
 

Analysts led by Krishnan Sambamoorthy at Motilal Oswal Research say: “The breadth of ITC’s FMCG product portfolio gives it an advantage in a rapidly changing demand environment. Its leadership position in some categories gives it pricing power to offset incremental input cost pressure in other categories, where pricing power is not as strong.” Despite inflationary headwinds in FY22, the company managed to sustain margins at 9.1 per cent with sales and operating profit growing 9-10 per cent each. Falling raw material prices would boost margins in the segment. A trigger for the company is the production-linked incentive scheme, which could drive exports of the company’s products across multiple categories of biscuits and cakes, snacks, dairy, and ready-to-eat items.

While the hotel business was among the worst affected over the past couple of years, it bounced back towards the end of Q4 with occupancies higher than the pre-Covid period. Average room rates have improved over last year but are still below the pre-pandemic levels. Barring its hotel venture in Sri Lanka, which is impacted by the economic crisis, the recovery in leisure travel, foreign tourist arrivals, and business travel augur well for the company, which has 113 hotels and 10,700 rooms. The company added 9 new properties to the portfolio last year and will hope to improve its profitability, which stood at 6 per cent in FY22.

Improvement in capital allocation is cited as one of the investment arguments. Analysts led by Percy Panthaki of IIFL Research highlight that capital expenditure (capex) in the FMCG and hotel verticals was considerably lower than the past five-year average, resulting in overall capex at 3.5 per cent of sales -- the lowest in the past several years. While free-cash-flow generation at 88 per cent is also higher than the past five-year average of 82 per cent, return ratios have improved, aided by a stable margin and higher asset turns. This helped the company maintain a dividend payout above 90 per cent for the second consecutive year, they add. Given the dividend yield in mid-single digits, it is a good defensive play in the current volatile environment with macro headwinds, point out brokerages.

Undemanding valuations, too, are expected to support the stock. While valuations of global tobacco peers have been restored to their pre-pandemic levels (Jan­uary 2019), ITC still trades at a 24 per cent discount to its January 2019 valuation of 25.4 times one-year forward earnings per share estimates, according to Motilal Oswal Research. The brokerage believes the stock should trade at a 65 per cent premium to the global peer average, given its strong visibility over the medium term and the defensive nature of the business.