Concerns overdone for ITC

Last Updated: Wed, Sep 12, 2012 04:40 hrs

Among the two fast-moving consumer goods (FMCG) heavyweights, ITC Ltd has underperformed Hindustan Unilever Ltd (HUL) over the last one year on bourses, gaining only 35 per cent. Concerns over a steep hike in taxes imposed on cigarettes and the likelihood of plain packaging norms getting implemented in India (thereby impacting cigarette volume and hence growth rates), have restricted ITC's stock performance in the current quarter. Against 18 per cent gains for HUL and seven per cent for BSE FMCG Index, ITC is up only two per cent.

But, the higher valuation of HUL (31 times FY14 estimated earnings) after a stupendous jump of 60 per cent in its share price in one year makes ITC's stock at 24 times attractive, say analysts. Analysts also say ITC's cigarette business has been relatively inelastic in the past and the fast growing non-cigarette FMCG business is expected to breakeven soon.

Some analysts also believe the recent concerns regarding packaging norms are not likely to materialise and issues pertaining to hike in value-added tax rates (VAT) will get sorted once goods and services tax (GST) is implemented. Though ITC's hotels business is impacted due to domestic issues, it is relatively very small in size (about three per cent of revenues and profits). For the remaining businesses (paper and agri), profit growth and return ratios have been good. In this backdrop, the risk-reward equation is favourable for the ITC stock.

Resilient growth
In the past, ITC's volumes have been affected (read flat to marginal decline) when it has taken steep price hikes to pass on increases in taxes. The company, however, has maintained earnings before interest and tax (Ebit) margin in a range of 26-31 per cent in last five years. "ITC's cigarette Ebit growth annually has been exceptionally stable in a tight band of 15-20 per cent over FY03-12, with the exception of FY04," note Arnab Mitra and Akshay Saxena, Credit Suisse analysts, in their report last month. This trend is likely to sustain even in FY13, believe analysts.

Despite a 20 per cent hike in excise duty in the Union Budget 2012-13 and sharp VAT increases by various state governments, cigarette volumes were largely flat (but in the positive territory) in the June quarter, while Ebit margins improved over 140 basis points. Credit Suisse analysts say: "The near-absolute pricing power of ITC in cigarettes enables it to pass on price hikes without a risk of market share loss. We expect stability in cigarette Ebit growth to continue and drive consistent earnings growth for ITC." Another analyst at a domestic brokerage says: "ITC is better-placed because of the nature of its business since 80 per cent of profitability comes from cigarettes where ITC has 75-80 per cent market share. However, other FMCG players get impacted if competition becomes aggressive."

In Rs crore FY12 FY13E FY14E
Net sales 25,174.0 29,702.0 34,356.0
% change y-o-y 17.3 18.0 15.7
Operating profit 8,849.0 10,398.0 12,199.0
% change y-o-y 19.4 17.5 17.3
Net profit 6,162.0 7,293.0 8,613.0
% change y-o-y 23.5 18.4 18.1
EPS (Rs) 7.9 9.3 11.0
P/E (x) 33.8 28.6 24.2
Standalone financials
Source: Company, Analysts Estimates

There are other potential gains for companies like ITC. A latest finding of Global Adult Tobacco Survey on tobacco usage in India says women consumers could be a potential new market for cigarette companies as tobacco usage is on the rise based on either daily usage or age of taking up smoking. It also says Indian smokers have low quit ratio (less than 20 per cent), compared with countries like the UK, the US and Brazil. Adds Abneesh Roy, an analyst at Edelweiss Securities: "Switch from non-cigarettes to cigarettes (15 per cent of total tobacco usage) on account of ban on gutka in many states (Maharashtra, Rajasthan, Kerala, Bihar, Madhya Pradesh and Himachal Pradesh) will also aid ITC."

Meanwhile, ITC's other (non-cigarette) FMCG business is also expected to break even soon as packaged foods (60 per cent of segment revenues) is already profitable and personal care's losses will come down further with increasing scale. Ebit loss margin of the division has come down drastically from 16.9 per cent in FY06 to 3.5 per cent in FY12 and further to 2.63 per cent in the June quarter.

Some hurdles though
Globally, regulatory concerns are escalating and many countries like Australia (plain packaging norm expected to be implemented on December 1), the UK (hike in taxes by two times historical average), Canada (stricter health warnings) and Russia (40 per cent annual tax hike till 2015) have started taking stringent action on smoking. In India, too, the tax environment for cigarettes is increasingly getting disruptive, leading to uncertainties. The number of states hiking VAT rates has only risen over past few years with average VAT (for ITC) rising from 12.5 per cent in FY09 to an estimated 18-20 per cent in FY13.

However, Credit Suisse analysts expect the uncertainly (increases in VAT rates) to remain until GST comes into force, which would fix the VAT rate nationally. The other recent concern stems from the possibility of India, too, implementing plain packaging norms like Australia. Says Nikhil Vora, co-head of research, IDFC Securities, in his report dated August 13: "Plain packaging would significantly dilute the branding power of cigarette players, hurt volumes and, we believe, prompt a de-rating of tobacco majors across the globe."

However, Mitra and Saxena aren't perturbed. They note: "We see very low probability of this move in India. Even if plain packaging were to come through, the impact on ITC would be minimal given that over 70 per cent volumes are sold in loose sticks."

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