ITC Rating: neutral; dependence on cigarette biz to persist

Dependence on cigarette biz to persist

Its share of Ebit may be as high as 82% in FY23; ESG concerns are a overhang; earnings outlook muted; ‘Neutral’ maintained

Cigarettes’ EBIT dependence will remain unaltered by ongoing ‘Other FMCG’ growth. We retain our Neutral rating on the ITC stock due to the following factors: While ITC efforts on the overall ESG (environmental, social, and corporate governance) front are truly commendable, the concern over its Cigarettes business from an ESG perspective remains at play – as more funds turn ESG-compliant (both globally and in India), affecting the valuations of global cigarette companies, including ITC.

Even if ongoing growth and profitability improvement in ‘Other FMCG’ leads to a 50% Ebit growth CAGR over FY20–23e, the Cigarettes business’ contribution to overall Ebit just barely reduces from 85% in FY20 to 82% in FY23e. Hence, this does not really move the needle from a Cigarettes dependency perspective. Part of the margin growth in ‘Other FMCG’ in H1FY21 could also be ephemeral, driven by a combination of elevated in-home consumption and soft commodity costs.

In our view, the possibility of GST hikes in the Feb’21 budget or any of the GST council meets remains high given weak government finances. Importantly, even in the 31-month period between Jul’17 (GST increase) and Feb’20 (NCCD increase) – when there was no GST increase on Cigarettes – cigarette volumes and Ebit performance had been tepid.

The earnings growth outlook in the latter half of the last decade considerably weakened v/s the former half, and ROEs saw sharp decline (despite corporate tax cuts). The FY20–FY23e outlook does not appear likely to change on either of these fronts. PBT growth in the last 5 years has been ~6.6% and is likely to be around 7.3% in the next 3 years. With acquisition-led growth gaining traction and self-imposed near-term moratorium on capex eventually being lifted, ROE could come under further pressure over the medium term.

Valuation and view

Despite the corporate tax cuts (of which ITC was a significant beneficiary), return ratios have come off by ~1000bp from the mid-30 levels seen during 2011–15. If a sustained high dividend payout beyond the stated 80-85% levels, combined with lower capex (given the weak demand environment), eventuates, it would offer some respite amidst a tough outlook for ITC’s revenue growth and earnings growth prospects. But a strong dividend yield alone is not enough of a comfort, particularly as it is in line with global peers in the Cigarettes business.

Valuations would trade closer to global tobacco peers given (i) the dependence on the Cigarettes business remaining high; (ii) far weaker earnings growth and ROCE v/s the earlier part of last decade; and (iii) the persistent risk of further ESG-based selling by investors. BAT trades at 8.1x CY21 EPS and Philip Morris at 13.9x CY21 EPS. Taking the average multiples of these two global peers and giving ITC a ~30% premium, as well as rolling forward to December 2022 EPS, we get TP of Rs 200 (14x December 22 EPS).