The Curious Case of ITC

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A lot has been discussed about ITC as most of the FMCG companies have seen re-rating multiple times owing to premiumization, growth driven by widening their distribution reach, and now because they are least impacted due to COVID-19.

However, ITC has grossly underperformed but it has always been on the radar for most investors especially for those who have missed the rally in other FMCG stocks.

In this article, we try to understand the factors that are dragging ITC’s performance.

Let’s begin!

Cigarettes manufacturing companies do not enjoy the same multiple as other FMCG companies

ITC has done a commendable job by increasing its revenue share from its non-cigarette business which stands at ~53% of the overall revenues.

However, nearly 84-85% of its operating profit still comes from the cigarette business.

Therefore, one must value ITC as a Cigarette Company and not as any other FMCG.

Globally, popular listed peer companies like Philip Morris and British American Tobacco generally trade at a multiple of 10-14x 1-year forward earnings.

Even in India, the valuation multiple of Godfrey and VST are lower compared to global players and ITC is currently trading at 17x 1-year forward earnings which is at a considerable premium.

Some would say it is justified as there are other businesses as well, but the answer would be that only the core FMCG business can command higher valuation but it only contributes 2.3% to its operating profits.

Even the other businesses (Hotels, Paper, and Agri) are somewhat cyclical in nature.

The second big overhang on the stock is the rising adoption of ESG norms

There have been growing concerns over institutional investors adhering to ESG norms. What are the ESG norms? ESG (Environmental, Social, and Governance) is a set of standards for a company’s operations that socially conscious investors use to screen potential investments.

This has gained momentum over the years and the trend is most likely to continue.

As a result, the FII holding in the stock has been consistently reducing in the company from 20.8% in Dec-2015 to 14.6% in June-2020.

Therefore, this continues to remain an overhang on the stock.

Core business performance has been lackluster and a possible hike in tax looms over its head

The financial performance over FY15-20 has been tepid with Sales and PAT CAGR of 4.9% and 10.3%. The PAT growth is largely driven by the corporate tax cut benefit as its PBT has grown by 6.9% CAGR during the same period.

This performance has been due to lower volume growth in the cigarette business and slow growth in other businesses.

Another thing to worry for the investors is the possible hike in tax for cigarettes.

We all know that the government has been struggling with its finances due to the pandemic and a tax hike on cigarettes is imminent but the question is by how much?

Irrespective, this would further add pressure on the already low volume growth of the industry and in-turn for the company.

Are we saying it is a bad investment choice? Of course not, the company has very strong fundamentals with no debt, excellent free cash flow generation; healthy dividend yield, and high return ratios (RoE/RoCE of 25%/32%).

In fact, the COVID-19 can aid market share gains in the cigarette business due to supply disruption in the import of foreign cigarettes.

Well, that’s a story for another day.

The important thing to know and understand the factors that are affecting the company and value it based on its core business which currently is cigarettes.

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