ITC: Volume recovery in cigarettes, scaling up of FMCG biz are positives

Traction for its fast moving consumer goods (FMCG) portfolio led by new launches, receding threat of higher taxation on cigarettes as well as attractive valuations are expected to lead to a rerating of the ITC stock. Analysts expect both the non-tobacco businesses as well as cigarettes to clock good volume growth as well as improved profitability in FY19.
 
Among the key triggers is the new product diversification and growth of its existing FMCG portfolio, which has in a short span of time resulted in three large brands comprising Aashirvaad, which recently crossed the Rs 40 billion mark, Sunfeast (a Rs 30 billion brand) and Bingo, Yipee, Classmate with sales of more than Rs 10 billion each. Though FMCG also includes personal care, lifestyle retailing, safety matches and incense sticks, the company’s significant success in the packaged foods segment is keeping investors excited. ITC is among the top two in branded wheat flour, cream biscuits, snack food and noodles categories. Among other sub-segments within the packaged food, it is present in the premium chocolates under the Fabelle brand, Coffee under Sunbean in addition to its juices brand B Natural.
 
Going ahead, ITC is looking to replicate its success in the branded wheat segment, where it leads with a 28 per cent market share, by launching new products/foraying into new segments under the umbrella of the flagship Aashirvaad brand. One such would be the liquid milk segment, where it already markets valued-added products such as Aashirvaad Svasti ghee and has recently launched milk pouch in Bihar. ITC will gradually scale up its presence in the milk pouch space, estimated at Rs 720 billion.
 
The other is the branded rice segment. While it is currently exporting rice, the launch at the end of the current year will mark its first foray into the domestic market in the Rs 220 billion branded rice market.
 
Given the existing base and the launch of new products, the company is hoping to more than double its revenues from the Aashirvaad brand to Rs 100 billion over the next five years. In the biscuit business, the company is expected to do well given its focus in the mid to premium segments, which is growing faster as compared to the value segment, resulting in higher market share. What should help add to the growth is an expansion of its distribution network comprising 2.7 million outlets? Post the implementation of the goods and services tax (GST), ITC would be a major beneficiary of a shift in consumption pattern from unorganised to organised segment and  the supply chain. Moreover, demand, especially rural is recovering.

Margin gains for the FMCG major

E: Estimates | Source: Nirmal Bang Institutional Equities

 
While the FMCG business contributed 19 per cent to revenues in FY17, given the growth from existing and new segments, brokerages estimate it to account for about 28 per cent by 2020.  Similarly, the business, which achieved break-even at the operating level in FY13 after posting losses for 11 years, is expected to improve margins from the current low single-digits to mid-single digits over the next two to three years. Analysts at ICICI Securities say that revenue growth and profitability of FMCG business would be the key catalyst for ITC’s long term growth. It would also help the company achieve sales of Rs 1 trillion from the FMCG segment by 2030 from Rs 114 billion estimated for FY18.
 
Meanwhile, what should add to the operating profit is the paper and packaging business, which is the second largest contributor to operating profit after cigarettes at seven per cent though in revenue terms it accounts for 11 per cent of sales. The paper and packaging segment is witnessing margin expansion on the back of higher volumes and lower raw material prices. Margins of the division, which were at 18 per cent in FY17 are expected to improve by over

250 basis points over the next two years.
 
Further, non-tobacco operations, according to analysts at JP Morgan, should do better in FY19 led by the good performance of the FMCG business and a demand revival in the hotel and paper division. This would help grow the non-tobacco business’ operating profits by 14 per cent annually over FY18-20.
 
The near-term trigger for India’s largest maker of cigarettes is relief on the tax front as the GST council at the recent meeting left rates untouched. After a muted 1.5 per cent growth in FY17 and a sharp fall in volumes in the previous quarters of FY18, cigarette volumes have started recovering from December 2017. Volumes in FY19 are expected to grow at 5.6 per cent as against an expected drop of 3.4 per cent in FY18. Better growth prospects for this business is critical as cigarettes still contribute about 86 per cent of ITC’s operating profit. 
 
Given the recovery in cigarette volumes and profit in FY19, analysts at Antique Stock Broking believe that the stock, which is trading at a 10-year high valuation discount of 32 per cent to FMCG peers, is deeply undervalued.