Attractive ITC stocks fail to cheer investors due to GST concerns

Expectations of additional tax burden in GST Council meet, competitive intensity may impact volume growth and margin of its mainstay cigarette biz

Even as pricey stock valuations of many fast-moving consumer goods (FMCG) companies are making the Street uncomfortable, some stocks like ITC are unable to find good investor support, despite attractive pricing.

The stock of ITC, which was trading at around 20x its 2020-21 (FY21) estimated earnings in the past few months, has seen further deterioration in valuation. 

It is now trading at 17-18x its FY21 estimated earnings — the lowest in five years (on the basis of one-year forward valuation).

A subdued volume outlook, long with expectations of an increase in the compensation cess on cigarettes in the upcoming goods and services tax (GST) council meet next week and rising competitive intensity, are making investors cautious on the stock.

Given that there were no material tax hikes on cigarettes in the past two years and overall GST collections by the government remain sluggish, a rise in taxes on cigarette cannot be ruled out.

According to Vishal Gutka, vice-president at PhillipCapital India: “If the cigarette category sees additional tax, it would further hurt the volume growth of ITC, which is already facing competitive intensity. The stock may see further pressure.” The tax issue has now become more worrisome for ITC due to rising competition.

ITC’s September quarter earnings had underlined the point of intensifying competition. According to Nitin Gupta, analyst at SBICAP Securities: “Companies like Godfrey Phillips India in the premium segment and VST Industries in the mass segment are aggressively focusing on volume and market share.”

Thus, if ITC passes on the additional tax burden, it could further hurt volume growth, which has also seen the impact of the overall sagging rural consumption. In fact, some analysts also believe that the competitive pressure seems to be a structural issue for ITC.

In the September quarter, ITC’s cigarette volume growth remained subdued for the second quarter in a row at around 3 per cent (see graph).

Though ITC has taken initiatives to offset competitive pressure through the launch of capsule-based cigarettes in the mass segment and new launches in the premium category, among others, analysts say the efforts are still not yielding desired results. However, the Street would keenly watch if ITC’s efforts fructify over the coming months.

Not only on the volume front, ITC’s cigarette business could also see some margin pressure. Gupta believes “the new players are preferring volumes/market share over margin, which is playing against ITC’s pricing power”.

Further, with rising prices of tobacco leaf, margins could face pressure once ITC’s low-cost tobacco leaf inventory is consumed.

Given that around 85 per cent of the company’s overall operating profit comes from the cigarette business, any dip in cigarette margins would hurt ITC’s overall operating profits.

In the September quarter, however, ITC had witnessed a sharp 115-basis point year-on-year expansion in gross profit margin amid benign input cost.

Some support, though, is expected from its other FMCG business. While high food inflation is worrisome, operating leverage and product premiumisation should help ITC’s other FMCG business, which includes food brands such as Bingo!, Aashirvaad, stationery brands like Classmate, among others.

Overall, investors are recommended to wait till there is clarity on the tax front and how the competitive intensity plays out.