Improved cigarette volumes may not lift ITC stock

ITC reported resilient performance in the September 2016 quarter (Q2). Among key businesses, cigarette volumes grew by an estimated 3-4% in-line with estimates, and aided top-line in the quarter. Some of the volume growth can be attributed to a low base of September 2015 quarter (when cigarette volumes fell 14%).

But, the fact that this is the second straight quarter of an increase in cigarette volumes for the company, is positive. Higher taxes and rising regulatory pressures on cigarettes had led to a contraction in this metric for eleven quarters since June 2013 quarter. The 7% year-on-year growth in cigarette revenues to Rs 8,528 crore also reflects that sales growth was well-balanced and driven equally by price hikes as well as volumes. The gains were also reflected in this segment's EBIT margin, which inched up 44 basis points year-on-year to 37.7% in the quarter.

A key positive in the results was the performance of its FMCG business. Revenue in this segment grew in healthy double-digits for the first time since September 2015 quarter. Healthy traction in the branded packaged foods business, particularly, Yipee, Aashirvaad, Bingo and Sunfeast brands fuelled this segment's growth in the quarter. Improving scale as well as product mix enabled the company to compress this segment's EBIT losses by 71% to just Rs 3 crore despite its continued investments in innovations and brand building activities. "FMCG sales growth is strong after four quarters of single digit growth led by new product launches and favourable base in noodles," says Abneesh Roy, Consumer analyst at Edelweiss Securities. All this comes at a time when performance of the FMCG sector is under pressure, especially on the volume front.

The smaller businesses of Hotels, paper and agri put up a muted show in Q2 with their revenue growth being anywhere between 0 and 2.5%. Sluggish macro and high inventory impacted hotels business. "Focus towards running hotel business via management contracts will help return ratios over longer term," says Roy. Weak demand in FMCG and cigarettes business along with rising competition from local and foreign players such as China impacted ITC's paper business in Q2. Lower input costs though aided 170 basis points margin expansion in paper business to 17.4%. Lower exports impacted ITC' agri business in the quarter and management expects it to pick up gradually.

At current levels, the ITC stock trades at 22 times one-year forward estimated earnings, which is much lower than the industry average valuations of about 40 times. The healthy show in Q2, however, is unlikely to lift sentiments meaningfully. This is because the company's cigarette business could possibly come under pressure if a higher tax rate in the form of "sin tax" is levied under GST on products such as cigarettes, liquor, etc, say analysts. Any significant increase in excise duty on cigarettes in the budget will be another negative for ITC. Both these concerns are likely to continue weighing on the ITC stock in the foreseeable future, ignoring the positive financial performance.