ITC: Easing regulatory overhang, valuations key positives

Strong pricing power in cigarette segment, consistent profitability make the stock a favourite

The stock performance of ITC has been a disappointment. The fast-moving consumer goods (FMCG) major, with returns of 14 per cent, has under-performed its peer index and the two benchmark indices. Falling cigarette volumes in the wake of an intensifying tax structure both at the Centre and state levels weighed heavily on the stock.

For 2015 though, the trend is likely to reverse, believe analysts. The government’s recent decision to put on hold anti-cigarette proposals such as a ban on sale of loose cigarettes and raising the age limit for smoking from 18 to 25 years, is one reason for their optimism. Attractive valuation is another.

After the sharp under-performance in 2014, the stock trades at a 26 per cent discount to the FMCG sector as against its historical average discount of 13 per cent. The scrip trades at a reasonable valuation of 25 times FY16 estimated earnings and seems to price in most of the negative news. Consistent hikes in taxes have led to falling cigarettes volumes in the past few quarters, but cigarettes Ebit (earnings before interest, tax) growth has remained strong thanks to consistent price hikes and relatively strong demand inelasticity. Over the past few quarters, ITC’s Ebit growth has been strong at 17-20 per cent.

“We remain positive on ITC due its relatively consistent and resilient earnings. ITC continues to grow at a significant premium to peers and has seen minimal consensus downgrades,” write analysts at Goldman Sachs.

In this backdrop, analysts expect ITC’s cigarette volumes to fall two-three per cent in FY15 and grow at a compounded annual rate of three per cent over FY15-17. The company’s Ebitda (earnings before interest, taxes, depreciation, and amortisation) margin is expected to grow 150 basis points in this period.

While ITC’s other FMCG business (22 per cent of overall revenue) continues to post strong revenue growth and expand market share across categories, its profitability has been under pressure due to intensifying competition and continued investments. Most analysts expect this segment to report full year profit for FY15. However, sustained and improving profit growth in this segment will be the key.

ITC generates strong operating cash flows and had a cash balance of Rs 9,000 crore as of FY14. Apart from making investments across all its businesses, it had a healthy dividend payout ratio of 57 per cent in FY14. Analysts expect this metric to inch up to 60 per cent. For now, the regulatory overhang over ITC has reduced and analysts remain positive on the stock.