ITC: Risk-reward compelling as stock is cheapest consumer pick

Street expects company to revert to volume growth in FY16, earnings rate to sustain at 18%

ITC is always in the news ahead of the Union Budget. Investors tend to beat the stock down on fears that a steep rise in taxes will affect volumes. This year, too, the Street is building in an increase of 8-10 per cent in central excise duty, but the stock is up.

The stock has underperformed the Sensex over the past 12 months as concerns over weak cigarette volumes have not shown signs of receding. But interestingly, the stock is not showing any sign of stress and has risen 14 per cent over the past month and eight per cent over the past fortnight.

ITC is one the cheapest consumer stocks, due to a sharp increase in regulatory concerns. The market is expecting a 10 per cent rise in excise duty in the Union Budget. In the worst-case scenario, if ITC passes the entire 10 per cent duty increase to consumers, its volumes could be affected 12 per cent in FY16. If volumes increase/decrease by five per cent, ITC's earnings would be impacted by plus/minus three per cent.

In a bear-case scenario, Deutsche Bank Markets Research expects FY16 earnings growth to remain flat, if volumes were to decline 12 per cent after a 10 per cent price increase. “Even if we apply a 22x P/E (the lowest multiple in the past five years), the implied valuation would be Rs 280,” adds the brokerage. Analysts believe that after last year's steep excise duty rise, rationality is expected to return to the sector. As a result, the Street expects single-digit volume growth to return over FY16-20. In a rational environment, analysts believe ITC's profit pool could increase nearly five times over the next 10 years.

Analysts expect earnings per share growth to average 18-20 per cent every year over FY16-20. Other than this, the overall environment for tobacco consumption is expected to benefit organised cigarette players such as ITC. Morgan Stanley claims its channel checks have shown the Indian duty-paid bidi industry (365 billion sticks per annum against 101 billion cigarette sticks per annum) is declining by two-to-three per cent a year. The brokerage estimates even if half of this translates into cigarette volumes, the industry would generate an incremental five per cent growth a year from this transition alone. Based on these expectations, Morgan Stanley is building in earnings compound annual growth of 17 per cent over FY14-17. The risk-reward is compelling, believe analysts, given that there is direct correlation between cigarette volumes and earnings.