BAT stake sale, tax overhang: 4 reasons why Jefferies has downgraded ITC

Jefferies downgraded the stock to 'hold' from 'buy' earlier with a target price of Rs 430, down a huge 17.3 per cent from its earlier price target of Rs 520.

ITC stock slipped over 4 per cent on Thursday after British American Tobacco (BAT) said it could sell some of its stake in the company, recovering partially in trade on Friday. The stock of the cigarette-to-hotels conglomerate traded at Rs 420 levels, rising 1.3 per cent in intraday deals as compared to the S&P BSE Sensex that traded flat for most part of the day.

The development, meanwhile, saw Jefferies downgrade the stock to ‘hold’ from ‘buy’ earlier with a target price of Rs 430, down a huge 17.3 per cent from its earlier price target of Rs 520.

Over the last three years, ITC stock returned over 3x from bottom to peak, Vivek Maheshwari, Kunal Shah and Jithin John of Jefferies said in a recent note, led by strong cigarette volume growth, scale-up in FMCG, improved capital allocation, & increase in FII holding. These factors, however, have largely played out, the note said, while cigarette volume growth is moderating now.

In the worst-case scenario, Jefferies sees the stock hitting Rs 340 levels, down 19 per cent from the current levels. Their best/bull-case scenario still pegs the stock price at Rs 520 levels, up nearly 24 per cent from the current levels.

Here are four key reasons why Jefferies has downgraded ITC.

Supply overhang: BAT is the largest shareholder in the cigarettes-to-hotel major with a holding of 29.03 per cent, worth Rs 1.5 trillion. A likely sale of 4 per cent by BAT to comply with the Indian norms of 25 per cent, Jefferies said would be valued at $2.5 billion and create a supply overhang in the Indian market that may be difficult to absorb immediately and cap the upside in the counter.

ITC shareholding

 

BAT, on the other hand, has been facing challenges from declining cigarette volumes across its key markets, notably the US, where it took a $32 billion write-down recently. BAT also has over $40 billion in net debt, according to Jefferies, which translates into around 3x Ebitda and nearly 60 per cent of its market capitalisation (market cap).

Taxation overhang: Over the next 12 months, analysts at Jefferies see some uncertainty creeping in on the tobacco taxation in India. Post the elections in April/May 2024), the new government will present a 'full' budget for fiscal 2024-25 (FY25) in July, which would be an important one for tobacco taxation, they said. Click here to view Budget exhibit

“In fact, after this, there would be another one in a matter of seven months (i.e., February 2025) as the usual budget cycle kicks in. Both events create uncertainty on tobacco taxation,” Maheshwari, Shah and John wrote.

Volume slowdown: Tepid volume growth is another cause for concern. At a recent analyst meet, Sanjiv Puri, ITC's Chairman highlighted the possibility of consolidation in near-term cigarette volumes, after reaching nearly a 10-year-high.

“This exactly played out in Q3-FY24, with cigarette volume declining nearly 2 per cent year-on-year (YoY) and cigarette margins seeing headwinds from input cost inflation (tobacco, filter rods). We expect volume growth to remain tepid in the near-term, in the 0-3 per cent range. Overall, earnings per share (EPS) growth is likely to be around 8 per cent in FY25,” the Jefferies note said.

Consolidation: The stock rally could take a breather now given the recent developments. In the last 2-3 years with a strong recovery in cigarette volumes post Covid-19, resulted in re-rating of the stock. With overhang from BAT stake sale, two taxation events over the next 12 months, and slowdown in volume growth, Jefferies expects the counter to remain range-bound going forward.

“We reduce our target multiple on cigarette business to 18x from 25x, given the overhang, as highlighted above. Downgrade ITC to Hold, with a revised price target of Rs 430 (Rs 520 earlier),” the note said.