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Holy Smoke
Can investors make the most of ITC's valuation discount?

Jash Kriplani

It has been bit of a roller-coaster ride for ITC investors. Since the beginning of the year, the stock had been gaining steadily from 270 levels to hit a high of 342 per share post the rollout of GST in July. But all that quickly changed when the government increased the tax rates on July 17th wiping the earlier gains of cigarette manufacturer. The stock corrected 12.6% in the following trading session, marking its steepest fall in a day, in more than 25 years. The stock has corrected 16.3% since the order (up to August 23rd), while market wealth of 66,307 crore has been wiped off. The reaction to the announcement has restored the discount that ITC traditionally trades to pure vanilla FMCG companies. 

Taxing times
For years ITC has always had the spectre of tax and duty hikes hanging like a Damocles’ sword over its cigarette business, which brings in nearly 86% of its profit. All this was set to change when GST was to roll out in July and the stock gained in anticipation. Apart from lower rates, GST was expected to cap the cess rates on cigarettes removing the uncertainty of tax rates on ITC and other cigarette manufacturers, once and for all.

When the GST rates were officially unveiled on July 1, the cigarette-makers got more than what they could have asked for. The average tax per cigarette was down by 7-9%, meaning that if retail prices were unchanged, net sales would increase by 9%. For FY17-FY20, estimates suggested an average earnings growth of 16% as against 5% seen in FY14-FY17. 

No wonder then, the domestic fund houses increased their stake in the stock from 4.23% in the June 2017 quarter from 3.08% in the previous quarter collectively buying 3 crore ITC shares from the market  bourses which is 0.25% of total shares outstanding. Currently part of mutual fund schemes managed by as many as 36 domestic fund houses, ITC is definitely a fund favourite. 

According to CIO of a fund house — which bought the bulk of the shares purchased in the June quarter — the tax relief came in as a pleasant surprise. A fund manager, whose 1,650-crore scheme’s exposure to the stock stands at 5%, recalls, “We felt that ITC would now be able to further improve its margin and if it decides to pass on the tax relief to the consumers, it would be able to improve its volumes as well. ITC seemed to be in a favourable situation,” he says.

But all that changed when the government decided to increase the tax rates in July According to a report by Edelweiss, the effective tax under GST was increased by 10-11%, which will result in cigarettes prices increasing by 8-9%. This with 6% hike in the Budget 2017-18 amounts to around 16-17% total hike in taxes for FY18.

Analysts were quick to lower growth forecasts. Motilal Oswal reduced its cigarette volume growth forecasts from 6% and 7% to 3% and 4% for FY18 and FY19, respectively and earnings growth for ITC was reduced from 14.9% and 20.4% to 10.4% and 11.4%, for the same period. “Sentimentally, the whole episode was a dampener. If they can hike taxes in just about two weeks, they can do it in one year as well. Now, the belief is that just like in pre-GST era, the taxation could change at any point of time. It is back to square one,” surmises the fund manager.

Since the beginning of the year,  ITC has already taken two sets of price increases — about 6% in March and 7% in July (total of 13%). The latest levy could lead to another round of price hike and put volumes under pressure since the tax incidence has not passed completely. ITC is not new to tax and duty hikes on its most profitable business (36% margins in cigarettes). The cumulative growth in tax incidence on cigarettes, after the latest increase in GST cess rates, stands at a 202% since FY12. In the last five years, ITC has contributed 1.38 lakh crore to the Government exchequer.

Over FY04-FY13, the duty hikes on cigarettes followed the wholesale price index. This kept cigarettes more or less affordable. During that period the cigarette business saw an average volume  growth of 3.3%. Since then, the Government increased excise duty on cigarettes by about 18% on an average resulting in a 20% drop in cigarette volumes. (See: Huff and puff)

In FY17 the cigarette volumes grew by 1.7% reversing three years of negative growth. While the cigarette business brings in over 62% of overall revenue, its revenue and Ebit growth rates have been significantly lower compared to its long-term growth rates due to the higher incidence of tax rates. Analysts expect to see a revenue growth of 9.4% in the cigarette business driven by price hikes, in the next two years.

Diverse bets
To counter the inherent risks in its most profitable business and to deploy the huge amount of cash it has generated over the years, ITC has diversified into a varied set of businesses including FMCG, hotels, paperboard & packaging and the agri business. Since its foray in 2002 into branded packaged foods, ITC has managed to build a large franchise in the FMCG space moving into personal care business in 2005. FMCG business currently contributes 19% to the company’s overall revenue. Over the last five years, the FMCG business has clocked an average revenue growth of 14%. Analysts expect the business to grow at an average of 12% from FY17 to FY20. Within the FMCG sector, the company has been constantly entering new categories and trying to create new brands, as it seeks to achieve its aspirational target of 1 lakh crore revenue by 2030. In FY17, ITC entered into newer categories such as juices, chocolates, dairy and coffee. The branded packaged foods business accounts for the largest pie of the FMCG business making up 77% of the segment revenue. Over the past five years, the business has grown at an average of 16.7% from 3,712 crore in FY12 to 8,034 crore in FY17.

 

Harit Kapoor Analyst, IDFC Securities

Besides these, the FMCG business also consist of stationery products, lifestyle retailing, incense sticks (agarbattis) and safety matches. Education and stationery products account for about 8% and 7% of segment revenue, respectively. However the growth in the non-food business is not as attractive as the foods business. Over the past five years, the business has only grown by an average of 6.8% from 1,827 crore in FY12 to 2,488 crore in FY17. 

Thanks to its brand building and investments in the distribution network, ITC is the market leader in packaged atta, premium cream biscuits and notebooks. It is the second largest player in snacks, instant noodles, deodorants and shower gels. Brands such as Aashirvaad and Sunfeast bring in over 3,500 crore and 3,000 crore respectively. Classmate, Yippee! & Bingo! are over 1,000 crore each while Vivel, Mangaldeep and Candyman are over 500 crore each. ITC has created a distribution network of around two million outlets next only to market leader HUL which has 3.2 million outlets.

But building those brands and the network hasn’t come cheap. The non-cigarette business accounts for bulk of (77%) of the operating capital that is being deployed by the company. (See: Lighting it up) “Over the last three years, ITC has invested about 5,800 crore in building capacities across these segments,” points out Harit Kapoor, analyst at IDFC Securities. Of this, FMCG accounted for 2,590 crore, hotels took in about 1,650 crore, agri business saw an investment of 500 crore and paper got the balance 1,060 crore. 

Naveen Trivedi Analyst, HDFC Securities

Given the significant investments made to scale up the business, the FMCG division after more than a decade turned profitable on operations level in FY14. It is yet to make any major contribution to ITC’s overall profitability given that it currently generates Ebit margins of just 0.2%. The profitability of the business or rather the lack of it remains a concern given the investment gone into scaling up the business and the leadership it enjoys in some of the categories. “It is important that FMCG sees improvement in margins as it has more scalability than other non-cigarette businesses,” says Kapoor.

Its other non-cigarette businesses haven’t had much to show for either, While the agri business and paperboard & packaging business accounts for 10% and 7% of revenue, the hotels business which was started in 1975, still only brings in a measly 2% of revenue.

Both paper and agri business are cyclical in nature. The paper business which has grown at an average of 8.2% over the past five years will typically see good volumes, when the FMCG industry is seeing good volumes. The agri business which supports four million farmers has always been volatile with an average growth of 8.8% over the past five years. However, a better  way to judge the business is how it supports the cigarette and food businesses through its sourcing rather than its revenue volatility. ITC’s non-cigarette business is expected to grow by an average 10% over the next two years. 

Anuj Bansal Analyst, Ambit Capital

Casting a wider net
If that is not diversification enough, ITC is now mulling a foray into healthcare after entering the diary business. Hospitals are a capital intensive business that is tough on execution  and one that doesn’t generate a very high return on capital employed (ROCE). The ROCE measures the efficiency of capital allocation for any company and in the case of the ITC, thanks to its investments across businesses, it  is already on  a one-way journey down. From 53% in FY14, it has plunged down to 36% as on FY17. (See: Losing efficiency) “All other businesses barring cigarettes are capital intensive. So from an ROCE point of view, it is dilutive,” says Naveen Trivedi, analyst at HDFC Securities.  

Analysts tracking the company fear that it is ‘over-diversifying’ and runs the risk of spreading its A&P resources thin. Anuj Bansal, analyst, Ambit Capital says, “If you can build umbrella brands and use those brands to enter newer categories then your A&P resources are more effectively used when you build umbrella brands. But ITC has not been very successful on that front. Aashirvaad is the only umbrella brand that they have created.” 

Playing the discount game
Despite its efforts to be perceived as a FMCG player, ITC has traditionally traded at a discount to the others in the sector because of its lower profitability in the non-cigarette business and the inherent risks in the cigarette business which brings in the bulk of the revenue and profit. 

ITC’s FMCG business is expected to see growth of 12% over FY17-FY19. On the other hand, market leader HUL is estimated to see a flat growth of 1% in FY18, followed by 12% in the next year. ITC’s overall revenue and profit is expected to grow by 9.5% and 11%. respectively in the next two years. Overall, ITC’s net sales have grown at an average of 7% over the last three years (FY14-FY17), while profit have grown at an average of 5%. 

ITC is currently trading at 26x one-year forward earnings. Competing players such as HUL, Nestle and Britannia are trading at an average of 45x one-year forward earnings. Over the past five years, the discount has been around 30% which has now widened to 40% thanks to the fall in its stock price. While the stock may remain subdued in the near term, the valuation discount does gives the margin of safety in the stock, making  ITC a defensive play in the current market scenario.

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