After a shaky 2013, markets worldwide are closing the year on a strong note. However, 2014 will be a challenging year, with investors having to deal with two major ‘known unknowns’. First, investors need to anticipate the timing of liquidity tapering by the US Federal Reserve, and also assess the market’s reaction to the taper. Second, it is clear that global and Indian investors believe that a change in the governing party at the Centre will place the country on a favourable economic path, although political analysts suggest that a decisive mandate appears unlikely. Investors must not only guess the results of the Indian general elections, but also anticipate the quality of the policy of the next government at the Centre.
Over the past two years, we have seen a steady and significant flow of foreign funds into select Indian equities, albeit limited to a few sectors. Foreign investors have bought into market liquidity, earnings growth and balance sheet strength and a number of stocks have started to look expensive in spite of an increase in earnings. The correlation between market performance and foreign investment flows has increased further over the last year, and an outflow of these funds will de-rate even the best performing firms, regardless of how positive the earnings outlook.
Given the risks investors face in the coming year, it is advisable for them to limit equity exposure to firms that are relatively immune to the major risks outlined above, yet at the same time thematically focus on earnings growth and quality over perceived value-picking. Applying such stringent qualitative filters only throws up a handful of names, the most prominent being ITC, which has corrected significantly over the past quarter.
Testing times
ITC has outperformed the Nifty index by over 80% in the two years leading up to July 2013. Yet, after a worse-than-expected performance last quarter that coincided with a broader portfolio re-allocation to more export-centric sectors, the stock has dropped 20% off its highs. Further dips will ensure an attractive entry point for an investor looking to hedge major macroeconomic risks, and at the same time ride the top pick in India’s most robust sector.
ITC’s outperformance over the past two years was due to earnings multiple expansion that followed successive earnings surprises that demonstrated the company’s pricing power in its tobacco business. For the past three years, excise duties on cigarettes were hiked at an average of 15%, compared with 10% for the three preceding years. While the next government’s stance on excise duties is not known, the outlook on duty hikes appears benign. Tobacco sales are an important source of government revenue and continuation of sharp hikes in duties could allow black market and unorganised sector sales — which don’t generate tax revenues — to gain market share. Data from ITC’s most recent quarter showed a slowdown in volumes, which indicates the organised market may be at an inflexion point if prices continue to rise.
As earnings growth expectations have fallen following the slowdown in volume, the company’s valuation multiples have come off their recent high. This lowers the chance of a further de-rating, going forward. Additionally, investors are also expecting the government to unload its 11% shareholding in ITC as part of its divestment programme. In the event such a sale is announced, any reason for a drop in share price would be largely technical, and should be seen as another buying opportunity. Institutional interest in ITC is also expected to remain strong as the company is one of the few in the world that dominate a large tobacco market that continues to grow at over 5% per year, compared with western markets that have either matured or are shrinking. The company continues to grow market share — which is currently higher than 80% — and faces very little competitive pressure from other manufacturers, which suggests that profit margin is likely to remain strong.
Still smoking
While tobacco sales continue to remain the main business of the company, ITC has also become a major player in the fast moving consumer goods segment. It has leveraged its cash flows and distribution network to gain significant market share. The company has developed premium brands in the personal care and packaged foods business, some of which have already gained double-digit market share. While the entire consumer products division — which already generates more than 20% of ITC’s overall revenues — is expected to break even during the coming year, ITC can continue to reap the benefits of its investment through brand extension and further leveraging of its retailer network, which has the highest distribution intensity in the country.
In the event excise duty increases on cigarettes are lowered to 2010 levels, ITC is likely to fall into a sweet spot of volume growth and margin expansion, with the additional benefit of profit contribution from the fast growing (over 20% per year over the past three years) consumer segment. ITC’s debt-free balance sheet and high free cash flow generation has traditionally supported a strong dividend policy and, over the past few years, payouts have increased from 45% to 60% and are likely to sustain.
At the current price of ₹315, ITC trades at 23 times FY15 earnings, which is below its average over the past two years and a significant discount to other large peers such as Hindustan Unilever (HUL) and Nestlé, and in line with much smaller mid-size players. Interestingly, the company’s historical average one-year forward price/earnings multiple is 22 times, close to the current valuation. ITC has more than double HUL’s margins, and is also expected to grow earnings twice as fast as HUL over the next three years, while generating greater free cash flow.
Given the medium and long term prospects of the company, ITC should be a staple in almost every Indian equities portfolio. Investors should capitalise on the current market environment and accumulate the stock at the current market price and on dips.
IndAsia and its clients may have a position in the above-mentioned stock
