Dear Client,

Three Big Picture Reasons leading us to Initiate Coverage on ITC are as follows

a.       Attractive Valuation

Since listing, ITC has traded at an average price/earnings ratio of 25 times. Post the bloodbath on Dalal Street owing to Covid-19, the price/earnings ratio of ITC has fallen to 11 times. This implies that stock is trading at 56% lower valuation than its historic averages.

b.      Expectations of Rise in Earnings Before Interest Tax (EBIT) Margins in FMCG Business

FMCG business contributes 25% of overall revenues for ITC. However, its contribution to profits just stands at 2%. This is set to change in this decade.

In the previous decade, ITC has spent a lot of money in building its brands such as Aashirvaad, Sunfeast, Bingo, Yippee. ITC incurred a lot of high upfront costs on brand investments. This is the prime reason behind ITC’s very subdued EBIT margins of 3% as compared to 20% of HUL and Nestle despite gross margins being at similar levels.

The annual consumer spends on its FMCG brands exceeds Rs 13,000 crore. Hence, the brands have reached a good quantum of scale to start earning margins similar to those of peers. Even if EBIT margins shows a expansion of 200 basis point from the current levels in FY22 and if we assume a moderate revenue growth of just 2% CAGR revenue growth in the next two years, EBIT from FMCG business will almost double in FY22.

By the end of the decade, we might even see margins settling between those earned by peers (i.e 15-20%). This will provide huge fillip to the profitability of ITC. Just assuming a 5% revenue CAGR from FY22 to FY30 and an EBIT margin of 15% in FY30, EBIT from FMCG business could scale up to Rs 3000 crore in FY30. That’s a 700% jump in absolute terms and 23% in CAGR terms. Hence, FMCG vertical poses a huge opportunity in this decade. The expansion in margins will drive a huge re-rating on the stock.

c.       Government Doesn’t Have Much Leeway to Impose Higher Taxation on Cigarettes

 In the legal cigarette industry, ITC has gained market share since 2012. Market share has increased from 76% in 2012 to 79% now. However, the entire legal cigarette industry has lost market share to illegal cigarette too. ITC too has lost market share to illegal cigarettes. Consumption of tobacco in cigarette is just at 10%. Balance 90% of the tobacco is consumed in the form of chewing tobacoo, bidis etc. Despite a mere consumption of tobacco in cigarette of 10%, cigarettes contribute to 80% of the overall taxes collected on tobacco products.

The over-reliance to gain tax revenues from cigarette has led to the onslaught of the illegal cigarette industry which comprises of smuggled foreign brands and counterfeit cigarette. India is the 4th largest illegal cigarette market in the world and currently accounts for 20% of the overall market share (legal + illegal). The emergence of these illegal cigarettes on account of disproportionate taxation is leading to

government losing revenues to the extent of more than Rs 13000 crores per annum.

 Not to forget, the impact on famers as around 5 crore livelihoods are dependent on tobacoo production. According to reports, it is estimated that in the four years since 2013-14, Indian tobacco farmers have suffered a cumulative drop in earnings of over Rs 4000 crores. Hence, any further increase in the cigarette taxes will only hurt the government revenues and farmers earnings.              

Stable Dividends in Forthcoming Years

The dividend per share declared by ITC in FY2019 stood at Rs 5.75. This leads to a dividend yield of 3.02% at current market price. ITC recently amended its dividend payout policy and stated that it will payout as dividend 80-85% of the net profits it earns in a year. Hence shareholders will be rewarded in the form of hefty dividends.

To add, previously cash flows generated from cigarette business were used to fund the capital expenditure (capex) requirement of FMCG business. However, with FMCG vertical generating higher profits going forward, the profits of this vertical will be self sufficient to fund its own capital expenditure requirement. This will free up a lot of cash flows of cigarette business which were earlier diverted to fund the FMCG vertical.

Target Price

We have derived at a target price of Rs 285 on the stock from a longer term perspective. Please download the attachment to get a detailed view of the report.