Steady performance in cigarettes business: One of the biggest surprises over the past few quarters has been the consistent performance of ITCs non-cigarettes FMCG business, which has delivered consistent 20%+ revenue growth. Sustained growth of the business combined with improving profitability will be a key catalyst. The cigarettes business continues to be steady and is likely to again deliver in FY14F (forecast). Volume growth in the cigarette business, which was negative in Q2FY14, should reverse into H2, which should also be a positive catalyst.
Performance in line with sector average on a YTD basis: ITCs performance so far this year has been largely in line with the FMCG index (ITC +7%, vs. FMCG index +7%). Given the strong run the stock has had since January 2011 (ITC +69%, Sensex +2%), YTD (year-to-date) performance has been modest. The stock has seen a 18% correction since 23 July 2013, vs. the Sensex up +3% in the same time period. It has also underperformed the FMCG index by 2%.
Operational performance has continued to be strong: The company has continued to deliver strong operational performance over the past few years, with cigarette business being the key growth driver for profits. Over the last five years, operating profits for the company have grown at an average of 19%, which is among the highest in the sector. Additionally, a large part of this has been driven by cigarettes, with contributions from other business to operating profits still under 20%.
Cigarette business on a strong footing: As with previous years, the company has been able to deliver strong Ebit growth in the cigarette business despite the fact that volume growth has continued to remain in the low single digit range. While the volume growth has averaged 3% over the last decade, Ebit growth in the cigarette business has been 16%+ over the same period. The company has now delivered eight consecutive years of 15%+ Ebit growththis level of consistent growth is unmatched elsewhere in the sector.
Strong pricing power key to medium-term growth: We believe the consistent performance will continue over the medium term on account of the strong market position and pricing power that ITC has. With over 70% volume share and a higher value share of the market, ITC is the undisputed No. 1 in the cigarette market in India. The company has also been able to pass on any increase in excise duty to consumers. For the most part, not only have price hikes been passed on, but given the higher impact on EPS from pricing as compared to volume growth, margins have seen a 10% point increase over the last decade.
Risk of tax increase less likely in the near term: Given the general elections next year, the risk of any increase in excise duty in the near term looks minimal. We believe there will not be mid-year changes to the taxation structure and any change to excise duty will only come through once the general elections are over next year. The new cabinet will be in place by May 2014 with the budget being presented in June 2014. This means there are at least three more quarters where there is minimal chance of there being any increase in taxes. This is a key positive as excise duty increases has been sharp in the last couple of years and it may well be that the company gets a respite in FY15F. In the year of the elections in 2004 and 2009, excise duty increases were in the mid-single digit range. While there is no way of estimating what would be the likely change next year, we believe risk of any sharp increase is minimal in the near term.
Valuations at a steep discount to HUL:The stock trades at a P/E multiple of 22.8x on FY15F earnings of R13.57, which is significantly cheaper than HUL at a P/E of 30.7x on FY15F EPS of R18.44 and also some of the other mid-cap consumer names. We maintain ITC as our preferred pick.