ITC’s cigarette business remains impacted by regulatory pressures in terms of sharp tax hikes and other anti-tobacco measures, which has led to pressure on volumes and Ebit growth. Other businesses i.e., FMCG, paper, hotels and agri, should see gradual uptick in growth and profitability, albeit small. We expect 11% EPS CAGR over FY17-20e, and valuations at 27.3x FY19e PE make risk-reward balanced. Assume coverage at Hold and PT of Rs 305.
Cigarettes (92% of total Ebit) hit by regulatory pressures
Prevalence of smoking is going down in India given a slew of anti-tobacco measures and sharp tax hikes over the past five years. The government recently did a U-turn by raising GST rates on cigarettes, leading to an overall tax increase of 15% in FY18e. We build in 7% Ebit growth in FY18e, driven by price hikes and 1% volume growth. Tax increases in FY19/20 remain key to stock performance, as any further double-digit tax increases would be difficult to absorb given widening gap vs the unorganised/illicit sector (now 20% of total and growing in salience).
Other businesses, albeit small, to see gradual recovery
Other FMCG businesses have seen healthy performance from packaged foods brands such as Sunfeast, Aashirvad, Bingo and Yippee, while personal care categories have been subdued. We remain positive on foods and stationery part of the portfolio. However, a slew of new launches like juices, dairy, chocolates etc and personal care losses would limit segment margin expansion potential. In terms of other segments, we expect a gradual improvement in growth and margin outlook for hotels and paper as demand trends pick up and operating leverage kicks in.
Overall, 11% EPS CAGR over FY17-20e
We expect 10% revenue CAGR and 130 bps Ebitda margin expansion over FY17-20e, leading to 11% EPS CAGR. We are 3-5% below consensus on FY18-20e EPS. We expect capex to remain steady at Rs 30-35 bn p.a.
Our SOTP-based Sep ’18e PT is Rs 305 (~8% potential upside from current levels). It is currently trading at 27.3x FY19 P/E, largely in line with its five-year average multiple, which seems to factor in recent negative regulatory developments. However, modest earnings growth and harsh regulatory environment limit positive earnings surprise and valuation rerating potential, leading to a balanced risk-reward. Upside risks: no or low cess increase in FY19. Downside risks would be 12%+ increase in cess in FY19/20 or higher share of ad valorem cess in the overall tax component.
Cigarettes remain sole earnings driver, Ebit CAGR at 11% over FY17-20E
ITC’s cigarette business has grown consistently in the past 10 years with Ebit CAGR at 14%, resulting in 92% share of the overall company Ebit (vs 85% in FY12). Cigarette Ebit growth has slowed down over past three years, given a slew of negative regulatory interventions (sharp tax hikes, ban on single stick sales, bigger pictorial warnings), resulting in pressure on volumes and overall Ebit growth trajectory. The government has been able to bring down prevalence of tobacco and smoking in India on the back of these steps, though at the cost of rising share of illegal tobacco and loss of revenue to the exchequer. India, being a signatory to Framework Convention on Tobacco Control (FCTC), has over the past few years implemented measures to control overall tobacco usage, primarily on cigarettes and smokeless tobacco. Taxation levels in India on cigarettes are high relative to other emerging markets, leading to lower affordability on PPP basis. Globally, anti-tobacco measures are getting stronger aimed at reducing overall consumption (e.g. recent news of US FDA reducing nicotine levels to non-addictive levels).
While GST implementation helps the company in terms of resolving wide state-level VAT differences (ranging from 12.5% to 75% previously), this has resulted in 8-9% weighted average tax increase which, coupled with 6% excise increase during February 2017 Budget, implies another year of 15% tax increase. The company would require 8-9% price increase to maintain its net realisation which has been implemented. We expect cigarette volumes to grow at 1% in FY18 given higher tax increase post GST and 3% CAGR over FY18-20 driven by a lower 11% CAGR hike in taxes. The government increase in cess on cigarettes going forward should now be a function of overall tax buoyancy in GST collections and if this is healthy, we might see lower tax increase, which could be a positive trigger for the stock.
The company negotiated a high tax increase regime earlier (FY11-14) without impacting Ebit growth, as price increases were well absorbed by consumers, resulting in no impact on volumes and Ebit growth. However, sustained high tax increase even during FY14-17, when overall inflation, income and consumption growth were muted, resulted in sharp volume decline due to increasing share of illegal industry . Volume growth outlook for organised cigarettes industry would rest on government policies, as there is a potential for gradual shift from unorganised and lower end tobacco usage (currently 89% of total tobacco consumed in India) to legal duty-paid cigarettes consumption which would be win-win for all stakeholders given higher taxation and lower price affordability, leading to lower consumption.
Other FMCG – some hits, some misses
ITC remains committed to scaling-up ‘other FMCG’ business and has invested significantly in this SBU. While revenues have grown at 15% CAGR over the past 10 years to reach Rs 105 bn, Ebit continues to remain muted with business just breaking even. The company has done well in the food segment with Aashirvad, Sunfeast, Bingo and Yippee gaining share in respective categories and cumulatively accounting for Rs 85 bn sales in terms of consumer spend. We expect these four brands to continue their steady growth momentum and contribute to overall Ebit improvement (we estimate these brands have high, single-digit Ebitda margins).
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