We pored over ITC’s FY19 annual report; the key insights are: ITC’s cigarette business’ contribution to revenues has been steadily declining over the years (now stands at 41%, excluding eliminations), but it accounts for the lion’s share in profits generated by the company with Ebit contribution of 85%. Notably, Ebit contribution from the cigarette business has remained at 85-86% in the last five years. Also, the FMCG-Others business has ramped up well, growing at 10.5% with segment Ebit almost doubling in FY19 (2% of total Ebit). However, it will take a few more years for the segment to contribute meaningfully to company’s profits.
Massive capex for the future continues The year saw an investment of Rs 27.6 bn across businesses. An investment outlay of `25 bn has been envisaged to support creation of several Integrated Consumer Goods Manufacturing & Logistics facilities (ICMLs) for its FMCG businesses, to build iconic luxury hotels and to strengthen distribution and the agri-backend. A major portion of incremental capex remains towards the FMCG-Others business segment with FY19 seeing capex of Rs 13.2 bn.
Flurry of new launches
During the year, the company executed more than 50 new product launches across geographies, apart from extending the distribution reach of several existing products in the portfolio. Currently, the company’s distribution network directly and indirectly covers over 6 million retail outlets across various trade channels.
Financials– return ratios improve
Net Working Capital Days decreased by 5 days and now stand at 57 days (calculated on average basis), driven by improvement in raw material and finished goods inventory. Free cash flow (FCF) for ITC remained healthy in FY19 (`90 bn), but saw a decline of 11% y-o-y as benefits of higher payable days seen in FY18 was absent this year. Return ratios improved slightly in FY19 (RoE stood at 22.8% v/s 22.3% in FY18 and RoCE inched up to 22.1% v/s 21.6% in FY18).
Valuation and view
Even 23 months since the last GST hike, Cigarette Ebit growth remains below 10%. Moreover, our moderate 9.3% earnings CAGR (FY19-21) estimate has a downside risk if the GST Council increases the rates applicable to cigarettes in its subsequent meetings. We believe that ‘more the delay, more the risk’ of a sharp tax rate increase, which would eventually exert significant pressure on volumes. An increase in the ad valorem duty would sour the investment case further. Despite favourable environment in FY19, cigarette Ebit grew only 9.1%. While ITC trades at a discount to Indian FMCG peers at 22.7x FY21e EPS, it is at a premium to global cigarette majors (1.5x-2.5x). Due to the uncertain cigarette earnings outlook (accounts for 85% of Ebit), we maintain Neutral rating with a target price of Rs 310 (25x June’21e EPS).