We upgrade the rating of ITC to Overweight from Underweight as we see compelling risk-reward. ITC has been a strong consensus buy–yet it has been one of the worst performing stocks in our coverage universe over the past 12 months, trailing the Nifty by 18%. The sharp increase in retail prices of cigarettes may have reduced the relative affordability for some consumers–the 2015 Union Budget marked the fourth consecutive year of >15% excise hikes on cigarettes.
ITC’s cigarette business volumes have declined through FY14-FY15, with average 14-15% volume decline in second half FY15 and 17% decline in first quarter of FY16, driving sharp de-rating over the past 24 months nearly 600bps compression in 12-month forward PER (price-to-earnings ratio), to 23.3x, below its five-year average of 26.5x. We believe ITC’s current share price factors in high-single-digit Ebit growth for the next 10 years versus 17% compound annual growth rate (CAGR) over the last 10 years. With an improving macroeconomic environment, we expect ITC’s non-cigarette businesses – i.e.,hotels, paper & packaging and FMCG – to perform well.
Global cigarette industry trends supports the new rating:Our analysis of global markets shows that quality businesses find a bottom, and that incremental stock performance is linked to earnings growth and visibility thereon. We reiterate our view that if cigarette volumes elasticity remains <-0.6, ITC would have sufficient pricing power to offset tax increases.
Further, out of the 72 countries analysed, 18 have illicit cigarette share >20% of total volumes sold. India’s share of illicit cigarettes was 19% in 2014, up from 12% in 2006. Moreover, India is unique in that only 12% of total tobacco consumption is in the form of duty-paid cigarettes. Lightly taxed or tax-evaded tobacco products (bidis, chewing tobacco, etc.) constitute 88% of total tobacco consumption. According to ITC, products representing 68% of overall tobacco consumption escape taxation. In our view, because of the rise in illicit volumes, there is increased probability of relatively benign tax policy in the upcoming Union Budget.
The new stance: Historically, ITC’s valuation was largely linked to cigarette volume growth. In FY11, however, this correlation broke, led by increased investor conviction in ITC’s ability to manage cigarette business profitability despite potentially sharp tax-driven price hikes. Over the three years from FY11 through FY14, ITC’s cigarette business reported nearly 19% average operating profit growth even as its price-earnings ratio expanded by nearly 600 basis points.
ITC is the top pick within staples: Valuations and earnings expectations are relatively benign. In addition, our analysis of global cigarette industry trends supports our new Overweight rating. We list three stock catalysts—cigarette volume elasticity over the next two quarters, pricing action and tax policy in the upcoming budget. We see high probability of a favourable outcome for these events, which combined could lift P/E (price-to-earnings multiple) to 30x FY17 estimate – a 15% discount to the average of our staples coverage, offering nearly 40% upside potential.
We cut our F16-F18 earnings estimates for ITC by 5-6%: This reflects weak performance across business segments in Q1FY16 results. With higher than expected volume decline in Q1, we now forecast 12% volume decline in FY16 (down from a 10% decline) and 19% weighted average cigarette price hike (our prior forecast was 22%).