At current valuation, very limited downside risk for ITC stock investors

Higher dividend yield and scaling up of FMCG business offer comfort

Despite being the most attractively valued amongst Nifty FMCG stocks, ITC continues to underperform peers as well as leading indices. In the calendar year 2020 so far, the ITC stock has lost a whopping 25 per cent as compared to about 2 per cent gain in the Nifty FMCG index and 5.3 per cent fall in the Nifty50 during the same period. However, analysts say, it may have hit a trough and with FMCG (non-cigarette) business gaining pace, cigarettes operations near normal and a high dividend yield, the stock is attractive.

Tax overhang and ESG (environmental, social and governance) concerns over cigarettes have been among key factors hurting investor sentiment. While the company earns over 85 per cent of its operating profit from cigarette business, which also justifies the Street’s concern, analysts believe there is very little to lose at current valuation levels of the stock.

At around 15.5 times 1-year forward estimated earnings, the stock of ITC is not only trading at 54 per cent discount to Nifty FMCG’s 1-year forward valuation but also 35 per cent lower than its own historical valuation mean.

According to Vishal Gutka, vice president at PhillipCapital, “Though there are some concerns such as a likely increase in cigarette cess, we believe ITC’s current valuation along with factors such as growing non-cigarette FMCG business and higher dividend yield indicates very limited downside risk for investors.”

While ITC announced its new capital allocation policy of paying 80-85 per cent of its profit after tax to shareholders in medium term in March this year, analysts at JM Financial believe that the FMCG business has potential to drive the stock’s re-rating in the medium term.

In June 2020 quarter (Q1), performance of ITC’s FMCG business was impressive with essential products portfolio (staples, convenience foods and health and hygiene) growing by 34 per cent year-on-year. Though sales of discretionary part of the FMCG segment remained under pressure in Q1, it is likely to normalise as the economy is getting unlocked. Notably, EBIT (earnings before interest and tax) of ITC’s overall FMCG business surged by by 60.7 per cent year-on-year to Rs 125.4 crore.

ITC has also been open to making acquisitions. In late July, ITC acquired spices manufacturer Sunrise Foods in an all-cash deal worth Rs 2,150 crore. This acquisition can add to the FMCG business' margins and is scalable too.

Though FMCG’s profit contribution is very minuscule (around 5 per cent) to boost the overall earnings of the company, Shirish Pardeshi, analyst at Centrum Broking, says, “ITC has all the ingredients to support the stock with scaling up its FMCG business. Also, given higher demand for packaged food in Covid-19 times, we can expect faster recovery in profitability.”

The management is also focused on improving productivity and operating leverage, he added.

While for cigarette business, competition is rising mainly in the lower-end of the segment, ITC’s large market share of over 75 per cent across the states and strong pricing power offers comfort.

Importantly, it is also rebounding well from the pandemic impact. In a report this month, analysts at Axis Securities say, “June and July have seen a healthy recovery in core cigarette business driven by rapid scale up in operations, supply-chain normalisation, market share gains (competition plants remained close), innovative product offerings (5 sticks cigarette pack vs 10 sticks standard pack, new launches in 64mm size) and trade promotions in king size/regular size filter tip. These, we believe could support earnings momentum in FY21.”

While its hotels business is facing rough times due to the fall in travellers on account of the pandemic and is likely to be a drag in FY21 (among reasons for flat earnings growth), the agri and paper & paper boards businesses to see gradual improvement, said analysts.

Last but not the least, given the high dividend payout policy, the dividend yield is also attractive at over 5 per cent, much more than the savings account rate and some of the fixed deposit tenures.