ITC: Worst case scenario factored in?

After sharp duty hikes in recent years that led to fall in tax collection from cigarettes, analysts believe further hikes by govt will be benign

Punitive tax regimes for cigarettes have proved to be a bane for ITC in the past. Sharp hike in duties on cigarettes in recent years has been no different.

Duties have been increased by over 15% in each of the last four Union Budgets. Though ITC has judiciously hiked prices to offset the duty increases, its cigarette volumes have taken a hit. The compounded effect has been that volumes have fallen in excess of 10% for three consecutive quarters starting Q3 FY15, leading to slowing EBIT growth in the business which has been the biggest contributor to revenue and profits of the company. Volumes are estimated to have fallen by 8-10% in FY15 and FY16 could see these come down by a similar number. And like during previous occasions when high taxes impacted volumes leading to the stock’s de-rating and thus underperformance, this time too the company has lagged on the bourses. 

Every time though after such periods of volume contraction, the stock has bounced back covering up for the underperformance. Will this time be different? 

Quite a few analysts believe the worst is factored in. ITC’s current market price already factors in the worst-case scenario of compounded annual growth of -6% in volumes and 16% in excise duty over FY15-20, said Rakshit Ranjan and Ritesh Vaidya of Ambit Capital. 

The analysts, who have a buy on ITC with target price of Rs 395, expect positive catalysts to emerge from 2HFY16, helped by a weak base and higher consumer demand. 

On 19 August, Morgan Stanley analysts, Nillai Shah and Indira Badrinarayan, upgraded the stock to overweight. They said, “There are risks with respect to continuing adverse policy action, yet valuations and earnings expectations are relatively benign.”

While it is anybody’s guess as to how much more duty increases the central and state governments will undertake, history suggests that increases beyond a level are detrimental. Led by the sharp increases in the past 3-4 years, the share of illicit cigarettes has increased sharply. Analysts estimate that the same has increased from 12-13% in 2009-10 to 18-20% currently, which is the highest in over 15 years. Recently, cheap Chinese brands have also made way into few Indian cities, taking away some of the volumes from organised players. As a result, absolute tax collections are down. Thus, analysts believe further increases will be benign. 

Morgan Stanley analysts say, “Drawing parallels with industry trends and evolution in 72 countries globally, we conclude that there is a higher probability of relatively benign tax policy from here.”

If duty increases are indeed reasonable, given the low-base effect, volume growth for ITC could look up again and rub-off positively on stock valuations. In a few months, clarity on the same will emerge.

Meanwhile, ITC continues to increase focus on its non-cigarette consumer businesses (FMCG). Notably, after nearly a decade of existence it reported a turnaround in FY15 with a profit of Rs 22 crore. Although its back in the red (small loss of Rs 8 crore) in the June quarter, its profitability should only rise from here on. Notably, ITC is reportedly looking at entering the dairy products segment, which among other categories is aimed at helping the company achieve its FMCG revenue target of Rs 100,000 crore by FY2030 (CAGR of 17%). An expected recovery in economic demand around end-FY16 should also rub-off well on its hotels and paper business. 

In the medium-term, post an estimated single-digit increase in FY16 earnings, ITC’s EPS is expected to grow by 14-15% each during FY16 and FY17. In all, these should drive the stock performance. The only key risk is government action on the tax/policy front.