ITC: Premium stock at discounted rate

In sharp contrast to most peers and the Sensex, the ITC stock has under-performed in the past three months, making it attractive due to strong earnings and cash flow visibility

The ITC stock has underperformed both the S&P BSE Sensex and the S&P BSE FMCG (fast-moving consumer goods) index through the past month, as well as the past three months. Pressure on cigarette volumes (falling since the past two quarters) and investors’ increased appetite for high-beta stocks could be some of the reasons for this underperformance.

However, the current valuations ignore positives such as strong pricing power in the cigarettes business and the continued traction in the FMCG business (revenues rose about 15 per cent through the past few quarters). At current market price, the stock is trading at 23.5 times the FY15 estimated earnings, a steep discount to peers such as HUL, GCPL, Dabur and Colgate, which are trading at 27-31 times the FY15 estimated price/earnings ratio. Also, the company’s historical average one-year forward price/earnings multiple is 22, close to its current valuations.

Most analysts remain positive on the stock and believe this correction offers a good entry point. “We continue to believe ITC will deliver mid-teens Ebit (earnings before interest and tax) growth in the cigarettes business through the next three years, which should drive a solid stock performance from current levels. We think the recent underperformance is a great opportunity to add the stock to portfolios,” says Manish Jain, consumer analyst at Nomura. He believes at current valuations, ITC’s discount to large caps such as HUL and Nestle is significantly higher than long-term averages.

Of the 14 analysts polled by Bloomberg since November 2013, 12 have buy ratings, while two have neutral views. Their average target price stands at Rs 367 a share, 16 per cent more than the current price of Rs 317 a share.

Cigarette volumes likely to recover
In response to the sharp rise in taxes by state governments, ITC had announced significant price increases. This hit the company’s volume growth in cigarettes. Historical data, however, suggests significant price rises are absorbed through two-three quarters, followed by a gradual pick-up in volumes. Once volumes rise, sentiment towards the stock improves.

“We are expecting a recovery in ITC’s volume growth to five per cent in FY15, compared with a decline of three-four per cent expected in FY14, especially since we do not see any risk of a major increase in the levies on cigarettes in the forthcoming Budget. Also, the 64-mm cigarette (which accounts for eight per cent of total cigarette volumes) is gaining good response in the domestic market and will support volume growth,” says a recent note by Sharekhan.

Most analysts rule out a significant rise in excise duty on cigarettes, on account of the coming general elections. However, even in the worst case, the downside for the stock will be marginal, believe analysts, some of whom have done a worst-case scenario analysis for ITC. “Our bear-case scenario assumes an elevated hike (15 per cent) in indirect taxes (for the third consecutive year), flat cigarette volumes and failure to turnaround the FMCG business. Even in such a scenario, our SOTP-based target price stands at Rs 303,” says Harsh Mehta, FMCG analyst at HDFC Securities. Assuming this bear-case target price, the downside is limited to four per cent from current levels.

FMCG business on track
Meanwhile, ITC’s FMCG business (which accounts for 21 per cent of its revenue) continues to do well, with gains in market shares in select segments. While its foods business (67 per cent of the FMCG business) is already making profits, break-even of the personal care business will be a key catalyst. Analysts expect the FMCG business to achieve Ebit break-even in FY15. In FY13, losses in the business fell 58 per cent to Rs 81 crore, compared to FY12. These fell an additional 54 per cent to Rs 31.6 crore. The company has been pretty aggressive, having launched many products across FMCG categories. Its recent new launches — Sunfeast Delishus gourmet cookies and Candyman Jellicious in the jelly segment — have seen good response. ITC plans to foray into the dairy and chocolates categories in the near future, and this could fuel further growth in the company’s FMCG business.

While potential in the FMCG business is huge, a major trigger for the stock will come once this business starts generating profits on a consistent basis, and that stage isn’t very far.

Among other businesses, paper has seen some pressure on profits, though this has been offset by gains in the agri business. The hotels business has also seen pressure, owing to the economic slowdown. However, expect this business to do well once growth picks up; most analysts are hoping this will happen from FY15.