ITC: Fears of a sharp decline in volumes unfounded

Stock trading at 29% discount to FMCG universe; 16% earnings growth likely this financial year

Consumer stocks are back in favour. The BSE FMCG Index has risen 10 per cent in three months, while the Sensex has risen five per cent in the same period. However, ITC continues to underperform the Sensex, even though the company's stock is trading at a 29 per cent discount to the fast-moving consumer goods (FMCG) universe. Historically, ITC has traded at a 13 per cent discount but with concerns emerging around curbs on cigarette sales, the discount has widened.

In the September quarter, ITC’s cigarette volumes are expected to decline two-three per cent and its net profit is estimated to grow 14 per cent year-on-year. Investors are not be betting on the stock on fears of weaker sales and profits from the cigarette division.

Analysts, however, remain bullish over the longer term. Given ITC's valuations, the estimated market-implied sales growth for ITC would be 13.3 per cent over 2014-2025 against 17.3 per cent average for the FMCG sector.

  However, Goldman Sachs believes this is unjustified as ITC's sales have grown at a compounded annual growth rate (CAGR) of 18 per cent over FY04-14, while post-tax profit has grown 19 per cent CAGR. The company has shown resilience in earnings growth and has seen minimal downgrades. The market is currently pricing in a cigarette volume of 22 per cent, which is unlikely to happen as price hikes are similar to previous levels.

Morgan Stanley is projecting a 16 per cent earnings growth in FY15 and in case cigarette volume growth is higher than estimates, then the valuation multiples for ITC would possibly expand.

Even if curbs on packaging and cigarette sales come into practice, analysts believe ITC's volumes would not be affected over the long-term. Experience from other international markets also suggests that have an impact on smoking habits. Morgan Stanley has another interesting observation. The brokerage expects ITC's volumes to grow four-five per cent CAGR over the next 10 years, as the unorganised sector (bidis) is declining at two-three per cent a year. Even if half this market switches to cigarettes, ITC's volumes would increase.

Brokerages such as Morgan Stanley and Goldman Sachs remain constructive on the stock as it is trading at a discount to other consumer staple companies, making the risk-reward attractive.