Higher tax on cigarettes: Dalal Street may be undervaluing ITC stock

"Buy when everyone is selling" explains one of the principles of Warren Buffett, the world's most celebrated investor, who is known for his "value investing". Fitting this maxim in the Indian context could be ITC, which investors may want to look at.
The ITC stock has been a clear underperformer, lagging the S&P BSE Sensex in the past 12 months. Compared to a rise of 27 per cent in the Sensex, ITC is up just about six per cent, because of a negative tax surprise for its key cigarettes business. But, if analysts are to be believed, it may be a good time to accumulate the stock as apart from an expected improvement in business prospects in the next fiscal year, the risk-reward equation is far more favourable.

For one, the stark underperformance also means that based on FY19 estimated earnings, ITC's stock valuations are now at 24-25 times, nearly half the 45-46 times of Hindustan Unilever. ITC's trailing 12 months' earnings (ending September 2017) valuation at 31.2 times is also a tad higher than its 10-year price-earnings multiple of 30.4 times. Low valuations typically provide cushion from potential future shocks.

The weak sentiment stems from the government's move in mid-July, where it corrected the anomaly in goods and services tax (GST) on cigarettes by increasing cess. In the first fortnight of the implementation of the GST, the tax on cigarettes was much lower than pre-GST levels, which saw the ITC stock surge 13 per cent in two days to its all-time high of Rs 353.20. But, it soon fell sharply as the tax anomaly was corrected. The sentiment has since remained muted, as ITC also warned about the pressure in the cigarettes business along with its September quarter (Q2) results.

Not surprisingly then, after falling by an estimated six-seven per cent in Q2, the Street expects cigarette volumes to decline marginally (by two-three per cent) or stay flat in Q3. With the high-margin cigarette business contributing 85 per cent to ITC's earnings before interest and tax or Ebit, market sentiment is bound to get impacted. But, it also seems the market is factoring in extremely low growth, say analysts. With earnings expected to be much better in FY19, analysts say it is a matter of time till the market rewards the stock.

The muted volume trend in cigarettes could continue for a couple of quarters, but an improvement is already on.

"We are witnessing early sign of volume growth stabilising and should gradually witness some momentum. In our view, the worst in terms of volume growth slowdown is behind us and we should witness improved volume growth in tobacco segment," analysts at JM Financial wrote in a January 1 report.

Moreover, the strong focus on the fast moving consumer goods (FMCG) business (excluding cigarettes) with a long-term goal to clock Rs 1 trillion in revenue by 2030 itself talks of its future potential; FY17 sales were Rs 105.37 billion. While FMCG's top line growth may appear to have slowed in the past two-three years, it is partly due to benign inflation. More importantly, it has been making profits (Ebit level) in the past four years, and the first half of FY18 has seen profitability improve further.

Compared to an Ebit of Rs 54 million in the June 2017 quarter and a loss of Rs 33 million in the year-ago period, it clocked an Ebit of Rs 205 million in Q2FY18. Edelweiss analysts expect this business to clock 15 per cent growth in revenue in Q3.

Among other businesses, hotels, too, have seen a marked improvement in Q2, while the paperboards, paper and packing business saw profits surge 18 per cent year-on-year. Paper, in fact, is in a sweet spot with companies being able to set prices amid some protection from imports. ITC is a leader in value-added paperboards and notebooks, and thus, better-placed to withstand potential industry headwinds.

Going ahead, the overall business environment is improving. Analysts also believe that the government is unlikely to raise taxes further on cigarettes in the forthcoming Budget. Already, high taxes are hurting the legitimate tobacco industry, while encouraging the grey market (smuggled/imported goods). Higher taxes are the only key risk to ITC's earnings for now. Interestingly, analysts argue that in the past two years, ITC has clocked at least five-seven per cent quarterly earnings growth even in the worst conditions.

On the road ahead, HDFC Securities analysts said last month-end, "We expect revenue/Ebitda/adjusted net profit to grow at a compounded annual rate of 9/10/10 per cent respectively over FY17-20. ITC operates at Ebitda margin of 36 per cent, along with core return on capital employed of 40 per cent." They maintain buy rating with a target price of Rs 358 for the stock trading at Rs 265.

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