More re-rating ahead for ITC; cigarette volume growth revives in Q1

Shares of ITC, which were under pressure until recently due to regulatory challenges faced by its flagship business of cigarettes, hit a 52-week high of Rs 307 during intra-day trade on Friday, before ending 5.2 per cent higher at Rs 302.2, after the company announced its June-2018 quarter (Q1) results late on Thursday. In a surprise, the company reported 1.5 per cent growth in cigarette volumes as against 1-2 per cent decline expected by analysts. There was 1 per cent growth in the year-ago quarter. 

In fact, this was the third consecutive quarter of a progress in cigarette volume growth (see chart). Given that cigarettes account for over 85 per cent of ITC’s profits, an improvement cheered the street. However, despite a 16 per cent gain in the past one month, many analysts still believe a further re-rating for ITC's stock is possible given the improvement across businesses and reasonable stock valuations. The ITC stock is currently trading at 26 times its FY20 estimated earnings versus 45-50 times for many other FMCG stocks.

This (re-rating) would be on the back of most regulatory headwinds being behind for the cigarette business. A gradual and consistent improvement expected in the other-FMCG business and upturn in other businesses such as hotels and paper, say analysts at Philip Capital in their note on ITC post its Q1 (June quarter) results.

A steep escalation in taxes under goods and services tax (GST) has weighed on ITC's cigarette business; the elevated share of illicit trade (including smuggled imports) has only made matters worse. All this restricted growth in the cigarette business in Q1 too, though year-on-year figures are incomparable due to the rollout of GST in the year-ago period. Analysts, however, say that after the steep hike last year, the duty hike has been milder. 

“This milder rate hike is likely to sustain since the GST rate collection, especially compensation cess, has been improving month-on-month. Hence, we believe, cigarette volumes will improve and if supported by the shift from illegal to legal cigarettes, can be an added boost to overall cigarette volumes,” said analysts at Edelweiss, in a report last Thursday.

Sachin Bobade, an analyst at Dolat Capital, agrees: “Given the favourable base of last year and no change in prices since the past two quarters, cigarette volumes should improve going ahead.”

Nevertheless, as growth in other businesses gains pace over time, the share of the cigarette business in overall revenue should fall further as seen in Q1. ITC's other-FMCG and hotels businesses performed well in Q1. Revenues from these two segments increased by 10.3 per cent and 11.9 per cent year-on-year, respectively. While demand was healthy for many packaged and ready-to-eat foods, continued premiumisation in confectioneries segment are some of the factors which pushed sales of the other-FMCG business. It's the hotel business too benefitted from higher room rates, robust food & beverage sales and operating leverage. The profit growth in other-FMCG, paper and hotels was much superior. Moreover, after a poor performance in the past four quarters, ITC's agriculture sales rose by 14.2 per cent year-on-year, supporting overall top line.

ITC, as per its FY18 annual report, has projected Rs 250 billion investment into these businesses and also launched new products in Q1. All these are indications of ITC's efforts to scale up the share of the non-cigarette business. This gives some comfort as the cigarette business, according to some analysts, could see some choppiness amid regulatory challenges. Hence, the upward trend in other segments’ profit contribution will auger well for the company.

Overall, ITC Q1 net profit rose by 10.1 per cent year-on-year in Q1 amid a 161 basis point expansion in operating profit margin to 39.2 per cent owing to cost control. ITC's other expenses as per percentage of net operating revenue dropped to 15.4 per cent in Q1 from 17.1 per cent in the year ago.

HDFC Securities' analysts Naveen Trivedi and Siddhant Chhabria, in their post results note titled 'Re-rating on the cards', say, "Our long-term positive stance on ITC derives from its status of being the cheapest consumer large-cap stock in India.” At 26x FY20 estimated earnings, ITC trades at an unfair discount of about 35 per cent to the sector, they add.


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