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Multiple drivers for rerating; upgrading to BUY
We see multiple drivers for ITC stock rerating from current (relative) cheap valuations. We expect consensus upgrades from a medium-term boost to profitability in FMCG as margins improve in the extant categories and likely delay in incubating new ones. We model FMCG EBIT to grow to Rs10bn by FY2021E – contributing 5% to company EBIT. Increase in FMCG margin, albeit transitory in our view, could be a key driver for stock rerating. No tax hike in cigarettes (yet) under the GST regime, improvement in volume growth (+5% in 9MFY19) and lower share of illegal cigarettes (declined to 18% from 25% (our view)) inspires confidence. Global tobacco stocks derating has also reversed over the past two months (see Chart 1). Upgrade to BUY.
* Medium-term boost to profitability in FMCG:
In our view, FMCG business could see profitability increase with improving profitability of extant categories and likely delay in incubating new ones (like dairy, chocolates, skimmed milk powder, coffee, tea, etc.). We model EBIT to grow to Rs6bn / Rs10bn in FY2020E / FY2021E – contributing 5% to company EBIT by FY2021E vs. slightly just over 1% in FY2018.
* No tax hike on cigarettes in FY19 leading to acceleration in volume growth, lower illegal cigarette trade:
Tax on cigarettes has remained unchanged in FY2019 (last hike in July 2017). This has led to over 5% volume growth in 9MFY19 – albeit on a low base (3% decline in 9MFY18). Since implementation of GST, ITC has hiked cigarette prices only recently – price hikes on select regional brands translating to c.3% price increase as per our calculations. The period of no tax increase / minimal price increase by ITC has reduced the share of illegal cigarettes to 18% from c.25% (our view). On the flip side though, ITC may find it difficult to justify any steep price hikes (assuming no tax increases) given already low affordability of cigarettes in India (see Chart 2) and low inflationary environment (see Chart 3).
* Valuation and risks:
We upgrade our earnings estimates c.2% due to faster-thanexpected margin expansion in FMCG and higher confidence in cigarette volume growth; modelling revenue / EBITDA / PAT CAGR of 12% / 16% / 15% over FY19- 21E. We upgrade to BUY (from ADD) with DCF based revised target price of Rs340 (Rs290 earlier). At our target price, the stock will trade at 28x P/E multiple Sep-20E. Key downside risk is tax hikes much ahead of inflation leading to volume pressure (on cigarettes) as price elasticity is still unfavourable.
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