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Aggressive investment continues in FMCG-Others segment
Near-term outlook for cigarettes uncertain; Valuations fair
We pored over ITC’s FY19 annual report; key insights highlighted below:
Cigarette sale mix continues to reduce EBIT contribution remains high
* ITC’s cigarette business’ contribution to revenues has been steadily declining over the years (now stands at ~41%, excluding eliminations), but it accounts for the lion’s share in profits generated by the company with EBIT contribution of 85%. Notably, EBIT contribution from the cigarette business has remained at 85-86% in the last five years. Also, the FMCG-Others business has ramped up well, growing at 10.5% with segment EBIT almost doubling in FY19 (~2% of total EBIT). However, it will take a few more years for the segment to contribute meaningfully to the company’s profits.
Massive capex investments for the future continue
* The year saw an investment of ~INR27.6b across businesses. An investment outlay of INR25b has been envisaged to support creation of several Integrated Consumer Goods Manufacturing & Logistics facilities (ICMLs) for its FMCG businesses, to build iconic luxury hotels and to strengthen distribution and the agri-backend. A major portion of incremental capex remains towards the FMCG-Others business segment with FY19 seeing capex of INR13.2b. Flurry of new launches n During the year, the company executed more than 50 new product launches across geographies, apart from extending distribution reach of several existing products in the portfolio. Currently, ITC’s distribution network directly and indirectly covers over 6m retail outlets across various trade channels.
Financials – Return ratios see slight improvement
* Net Working Capital Days decreased by 5 days and now stands at 57 days (calculated on average basis), driven by improvement in raw material and finished goods inventory. Free cash flow (FCF) for ITC remained healthy in FY19 (INR90b), but saw a decline of 11% YoY as benefits of higher payable days seen in FY18 was absent this year. Return ratios improved slightly in FY19 (RoE stood at 22.8% v/s 22.3% in FY18 and RoCE inched up to 22.1% v/s 21.6% in FY18).
Valuation & View
* Even after 23 months since the last GST hike, Cigarette EBIT growth remains below 10%. Moreover, our moderate 9.3% earnings CAGR (FY19-21) estimate has a downside risk if the GST Council increases the rates applicable to cigarettes in its subsequent meetings. We believe that ‘more the delay, more the risk’ of a sharp tax rate increase, which would eventually exert significant pressure on volumes. An increase in the ad valorem duty would sour the investment case further. Despite favorable environment in FY19, cigarette EBIT grew only 9.1%. While ITC trades at a discount to Indian FMCG peers at 22.7x FY21E EPS, it is at a premium to global cigarette majors (1.5x-2.5x). Due to the uncertain cigarette earnings outlook (accounts for 85% of EBIT), we maintain Neutral rating with a target price of INR310 (25x June‘21E EPS).
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