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Muted Cigarette volumes; Other FMCG margin pressures weigh on ITC

* Tapering in-home consumption and sharp commodity cost inflation could affect strong EBIT growth in the Other FMCG segment, preventing the contribution of Cigarettes in overall EBIT to decline much (likely to reduce to ~80% in FY23E which is still within its ten-year range of 80-86%).

* Cigarette volumes for ITC and even other players globally have been on a declining trend, given the increased health consciousness among consumers over the last decade. With the government having recently (Oct’21) set up an expert panel tasked with preparing a comprehensive tax policy proposal for all forms of tobacco from a public health perspective, the overhang of a policy change that may affect cigarette volumes remains on the stock.

* The rumored demerger of ITC Infotech, even at INR200-250b, is only 6-8% of ITC’s current market capitalization and is partly factored in the price already. In our opinion, it does not portend demerger of other FMCG or the Hotels business in the near term, nor does it reduce the dependence on its Cigarette EBIT.

* While ITC’s efforts on the overall ESG (environmental, social, and corporate governance) front are truly commendable, the concern over its Cigarettes business from an ESG perspective remains in play, as more funds turn ESG-compliant globally, affecting the valuations of global Cigarette companies, including ITC.

* The earnings growth in the latter half of the last decade considerably weakened v/s the first half. We don’t see any significant pickup in the earnings trajectory going forward (7.7% PBT CAGR over FY20-23E). RoE saw a sharp decline in the latter half of the decade, despite the corporate tax rate cut. With the self-imposed near-term moratorium on substantial capex eventually being lifted, as well as the possibility of future acquisitions, RoE could come under further pressure over the medium term.

EBIT dependence on Cigarettes to remain unaltered despite healthy topline growth in Other FMCG

* Growth lackluster in the Other FMCG business: ITC's Other FMCG business saw strong topline momentum in FY21 (15% sales growth YoY) owing to healthy in-home consumption of noodles, biscuits, snacks, and atta (wheat flour) amid the COVID-19 outbreak. This has since tapered away, with 1QFY22/2QFY22 sales growth at 10.4%/2.9%. While margin expansion for the business was impressive in FY21, owing to: 1) soft commodity costs, 2) lower trade discounts (on healthy demand), and 3) likely lower ad spends-tosales ratio, these contributing factors are not sustainable. With the company already calling out sharp input cost inflation in its 1HFY22 result, we forecast FY22E EBIT margin to be under pressure, given the likely impact on 2HFY22 as well. This will result in lower EBIT margin growth in FY22E and possibly FY23E as well compared to our earlier estimates.

* Cigarette business contribution to overall EBIT to remain high: We do not see the contribution of cigarettes to ITC’s overall EBIT changing materially until FY23E (~80% in FY23E which is within its ten-year range). As a result, overall earnings growth and multiples will remain under pressure. The contribution of the Other FMCG segment to overall EBIT will remain 6-7% even in FY23E, due to the huge difference in EBIT margin between Cigarettes (~75% in FY23E) and Other FMCG (~7% in FY23E).

* Cigarette volumes remain tepid: Cigarette volumes are estimated to have grown by 31%/9% YoY in 1Q/2QFY22 on a low base, with two-year average volume growth remaining negative (-3%/-1.5%). As highlighted in our 2QFY22 result note, we estimate a near term uptick in volumes on the back of: a) a weak base, b) better mobility with easing restrictions, and c) the launch of a modernized and refreshed packs for key brands. The average two-year volume growth ending FY22 is likely to be -0.6% and remains uncertain going forward as well, given the trajectory over the last five years (-1.7% average volume growth over FY16-20), even without any GST increase in the preceding four years, barring the Feb’20 rise. The government has also recently (Oct’21) set up an expert panel tasked with preparing a comprehensive tax policy proposal for all forms of tobacco from a public health perspective. We await the recommendations of the panel and believe that the potential for an adverse policy announcement remains an overhang on the stock. Our base case does not factor in any volume impact of a possible hike in GST for cigarettes.

* Plague of illicit cigarettes/bidis: As per our estimate, the illicit cigarette trade accounts for 23-25% of the industry, with 40-50% of illicit cigarette supply accruing from outside India. The salience of illicit cigarettes was lower in CY15 at 17-18%, but gained ground owing to higher taxes on legal cigarettes. This has also encouraged downtrading from lower-end cigarettes to bidis. An increase in GST rates for cigarettes will likely lead to the illicit industry maintaining its grip.

* ESG-related concerns on Cigarettes remain prominent: Sustainable/ESG investing has seen its prominence grow globally, with AUMs of over USD35t (source). Within ESG assets in the US, ~75% of the universe is underweight tobacco in the largecap equity space, and 50-70% avoids the sector completely. ITC’s high profitability dependence on the Cigarettes business has come under scrutiny of sustainability-compliant investors worldwide in recent years. Philip Morris/British American Tobacco (BAT) witnessed 27%/60% contractions in their multiples in the last five years. Along similar lines, with ~86% of ITC’s EBIT coming from Cigarettes in FY21, the stock saw a significant correction in multiples. The contraction in ESG-related multiples are unlikely to abate anytime soon, leading to continued selling from funds that are turning ESG-compliant in both India and globally.

Valuation and view

* While ITC’s stock has delivered ~12% return over the last three months, it has considerably underperformed its benchmark and Consumer peers over the last five years as well as the last 12 months.

* The concerns we highlighted in our detailed note in Dec'20 have continued to remain in play with: a) the Cigarettes’ business contributing nearly 80% of ITC's overall EBIT, even in FY23E, raising ESG-related concerns, b) weak cigarette EBIT growth for several years now (4.1% over FY17-23E), c) tepid growth in the Other FMCG segment, and d) overhang of a GST increase on cigarettes.

* With PBT growth over FY20-23E (7.7% CAGR) likely to remain similar to growth in the preceding five years, valuations although relatively cheap compared to its consumer peers in India, are fair considering the concerns stated above. Taking into account the average one-year forward valuation of global peers at 11x, ITC trades at a 45% premium (16.3x).

* We expect a dividend yield of 5-5.5% over the next two years, in line with that of other global Cigarette players.

* We value ITC at 15x Dec'23E EPS and maintain our TP of INR240/share and our Neutral rating.

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