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Time to ADD - Macro & micro turning favourable

We expect ITC (stock) to benefit from (1) expectation of Value (on current FCF profile basis) to outperform Growth/Expensive basket, (2) potential price hikes in cigarettes in the current inflationary environment (better consumer acceptance likely), (3) good underlying performance in the FMCG business along with higher profit (& EVA) focus, and (4) improving outlook for the hotels business (likely cyclical upturn). Besides, focus continues on augmenting (overall) distribution. We see (1) potential market share gains in cigarettes, (2) FMCG scale up and profitability improvement to continue and (3) potential to accelerate cost savings through a supply chain recast.

Recent media reports indicate that the government panel (formed to decide on the future taxation policy for tobacco) is suggesting ways to tax tobacco (not just cigarettes). While near-term volume/profitability trajectory may be sensitive to this outcome, we believe a rational policy can provide some certainty in the medium-term. Reiterate ADD; TP Rs250.

* ‘Value’ may potentially outperform ‘Growth’: We (including consensus, to some extent) believe that the Value stocks may outperform Growth basket (over medium term). We reckon tobacco stocks may perform well in these times with some optimism/buying already reflected in select global stocks like BAT Plc.

* Not ‘top-down’ bullish on staples: As highlighted in our recent notes, we have a neutral to underweight stance on consumer staples. We recommend a bottom-up strategy based on (either) (1) improving/changing fundamentals, (2) earnings upgrades expectations (tied to first), or (3) improving narrative.

* Environment conducive for price hikes in cigarettes: We expect ITC to implement selective price hikes in cigarettes (the last (material) hike was taken two years back). We understand in the last few years ITC did struggle to take price increases in cigarettes, without adverse price elasticity. However, it is important to note that we are (likely) coming out of a long period where (broad-based) inflation was missing. The key point – standalone inflation in cigarettes (overall low inflation) will hurt more compared to the times when there are price increases across (overall environment is inflationary).

* Consensus appears excessively pessimistic on the tobacco committee: We note recent media reports indicate that the government panel (formed to decide on the future taxation policy for tobacco) is suggesting ways to raise tax on tobacco. While this creates a (regulatory-led) uncertainty, we believe (1) the mandate is to suggest tax measures for ‘all forms of tobacco’ – cigarette is already the most taxed tobacco product in India, (2) even if there are tax hikes, (as highlighted above) we believe, the environment to take price increases (for passing on the impact) is much more conducive.

* Expect double-digit EBIT growth in cigarette in FY23E: We model 12% growth in cigarette EBIT (for ITC) for FY23E. We note that a key marker/driver for ITC’s (stock) performance (for consensus) is whether cigarette business delivers a ‘double-digit’ growth. We believe (1) the current environment is conducive to price hikes (as explained above) and (2) there is potential for ITC to gain shares in the category.

* FMCG business shaping up well with improved margin focus: As highlighted in our recent note (NPD#2 – ITC: Template is set), we believe ITC’s FMCG scaleup has ingredients to drive a long-term success story. We like the focus on: (1) creating sub-categories (adjacencies) over targeting (direct) share gains, (2) power brands and mother brands, (3) developing deep R&D capabilities, (4) dedicated COO (structure) for large (food) categories and (5) calibrated spends with a focus on capital allocation. ITC’s NPD aggression has been robust for the last few years. Furthermore, it displayed one of the best abilities to leverage previous year’s hygiene tailwinds (Savlon).

* Hotels – looking up: While ITC’s hotel business has been a drag for the last two years, we believe the outlook is favourable. Adhidev Chattopadhyay, I-Sec real estate analyst (link) believes that branded (hotel) players would benefit in the medium term led by (1) limited branded hotel inventory, (2) leisure sector has been a key demand driver during CY20-21 and (3) new supply of hotels may be delayed further owing to Covid. We note that in the past, ITC used to enjoy segmental margins of >40% for Hotels.

* Valuation and risks: Our earnings estimates are unchanged. Maintain ADD with a DCF-based target price of Rs250. At our target price, the stock will trade at 18x P/E multiple Mar’23E. Key downside risk is tax hikes much ahead of inflation leading to volume pressure (on cigarettes).

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