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Strong near-term visibility; environment conducive

* Cigarette demand resilient: Demand was quick to recover to pre-pandemic levels after the second COVID wave. Our channel checks suggest that demand continues to remain robust. There has been relative stability with regard to taxes on Cigarettes in recent years. This has enabled ITC to calibrate its price increases to avoid disrupting demand, unlike the higher tax increase environment between FY13 and FY17. If not for the significant impact of the pandemic, we believe volume growth would have been 3-4% v/s 1-2% over the previous decade. With the intensity of further COVID-19 waves decreasing, we now expect a volume growth of 3-4% over the next couple of years, especially if the tax incidence remains benign. The Cigarette mix has been getting richer, aided by innovation, improved local manufacturing of capsule cigarettes, and better last-mile reach. With lower RM inflation and little evidence of downtrading so far, margin resilience is evidently superior to other Consumer categories.

* Revival in mobility to benefit the FMCG business: As educational institutions reopen their doors, the demand for notebooks and stationery (a margin accretive category) has seen a revival. Out-of-home categories like biscuits and small juice packets are also seeing a recovery. RTC noodles may see slower growth, given the high base in the last two years. While margin may be affected by steeply higher input costs, the price hikes given ITC’s leadership position, cost management, supply chain optimization, and premiumization may offer some cushion to margin. Over the medium-term, the management targets double-digit growth in revenue and profit for the FMCG–Others business.

* The lag on margin in Hotels to reduce: With ARR and occupancy rates reverting to pre-pandemic levels, the Hotels business is expected to deliver a better performance than that over the previous two years. While profitability may still be impacted, its lag on the overall business will reduce substantially.

* Capex plans: We don’t expect capex to have an annual run-rate of more than ~INR30b over the next three years. Of this, 35-40% will be allocated towards FMCG for creating new capacity. The Paperboard segment will be allocated 25-30% of the capex. The Agri business, digital, and sustainability investments will also be a focus area. Hotels will receive ~10% of incremental capex, given ITC’s pivot to an ‘asset-right’ model.

* High dividend yield: ITC’s payout policy of 80-85% of profit was reiterated by the management at its recent analyst meet in Dec’21. Lower capex requirements should result in better free cash flow and higher payouts. ITC’s higher dividend yield (4-5%) makes it an ideal defensive bet in the current volatile interest rate environment.

Valuation and view

* A) A better than expected demand recovery and a healthy margin outlook in Cigarettes, b) healthy sales momentum in the FMCG business, c) lower drag from the Hotels business, and d) better capital allocation in recent years leads us to turn constructive on the stock.

* A stable tax environment for Cigarettes in recent years has allowed ITC to calibrate price increases to avoid a disruption in demand. We expect this trend to continue and should result in improved Cigarette volumes and earnings visibility over the medium-term.

* The breadth of ITC’s FMCG product portfolio gives it an advantage in a rapidly changing demand environment. Its leadership position in some categories gives it pricing power to offset incremental input cost pressures in other categories, where pricing power is not as strong.

* The resilient nature of its core business, amid an uncertain environment in the sector, and 4-5% dividend yield makes it a good defensive bet in the ongoing volatile interest rate environment.

* Earning CAGR at the PBT level stood at 5% over FY17-22. We expect ITC to post 15% earnings CAGR over FY22-24.

* While valuations of global Tobacco peers have been restored to their prepandemic levels (Jan’19), ITC still trades at a 27% discount to its Jan’19 valuations of 25.4x one-year forward EPS. We value ITC at 21x FY24E EPS, representing a 65% premium to its global peer average. We believe the premium multiples are justified, given its strong visibility over the medium-term and the defensive nature of its business, especially in a volatile macro environment.

* We value the stock at 21x FY24E EPS. We arrive at a TP of INR335 per share and upgrade our rating to Buy

Robust Cigarette demand with good near-term visibility

* Demand was quick to recover to pre-pandemic levels after the second COVID wave. Our channel checks suggest that demand remains robust.

* Cigarette mix has been getting richer, aided by innovation, improved local manufacturing of capsule cigarettes, and better last-mile reach. ITC’s Cigarette business has a reach of 7m outlets, or twice that of the second-largest player.

* The stability in taxes in recent years has enabled ITC to calibrate its price increases to avoid disrupting demand, unlike the higher tax increase environment between FY13 and FY17. If not for the significant impact from the pandemic, we believe volume growth would have been 3-4% v/s the 1-2% over the previous decade. With the the intensity of further COVID-19 waves decreasing, we now expect 3-4% volume growth over the next couple of years, especially if the tax incidence remains benign.

* ITC also has the best laddered portfolio among peers to respond to tax increases, if any

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