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Well-positioned for value-creation; we cite three key drivers

We see potential for ITC to reverse the long period of lacklustre performance. We cite government’s increasingly logical stance on tobacco taxation to be one key value driver for the stock going forward. To us, it’s not so much about tax-hike being skipped for one more year, but more about how the government is likely now able to better appreciate the legal industry’s logic that a punitive taxation regime on legal cigarettes alone does not necessarily help control use of tobacco in the country but instead causes migration out of tax-paid cigarettes into illegal channels. We outline three key drivers below that we believe would support the stock’s performance hereonwards

1. A more rational stance on tobacco taxation at the government’s end: ITC’s data suggest that steep tax-increases could be sub-optimal for tax revenue collections whilst a relatively stable tax regime could better augment tax resources (Exhibit 2). The government seems to have slowly but surely realised this. While one cannot expect a scenario where tobacco tax hikes are entirely dispensed with, the fact that the hits are now more phased out perhaps suggests a better understanding of the issues faced by the legal industry. If this is indeed the case, the tobacco tax regime in India should logically transform from one that has been only cigarettes-focused to one that is more broadbased, given that legal cigarettes account for just 8% of total tobacco consumed in the country. The fact that India’s per-capita cigarettes consumption is just 11% of global average whilst its per-capita tobacco consumption is 60% of global average tells a lot about the quantum of non-cigarettes tobacco that get consumed in the country - most of which are un-taxed. Recent approach on tobacco taxation seems to slowly cognise for these aspects, in our view.

2. Growth, operational metrics likely to look much better going forward: ITC’s earnings had grown at 12% CAGR between FY16-20 (prior to the pandemic) and still the stock fell 15% (cumulative) during that period. The company has since upped payout ratio (>90% average over last two years vs 67.5% for three years prior; dividend yield of c.5% at CMP), significantly enhanced quarterly-results-related disclosures, stepped up investor engagement, and laid out a refreshed strategy that focuses significantly more on capital efficiencies and driving sustained value-creation by focusing on segments of the future. We expect FY23E to be one of the stronger years in recent times on growth fronts. Cigarette volumes just about getting back to the pre-pandemic level would itself mean a c.5% volume growth for FY23E; and with a reasonably benign tax regime for the year, we believe the stage is set for ITC to get back to double-digit EBIT growth in cigarettes – an important aspect for driving stock momentum, in our view.

3. Efforts on creating a very large FMCG business have begun to bear fruits: ITC has over the years incubated a reasonably large FMCG business with FY22E revenue of c.INR158bn and EBITDA of c.INR15bn. Profitability has improved significantly in recent years and we expect margin to be in double-digit in FY23E. Notably, this business has been created at sub-2x price-to-sales and addresses market-opportunities that are larger than even HUL’s size-of-markets and more than 3x that of Nestle India’s. Going forward, a topline growth rate that ranks in the top-quartile amongst peers, and sustained margin expansion trajectory are what management is aiming to deliver overall. Historical performance tells a good story – some of the core categories delivered 18-42% CAGR over the past decade (Exhibit 4), helped by successful leverage of institutional strengths within ITC, e.g. brand-building skills, multi-channel distribution, agri-sourcing, culinary expertise, R&D, etc. A lot of thrust is now on moving beyond the core into value-added adjacencies. ITC has, in fact, led the premiumisation and innovations agenda in Biscuits that helped it achieve leadership in the premium segment despite presence of 100-year old legacy players in the space.

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