ITC rating – Hold: Core business concerns limit prospects

A large dividend yield (4.4% FY22e) could still act as a floor to the overall valuation even without structurally being positive.

Our recent downgrade of ITC to Hold generated much debate. Key points of contention were (i) whether we are too conservative on the Cigarette business and perhaps a weak stock price and cheap valuation already factors in any risks and lack of growth; (ii) since Other FMCG has become a formidable business, whether we had considered that value can be unlocked if ITC were to restructure or carve out this business and even Hotels; and (iii) how we think about the overall investment case. We offer the following thoughts.

Scenarios for Cigarette business: Cigarettes accounted for 85% of ITC’s earnings in FY21 and the segment’s valuation (i) the hurdle rates for investors to invest in tobacco (which is implicitly rising). We consider these scenarios: If segment Ebit were to be flat forever, this would represent Rs 75 per share; 4% Ebit growth for next 15 years before becoming flat would yield Rs 106; and 7% Ebit growth would yield Rs 135. Cigarettes volumes are in a structural decline (post-COVID this could worsen). After years of price increases (fuelling strong earnings), price elasticity has risen and the volume mix is inferior.

Result: The average Ebit growth rate for the past 20 quarters was c7% vs 16% for FY03-14. For the next 15 years, even a 4-5% CAGR could be challenging. A large dividend yield (4.4% FY22e) could still act as a floor to the overall valuation even without structurally being positive.

Scenarios for Other FMCG business: ITC has built a formidable Other FMCG business (especially foods) with expanding margins. Consider these scenarios: (i) If ITC were to increase Other FMCG revenue at a 10% CAGR for 15 years (5.5% thereafter) and improve its Ebitda margins from 9% to even 15% gradually, we estimate it would be worth Rs 47 per share; and (ii) if structural revenue growth were to rise to 14% from 10%, it would be worth Rs 73; this would imply ITC would trade at c38x FY24 EV/Ebitda – still a significant premium to the sector. Consider the facts: (i) ITC’s revenue growth for the past 10 years was c13%; and (ii) the bulk of revenue is still from the lower margin foods businesses. While margins are set to expand, they are unlikely to reach HPC levels. We still account for an upside risk of value realisation for this business, assigning a valuation of Rs 73 per share in our SOTP approach. Hotels appear less meaningful even considering value unlocking in the overall scheme of things.

Hence, we believe that unless investors are willing to assign an aggressive valuation to Cigarettes, it is difficult to build a case for substantial stock price upside. We retain our Hold and TP of Rs 230.