Investors are not high on cigarette-to-soaps conglomerate ITC Ltd at the moment. The stock has declined by 6.7% so far this fiscal year. In comparison, the Nifty 100 index has risen by 1% whereas the Nifty FMCG index has declined by 2.6% during the same time frame.

One of the reasons for the sluggish sentiment for the ITC stock has been general fears over any increases in tax rates on cigarettes and tobacco products, especially with the Union budget coming up on 5 July.

“We see a high probability of rational tax increases post two years of muted/low single digit tax collections from cigarettes to the exchequer," said a Deutsche Bank report on the March quarter results update last month.

While worries about higher taxation are weighing on the stock, investors would be relieved to see an all-round improvement in the company’s financials last year.

ITC recently released its annual report for FY19.

“We conclude that ITC’s disclosure levels are adequate and it boasts an all-round top-notch financial health—volume growth, free cash flows, working capital and EBITDA to operating cash flow conversion," wrote analysts from Edelweiss Securities Ltd on 20 June, commenting on the company’s annual report. Ebitda, or earnings before interest, tax, depreciation and amortization, is a measure of profitability.

Further, the contribution of the cigarette business in overall revenues has reduced in FY19 compared to FY18.

Still, Ebit contribution of the cigarette business remained pretty much constant at around 85%.

On the cigarette volume growth front, the company appears to have done well. While ITC does not provide volume details, analysts from Motilal Oswal Financial Services Ltd estimate cigarette volume growth for FY19 at 5.5%.

This comes after six years of weak performance in the measure.

(Photo: Vipul Sharma/Mint)
(Photo: Vipul Sharma/Mint)

As such, the base was favourable for FY19 and it is possible that the company could benefit from a favourable base for FY20 as well.

Sure, the non-cigarette portion of the fast-moving consumer goods (FMCG) business is ramping up well. Ebit contribution of this segment expanded robustly. However, the segment is too small to move the needle at the moment and as such, will take a while to contribute substantially to the company.

During FY19, ITC launched more than 50 new FMCG products, across categories such as foods, personal care and stationery products.

Meanwhile, valuations remain understandably lower than peers, given the high regulatory risks associated with the cigarette business.

Currently, ITC shares trade at 24 times estimated earnings for FY20. In comparison, the Nifty FMCG index trades at 34 times one-year forward earnings.

If tax-related developments do not disappoint over the year, valuations may get some room for expansion.