The Street’s focus on ITC’s cigarette biz has weighed on the stock, which is 30% lower from Jan highs
For ITC, the FMCG segment’s better performance could lead to a re-rating of valuation multiples
The Street’s undivided attention on ITC Ltd’s cigarette business has dimmed the lights for the stock. From the pre-covid high of ₹243 seen in January on NSE, ITC’s shares have declined by as much as 30%. Currently, the stock trades at about ₹170 apiece.
“ITC has undergone time correction/de-rating over the past eight years notwithstanding EPS/FCF compound annual growth rate of 10%/15% (FY2012-20). We believe concerns around taxation in view of stretched government finances and rising focus on ESG-compliant investment are more-than-adequately priced in," said Kotak Institutional Equities’ analysts in a report on 24 September. EPS is earnings per share and FCF is free cash flow.
But the bad news keeps flowing in. Recently, Maharashtra banned sale of loose cigarettes. That’s a potential risk to volumes depending on how strictly the rules are implemented. During the June quarter, cigarette volumes had understandably taken a sharp beating thanks to covid-19 disruptions.
The much smaller fast-moving consumer goods (FMCG) business had, however, fared well due to an increase in stay-at-home consumption. Analysts and investors are beginning to take note of this otherwise ignored part of ITC’s business.
“ITC’s FMCG segment is possibly one of the most under-appreciated businesses in the Indian consumer space in recent times, in our view," wrote analysts from JM Financial Institutional Securities Ltd in a report on 25 September.
The outlook for FMCG sector seems more promising in these uncertain times as most of the products are considered essential; demand for which is stable unlike that of discretionary items. Moreover, the FMCG sector tends to fetch higher valuations.
For ITC, in particular, the scope of growth for the FMCG business appears huge. JM Financial points out, “ITC in FY30 could clock an FMCG Ebitda higher than the combined FY20 Ebitda of Nestle India Ltd, Britannia Industries Ltd and Tata Consumer Products Ltd. If that be the case, using current market capitalization of these companies as benchmark for ITC FMCG’s FY30-based valuation (discounted to present value), FMCG alone would justify half of ITC’s present market value." In other words, this implies that cigarettes business (85% of profits) is currently valued at just 4-5 times price-to-earnings ratio, as per the brokerage.
Currently, lower profit margins of the FMCG segment means, on an overall basis, it doesn’t move the needle for ITC and this is a dissuading factor for investors. For perspective: in FY20, the cigarette business’s Ebit margin stood at 67%, on a consolidated basis. Ebit is earnings before interest and taxes. On the other hand, FMCG’s Ebit margin was a measly 3.3%. An expansion in FMCG margins would be helpful in improving business sentiments and in turn, for the stock. It’s this large gap that makes most investors ignore while valuing the firm.
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