Risk-reward ratio is turning for the better on the back of a stable taxation regime for cigarettes and an improving business mix
In this week’s tactical pick, our recommendation is ITC.
The stock has tumbled in the past three months and trades at a steep discount (19.8x FY21e earnings) to the earnings multiple of largecap FMCG sector (~38x).
We believe that this is in contrast to the improving fundamentals of new businesses ITC is exposed to. Further, with relatively stable taxation regime for cigarettes business and improving business mix towards FMCG/food processing industry, the current risk-reward appears favourable for investors.
In addition to attractive valuation, the following makes us constructive on the stock.
The thesis of broadening of growth levers for ITC is unfolding as expected. A few of ITC’s businesses have witnessed encouraging growth traction in recent times: volume growth in the FMCG business (other than cigarettes) and growth outlook in the hotel and paper business.
We are enthused about operating leverage playing out for FMCG business (22 percent of sales in Q1 FY20) in particular. In FY19, FMCG business EBITDA has grown by 51 percent. A back of the envelope calculation suggests that normalisation of ITC’s FMCG business margins in line with peers could help its overall EBITDA margin perk up about 250 bps, ceteris paribus. In the quarter gone by, FMCG sales grew by 8 percent YoY after excluding the impact of restructuring of Lifestyle retailing. The company highlighted that FMCG EBIT witnessed a strong move of 56 percent YoY led by better product mix and operating leverage.
Capital allocation also remains pertinent. The conglomerate continues to deploy healthy operating cash flows (Rs 12,651 crore in FY19), mainly from cigarettes business, for investment across businesses (Rs 2,767 crore). Of this, almost 50 percent of the investment has gone into FMCG business.
In fact, the company has set aside an investment outlay of Rs 25,000 crore which among others looks to create Integrated Consumer Goods Manufacturing & Logistics facilities (ICMLs) for its FMCG businesses and strengthen distribution for the agriculture back end. This makes it increasingly a beneficiary of policy measures taken for food processing industry. And in this context, the federal Budget has potentially more to offer to the stock.
Risk factors to watch
Recent strong results from Godfrey Phillips and VST industries, along with ITC’s cigarettes volume growth moderation in Q1 FY20, suggest increased competitive intensity in the organised sector. However, ITC’s strong volume growth in the previous quarter (Q4 FY19) and margin expansion in Q1 FY20 for the segment implies the company is not on a weak wicket though it requires a close watch.
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