ITC - Fairly valued

Despite decent growth rates estimated for this fiscal, there is limited upside to the ITC stock.

For a large part of 2008 and until March 2009, the stock of ITC outperformed the broader markets, thanks to its defensive attributes including steady financial performance and strong cash flows that find favour during uncertain market conditions. But, at current valuations as well as considering some recent developments, it makes one wonder whether the stock will continue to deliver outperforming returns. While among recent events are the company’s March 2009 quarter performance, which was somewhat subdued, and the hike in value-added tax (VAT) by the Maharashtra government, the stock’s current valuation (PE of 19.4 times estimated 2009-10 earnings) is also not cheap.

Recent concerns?
Last week, the Maharashtra government recommended a hike in the VAT rate on cigarettes from 12.5 per cent to 20 per cent. While analysts estimate that Maharashtra accounts for about 10 per cent of ITC’s cigarette sales (in value terms) and a small price hike across key brands could offset the proposed hike in VAT, they fear that similar moves by other state governments (or a significant hike in the forthcoming Union Budget) could force ITC and other players to raise prices. “Thus, it poses a threat to ITC’s cigarette volumes in 2009-10,” Sharekhan’s analyst said in a note.

While the fears could well prove unfounded, the past data indicates that price hikes have a strong impact on volume growth (See chart). Any sharp increase in prices negatively impacts volume growth—a moderate price hike can still support healthy volume growth. Even in the last two fiscal years, when the tax on cigarette was hiked by 30 per cent (2007-08 Union Budget) and excise duty on non-filter cigarettes was hiked between 140-390 per cent (2008-09), it has had an impact on ITC’s cigarette volumes.

For ITC though, it has a fairly robust track record in the business, which enjoys a domestic market share of over 75 per cent. The company has been consistently investing in its business through use of technology, product innovation, marketing, and has strong brands. While these have helped it in passing on any cost increases to consumers, they have also helped in overcoming extra-ordinary times. For instance, after the hike in duty on non-filter cigarettes last year, ITC discontinued sales of such products and through various measures was able to upgrade a majority of customers to the higher priced filter cigarettes.

This along with select price increases helped its cigarette revenues to grow by 13.9 per cent to Rs 7,557 crore and profits by 15.1 per cent to Rs 4,184 crore in 2008-09, even as volumes are estimated to have declined by 3-4 per cent.

However, says an analyst, “going by history, ITC’s stock valuations are largely linked to the growth in its cigarette volumes. The sentiments get impacted as the government tries to curb the category and that impacts the PE.”

Hoping that there won’t be any major negative surprises, and assuming (at worst) a moderate hike in taxes, analysts are expecting ITC to clock volume growth of 4-5 per cent in the cigarette business in 2009-10. This is comparable to the average growth in the last five years and suggests that the company should continue to generate strong cash flows to pay dividends as well as nurture other businesses.

Non-tobacco FMCG
Most of these businesses, like packaged foods, apparels and personal care, have strong growth potential. But, in the last two quarters (Q3 and Q4 of 2008-09), growth rates have slowed down to 10-15 per cent year-on-year as compared to 28-30 per cent in Q1 and Q2 of 2008-09 and 45-50 per cent quarterly growth in 2007-08.

While the economic slowdown could be partly responsible, in the branded packaged foods business the company has been focussing on consolidating its portfolio in select high margin categories.

The branded apparels sales were also impacted, especially the mid-segment brand ‘John Players’. Here too, ITC is taking various measures (closing unviable stories, renegotiating rentals) to improve productivity.

Going ahead, while the company continues to invest towards scaling up these businesses, analysts expect the focus on profitability to result in the segment’s losses reducing by about 20 per cent in 2009-10.

Also, given the high base (sales of Rs 3,000 crore), sustaining high growth rates may not be possible and hence, they are projecting sales to rise by 15 per cent in 2009-10.

Others
Among other key contributors, the agri and paper and packaging businesses have shown an improvement in profitability. Last year, the company completed the expansion of capacities of pulp and paperboard leading to better sales growth and profitability in the latter half, which is expected to sustain in the current year as well.

In the agri business, while revenues were flat in 2008-09, it was largely due to a 51 per cent fall in sales (led by lower soya volumes and rationalisation of the commodity portfolio) in the March 2009 quarter. Notably, profit margins improved due to better realisations in the leaf tobacco business; profits thus nearly doubled to Rs 256 crore in 2008-09. While analysts don’t expect sales growth to be high in this business, margins are likely to be sustained in 2009-10.

The weak economic environment and terror strikes in Mumbai last year impacted the industry’s fortunes and, ITC too reported a decline in sales and profits. The current year however, may find some cushion from commissioning of new capacities. Nevertheless, hotels contributed less than 7 per cent to profits in last year.

Outlook
Overall, the key growth drivers for ITC in 2009-10 are seen as the cigarette, non-tobacco FMCG and paper businesses. Analysts expect the company’s total sales to grow by 14-15 per cent and profits by 16-18 per cent over the next two years.

While the longer-term prospects look decent given the investments ITC is making in growth potential non-tobacco FMCG businesses among others, at Rs 197, the stock trades at 19.4 times the estimated 2009-10 earnings (and 16.7 times 2010-11 EPS), which is not cheap and is also not far from its fair value (based on a sum of parts valuation) of Rs 206 per share, as estimated by analysts.