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    Serious underperformance: Is ITC stock a value bet or a value trap for investors?

    Serious underperformance: Is ITC stock a value bet or a value trap for investors?

    Serious underperformance: Is ITC stock a value bet or a value trap for investors?
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    By Mangalam Maloo   IST (Updated)

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    At 19X FY21e, ITC’s 66 percent discount to HUL’s valuations is the highest it has ever been. With steady financial performance in recent quarters and some improvement in non-tobacco business, investors are wondering whether ITC is a value bet or a value trap?

    FMCG-to-hotel major ITC’s underperformance vis-à-vis other FMCG companies over the last few years has been fairly pronounced.
    In a year that saw Titan, Britannia and Nestle’s inclusion in the Nifty by virtue of market cap growth, ITC gave its FMCG market cap leadership away to HUL.
    Throughout this period, the perennial argument of ITC being an attractive value bet only increased as the expensive stocks got pricier and the cheap ones continued to underperform.
    At 19X FY21e, ITC’s 66 percent discount to HUL’s valuations is the highest it has ever been. With steady financial performance in recent quarters and some improvement in non-tobacco business, investors are wondering whether ITC is a value bet or a value trap?
    Tobacco business is stabilising
    The key regulatory overhang on ITC has been that of an unannounced, sudden rate change in cigarette taxes. That hurdle was most felt during the GST transition which resulted in serious volatility for the stock. However, since the last announcement on tobacco cess revision in July 2017, no major change on tobacco taxation has been announced. While that sword still hangs over the heads of ITC and other tobacco companies, the government increasingly is mindful of the impact created by contraband (smuggled cigarettes) on the industry. Legal tobacco sellers have been making the case for stable taxes as it would further dissuade smugglers from peddling illegal cigarettes into the marketplace.
    After acclimatising to the new tax regime and once volumes started stabilising, ITC did take selective price hikes on its cigarette portfolio amounting to 3-4 percent. This helped the company mitigate the impact of higher leaf tobacco prices and ameliorate cost pressures arising from the increasing salience of capsule (switch) cigarettes. This has led to a gradual improvement in ITC’s cigarette margins.
    While incremental market-share erosion has been a concern for ITC, the government’s recent ban on e-cigarettes does come as a relief for traditional cigarette companies given the scorching pace at which these vapes were growing.
    Improvement in non-tobacco businesses
    Under chairman and managing director Sanjiv Puri, the key improvement that ITC has shown are in its non-tobacco verticals. Not only has the company doled out a whole host of FMCG-food products in the recent past, it’s also pulling back investments from businesses that haven’t been doing well. ITC’s FMCG operating profit has improved substantially over the last few quarters, aided further by restructuring of its lifestyle business.
    To further cut back on loss making verticals, ITC sold John Players to Reliance Brands.
    Steady addition to its ever-increasing presence in the hotel sector has further boosted their revenue growth. In the recent past, ITC has opened large properties in Kolkata and NCR and has a line-up of properties in Ahmedabad and Colombo coming on-stream in early 2020.
    Sale by large stakeholders?
    Among other risks that plague the ITC stock, fear of supply from either the government or FIIs continues to plague the stock. The Government of India holds 7.94 percent stake in ITC via SUUTI while insurance companies (mostly state-owned) own 21.7 percent. The government may not be too keen to immediately pare its stake in the company given their current shareholding in ITC is at par with British American Tobacco’s holding at 30 percent through its subsidiaries.
    The government’s aversion to further dilute stake in ITC was also witnessed at the launch of Bharat 22 ETF’s additional offer in February 2019. According to a statement issued by ICICI Prudential AMC, “the government will not disinvest shares of ITC which forms part of the underlying index through this Additional Offering.”
    Foreign portfolio investors have been thinning their positions in ITC for the last six quarters. At rock-bottom valuations, and as things look better, there is a case to believe that the last FIIs standing will continue to stick around given they have stuck around through the stock’s longest period of underperformance.
    Key risks
    Despite the current optimism on ITC, the risk of an adverse regulation on tobacco taxation keeps investors from breathing easy. Given the fiscal constraints after the finance minister’s tax cut announcement and lower-than-estimated GST collection, some would say there is a strong case to tax sin-goods further.
    While the government hasn’t shown any intent to sell its holding in the tobacco major, recently, one can’t fully rule out the possibility of the government’s stock supply flooding the market.
    Another risk that ITC faces is that of losing incremental market share to Godfrey Phillips, VST Industries and the illegal cigarette industry. In Q1FY20 Godfrey Phillips and VST Industries outpaced ITC in their volume growth. Godfrey Phillips has been quite aggressive on new launches, higher distribution. The introduction of a Rs 10 Marlboro stick in select markets is reflective of their future intent.
    What ITC and Puri do to stomp over competition and continue their growth path remains an important monitorable going forward.
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