ITC was the highest Nifty gainer in Wednesday’s session after a long period of underperformance. A large part of the street that things for ITC are coming together and some pieces of this massive jigsaw are falling in place. Let’s try and take a look at a few of those pieces
The Good News
An important piece of news that showered gains on the entire FMCG sector was IMD’s announcement of normal monsoons in 2018. If both IMD & Skymet’s predictions do come true, it would make for a hat-trick of normal monsoons and hopefully spur rural demand. It’s because of this belief that most FMCG Stocks, like, HUL, Godrej Consumer, Pidilite, Britannia and Nestle hit record highs despite trading at record high valuations too.
The Valuation Argument
ITC’s underperformance compared HUL can be summarized in the following charts. While the latter narrowed it’s gap with ITC’s market cap, the valuation gap between the two only widened. Usually, it has been seen that ITC trades at a 40% discount to HUL’s valuation during an unfavorable tax regime, which narrows to 25% during stable times. But as of Tuesday’s close, ITC traded at a 50% discount to HUL’s valuations, a discount which is arguably the widest ever, at a time when the optimism over Co’s Non-Tobacco Business is the highest ever. Something, somewhere, had to give.
Hotels Check In
This is where it gets all the more interesting. A part of ITC that we often overlook, their hotel business. ITC runs one of the largest and fastest‐growing hospitality chains in the country. Hotel Stocks have been on a tear this week owing to favorable demand-supply situation, optimism towards the industry’s pricing power & occupancy and premium valuations of the latest listing, Lemon Tree Hotels. Stocks like Taj GVK, Royal Orchid & EIH Associated Hotels gaining anywhere between 26-30% in the last two sessions. Earlier, analysts on the street would ascribe a valuation of 15X EV/EBITDA (`5/share) to ITC’s hotel business. But with the current lot trading above 30, 40 & even 50X EV/EBITDA, the case for a re-rating of ITC’s hotel biz only strengthens.
After Wednesday's move, ITC now trades at 48% discount to HUL, the highest in the last 10 years. However, The company’s earnings growth over FY15-18 has been about 5%, the lowest in the last 20 years. Irrespective of the optimism around ITC’s Non-Tobacco business, the truth is, Cigarettes still account for nearly all of ITC’s operating profits and free cash flow. Only an annual tax-hike of less than 10% in 2018 to lead to a substantial growth in cigarette volumes and earnings. Earnings growth is the one ball needs to be kept a watchful eye on and that depends solely, on how the Tax Regime on Tobacco pans out in the very near future. The Big Question – Value or Value Trap?