Nomura Initiates 'Neutral' Coverage On ITC Over Rising Risks

Nomura Holdings has initiated coverage on ITC Ltd. with a 'netural' rating, citing rising risks of a tax hike on cigarettes amid lower-than-peers' earnings growth.

"We see risk-reward turning unfavorable with growing risks, no longer cheap valuations, and lower-than-peers earnings growth," said Nomura.

ITC is a diversified conglomerate with businesses in cigarettes, fast-moving consumer goods, agriculture, paperboards, paper, packaging, hospitality, and information technology.

The neutral rating indicates that the stock is likely to perform in line with the benchmarks over the next 12 months.

Nomura has set a target price of Rs 360, implying an upside of 8.4%. Out of the 37 analysts tracking the company, 33 maintain a 'buy' rating and four suggest to 'hold' the stock, according to Bloomberg data.

• Any significant change in taxation on cigarettes.

• Impact of taxation changes on the volumes of the business.

• There is looming concern if volumes shift from the legal tobacco industry to the illicit segment.

• Change in demand for new product launches

• Change in input costs and its impact on margins for non-cigarette business.

Shares of ITC have gained 30.99% so far in the current fiscal till Jan. 11, 2023, compared with a 1.27% advance in the NSE Nifty 50 Index during the same period, according to Bloomberg data.

Nomura highlights the factors that led to the strong stock performance in fiscal 2022-23:

• Shift in investor preference from growth trading to value trading following the Russia-Ukraine crisis.

• There is no change in the tax rate on cigarettes in the current fiscal.

• Increased mobility, or economic opening, is driving all-around improvements in business performance.

• Inclusion of ESG-led investor exits, resulting in a de-rating.

• Investor expectations of value unlocking with an expected divestment of the FMCG division are now less likely, says  Nomura.

The sales mix of the company in the financial year 2021–22 showed that it made the highest sales from the cigarette business at 36%, followed by FMCG at 29% and agribusiness at 22%.

The paperboard, paper, and packaging business along with the hospitality business saw sales of 11% and 2%, respectively, in the previous fiscal.

The earnings before interest and tax in the last fiscal show that the cigarette business takes the lion's share of the pie at 79%, followed by the paperboard, paper, and packaging businesses at 9%, and the agribusiness at 6%. The FMCG business and the hospitality business saw sales of 5% and -1%, respectively, in the previous fiscal.

The tax rate changes on cigarettes have always remained unpredictable, given the impact they have on volumes and eventually stock performance, according to Nomura. The brokerage warrants a probabilistic view on these changes to gauge risk and reward appropriately.

Other highlights from Nomura's report on the cigarette business include the following:

• The likelihood of the government increasing the basic excise duty and national calamity contingent duty on cigarettes in the upcoming budget is high.

• The GST-specific cess, GST rate, and ad valorem cess on cigarettes remain under the jurisdiction of the GST Council.

• The risk of its largest brand, Gold Flake (Regular), downtrading is increasing, as it may cross the convenient price of Rs 10 per stick if taxes rise.

• At the lower end of the sector, cigarette revenue growth was seen at a modest rate of 8% over FY24–25.

• The rising risk of the government's long-standing social cause to reduce smoking and its harmful health hazards could have a significant impact on volume.

• ITC has been a beneficiary of lower volume contributions from the illicit segment in the last three years due to the pandemic and an increase in vigilance activities from the authorities. However, a tax increase and its impact on retail prices could reintroduce the illicit market.

• Cigarette and tobacco product companies are expected to continue to score low on the ESG due to harmful health issues related to the consumption of these products.

• ITC has scaled up its FMCG business over FY10–22 and now holds the second position, versus the fifth position it held in FY10, in the domestic FMCG industry in terms of the revenue base in FY22.

• The company is now focusing on niche growth categories to drive.

• Premiumisation with value-added premium offerings in order to improve margins.

• ITC invested in the FMCG business by leveraging its cigarette distribution and other strong sourcing capabilities from its agri and paperboard businesses, as well as the large cash flow generated by its cigarette business.

• Given the multiple competitive advantages, Nomura says that there is a stronger case of ITC’s FMCG business to likely be within the group structure rather than being divested as a separate entity. 

• As per Nomura, the company's higher exposure to large, commoditised food-led categories will likely keep its Ebitda margin range-bound. Despite improving trajectory, Nomura expects ITC Ltd. to remain lower-than-peers over the near to medium term.  

• ITC has been focusing on accelerating launches of its value-added offerings across horticulture, spices, coffee, frozen marine products, medicinal and aromatic plants, and processed fruits.

• ITC is leveraging digital technologies to create an online ecosystem for farmers by initiating the 'e-Choupal 4.0' platform.

• ITC’s paperboard and packaging business is a clear market leader in terms of scale and profitability, according to management.

• ITC operates over 10,700 rooms across 113 hotel properties under four brands.

• The hospitality section is undergoing a transition in its business model to an asset-right model. This means that ITC is focusing on room inventory expansion through management contracts instead of asset acquisition.

• Managed properties currently account for more than 50% of ITC’s room inventory, and going forward, Nomura believes more than 90% of its room additions are slated to happen through management contracts.