ITC:Downgrade to Hold,In-line Q4,now limited upside

Downgrade to Hold: ITC’s share price has run up c38% from the post demonetisationlow in Q3 (vs Sensex +20%), largely driven by a modest increase in taxation on cigarettesin the Budget in February and more recently a GST rate on cigarettes that seems tosuggest that taxation on cigarettes is likely to be neutral in the short term. This has raisedexpectations that earnings growth in FY18 and beyond will now accelerate.

    In our view, this positivity might last a very short time as taxation on cigarettes will remainpunitive in the long term and it is highly unlikely that the post GST era for cigarettes islikely to see benign and predictable taxation. ITC at our target price requires long-termearnings growth of c12%, which we think plausible, but this leaves little alpha to capture.

    Consider this: In the last decade, cigarette EBIT CAGR has grown by c15%, when ITCtook price increases with impunity and cigarette volumes were virtually inelastic to priceincreases, until FY15, when cigarette volumes plummeted, and ITC moved a large part ofits cigarette volumes to 64mm (low taxed cigarettes) to avoid having to take priceincreases. It seems unlikely to us that the last decade’s performance will be replicated inthe next decade. We pencil in a cigarette EBIT CAGR of 11-12% in the next decade.

    ITC’s other FMCG business, which is very large now but which earns a negligible profit,will eventually see a margin improvement, but it will add c1% to the overall earningsCAGR given the large profit pool of cigarettes. We see limited share price upside fromthese levels and downgrade the stock to Hold with a new TP of INR320 (from INR300) aswe revise our estimates and roll forward our valuation. We think investors are likely to usethe incremental short-term positive news as a good reason to book profits.

    Key details from Q4 results: Revenue, EBITDA and PAT grew by c6%, c8% and c12%y-o-y, respectively. 1) Volume growth in cigarettes was flat y-o-y. Cigarette revenue grewat 4.8% while overall cigarette EBIT grew c8% y-o-y. 2) Other FMCG revenue grew by6.5% y-o-y, as most categories recovered after demonetisation-led disruption in Q3 butthe impact on lifestyle retailing, and the education & stationary products business wasrather prolonged. 3) Hotels’ top line grew at 6.5% y-o-y. 4) Agri business revenueincreased 6% y-o-y, while margin compression led to an EBIT decline of c21% y-o-y. 5)The Paperboards, Paper and Packaging (PP&B) segment’s revenue grew by c4% butPP&B margin expansion led to c18% EBIT growth.