ITC Share price: CLSA see significant value creation opportunity as FMCG business scales

CLSA’s recent ITC upgrade to buy was based on a belief that the market is ignoring long-term positives, particularly K-shaped acceleration in ITC’s fast-moving consumer goods (FMCG) business, with scale driving margin acceleration even as incremental capital intensity falls. ITC’s derating in the past year was a factor of ESG-related concerns, regulatory tightening, capital allocation and Covid-19 uncertainty; most of these concerns are set to be addressed as the FMCG business is at an inflection point and capital-allocation issues are being addressed. While the stock has rerated 15% since October, CLSA still sees 25% upside, including about 5% dividend yield. In their reverse-DCF analysis, we see implied revenue-ask at just 5% in the next 10 years versus 10% in the last decade and 15-20% expectation built in on other FMCG names. CLSA retains a BUY rating and an Rs 235 target price on ITC.

FMCG business upside remains relatively under-appreciated:

CLSA sees ITC’s FMCG business shaping up well for K-shaped acceleration, as explained in our October note. Operating margin at 10% in 2QFY21 may reverse a bit but the segment is on track to drive double-digit margin starting in FY22, with scale-up of categories with relevant extensions. We see efforts in the last two decades to set up largely organic FMCG business as materialising, with accelerated share gains across categories during the pandemic period. CLSA still sees ITC’s FMCG business as creating significant shareholder value, with an expected 30% EBITDA CAGR in FY2020-23. ITC’s much larger category basket versus peers, improving sales mix, falling incubation costs, operating leverage benefits, and an ability to move into new categories with limited incremental investments offer long term growth visibility and partly offsets a lower margin profile, in CLSA’s view.

Reverse DCF implies just 5% sales/EBITDA/FCF CAGR in FY20-30:

CLSA reverse-DCF analysis, employing a terminal growth rate of 4% and a WACC of 12%, suggests just a 5% 10-year sales/EBITDA/FCF CAGR. They expect broadly flat or declining YoY cigarette sales volumes in the coming years amid tax hikes and a strict regulatory environment.

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Rerating likely to sustain as corrective actions in place, outcomes getting in shape:

Falling capex for FMCG, a new asset-light model for the hotels business, and a sharp increase in dividend payouts (80-85% of profit after tax) should progressively address investor concerns on capital allocation. Stock valuations are too attractive for ITC to consider a buyback (US $4.2bn of liquid assets in September), in our view. CLSA SOTP-based Rs 235 target price implies 25% upside, including dividend yield.