Morgan Stanley believes ITC has exited a painful decade of high cigarette taxes, ESG headwinds, diverging global trends, an underperforming FMCG business, and the loss of foreign flows. While not all of these headwinds will go away, Morgan Stanley sees these two that could drive a re-rating. Morgan Stanley maintains an overweight rating on ITC with a target price of Rs 251. ITC share price closed at Rs 217.65 in yesterday's session, up Rs 7 or 3.35%.

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Stable tax environment:

Morgan Stanley expects cigarette tax regulations to be benign relative to the 150% increase seen in 2010-19. The tax increases could be similar to the 80% seen in 2001-09, and over the next few years could echo the 2003-07 period when economic growth was strong and tax increases were reasonable. The recent Union budget adds to our confidence regarding moderate taxes as there was no announcement of a tax increase on tobacco despite lower government revenues due to the pandemic. Over the medium term, Morgan Stanley built in annual volume growth of 3-4% and EBIT growth inching to low double digits, as compared to -1.4% and 5.8% in 2015-20.

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Gradual FMCG turnaround:

The FMCG business continues to scale and is the second largest listed play in India by revenue. Beyond scale, we believe the company's focus on increasing confidence in the FMCG turnaround will be another important catalyst for stock outperformance over the medium term. We expect the FMCG profit contribution to gradually increase to 8.5% and 12% over the next 5 and 10 years from 3% currently. We estimate margins will improve to 11% and 17.6% by F25 and F35 (still lower than peers). More importantly, Sharekhan expects the FMCG business to contribute to dividends over the next 5 years.

Valuations attractive, adjusting for ESG for ITC:

ITC trades at 16x F22 P/E - a 35% discount to its 5-year and long-term averages – mainly due to ESG concerns related to tobacco. Sharekhan argues that this discount is likely to narrow to 25%, implying that the stock would trade at around 19x. On Morgan Stanley’s estimates, only 30% of ITC's stock value is from future growth while 70% comes from current operations – the opposite of consumer staples – showing how little growth is priced in.

Key risks to Morgan Stanley’s call:

1)      An economic slowdown and a fall in affordability
2)      sharp tax increases
3)      FMCG profitability remains poor
4)      ESG acceptance becomes more widespread