SAMCO Research has recommended long term BUY Call for FMCG and Cigarettes major ITC. ITC generates higher margin from cigarettes business but the company has been shifting focus to FMCG sector with many powerful brands under its umbrella. While FMCG segment offers lower margin, ITC will reduce the long term risks to its business with diversification. A review and investment rationale by SAMCO Research follows...

Shifting Focus to FMCG Business - As the cigarette division is slowly losing steam, ITC has been making steady progress to ramp up its FMCG business. From single digits a decade ago, this segment now covers over a quarter of its revenue with some powerful in-house brands such as Aashirvaad, Sunfeast, Bingo!, Classmate, YiPPee!, etc. The idea of leveraging its retail brands to boost sales, in the midst of regulatory and rising tax issues on its tobacco business, is a sound strategy given that the Company has already created loyalty with its retail product brands.

Perks of a Cash Rich Balance Sheet - With a pile of positive free cash flows of over Rs 9,000 Cr and virtually no debt on its books, ITC is a fine choice as the Company can use its free cash flows for expansion and increase returns to shareholders in the form of dividends. Its dividend payout ratio is around 56%. Also, the company is always on the look out for inorganic growth opportunities to strengthen its existing portfolio.

Tactical Capital Allocation - Since the year 2002, ITC has distributed an average 60% of profits by way of dividends, 15-20% have been applied to scale up capacities across various business segments and remaining amount is held in non-core investments and cash balances. Further, the company in March announced dividends of 80-85% of its profits to shareholders in the medium term on back of minimal capex requirement going forward.

Strong Profitability Ratios - ITC has shown continuous improvement in its operating margins due to management's efforts to capitalise on economies of scale, setting up of integrated manufacturing facilities, rationalization of loss-making categories and improving distribution reach. Its average ROE is around 24% for the past 5 years and average ROCE is 37% for the same period.

Valuations - ITC is a professionally managed company which is currently undervalued at a P/E of 15x compared to its sectoral FMCG index P/E of 31x which makes it an extremely attractive bet.

Key Risks

Environmental, Social, and Governance (ESG) Concerns - In a race to become ESG compliant, majority of the global funds may shy away to associate with tobacco companies and this could be one of the reasons for reduced FII holdings over the past decade.

Dull Growth in Cigarette Market - High taxes make cigarettes unaffordable to a large section of consumers which is propelling a shift towards the consumption of beedi and other forms of smokeless tobacco.

Covid Impact - Persistence of lockdowns and travel restrictions can lead to disruption to its hotel business and its stationary products due to delay in commencement of the academic sessions. The risk though high, both these divisions form around 12% of the Company's revenues.