Buy Blue-Chip FMCG Stock ITC Ltd for 45% Gain & Dividend Yield of 10%

Re-strategising capital allocation…

ITC has declared its dividend policy, increasing its payout to 80-85% of earnings. Moreover, it is expected to pay out a special dividend along with its fourth quarter results. The company is holding cash & investments of ~Rs 16000 crore as on September 2020. We believe the company could pay 50% of its cash & investments as special dividend, which translates to dividend per share of Rs 6 /share. This, along with the 80% payout, is expected to result in dividend of Rs 16/share and a dividend yield of 10%. Even without this, special dividend yield is at 7%. Currently, the stock is trading at 10x FY22E earnings.

FMCG margins to witness significant improvement

The company has witnessed operating margin (EBITDA) improvement in the FMCG segment from 4.2% in Q3FY18 to 7.7% in Q3FY20. With the strong distribution network of ~6.0 million outlets along with the robust & wide food portfolio, we expect margins to further improve to double digits in the next four to five quarters. Given the continuous improvement in FMCG margins along with sustainable growth, it would start contributing to earnings. The company has a vision of reaching 1.0 lakh crore FMCG sales by 2030. Though we believe the company would witness sustainable growth in the next decade, it would still be dependent on acquisitions to reach this ambitious milestone.

Cigarettes margins to improve

With the excise duty increase in Budget 2020, the company has taken a hike of 12-20%. This hike would pass on the entire excise increase in Budget but would also improve the margins of the cigarette business. Though we believe the company would witness lower volume growth in FY21E, it would be able to increase the operating margins of the cigarettes segment. The biggest challenge for the cigarettes industry remains the illicit cigarettes market, which is contributing more than 25% of industry volumes. Moreover, smaller peers of the company have also gained market share at the expense of ITC in the last two years.

Valuation & Outlook

In the recent market fall, ITC witnessed a significant correction of ~30%. At the current price, the stock is trading at 11x & 10x its FY20E & FY21E earnings. Though the current economic conditions would have an adverse impact on ITC’s earnings for a quarter or two, we believe the company would be able to sustain the earnings growth in the long run backed by improvement in cigarettes as well as FMCG segments. Moreover, with the recent change in dividend policy, the stock is trading at attractive dividend yield (on account of dividend policy & special dividend). We value the stock at sum of the part valuation method (valuing cigarettes business at 14x FY22 earnings, FMCG at 5x price to sales) and arrive at a target price of Rs 230 per share with a BUY recommendation.