Seeking value in ITC and Godfrey Phillips? Tobacco stocks gain momentum in FMCG play

As rising retail inflows into mutual funds and steep valuations of Indian equities push investors towards defensive sectors like fast-moving consumer goods (FMCG), tobacco companies have emerged as one of the top investment picks despite their lacklustre near-term growth prospects.

With the premiumisation theme continuing unabated in India’s consumption story, market participants are betting on cigarette companies to perform better in the long run as rural demand recovers from the post-covid lows, boosting FMCG companies, analysts said.

Stocks of the top listed cigarette makers–ITC, Godfrey Phillips India, NTC Industries, VST Industries, and Sinnar Bidi Udyog—have posted an average return of almost 60% in the last six months. Only Golden Tobacco, which is in the midst of a corporate insolvency resolution process, has lost around 21% in the same period.

Meanwhile, the Nifty FMCG Index has posted a return of around 19% in the last six months. Some analysts feel the recent earnings of most companies in the cigarette pack do not justify their valuations.

Pure-play tobacco companies like Godfrey Phillips reported a 24% on-year decline in its standalone net profit to ₹223 crores, while NTC Industries’ standalone net profit fell almost 78% to ₹44 crores in Q1 FY25. Even ITC, the most diversified player in the tobacco business, reported a mere 0.3% on-year rise in its standalone net profit to ₹4,920 crore in the same period.

Also Read: ITC shares hit a new high post budget. What is next?

However, ITC’s cigarette business revenue grew around 7% on-year to ₹7,900 crore, while its Ebit margins increased 20 basis points on-year to 62.6% in the quarter ended June. Ebit stands for earnings before interest and taxes.

"ITC’s premium products helped them protect their (profit) margins despite inflation in raw tobacco,” Abneesh Roy, executive director and head of research committee at Nuvama Institutional Equities told Mint. “These (premium products) will be growing much faster than their economical offerings.”

The company's premium offerings like slim and capsule cigarettes have helped diversify its product mix, analysts said, but remain sceptical of its current valuation.

“Even as we remain convinced about the longer-term earnings growth prospects, limited upside leads us to downgrade our rating on ITC to ‘accumulate’ as we await a better entry point,” a Nirmal Bang Institutional Equities report said.

Limited upside

As the Indian government refrained from hiking taxes on cigarettes in the current fiscal year, it helped the organised tobacco sector to claw back some market share from the illicit segment. Exorbitant cigarette taxes are the primary drivers of this underground economy for cigarettes.

The shadow market of contraband cigarettes, which includes both smuggled imports and locally produced goods avoiding taxes, constitutes nearly 25% of India's tobacco market, according to a Business World report.

“Given no tax change this year, we expect low-mid single digit volume growth to continue for the legal (tobacco) industry,” Siddhant Chhabria, research analyst and fund manager at Mirae Asset Investment Managers (India) told Mint.

ITC reported volume growth of 3% for the Juner quarter of FY25. Analysts expect a 4-5% volume growth for the overall industry in FY25.

“The cigarette industry has seen some mild growth recently. There can be some market share growth from the illegal industry, but that will be a one-off scenario. It won't happen every year,” Roy said.

Tax hikes are a double-edged sword for the industry. While they slash the legal players’ market share, reducing their volume growth, they also allow them to pass on higher prices to consumers, improving profitability. However, since the government did not hike taxes this fiscal year, tobacco companies could not raise product prices. This has kept their profit margins subdued lately.

A meaningful improvement in these companies’ profit margins would be a key trigger for further upside momentum in their stocks, analysts said. However, a recent surge in raw tobacco prices due to global supply disruptions and their inability to hike prices of cigarettes have limited any upside potential for the companies in the near term, they said.

Defensive play

Despite limited opportunities, investors have gravitated towards the tobacco pack mainly from a strategic point of view, analysts said. As investment corpus continues to balloon, investors are scrambling to find value investments in the world’s most expensive equity market.

Inflows into open-ended equity funds stayed in the positive zone for the 42nd month in a row in August, and net assets under management (AUM) of the mutual fund industry touched almost ₹67 trillion, according to recent Association of Mutual Funds of India (Amfi) data.

“Stocks have run up a lot lately, and there is a continuous flow of money in mutual funds. They must deploy it somewhere,” a vice president of equities research at a domestic investment and advisory firm told Mint.

“They went overweight in many of the high growth sectors like defence and PSUs (public sector undertakings) which have disappointed. Which is why they have been buying defensive stocks.”

Narratives of a revival in rural demand growth and premiumisation of consumption playing out for the next couple of years have also supported buying, analysts said. Moreover, recent uncertainties in pharmaceuticals, IT and metals, have made FMCG, which has been relatively cheaper and safer, a more lucrative choice for investors, they added.

Additionally, many FMCG companies, including tobacco stocks, pay rich dividends to shareholders, which add value to investor portfolios. This is why tobacco companies are seen as defensive bets in the industry, market participants said.

Godfrey Phillips will pay a ₹56 per share dividend to its shareholders for FY24, while ITC will pay a ₹13.75 per share dividend for the same period, both the companies informed exchanges recently.

“However, pure-play FMCG companies can offer higher growth than cigarette (companies) moving ahead, as it (cigarette) is not a high growth industry,” Roy said.

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