India's largest branded cigarette manufacturer, ITC, will report fiscal 2015 fourth-quarter results next week. We will be keenly watching the volume growth and profitability numbers for its cigarette business, which accounts for 56% of sales and 34% earnings before interest and tax for the company. Not only are these two the most critical factors that determine earnings per share growth at the firm, but these are also the triggers that will drive the stock price to meet our fair value estimate of INR 406 on this narrow-moat-rated stock. The increased excise duties have resulted in higher pricing of products as a way to pass on the excise to customers, which has hurt volume in the short term. As branded cigarette consumption continues to be an urban phenomenon, we believe a return to growth in urban consumption as wages rise and food inflation cools off will have a rub-off effect on ITC's cigarette sales and volume growth as well.
While ITC's consumer packaged goods business has some adjacencies to its current retail presence, this business contributes 15% to its top line and negligibly to its bottom line. We await this consumer packaged business to reach scale to begin adequately adding to EPS. We are not particularly positive about continued investment behind this segment and would rather that management return excess cash thrown off by the cigarette business to shareholders. We continue to believe that ITC is undervalued, trading at a 4-star valuation presently. The key trigger for the stock price to move up will be cigarette volume, which could take two to three quarters to revive without any further excise duty hikes.
