ITC - Keeps the date: Kotak Sec

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ITC (ITC)
Consumer products
Keeps the date. 2Q results—marginally ahead of estimates—were a further
demonstration of ITC’s market dominance in cigarettes (price increases in an
environment of high food inflation) and the confluence of good performance by all
business divisions. Key areas to watch, (1) improving profitability of extant foods
businesses, (2) growth in personal care (a tad disappointing in 2Q) and (3) competitive
activity by Marlboro in relevant markets. Upgrade FY2010-12E earnings by 2%; ADD.




Confluence of all businesses performing well, as expected
ITC reported net sales of Rs50.6 bn (+16%, KIE Rs49.5 bn), EBITDA of Rs17.9 bn (+16%, KIE
Rs17.3 bn) and PAT of Rs12.5 bn (+23%, KIE Rs11.5 bn).
􀁠 The cigarette segment sales grew 15% to Rs48 bn—volumes were likely flat which is a key
positive given that the company effected price hike of 15% post the budget in an environment
of high food inflation.
􀁠 Other FMCG sales grew 22% yoy—led by branded packaged foods at +26% (Sunfeast +32%,
staples +29%, confectionary +18%).
􀁠 Step up in soya and wheat sales helped agri business register growth of 22%.
􀁠 Cigarette margins improved 40 bps to 30.3% likely on the back of improvement in sales mix
and lower trade spends. Sharp improvement in other FMCG margins (350 bps) is a significant
positive as it likely demonstrates ITC’s ability to turn extant businesses profitable.
􀁠 The paperboard business grew 32% with surprisingly high margins of 25.6% (300 bps
improvement) as it benefited from (1) better mix—higher proportion of value-added
paperboard, (2) benefits of backward integration (commissioning pulp capacity) and (3) higher
realizations.
􀁠 +74% increase in other income (dividends) boosted PAT margin by 140 bps to 24.6%.
􀁠 The company has launched Sunfeast Yippee instant noodles in select markets (Bangalore and
Coimbatore). In the last one year, ITC is the third new entrant in this segment after GSK
Consumer and HUL.

Needle movers are potential increases in dividends and improving return ratios
􀁠 Potential for increase in dividend payout ratio exists. We assign a high probability for
an increase in the dividend payout in FY2010-12E as ITC is likely to generate FCF of Rs48
bn and the company is likely to have surplus cash of Rs50 bn (Rs13/share) by end-
FY2011E.
􀁠 Improving ROCE as all businesses will likely contribute incrementally to profits and capex
as a percentage of sales trends downwards.
􀁠 Entry of Philip Morris (Marlboro) in RSFT. While our channel checks suggests muted
consumer acceptance of Marlboro Compact (despite the brand being well known in big
cities), we keenly watch the market performance of it in the RSFT segment (smaller
cigarette, 69mm).
In our view, the cigarette market scenario still favors ITC as, (1) Godfrey Philips (GPI) and
Philip Morris need to ensure that Marlboro Compact (owned by Philip Morris directly) do
not cannibalize GPI's sales, and (2) relatively limited geographical distribution reach of GPI
versus market leader ITC.
Marlboro has premium positioning globally—its strong brand equity means that it faces
limited head-on competition. Competitors prefer to have an “aggregation of niches
strategy” (various brands against Marlboro at multiple price points closer to Marlboro
price).

Retain ADD, moderate increase in estimates, TP increases to Rs180
We model higher cigarette margins (mix improvement) and increase FY2010-12E earnings
estimates by 2% and target price to Rs180 (Rs175 previously). Our EPS estimates are Rs6.5
and Rs7.6 for FY2011E and FY2012E, respectively. Key factor favoring ITC is likely stability in
regulation as most of the penal actions are behind it (including threat of indiscriminate
increase in VAT by states—current effective VAT rate of ~15%). We see strong possibility for
further earnings upgrades as cigarette volumes could surprise positively in 2HFY11E.
Media reports suggest that implementation of GST is likely postponed from the earlier
deadline of April 1, 2011. While there is no structural change to our ITC view based on this,
we note that this potentially removes the near-term uncertainty for ITC in managing
cigarette portfolio pricing (calibrated price changes typically has lesser impact on volumes).
Key risks are (1) unexpected higher losses in other FMCG, and (2) any aggressive marketing
strategy by Philip Morris to promote Marlboro.