Accumulate ITC – 3QFY2011 Result Update - Angel Broking

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ITC – 3QFY2011 Result Update

Angel Broking upgrades on ITC from Neutral to Accumulate with a Target Price of Rs. 186.

For 3QFY2011, ITC posted a strong set of numbers on the revenue and earnings

front. The company’s revenue came in line with our estimates, while earnings
were marginally above estimates. The key highlights of the results include
1) double-digit sales and EBIT growth in cigarettes, 2) continued reduction in loss
reported by the non-cigarette FMCG business and 3) EBIT margin expansion in
agri and paperboards businesses. We upgrade the stock to Accumulate.

All segments deliver, earnings growth boosted by other income: ITC declared
steady top-line growth of 18.6% yoy to `5,453cr (`4,599cr). The cigarette division
registered 18.4% yoy growth in gross revenue (15.6% yoy growth in net revenue)
on the back higher volumes and improved product mix. Earnings grew by robust
21.4% yoy to `1,389cr (`1,144cr), largely on account of steady top-line growth, a
112bp yoy decline in tax rate and a 22% yoy jump in other income to `253cr
(`207cr); however, earnings were dragged down by higher interest expense (up
111% yoy) and depreciation expense (up 8.5% yoy).
Outlook and valuation: We continue to like ITC’s diversified business model and
its ability to generate and invest strong cash flows in high-potential businesses.
We believe ITC is least susceptible to raw-material and food inflation, given
its strong presence in the back-end agri raw-material sourcing and benign
tobacco price environment. Hence, we upgrade the stock from Neutral to
Accumulate with a Target Price of `186, based on our SOTP model.


All segments except paperboards deliver double-digit top-line growth
ITC declared steady top-line growth of 18.6% yoy to `5,453cr (`4,599cr). The
cigarette division registered 18.4% yoy growth in gross revenue (15.6% yoy growth in
net revenue) on the back higher volumes and improved product mix.


Amongst other segments, the agri and non-cigarette FMCG businesses posted strong
growth of 17.9% and 16.7% yoy, respectively; hotels registered robust 14.6% yoy
growth albeit on a low base (occupancy level increased to ~50%); and paperboards
grew by 8.4% yoy.

Earnings grow strong by 21.4% yoy, partially aided by other income
Earnings grew by robust 21.4% yoy to `1,389cr (`1,144cr) largely on account of
steady top-line growth, a 112bp yoy decline in tax rate and a 22% yoy jump in other
income to `253cr (`207cr). Earnings, however, were dragged down by higher
interest expense (up 111% yoy) and depreciation expense (up 8.5% yoy). Operating
margin remained flat for the quarter at 36.1% despite savings in other expenses,
negated by higher raw-material costs. In terms of segmental margins, cigarettes
posted a 34bp yoy contraction, non-cigarette FMCG business posted reduction
~`12cr yoy in losses and paperboards margins contracted by 295bp yoy.

Cigarette segment registered double-digit sales and EBIT growth
During the quarter, ITC’s cigarette division registered 18.4% growth in gross revenue
(15.6% yoy growth in net revenue) on the back of higher volumes (we estimate an
increase of 1–2% in volumes) and improved product mix. EBIT margins contracted by
34bp to 29.3% on account of higher production cost related to micro filters.
We believe the cigarette business is well poised to post double-digit revenue and
EBIT growth in FY2011E. We have modeled in 1.4% volume growth in cigarette
volumes for FY2011 (likely to be back-ended in 2HFY2011E).

Non-cigarette FMCG witnessing strong revenue traction
ITC’s non-cigarette FMCG business registered a strong uptick of 23.8% yoy in
revenue to `1,104cr (`892cr), driven by impressive performance from its branded
packaged foods (up 24% yoy). However, while the segment reported lower loss by
~`12cr yoy to `74cr (`86cr), it reported higher loss by ~`7cr on a sequential basis,
indicating step-up in investments to support new launches in skin care.
During the quarter, Sunfeast, Bingo and the stationary business grew by 48%, 28%
and 50%, respectively. The company also launched Vivel Glycerine Milk Cream – a
new offering in the winter segment, while Vivel Deo Spirit, in the freshness segment,
was extended to Andhra Pradesh, Kerala and Karnataka during the quarter. Going
ahead we expect, revenue traction in the segment to continue and losses to reduce,
albeit at a slower pace than FY2010, though breakeven is likely to be achieved only
in FY2013.

Hotel business shows recovery as ARR improves
ITC’s hotel business registered robust growth of 14.6% yoy to `303cr (`265cr) during
the quarter, aided by the festive/holiday season. The business segment reported EBIT
margin of 29% (expansion of 37bp yoy), driving strong 16% yoy growth in EBIT. We
believe the hotel business is well on track to post a 21% CAGR in revenue during
FY2010–12E, aided by low base and an uptick in economic activity. Moreover,
margins are likely to register significant improvement as ARR recovers.

Paperboards and packaging suffer on the margins front
The segment registered modest revenue growth of 8.4% yoy (8% on a net level) to
`917cr (`845cr). However, the segment’s EBIT margin registered a significant
contraction of 294bp yoy to 20.9%, leading to a decline of ~5% yoy in EBIT due to
packaging inventory depletion caused by the uncertainty around the change in
graphic statutory warnings on cigarette packaging. Going forward, we expect the
segment to post a modest 16% CAGR in revenue during FY2010–12E, driven by
commencement of new units and margins to improve by ~150bp from current
levels, aided largely by a better product mix.

Agri business registers another quarter of steady revenue growth
ITC’s agri business registered steady 17.9% yoy growth in revenue to `1,066cr
(`905cr), partially aided by higher coffee and soya trading volumes and improved
leaf tea exports. The business segment reported an EBIT margin expansion of 173bp
yoy to 13.2%, aiding 35.5% yoy growth in EBIT. Going ahead, we expect this
segment to register a 22% CAGR in revenue over FY2010–12E and margins to
remain stable at ~11% levels.

Investment rationale
􀂄 Model double-digit sales and EBIT growth in cigarettes: We have modeled in
1.4% volume growth in cigarette volumes for FY2011 (likely to be back-ended in
2HFY2011E) despite the price hikes (~15% weighted average price hikes taken
in 1HFY2011 and the recent ~5% weighted average price hikes), likely to fully
offset – 1) a ~17% excise hike in budget and 2) rise in VAT announced in
several states. We believe the cigarette business is well poised to post doubledigit
sales and EBIT growth in FY2011E. Moreover, we highlight that over the last
12 months, ITC has strengthened its brand portfolio significantly by launching
brands such as Flake Excel and Duke Filter; and Lucky Strike and Armenteros
cigars (launched in select metros) at premium-end; along with having testmarketed

59mm mid-size filter (micro-filters).
􀂄 Non-cigarette EBIT to post a 35% CAGR over FY2010–12E: While cigarettes
remain the main profit centre for ITC, investments in non-cigarette businesses
such as FMCG, hotels and paperboards have started yielding positive results.
During FY2010–12E, we expect non-cigarette EBIT to post a 35% CAGR, aided
by – 1) reduction in non-cigarette FMCG losses, 2) improvement in hotel
margins aided by higher ARR and 3) higher margins in paperboards.
􀂄 Return ratios to improve across segments boosting cash flow generation: Over
FY2010–12E, we expect return ratios to improve across segments, driven by
higher margins (refer Exhibit 19). Moreover, going ahead, we expect capex to
plateau from the peak of FY2007–08, driving strong cash flow generation post
dividend payout at ~50%. Hence, we expect ITC to achieve strong net cash
surplus of ~`6,000cr in FY2012E, equating to `8 per share

Outlook and valuation
We continue to remain positive on ITC’s diversified business model and expect the
cigarette business to witness strong growth, driven by higher volumes and benign
tobacco price environment. Moreover, broad-based growth across segments,
including potential recovery in hotels, strong growth in agri-business and reducing
losses in non-cigarette FMCG businesses will help ITC sustain strong earnings growth
for ensuing quarters. We believe ITC is least susceptible to raw-material and food
inflation given its strong presence in the back-end agri raw-material sourcing and a
benign tobacco price environment. Hence, we upgrade the stock from Neutral to
Accumulate with a Target Price of `186, based on our SOTP model.