JP Morgan- ITC Q3FY11 : strong quarter; encouraging cigarette volume growth trends

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ITC Limited Overweight
ITC.BO, ITC IN
Q3FY11 : strong quarter; encouraging cigarette volume growth trends

• Q3FY11 earnings 5% above estimates: Net sales, EBITDA, and PAT
grew 19%, 19%, and 21% y/y, respectively. Higher-than-estimated
cigarette, agri and other FMCG business revenues led to sales coming in 4%
above our expectations. However, EBITDA was in line with our
expectations as lower (than estimated) margins for cigarette and paper
business offset margin gains for agri and hotel business. Higher other
income (supported to some extent by sale of some investments) led to
higher PAT growth.
• Cigarette vol growth trends are encouraging with revenues rising 18.4%
y/y and we estimate volume growth contributing 2-3% to the same (vs. c-
2% vol growth during 1HFY11). However, margins were marginally weak
(-30bp y/y) during Q3FY11. Importantly, product mix changes remain
encouraging and recent price hikes undertaken by the company should be
positive for margins in coming quarters. Lower procurement costs for
tobacco (c-10% y/y) should further support FY12 margins.
• Non-tobacco business: A mixed bag: Agri business posted impressive
performance driven by higher trading of coffee & soya and better margins
for leaf tobacco. While revenue growth for Other FMCG was healthy, losses
increased sequentially due to expenses on new launches (noodles, skin care)
and firm input costs. Hotel division reported modest recovery with improved
ARRs (+8-10% y/y) and higher occupancy levels (65-68%). Paper business
performance was subdued due to one-off pipeline correction in view of
uncertainty related to change in pictorial warning for cigarette packaging.
• Tobacco and taxes: Over the next few days there will probably be a debate
on the extent of excise duty hikes likely on cigarettes, particularly against
the backdrop of a strained fiscal situation. As demand trends are healthy, we
believe the industry can absorb an excise duty hike of up to 10% (implying
price hike of 4-6%) without impacting demand meaningfully. At constant
prices, the current sensitivity to earnings of excise duty is 1%.
• Maintain OW: We expect ITC to deliver EPS CAGR of 18% over FY10-
13E. It is our preferred pick in consumer staples sector and in the current
volatile market, should do relatively better.


Cigarettes – volume growth trends are encouraging
Revenue growth of the cigarettes division at 18.4% during Q3FY11 was 2% ahead of
expectations. We estimate that volumes grew 2-3% during the quarter, recovering
sequentially from c2% decline witnessed in H1FY11 post sharp excise duty hikes
announced in the budget. We expect volumes to pick up in subsequent quarters and
believe ITC could well finish full-year FY11 with marginal positive volume growth.
We believe ITC’s premium cigarette portfolio grew during the quarter, ahead of
regular filters, as price hikes implemented for premium filters was lower than for
regular filters.
ITC continues to improve its product portfolio, trying to capture various price points
and has introduced new brands and variants like Lucky Strike, Classic Menthol Rush,
Gold Flake SLK and Player’s Gold Leaf brand (positioned at the premium regularsize
filter segment).
During Q3FY11, EBIT margins for cigarettes were marginally weak (-30bp y/y). We
expect full-year FY11 EBIT margins to expand 40-50bp though. Recent price hikes,
coupled with good demand trends, should support cigarette EBIT growth to be
upwards of 16% in FY11E/12E.

Other FMCG: profitability is key

Other FMCG division revenues grew 24% y/y, the fifth consecutive quarter of strong
growth. This was driven by healthy growth for branded packaged foods (revenues up
24% y/y) and education & stationery products (+50% y/y). The branded packaged
foods sub-segment registered 24% sales growth during the quarter on the back of
higher realizations, improved product mix, and addition of new variants. Snacks
portfolio (Bingo brand) and biscuits registered sales growth of 48% and 28% y/y,
respectively. Recent launch of instant noodles has witnessed good consumer
response and the product is in the process of being rolled out to more markets.
Performance of personal care continues to be steady, aided by new variant launches
and increased distribution. The company is in the process of extending its skin care
portfolio (Vivel Active Fair) to more states.


While EBIT losses as a % of sales were lower 300bp y/y, they rose marginally by
30bp q/q on account of firm input costs and expenses related to the launch of instant
noodles and increasing distribution for the skin care portfolio.
We expect overall revenues for other FMCG to grow at 20-25% and expect EBIT
losses to decline by 15-25% p.a. over the next two years, aided by scale benefits,
price hikes and improved product mix gains.


Hotels – modest recovery; looking forward to strong FY12
While the hotels division continued to witness improvement, with revenues growing
15% y/y and margin expansion at 40bp y/y, it was below our expectations. While
average room rates (ARR) have increased 10% y/y, occupancy levels have risen to
67-69% now. Subdued response to Commonwealth games was also a demand
dampener in the previous quarter.
ITC’s expansion plans include commissioning a 600-room hotel in Chennai in FY12,
and by FY13 a boutique resort in Gurgaon (100 rooms) and a 300-room hotel in
Kolkata.
We remain optimistic about growth picking up significantly in FY12 as ARRs will
likely firm up further. As per our channel checks, room rates in some leading hotels
have been raised by 5-10% over the last month or so. We forecast revenue and
EBITDA CAGR of 20% and 32%, respectively, during FY10-13E for this division


Agri business – surprises on all metrics
Agri business reported strong revenue and EBIT growth of 18% and 36% y/y,
respectively, during Q3FY11. The good performance was driven by higher soya and
coffee trading volumes and improved performance of leaf tobacco exports.
Traded commodities now account for 40-45% of ITC’s agri business turnover and
profitability and revenue potential for these is quite opportunistic depending on
demand supply trends for these commodities. However, we expect current
profitability for agri business to sustain (10-11% EBIT margins) as most agri
commodity prices remain firm and export prices for leaf tobacco are stable (though
leaf procurement costs have come down). We expect agri business revenues and
EBIT to grow at a CAGR of 15% over FY10-13E.


Paper: impacted by one-offs
Sales and EBIT growth for the paper division was subdued at 8.4% and -5% y/y in
Q3FY11, respectively. The growth rates were impacted due to pipeline correction for
cigarette packaging inventory caused by the uncertainty around the change in graphic

statutory warnings on cigarettes. This led to a lower share of high-margin cigarette
packaging during the quarter which also weighed on margins. It is important to note
that Q2FY11 margins were at an all-time high of 25.6%, as some of the demand for
cigarette packaging was preponed due to expectations of a change in pictorial
warnings.
We expect the operations to be normal starting Q4FY11 and estimate revenue and
EBITDA CAGR of 17% and 20%, respectively, for this business.