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ITC Ltd.
Compelling Risk-Reward: Upgrade to OW
What's Changed
Rating Equal-weight to Overweight
Price Target Rs160.00 to Rs184.00
EPS estimates, F11-13 +5.0%, +4.4%+ 4.3%
We continue to prefer ITC over HUL: We see three
drivers of a stock re-rating.
Re-rating driver #1 – strong fundamentals for
cigarette business: ITC’s cigarette business has
demonstrated remarkable resilience to tax shocks in the
past. In fact, cigarette EBIT growth in F08, F09 and F11e
is just 40bps lower than average for the last seven years.
During two (F02 and F08) of the four occasions of a
harsh union budget (tax increase exceeding 10%), ITC
underperformed the Sensex. Even in F09, while ITC
outperformed in a volatile macro environment, on an
absolute basis the stock was down 11% for the year.
However, notwithstanding the February 2010 budget
and its 15% tax increase, ITC has since outperformed
the Sensex by 16%.
Investors now seem to have increased conviction in the
company’s ability to manage profitability in the cigarette
business – even in an environment of sharp tax-driven
price hikes. The correlation of ITC’s stock price to
cigarette volumes seems to be breaking down.
Re-rating driver #2 – we expect non-cigarette RoE to
increase by over 500bps from F10 to F13: We believe
that the negative perception about ITC’s investments in
non-cigarette businesses is changing. A structural
improvement is taking place in the profitability of the agri
and paper businesses.
Re-rating driver #3 – we look for ITC’s dividend
payout to increase: From ~50% in F09-F10, we project
60% in F11 and ~64% by F13. The F11e dividend yield
(2.2%) is better than the market’s (1.7%). We forecast
F10-13e earnings CAGR of 18% for the company
Continuing Improvement in Paper and Agri Business Profitability
Market View
Investors believe that ITC will continue to invest its cigarette cash flow in valuedestroying businesses
Our View:
First, we believe that ITC's paper and agri businesses have shown sustained
s model, which will continue to create improvement in their profitability/busines
economic value in these two operations.
We believe that the negative perception about ITC’s investments in non-cigarette
businesses is changing. A structural improvement is taking place in the
profitability of the agri and paper businesses. Profitability trends for hotels and
FMCG (fast-moving consumer goods) operations are also better.
Agri Business:
1. Secular shift in leaf tobacco export profitability
a) Change in global supply dynamics;
b) Restocking by international companies;
c) Better leaf tobacco quality ~improved realizations
2. Exit from low value-added commodity exports.
Paper Business
1. Stabilized operations & optimum capacity
utilization of new pulp mill and paper machine.
2. Fully backward integrated for hardwood pulp.
Profitability trends for hotels and FMCG operations are also better
Hotel Business:
1. The value of ITC’s hotel business is likely to be quite
volatile, although less volatile than its peers’ in
view of their operating as well as financial leverage.
ITC has only operating leverage, as its entire hotel
business is funded out of tobacco cash flows
2. We expect gradual ROE improvement from the
F2010 trough.
Other FMCG business
1. ITC is fully committed to its non-tobacco FMCG
businesses, particularly personal care.
2. ITC has entered the attractive skin care category
in F2011.
3. The biscuit operation has now turned profitable.
Increase in dividend payout likely
Capex Reaching a Plateau:
1. We expect ITC’s dividend payout to increase from
50% to 64% in F13. We believe this could lead to a
P/E re-rating for the stock.
2. ITC’s dividend yield of 2.2% is better than the
market dividend yield of 1.7% for F11E
3. We expect ITC’s capex requirements to plateau at
Rs15bn each year (F2010-13E)
4. We also expect ITC’s FCF yield to improve from 2.9%
to 4% (due to lower capex requirement).
ITC: Risk-Reward and Valuation
estimates Source: Bloomberg, E = Morgan Stanley Research
We have an Overweight ¾
rating on ITC, reflecting
increased conviction in the
company’s ability to manage
cigarette profitability despite
sharp excise-driven price
hikes.
More importantly, ITC’s ¾
paper and agri businesses
are now delivering
economic returns.
We believe ITC will be ¾
relatively immune to a
possible increase in
competition that other
FMCG companies may
face.
Although regulatory and tax ¾
risks persist for ITC, the
company has demonstrated
strong pricing power and
has been able to capitalize
on improved farm incomes.
ITC: Price Target Calculation – Rs184
rolled our We continue to value ITC on a residual income-based sum-of-the-parts (SOTP) method. Our assumptions are unchanged, but we have
sses. We then apply a ing probabilities to the different scenarios for each of the busine model forward one year. We arrive at our valuation by assign
d assign the balance holding discount of 5% to arrive at our target price. We assign a 80% weighting to the base case for the cigarettes business an
residual income 20% weighting of bull case value to arrive at our target price. Hence, to derive our current target price, we assume base-case
values for the paper, agri, non-tobacco FMCG and the hotels business.
Why Upgrade to Overweight?
• We have increased conviction in ITC’s
ability to manage cigarette profitability
despite sharp excise-driven price
hikes.
• More importantly, ITC’s paper and
agriculture businesses are now
delivering economic returns.
• We believe the company will be
relatively immune to a potential
increase in the competition that other
FMCG companies may face.
• Although regulatory and tax risks
persist for ITC, the company has
demonstrated strong pricing power
and has been able to capitalize on
improved farm incomes.
• Improvement in dividend payout ratio
Key Value Drivers
• Cigarette volume growth
• Profitability of non-tobacco FMCG
businesses
• Investments/returns in agriculture,
hotels and paper businesses
Potential Catalysts
• Government regulation (excise duty
and taxes on cigarettes)
• Cigarette prices and volume
• Turnaround in FMCG business
• Entry into new personal products
categories
• Market environment for cyclicals
Risks
• The market could still receive tax
increases >10% negatively
• New personal products categories
increasing segment losses
• Lower-than-expected cigarette
volume growth.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
ITC Ltd.
Compelling Risk-Reward: Upgrade to OW
What's Changed
Rating Equal-weight to Overweight
Price Target Rs160.00 to Rs184.00
EPS estimates, F11-13 +5.0%, +4.4%+ 4.3%
We continue to prefer ITC over HUL: We see three
drivers of a stock re-rating.
Re-rating driver #1 – strong fundamentals for
cigarette business: ITC’s cigarette business has
demonstrated remarkable resilience to tax shocks in the
past. In fact, cigarette EBIT growth in F08, F09 and F11e
is just 40bps lower than average for the last seven years.
During two (F02 and F08) of the four occasions of a
harsh union budget (tax increase exceeding 10%), ITC
underperformed the Sensex. Even in F09, while ITC
outperformed in a volatile macro environment, on an
absolute basis the stock was down 11% for the year.
However, notwithstanding the February 2010 budget
and its 15% tax increase, ITC has since outperformed
the Sensex by 16%.
Investors now seem to have increased conviction in the
company’s ability to manage profitability in the cigarette
business – even in an environment of sharp tax-driven
price hikes. The correlation of ITC’s stock price to
cigarette volumes seems to be breaking down.
Re-rating driver #2 – we expect non-cigarette RoE to
increase by over 500bps from F10 to F13: We believe
that the negative perception about ITC’s investments in
non-cigarette businesses is changing. A structural
improvement is taking place in the profitability of the agri
and paper businesses.
Re-rating driver #3 – we look for ITC’s dividend
payout to increase: From ~50% in F09-F10, we project
60% in F11 and ~64% by F13. The F11e dividend yield
(2.2%) is better than the market’s (1.7%). We forecast
F10-13e earnings CAGR of 18% for the company
Continuing Improvement in Paper and Agri Business Profitability
Market View
Investors believe that ITC will continue to invest its cigarette cash flow in valuedestroying businesses
Our View:
First, we believe that ITC's paper and agri businesses have shown sustained
s model, which will continue to create improvement in their profitability/busines
economic value in these two operations.
We believe that the negative perception about ITC’s investments in non-cigarette
businesses is changing. A structural improvement is taking place in the
profitability of the agri and paper businesses. Profitability trends for hotels and
FMCG (fast-moving consumer goods) operations are also better.
1. Secular shift in leaf tobacco export profitability
a) Change in global supply dynamics;
b) Restocking by international companies;
c) Better leaf tobacco quality ~improved realizations
2. Exit from low value-added commodity exports.
Paper Business
1. Stabilized operations & optimum capacity
utilization of new pulp mill and paper machine.
2. Fully backward integrated for hardwood pulp.
Profitability trends for hotels and FMCG operations are also better
Hotel Business:
1. The value of ITC’s hotel business is likely to be quite
volatile, although less volatile than its peers’ in
view of their operating as well as financial leverage.
ITC has only operating leverage, as its entire hotel
business is funded out of tobacco cash flows
2. We expect gradual ROE improvement from the
F2010 trough.
Other FMCG business
1. ITC is fully committed to its non-tobacco FMCG
businesses, particularly personal care.
2. ITC has entered the attractive skin care category
in F2011.
3. The biscuit operation has now turned profitable.
Increase in dividend payout likely
Capex Reaching a Plateau:
1. We expect ITC’s dividend payout to increase from
50% to 64% in F13. We believe this could lead to a
P/E re-rating for the stock.
2. ITC’s dividend yield of 2.2% is better than the
market dividend yield of 1.7% for F11E
3. We expect ITC’s capex requirements to plateau at
Rs15bn each year (F2010-13E)
4. We also expect ITC’s FCF yield to improve from 2.9%
to 4% (due to lower capex requirement).
ITC: Risk-Reward and Valuation
estimates Source: Bloomberg, E = Morgan Stanley Research
We have an Overweight ¾
rating on ITC, reflecting
increased conviction in the
company’s ability to manage
cigarette profitability despite
sharp excise-driven price
hikes.
More importantly, ITC’s ¾
paper and agri businesses
are now delivering
economic returns.
We believe ITC will be ¾
relatively immune to a
possible increase in
competition that other
FMCG companies may
face.
Although regulatory and tax ¾
risks persist for ITC, the
company has demonstrated
strong pricing power and
has been able to capitalize
on improved farm incomes.
ITC: Price Target Calculation – Rs184
rolled our We continue to value ITC on a residual income-based sum-of-the-parts (SOTP) method. Our assumptions are unchanged, but we have
sses. We then apply a ing probabilities to the different scenarios for each of the busine model forward one year. We arrive at our valuation by assign
d assign the balance holding discount of 5% to arrive at our target price. We assign a 80% weighting to the base case for the cigarettes business an
residual income 20% weighting of bull case value to arrive at our target price. Hence, to derive our current target price, we assume base-case
values for the paper, agri, non-tobacco FMCG and the hotels business.
Why Upgrade to Overweight?
• We have increased conviction in ITC’s
ability to manage cigarette profitability
despite sharp excise-driven price
hikes.
• More importantly, ITC’s paper and
agriculture businesses are now
delivering economic returns.
• We believe the company will be
relatively immune to a potential
increase in the competition that other
FMCG companies may face.
• Although regulatory and tax risks
persist for ITC, the company has
demonstrated strong pricing power
and has been able to capitalize on
improved farm incomes.
• Improvement in dividend payout ratio
Key Value Drivers
• Cigarette volume growth
• Profitability of non-tobacco FMCG
businesses
• Investments/returns in agriculture,
hotels and paper businesses
Potential Catalysts
• Government regulation (excise duty
and taxes on cigarettes)
• Cigarette prices and volume
• Turnaround in FMCG business
• Entry into new personal products
categories
• Market environment for cyclicals
Risks
• The market could still receive tax
increases >10% negatively
• New personal products categories
increasing segment losses
• Lower-than-expected cigarette
volume growth.
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