Buy ITC: Tackling taxes Cigarette profits shrug off excise hikes; non-cigarette outlook strong  Motilal Oswal

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Tackling taxes
Cigarette profits shrug off excise hikes; non-cigarette outlook strong
 Cigarette EBIT CAGR 15% since 2000 despite excise CAGR of 9.2%.
 Only consumer company to benefit from INR depreciation
 Non-cigarette EBIT to post 25% CAGR over FY11-13; Outlook positive
 Strong cash flows and improving payout ratio positive; Maintain Buy
Cigarette EBIT CAGR 15% since 2000 despite excise CAGR of 9.2%: The ITC
stock gets a drubbing every year ahead of the Union Budget due to concerns over an
increase in excise duty on cigarettes. However, ITC's cigarette EBIT posted 15%
CAGR since 2,000 despite excise, VAT increases and regulatory changes. We believe
increase in excise duty should not act as a drag as cigarettes are placed under
specific excise duty, which does not cover the impact of inflation in duty collection
unlike in other products. Excluding the impact of a sharp increase in excise on micros
and plains in FY09, excise has increased in line with WPI. However we believe VAT is
a key factor because (1) it is an ad valorem tax and has a greater cascading impact
and (2) VAT has a wide range of 12.5-40% as it is a state subject. ITC has already
taken a pre-emptive price increase of 2% in the month of December.
State taxes on non-cigarette tobacco are steps in the right direction: Currently
excise on cigarettes is 25x the excise duty on bidis as cigarettes are looked on as
being harmful. In FY12 some states imposed VAT on non-cigarette tobacco at par
with cigarettes and a few states increased it significantly. Imposition of a similar
strategy at the excise duty level can have far-reaching implications on government
revenue and growth in cigarettes. We expect volume growth in cigarettes to accelerate
as it becomes a preferred tobacco option for the younger generation. We model 7%
and 6% volume growth for ITC in FY12 and FY13 respectively with 17% EBIT CAGR.
Non-cigarette EBIT to post 25% CAGR over FY11-13; INR depreciation to provide
upside: ITC is the only consumer company to benefit from INR depreciation due to
net exports of INR18b and higher margins in paper. We estimate for every 1%
depreciation of the INR, ITC EPS will increase by 0.4%. ITC posted non-cigarette
EBIT of 25% CAGR over the past five years and EBIT of 27.4% in 1HFY12. We
estimate 25% CAGR in ITC's non-cigarette business over FY11-13, driven by 31%
CAGR in loss reduction in FMCG, EBIT of 22% CAGR in hotels and EBIT of 15-17%
CAGR in paperboards and the agri business.
Strong cash flow, improving payout ratio positive; Maintain Buy: ITC's dividend
payout jumped from 45-50% until FY09 to 115% and 80% in FY10 and FY11
respectively, due to payment of one-time dividend. We believe there is a strong case
for ITC's dividend payout ratio being higher than in the past as (1) capex as a proportion
of cash flows declined from 62% to current levels of 18-19% and (2) ITC's cash and
liquid investment will increase to INR95b from INR67b at a payout ratio of ~50%. We
expect ITC to post 19% PAT CAGR over FY11-13 powered by 17% growth in cigarette
EBIT and 24% EBIT growth in its non-cigarette businesses. Upside to estimates can
come from (1) higher volume growth in cigarettes, (2) gains from rupee depreciation in
the agri and paper and (3) faster recovery of the hotels business. The stock trades at
26.4x FY12E EPS and 22.3x FY13E EPS. Maintain Buy with a target price of INR230.