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ITC Limited Management meet reaffirms confidence; Buy
„Play the all round structural growth story; Buy
„ Cigarettes on a strong growth path: ITC remains confident of low-mid
single digit volume growth if tax hikes are moderate. This is led by rising
consumer spending leading to1) increase in consumption by existing smokers
2) up-trading of bidi smokers and 3) few new consumers taking up smoking.
„ Cigarette margins should rise: We see cigarette margins moving up as 1)
consumers up-trade from Regulars to Kings 2) lower leaf tobacco prices
(down 10-15% yoy) to reflect from Mar Q and 3) no sharp hike in A&P spends
as impact of Marlboro appears limited despite launch of Marlboro Compact.
„
FMCG losses should continue to fall: Expect breakeven by FY13. Personal Care
expected to break even by FY15. Aim to achieve 10% share in Personal Care in 4-5
years as spends on A&P and R&D should help take on foreign players.
„ Hotels should witness improved margins: Occupancy rates have gone up to
~65% vs 50% last year. Avg Room Rate is, however, largely flat due to recent
capacity addition. Expect strong recovery in ARR over the next 2-3 years on low
capacity addition. ITC plans to invest Rs20bn to set up properties in Chennai, Kolkata,
Gurgaon, etc and double the current room count in next 5 years.
slated to be added by mid FY12 to sustain volume growth. In Agri, focus remains on
value-added exports like tobacco, coffee, pulp etc, and bulk exports of wheat and
soya will be taken up only on an opportunistic basis.
Strong fundamentals and attractive valuation; Buy
We believe ITC will maintain a healthy 21% EPS CAGR over FY10-12E. Valuation
at 21x FY12E pegs ITC 10% below sector average. This, we believe, leaves
upside room on potential re-rating given improved earnings growth trajectory.
Structural growth outlook remains
robust
Post our meeting with the company management, we remain confident that ITC
will be able to maintain a healthy 21% EPS CAGR over FY10-12E. We believe
the current sweet spot that ITC is enjoying, with most of its segments performing
well, will continue over next couple of years as well. We believe there could be
upside risk to our estimates if ITC manages to continue its rising margin trend
across all its segments.
Set for an all round strong growth
„ Cigarettes: We estimate 13-14% top-line growth in cigarettes led by a 2%
volume growth in FY11E and ~6% growth in FY12E. We are building in a
13% price hike in FY11E and 7% price hike in FY12E. We expect margin
gains to be ~90bp over FY11-12E driven by 1) consumer up-trading 2) strong
price hikes and 3) 10-15% lower leaf tobacco prices in FY12E. This should
lead to a healthy 15% EBIT CAGR over FY11-12E.
„ FMCG: Top-line growth will remain healthy at 23% led by continued
momentum in Foods and new product launches in Personal Care. Also, with
gestation costs for Foods (except Snacks) now behind us, we expect
profitability to improve. We are building in ~20% decline in losses in FY11E
and breakeven by exit of FY13E.
„ Papers: We expect top-line growth to moderate down to ~12% in FY12E as
we near capacity constraints. However, new commissioning going forward
should improve the volume growth. We are building in a sharp margin
improvement over FY11-12E driven by mix improvement, price hikes and
scale efficiencies from new capacity. There will likely be be some decline in
margins in FY13E post capacity expansion, but that should be made up by
better top-line growth, in our view.
„ Hotels: After a dismal FY10, we expect a strong recovery in FY11-12E.
Occupancy rates should go up to 65-70% vs 50% in FY10. However,
Average Room Rates (ARR) are not expected to move up much in FY11E
due to overcapacity. Structurally, however, ARR should improve as new
capacity is not expected to come up over the next 2-3 years. We estimate a
very robust 45% EBIT CAGR over FY11-12E.
„ Agri Business: Top-line growth should remain muted at ~14% for agri
business as the product basket is unlikely to be expanded significantly, in our
view. Also, post a sharp jump in margins in FY10E, we expect a more muted
200bp gain over FY11-12E led mainly by mix improvement in rise in leaf
tobacco prices. We estimate an EBIT CAGR of ~21% during this period.
Cigarettes – structural strength
comes to fore
ITC has demonstrated the strength of its cigarettes business by reporting a 16%
growth in 1HFY11 despite a steep 14% tax hike. By taking higher than required
price hikes (15% vs 8% required), ITC has more than passed on the tax hikes to
consumers. This has helped them to report strong overall growth despite weak
volume growth. In years when tax hikes are benign, it takes lower price hikes and
drives growth to volumes (as shown in FY10), but in years where tax hikes are
high, it takes higher price increases and manages strong EBIT growth by
compensating for lower volumes through higher margins.
Volume growth expected to move into positive territory
ITC has managed to reach a flat to marginal volume decline in Sep Q. This would
imply potentially positive growth from Dec Q onwards. The company believes that
consumers are now used to the current sharp price hikes and are reverting back
to original consumption levels. Given that 2H is generally stronger than 1H, we
expect positive growth in 2H to lead to an overall volume growth in FY11E.
Assuming a 5% tax hike (6% price hike) in FY12E, we are building in 1 6%
volume growth in FY12E on the back of a relatively lower base of FY11E.
Margin gains to continue going forward
Based on management inputs we believe cigarettes should continue to witness a
strong margin gain trend. This is expected to be led by three key factors:
„ Sharp price hikes: Weighted average price hike of 15% in FY11E is leading
to margin gains in cigarettes business as these hikes more than offset the
increase in taxes.
„ Up-trading from Regulars to Kings: Price hike by ITC has been lower for
its higher end Kings segment and higher for its lower end Regulars segment.
This is in line with change in tax structure. With this the gap in pricing for
Kings and Regulars has come down, leading to a shift in demand from
Regulars to Kings. This is aiding margin gains for ITC.
„ Expected fall in leaf tobacco prices: Prices for leaf tobacco are down 10-
15% yoy after strengthening over the last two years. This is yet to reflect in
the cost structure of ITC, as it carries long-term raw material inventory.
Benefit of lower input costs on margins should start reflecting in FY12E.
Competitive intensity is manageable
ITC is aware of rising competitive activity from Marlboro, especially with the
launch of Marlboro Compact which competes with ITC’s Regulars portfolio.
However, as of now, ITC believes it has been able to hold on to its market share
and the impact of Marlboro’s aggression has been limited. ITC has also launched
Lucky Strike in the Kings segment to further strengthen its portfolio in that
segment.
Shutdown due to pictorial warnings is a non-issue
We believe temporary shutdown of manufacturing due to non-resolution of
pictorial warnings is not a concern. ITC maintains strong product inventory to tide
it over loss of production. Also, pictorial warnings to date have failed to have any
significant impact on sales, and we are not concerned about this norm becoming
stricter. Also, last time ITC had to take writeoffs in its packaging division
(June Q FY10) due to pictorial warning changes. So we prefer a temporary
shutdown in production rather than writeoffs at a later stage.
FMCG – lowering of losses will
continue
With revival in the retail division and launch of new categories in personal care,
we expect ITC to do well in terms of top-line growth in the division. Also, with the
exception of the personal care portfolio and snacks, the gestation costs for other
categories are now behind us. This has helped in improving profitability for the
overall segment and we expect this trend to continue. We believe that the
segment should break even as we exit FY13E.
Profitability is improving in Foods; Noodles is the next step
Food is expected to remain a key focus area for ITC given the strong growth and
profitability being witnessed in the category. The latest development is ITC’s entry
into the Noodles market, where it has launched through modern trade. Two
variants – Classic Masala and Magic Masala at price points of Rs10 and Rs5 –
have been launched. Given the strong growth of this category, we think success
in noodles could drive significant growth for the overall Foods segment.
Personal Care – Market share of 10% is the aim
ITC has set itself a target of achieving a 10% market share in the Personal Care
space over the next 4-5 years. As of now it enjoys a 5% market share in Soaps
and 3% share in Shampoos. ITC believes it has strong R&D capability and is
ready to invest the required amounts in terms of A&P spends and R&D to take on
well-established foreign FMCG players. This is the key differentiating factor that
ITC believes will give it a better success rate vs other domestic FMCG
companies. Continued investment behind existing categories and new launches
like fairness cream being test marketed are expected to lead to losses in this
category till FY14-15E.
Papers – margins to improve;
capacity constrains growth
ITC’s backward integration has helped it to maintain strong growth during FY10-
11E as it will not be hit by the rising pulp prices. For ITC 70% of its pulp
requirement is fulfilled in-house. With the pulp cycle reversing now, ITC should
benefit from lower costs of raw material for the remaining 30% raw materials it
needs to source. Also, ITC believes it will be able to maintain pricing as it is
involved in higher end specialty paper and paper board where it has pricing
power. We expect a healthy 34% EBIT growth this year led by strong volume
growth on utilization of new capacity set up last year and steep 15-18% weighted
average price hikes.
New capacity addition being planned
Growth is expected to taper down to 18% next year as volume growth will be
constrained by capacity. ITC intends to set up a new 100,000T paper board
facility by the middle of next year with an investment of Rs6bn. This would likely
impact margins next year during the stabilization phase but should be a longer
term growth driver as it will allow further volume growth and improve margins post
stabilization as production from this facility will contribute to improvement of mix.
Hotels – longer-run growth looks
strong
We expect ITC to show strong growth in its Hotels business on a very weak base
of FY10 which was impacted by economic slowdown. We are building in a 45%
EBIT CAGR over FY10-12E. Key driver for the improvement is expected to be
significantly higher Occupancy Rates in the near term followed by improvement in
Average Room Rates over the longer term.
Occupancy rates improving sharply
ITC is currently running at ~65% Occupancy rate after a dismal FY10 which had
witnessed Occupancy rates of 50%. Pickup in both business and leisure travel is
helping to improve the Occupancy rates. We expect marginal improvement from
current levels as consumer and business sentiment continues to improve.
Average Room Rates to pick up going forward
We are, however, disappointed by Average Room rates, which are up only 1%
yoy. This is due to overcapacity in the Hotels industry from new properties that
were set up during the downturn. ITC, however, believes that India will not
follow South East/East Asia in terms of structural lowering of ARRs as in
the longer run it believes demand will outstrip supply. It sees very low new
capacity addition over the next 2-3 years and expects sharp improvement in
ARRs
Plans for new properties in Chennai, Gurgaon and Kolkata
ITC has already commissioned its new property in Bangalore in a Super Luxury
category. The initial response to the property has been encouraging. The
development of Chennai property with 600 rooms is expected to be
commissioned by the end of FY11. While these two properties are already
factored in our estimates, we expect further upside from three new properties
being planned by ITC over FY12-13E. Of these, the first one, due to be rolled out
by FY12, is the Golf Boutique resort in Gurgaon with a capacity of 100 rooms.
Also, by FY13E, a premium property is being developed in Kolkata with a 500
room capacity and a Fortune hotel is being launched in Bangalore. As a broad
benchmark, ITC wants to double its existing 3,100 rooms capacity over the next 5
years. ITC plans to invest Rs20bn over this period to develop these properties.
Agri business – current profitability
sustainable
The product basket for ITC’s agri exports has now been completely rationalized,
with ITC cutting down trades in low value and politically sensitive commodities.
Currently leaf tobacco, wheat and some other high-value commodities are part of
the basket. With this ITC has now managed to structurally move up the
profitability of this division aided to an extent by sharp inflation in global leaf
tobacco prices due to supply constraints. We expect the current margins to
sustain, with scope for further improvement due to continued rise in agri
commodity prices.
Leaf tobacco exports are on a structural uptrend
The company believes that lowering of leaf tobacco prices in India will not
hurt its pricing power for exports and should help improve its margins. Two
reasons for export prices to remain firm are: 1) Global demand/supply situation
still remains favorable, and 2) Indian tobacco is now increasingly used as a key
component for blending by most global cigarette brands. This has helped to move
Indian tobacco higher in the value chain vs earlier when it was mostly used as a
filler by global brands.
Valuation looks attractive; Buy
ITC is currently trading at 25x FY11E and 21x FY12E. This is in line with its last
5-year average. ITC’s premium to Sensex, at 16%, is lower by 20% vs its last 5-
year average. We believe the earnings outlook for ITC is improving, especially in
cigarette, which is seeing a revival in volume growth and improved profitability
across all its business segments. We maintain our target multiple for ITC at 24x
FY12E to peg it at a 20% premium to its last 5-yr average to reflect improved
earnings growth potential and structural re-rating of the stock given increased
confidence on ITC’s ability to weather steep hike in taxes for cigarettes. This on
an EPS of Rs7.8 for FY12E gives us our PO of Rs190, implying 13% potential
upside from current levels. A dividend yield of ~3% further adds to the risk/reward
ratio.
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