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India Equity Research Reports, IPO and Stock News
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• Why we love tobacco business? This is probably the only Indian consumer
business whose pricing power is intact given low competition, high entry
barriers and strong brand affinity. With favorable demograhics (nearly half the
population under 25 years of age) and potential to raise prices (and trade up)
with rising income levels, tobacco remains a growth business for foreseeable
future. Tobacco is also far less susceptible to input cost pressures, unlike other
consumer staples stocks. We think tobacco is the most defensive of consumer
staples sectors and ITC has outperformed markets during difficult times. In our
view the combination of reasonable valuations and relative security of earnings
estimates makes it our preferred pick in staples space.
• Most of the growth will come from ASP increase. A key investor concern
about sustainability of ITC’s revenue/profit growth is that much of the growth is
driven by pricing, and therefore must be limited. We differ. In our view, pricing
still has significant room to increase given considering 1) its habit forming
nature which leads to low demand elasticity, 2) cigarette pricing has lagged
GDP per capita inflation over past 10 years, 3) reasonable price levels relative
to other consumables, 4) uptrading leverage from premium products and 5)
consolidated industry supports pricing power.
• Focus on revenues and earnings and not volumes. Over last 10 years ITC’s
revenue and EPS have grown at a CAGR of 16% and 18% despite cigarette vol
CAGR of 3%. A case in point is US tobacco market which saw lack of profit
growth historically on account of pricing strategy from industry leader which
was based on market share and volume targets rather than profit growth.
• FCFs and payout ratio to maintain upward trend. Steadily expanding
margins for cigarettes, stable capex needs coupled with improved profitability of
non-tobacco businesses would lead to higher FCF generation which would
eventually lead to higher dividend payout and steady re-rating in our view.
• Valuations to sustain despite recent outperformance. We believe P/E
multiple expansion for ITC has fundamental support in higher earnings growth.
It still looks attractive relative to other staple names, with lower susceptibilty to
input cost pressures and higher pricing power. We raise TP to Rs209 driven by
2-4% increase in EPS and extending timeframe to Mar’12.
Cigarettes - Pricing growth is sustainable
One of the concerns investors often raise about the sustainability of ITC’s cigarette
profit growth is that much of it is driven by pricing, and therefore must be
unsustainable. We however believe that cigarette pricing still has room to increase
considering 1) its habit forming nature which leads to low demand elasticity, 2)
cigarette pricing has lagged GDP per capita inflation over past 10 years, 3)
reasonable price levels relative to other consumables, 4) uptrading leverage from
premium products and 5) consolidated industry supports pricing power.
Low price elasticity and stability of demand
Cigarette’s habit forming nature imparts it low price elasticity. Despite tough
government stance towards cigarette industry (in view of harsh tax hikes), industry
has displayed commendable resilience. ITC’s cigarette volume growth has grown at a
CAGR of 2% over past five years and 2.5% over past decade. While government
taxation policies will continue to influence cigarette consumption, longer term ITC’s
volume growth prospects remain intact.
India is the second largest producer of tobacco in the world (after China) and has
275mn users of tobacco. Given that about 25% of the population consumes tobacco,
it is significant to note that large part of this consumption is in non-cigarette form. In
India, cigarettes account for just 15% of the total tobacco consumption and per capita
cigarette consumption remains the lowest in the world (refer Fig below). On an
average, cigarettes account for about 90% of the tobacco consumption globally.
However if we were to include bidi consumption, this statistic will improve
significantly.
We expect fundamental drivers of rising income levels, higher aspirations
(particularly for younger generation who enters the smoking age) and increased
awareness levels to lead to gradual shift towards cigarettes from other forms (such as
bidis).
Consolidated Industry further supports pricing power
ITC’s medium-term investment case will depend on pricing power in our opinion.
With ITC holding lion’s share of cigarette at 77%, it has considerable pricing power
over its much smaller peers (in terms of share). ITC’s strong competitive position
has allowed it to pass on the tax burden to end consumers. This has been made
further easier by strong brand loyalty, low demand elasticity and non-existence of
any price ceiling.
Over 80% of the cigarette sales within India are through small kiosks referred to as
‘paan-beedi’ shops. Servicing these outlets is a big challenge, and this creates a
significant entry barrier for the tobacco business because of the fragmented nature of
distribution. ITC currently has, by far, the maximum retail penetration which is
difficult to mirror for other players.
Over past five years cigarette ASP for ITC has grown at a CAGR of 13%,
significantly ahead of volume CAGR of 2% over similar period. Another test for
pricing power is company’s ability to maintain or enhance margins and in case of
ITC’s cigarette business we have seen EBIT margins expanding considerably from
24% five years ago to 29% now.
Uptrading leverage from premium products
Consumer migration from discount to premium brands is the key focus of
ITC as margins are significantly improved in the premium segment. We believe
cigarette manufacturers ITC will seek higher unit margins to compensate for lower
volumes over longer term. Looking at table below we find that share of premium
cigarettes has risen across various markets including India.
GDP and per capita income growth to drive pricing and
uptrading
Strong GDP growth coupled with population growth should in our view drive
continued pricing growth and uptrading. Over past 10 years nominal GDP per capita
has grown at a CAGR of 12% while ITC’s average cigarette price has increased at a
CAGR of 9%, implying that cigarettes have perhaps become more affordable on a
relative basis. Given cigarettes are considered as an inexpensive luxury and an
affordable status symbol, demand for cigarettes will likely rise more than bidis as
disposable income levels increase.
Performance of non-tobacco businesses remains
encouraging
The non-tobacco businesses have emerged as an important valuation driver. The
financial trends in most of these businesses have shown significant improvement in
the recent past. We expect them to deliver EBIT growth of 30% over FY11-13E and
their EBIT contribution to increase from 19% in FY11 to 23% in FY13. We expect
increased focus on business such as hotels, paper and foods to drive long-term
earnings and value for the company. We are assuming stable EBIT margin trends for
business such as paper and agri trading.
We believe quantum of EBIT losses for other FMCG division are likely to continue
to decline in coming quarters (on Y/Y basis) as benefits of cost management, price
hikes and efficiencies of scale (particularly for the personal care and foods segment)
kick in. Profitability for hotels division will improve as demand picks up further and
new properties ramp up.
Valuation to be sustained despite recent outperformance
Due to its dominant market positioning, ITC has generally traded at a premium to its
domestic and global peers. As it has registered consistent earnings growth, its
valuation compared to other FMCG companies within India also has narrowed
considerably. The stock has outperformed Sensex by 38% over past 12 months. We
believe these valuations will sustain over the next 9-12 months and expect the stock
price to move up in absolute terms.
P/E multiples supported by earnings growth
We believe P/E multiple expansion for ITC has fundamental support in higher
earnings growth. PEG analysis demonstrates that although ITC is trading close to 10
year highs on absolute P/E and relative to the market, this multiple expansion is led
by higher earnings growth.
We believe ITC still looks attractive relative to other staples, with lower susceptibilty
to cost input pressure and higher pricing power. We expect continued earnings
growth supported driven by cigarette pricing and improving profitability of nontobacco
businesses.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
• Why we love tobacco business? This is probably the only Indian consumer
business whose pricing power is intact given low competition, high entry
barriers and strong brand affinity. With favorable demograhics (nearly half the
population under 25 years of age) and potential to raise prices (and trade up)
with rising income levels, tobacco remains a growth business for foreseeable
future. Tobacco is also far less susceptible to input cost pressures, unlike other
consumer staples stocks. We think tobacco is the most defensive of consumer
staples sectors and ITC has outperformed markets during difficult times. In our
view the combination of reasonable valuations and relative security of earnings
estimates makes it our preferred pick in staples space.
• Most of the growth will come from ASP increase. A key investor concern
about sustainability of ITC’s revenue/profit growth is that much of the growth is
driven by pricing, and therefore must be limited. We differ. In our view, pricing
still has significant room to increase given considering 1) its habit forming
nature which leads to low demand elasticity, 2) cigarette pricing has lagged
GDP per capita inflation over past 10 years, 3) reasonable price levels relative
to other consumables, 4) uptrading leverage from premium products and 5)
consolidated industry supports pricing power.
• Focus on revenues and earnings and not volumes. Over last 10 years ITC’s
revenue and EPS have grown at a CAGR of 16% and 18% despite cigarette vol
CAGR of 3%. A case in point is US tobacco market which saw lack of profit
growth historically on account of pricing strategy from industry leader which
was based on market share and volume targets rather than profit growth.
• FCFs and payout ratio to maintain upward trend. Steadily expanding
margins for cigarettes, stable capex needs coupled with improved profitability of
non-tobacco businesses would lead to higher FCF generation which would
eventually lead to higher dividend payout and steady re-rating in our view.
• Valuations to sustain despite recent outperformance. We believe P/E
multiple expansion for ITC has fundamental support in higher earnings growth.
It still looks attractive relative to other staple names, with lower susceptibilty to
input cost pressures and higher pricing power. We raise TP to Rs209 driven by
2-4% increase in EPS and extending timeframe to Mar’12.
Cigarettes - Pricing growth is sustainable
One of the concerns investors often raise about the sustainability of ITC’s cigarette
profit growth is that much of it is driven by pricing, and therefore must be
unsustainable. We however believe that cigarette pricing still has room to increase
considering 1) its habit forming nature which leads to low demand elasticity, 2)
cigarette pricing has lagged GDP per capita inflation over past 10 years, 3)
reasonable price levels relative to other consumables, 4) uptrading leverage from
premium products and 5) consolidated industry supports pricing power.
Low price elasticity and stability of demand
Cigarette’s habit forming nature imparts it low price elasticity. Despite tough
government stance towards cigarette industry (in view of harsh tax hikes), industry
has displayed commendable resilience. ITC’s cigarette volume growth has grown at a
CAGR of 2% over past five years and 2.5% over past decade. While government
taxation policies will continue to influence cigarette consumption, longer term ITC’s
volume growth prospects remain intact.
India is the second largest producer of tobacco in the world (after China) and has
275mn users of tobacco. Given that about 25% of the population consumes tobacco,
it is significant to note that large part of this consumption is in non-cigarette form. In
India, cigarettes account for just 15% of the total tobacco consumption and per capita
cigarette consumption remains the lowest in the world (refer Fig below). On an
average, cigarettes account for about 90% of the tobacco consumption globally.
However if we were to include bidi consumption, this statistic will improve
significantly.
We expect fundamental drivers of rising income levels, higher aspirations
(particularly for younger generation who enters the smoking age) and increased
awareness levels to lead to gradual shift towards cigarettes from other forms (such as
bidis).
Consolidated Industry further supports pricing power
ITC’s medium-term investment case will depend on pricing power in our opinion.
With ITC holding lion’s share of cigarette at 77%, it has considerable pricing power
over its much smaller peers (in terms of share). ITC’s strong competitive position
has allowed it to pass on the tax burden to end consumers. This has been made
further easier by strong brand loyalty, low demand elasticity and non-existence of
any price ceiling.
Over 80% of the cigarette sales within India are through small kiosks referred to as
‘paan-beedi’ shops. Servicing these outlets is a big challenge, and this creates a
significant entry barrier for the tobacco business because of the fragmented nature of
distribution. ITC currently has, by far, the maximum retail penetration which is
difficult to mirror for other players.
Over past five years cigarette ASP for ITC has grown at a CAGR of 13%,
significantly ahead of volume CAGR of 2% over similar period. Another test for
pricing power is company’s ability to maintain or enhance margins and in case of
ITC’s cigarette business we have seen EBIT margins expanding considerably from
24% five years ago to 29% now.
Uptrading leverage from premium products
Consumer migration from discount to premium brands is the key focus of
ITC as margins are significantly improved in the premium segment. We believe
cigarette manufacturers ITC will seek higher unit margins to compensate for lower
volumes over longer term. Looking at table below we find that share of premium
cigarettes has risen across various markets including India.
GDP and per capita income growth to drive pricing and
uptrading
Strong GDP growth coupled with population growth should in our view drive
continued pricing growth and uptrading. Over past 10 years nominal GDP per capita
has grown at a CAGR of 12% while ITC’s average cigarette price has increased at a
CAGR of 9%, implying that cigarettes have perhaps become more affordable on a
relative basis. Given cigarettes are considered as an inexpensive luxury and an
affordable status symbol, demand for cigarettes will likely rise more than bidis as
disposable income levels increase.
Performance of non-tobacco businesses remains
encouraging
The non-tobacco businesses have emerged as an important valuation driver. The
financial trends in most of these businesses have shown significant improvement in
the recent past. We expect them to deliver EBIT growth of 30% over FY11-13E and
their EBIT contribution to increase from 19% in FY11 to 23% in FY13. We expect
increased focus on business such as hotels, paper and foods to drive long-term
earnings and value for the company. We are assuming stable EBIT margin trends for
business such as paper and agri trading.
We believe quantum of EBIT losses for other FMCG division are likely to continue
to decline in coming quarters (on Y/Y basis) as benefits of cost management, price
hikes and efficiencies of scale (particularly for the personal care and foods segment)
kick in. Profitability for hotels division will improve as demand picks up further and
new properties ramp up.
Valuation to be sustained despite recent outperformance
Due to its dominant market positioning, ITC has generally traded at a premium to its
domestic and global peers. As it has registered consistent earnings growth, its
valuation compared to other FMCG companies within India also has narrowed
considerably. The stock has outperformed Sensex by 38% over past 12 months. We
believe these valuations will sustain over the next 9-12 months and expect the stock
price to move up in absolute terms.
P/E multiples supported by earnings growth
We believe P/E multiple expansion for ITC has fundamental support in higher
earnings growth. PEG analysis demonstrates that although ITC is trading close to 10
year highs on absolute P/E and relative to the market, this multiple expansion is led
by higher earnings growth.
We believe ITC still looks attractive relative to other staples, with lower susceptibilty
to cost input pressure and higher pricing power. We expect continued earnings
growth supported driven by cigarette pricing and improving profitability of nontobacco
businesses.
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