ITC Ltd - Buy on dips to Rs 329 - Rs 342 for Target of Rs 370 in 1 quarter ::HDFC Sec, report

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In our Q2FY15 result update dated Nov 07, 2014, we had recommended existing investors to buy ITC at the then CMP of Rs. 355.7 and add it on dips to Rs. 326-341 for a price target of Rs. 377. Thereafter the stock met our price target on Nov 19, 2014 and subsequently touched a high of Rs. 400 on Dec 12, 2014. Currently, it is quoting at Rs. 366.6. ITC’s Q3FY15 results were disappointing & below our estimates. We present an update on the stock. Q3FY15 Results Review Y-o-Y:  Net sales increased marginally by 2.1% Y-o-Y to Rs. 88 bn as against Rs. 86.2 bn in Q3FY14. The growth was impacted by 14-15% decline in cigarette sales volumes on the back of significant price hikes undertaken by the company over the last few quarters to pass on the excise hike & VAT increases during FY15. The cigarettes business net sales grew marginally by 0.6% Y-o-Y. The growth was also impacted by poor performance from Agri (due to lower soya sales) and Paperboad & Packaging businesses (due to slowdown in FMCG & cigarettes sector), as their revenues de-grew by 10.6% & 4.7% Y-o-Y respectively. FMCG business reported relatively better growth of 11.4% Y-o-Y (though not impressive, but in line with overall slowdown in FMCG industry). Hotels continued to report subdued performance, with the segment net sales growing marginally by 4.7%.  The core operating profit grew by 4.4%, while the OPM improved by 86 bps Y-o-Y to 37.8%, aided by lower material cost (up 1.1% Y-o-Y) and decline in other expenses (down 1.3% Y-o-Y). However, relatively higher growth in the employee cost (up 4.6% Y-o-Y) restricted further margin expansion. Cigarettes & Agri business witnessed margin expansion of 524 bps Y-o-Y & 345 bps Y-o-Y, while margins of Paper Board & Packaging fell by 58 bps Y-o-Y and that of Hotels witnessed a steep fall of 1103 bps Y-o-Y. FMCG business reported 10.7% Y-o-Y growth in PBIT, while its PBIT margins stayed flat.  PAT grew at a relatively better rate by 10.5% Y-o-Y, aided by higher other income (up 46.4% Y-o-Y) and decline in the interest cost (down 8.4% Y-o-Y, though on a small base). PAT margins improved by 228 bps Y-o-Y to 29.9%. EPS for the quarter stood at Rs. 3.3 vs. Rs. 3 in Q3FY14. Q-o-Q:  Sequentially, the net sales de-grew by 1.5%, impacted by Cigarettes, Paperboard & packaging and Agri business (down 2.6%, 6.6% & 22.4% Q-o-Q). Hotels & FMCG grew by 26.3% & 5.4% Q-o-Q respectively.  Operating profit rose 2.6% Q-o-Q, while OPM rose by 150 bps Q-o-Q, aided by decline in material cost (down 2.2% Q-o-Q) & flat other expenses. PAT grew by 8.7%, while PAT margins improved by 279 bps Q-o-Q, aided by higher other income (up 61.1% Q-o-Q), decline in the interest cost (down 54.5% Q-o-Q) and lower effective tax rate (down 166 bps Q-o-Q).

Conclusion & Recommendation: ITC’s Q3FY15 results (Y-o-Y) were disappointing and below our estimates. The revenue growth was impacted by steep decline of 14-15% in cigarette sales volumes due to substantial price hikes taken by the company to pass on the excise hike & VAT increases during FY15. The business grew marginally by 0.6%. The overall growth was also impacted by poor performance from Agri (due to lower soya sales) and Paperboad & Packaging businesses (due to slowdown in FMCG & cigarettes sector), as their revenues de-grew during the quarters. Hotels reported marginal growth in low single digits, thus remaining subdued. FMCG business performed relatively better compared to other businesses, though the growth was not impressive (in low double digits), as the FMCG industry continues to witness slowdown. Lower material cost & decline in the other expenses aided in marginal margin expansion. Profit growth was not so encouraging, as it was largely aided by higher other income (due to higher dividends from subsidiaries). After three consecutive years of sharp excise duty hikes (~18% in 2012 Budget, ~20% in 2013 Budget , 11-72% in July 2014 budget - 72% on cigarettes of length not exceeding 65 mm and to 11-21% hike for cigarettes of other lengths) and consequent price hikes undertaken by ITC, its cigarettes business, which displayed strong resilience in the past and was considered to be of inelastic nature has started to feel the pressure. While the volume decline over the past few quarters was in the range of 2-4%, suddenly that accelerated to 14-15% in Q3FY15, which is a cause of concern. Recent sharp increase in VAT rate in ITC’s key markets like Tamil Nadu, Kerala and Assam (30% of ITC’s cigarettes volumes) also affected the volume growth. We expect the volume growth to continue to decline in the coming quarters, though it would be in mid to high single digits. Another round of 15-20% excise duty hike in FY16 Union Budget (on Feb 28) is possible, considering the government’s recent measures to curb the tobacco consumption in India. This could put more pressure on the cigarettes sales volumes. The Union Health Ministry in Oct 2014 issued a notification making it mandatory for cigarette manufacturing companies to carry statutory warning against smoking on both sides of a cigarette pack & covering at least 85% of the packaging. Further, the Government is proposing to ban sale of loose stick cigarettes along with other stiff measures like raising the minimum legal age for buying tobacco from 18 to 21 years, increasing fine for smoking in public places from Rs. 200 to Rs. 1000 and removal of designated smoking zones in hotels & restaurants. If all these proposals are implemented, it could impact the entire cigarettes industry & ITC’s cigarettes business significantly.

Growth in the FMCG business continues to moderate (on expected lines), impacted by slowdown in consumption expenditure. We expect the volume growth in FMCG business to improve in the coming quarters, as we expect the improvement in consumer spending due to economic revival and as the company is expected to pass on some benefit of input cost decline to the consumers. However, we feel the profitability would pick up at a gradual pace, as ITC would continue to focus on scaling up its business and invest aggressively behind existing & new brands to improve its market share. ITC’s other businesses like Agri, Paperboard & Packaging and Hotels are not performing well to the extent anticipated. Hotel business revenue growth could continue to remain subdued until there is a meaningful improvement in domestic travel & tourism industry, which could be possible only if the global environment improves. The growth in Agri business should have improved in Q3FFY15 due to scaling up of operations at the recently commissioned state-of-the art green leaf tobacco threshing plant in Mysore, but the same did not happen due to lower soya sales. Similarly, Paperboard & Packaging Business was expected to do well in Q3 after the commissioning of in-house pulp manufacturing capacity at the Bhadrachalam unit in Q3FY15; the same seems to have got delayed due to slowdown in FMCG & cigarettes business. We would closely monitor the growth in these two businesses in the coming quarters. We feel ITC could miss our FY15 & FY16 projections. Hence we are downgrading our net sales, operating profit & PAT estimates by 3.4%, 3.2% & 2.3% respectively for FY15 and by 7.6%, 7.4% & 5.5% respectively for FY16. Accordingly, Revised EPS for FY15 & FY16 is estimated at Rs. 12.2 & Rs. 13.7. The recent underperformance by cigarettes business (43% of the total revenues & 85% of the total profits) raises doubts on ITC’s ability to continue delivering double-digit growth (like in the past) going forward, since its other businesses are not picking up to the extent anticipated. Cigarettes business could continue to face pressure if sharp excise hikes continue and if health ministry’s stringent proposed are implemented. At the CMP, the stock trades at 26.8xFY16, which is at a significant discount of 30-40% to its FMCG peers. The discount has widened over the last few quarters (compared to historical discount of 12-13%) on the back of cigarettes industry being taxed heavily (over the last two years) due to increasing health issues due to smoking and rerating of other FMCG stocks. Until more clarity comes up on the proposals & extent of further excise hikes in the upcoming budget, the discount in valuations could continue and the stock price could continue to underperform. For better valuations, it is essential that ITC’s other businesses pick up growth. While we expect the upside in the stock price to remain capped, the downside is also protected, since the ongoing concerns in cigarettes and its potential impact on profits have been largely discounted in the stock price. Valuing the stock at 27xFY16RE EPS, we arrive at price target of Rs. 370 (reduced from Rs. 377 earlier). We feel investors could buy the stock on dips to Rs. 329-342 (24-25xFY16E EPS) to earn decent returns over the next quarter. If the negatives (pertaining to cigarettes business) do not play out to the extent anticipated in the upcoming budget, then the stock price could start performing, as the investors’ fears would subside. We would revisit our estimates & our price target if necessary post FY16 Union Budget. Until then, we prefer valuing ITC on a conservative basis

LINK
http://www.hdfcsec.com/Share-Market-Research/Research-Details/StockReports/3011173