Concerns over valuations, cigarette volumes weigh on ITC

Though June quarter performance was slightly ahead of expectations, the Street will be closely monitoring the growth in volumes in the current year

ITC’s June quarter numbers were slightly ahead of Street expectations. Higher-than-expected cigarette volume growth of about one per cent against expectations of a two per cent decline, expansion in margins and good performance of the consumer goods, agricultural and paper businesses helped ITC post robust results. However, the stock fell two per cent to close at Rs 249.45 on Thursday, as against the Sensex’s fall of 0.2 per cent.

Though ITC is expected to post a strong performance this financial year as well, some analysts are worried over the growth in cigarette volumes in 2012-13. Analysts are also divided in terms of stock valuations, which are not cheap at current levels.

At nearly 30 times FY13 estimated earnings, the stock is trading at the higher end of its one-year forward price/earnings band of 18-30 times seen in the past five years. It has been seen in the past five years that whenever the stock’s one-year forward PE comes close to the higher band, it tends to underperform/fall thereafter for a couple of months. However, the current weak macro environment could continue to play in its favour (read: demand for defensives), at least till the ‘risk on’ sentiment gains.
 

CONCERNS OVER CIGARETTE VOLUMES
In Rs crore	Q1’ FY13	FY13E
Net sales	6,652	29,144
% change y-o-y	15.3	15.8
Ebitda margin (%)	34.7	35.9
Y-o-Y change (bps)	223	70
Net profit	1,602	7,173
% change y-o-y	20.2	16.4
Cigarette volume growth (% YoY)	1.0	-3.0
Others-FMCG growth (%)	23.0	19.0
P/E (x)	–

24.6 E: Estimates                                      Source: Company, analyst reports

V Srinivasan, research analyst at Angel Broking, says, “ITC posted healthy sales and net profit growth. We continue to remain neutral on the stock, as we believe it is fairly priced at current levels.”

On the other hand, analysts at Morgan Stanley Research wrote in a post-results note, “ITC results were overall in line with expectations. We reiterate our overweight rating on ITC, given unparalleled visibility for earnings growth, which will likely continue to support valuations, we believe.”

The difference on valuations perhaps also stems from the fact that analysts are divided on cigarette volume growth, wherein estimates vary between minus three to plus three per cent for FY13. That’s because some believe ITC would raise prices to the extent that it fully passes on the cost increases seen, while others believe partial hikes will be taken. Data from the past 15 years (as compiled by IIFL Research) shows a strong inverse correlation between price increases and ITC’s cigarette volumes. When price rises are in excess of seven per cent, volume growth in the cigarette business tends to be muted and vice versa. In FY13 so far, analysts say, ITC has already taken a price rise of about 15 per cent, led by an increase in taxes, and some more is in the offing.

The silver lining could be the entry of ITC in the sub-65 mm segment. ITC is already testing its products in 64-mm cigarettes in UP and Bihar. Analysts believe this segment could provide support to volumes to the extent of one to two per cent, even as they are monitoring the situation, given the price differential with unorganised cigarettes.

Beyond cigarettes, which account for over 80 per cent of ITC’s profits, the break-even of the other fast-moving consumer goods (FMCG) business would act as a key trigger to earnings growth. Also, pick up in its hotels business will remain a key monitorable.

Q1: Strong performance
Meanwhile, as against Street expectations of a flat to two per cent fall in cigarette volumes, the company delivered a one per cent increase on this front. This figure appears to be strong, given the dual headwinds of higher excise duty (up 17-18 per cent) and strong price increases of 14-15 per cent, believe analysts. Price increases eclipsed the muted volume growth, enabling the company to post a 15 per cent growth in cigarette revenues for the quarter. The rises also boosted cigarette margins by 140 basis points, to 31.3 per cent.

Notably, this segment’s earnings before interest and taxation growth has been over 19 per cent for the fifth quarter in a row.

ITC’s other FMCG business also did well, with revenues rising 23 per cent over the year and losses halving to Rs 38.9 crore. Given that losses were higher than the Rs 16.7 crore in the March quarter, experts believe the break-even of other FMCG segments might take some quarters to fructify.

Higher efficiencies and a richer product mix enabled ITC’s agri and paper businesses to report strong profit growth in the June quarter. However, its hotels business felt the heat.