With strong pricing power in cigarettes segment, revival in hotel prospects as tourism picks up and a healthy other business growth estimates ITC is in a sweet spot right now.
The FMCG sector has seen healthy top-line growth (ranging from 2-18%, with HUL bringing up the rear) spurred by strong demand in FY10 to date. The icing to the cake has been a significant expansion of gross margins in this period, to the tune of about 250 bps y-o-y as per HSBC estimates. This is because this year input costs deflated faster than companies corrected product prices, which were hiked in early FY09 when there was high inflation.
This earnings boost is likely to be reinvested in higher advertising and brand support spending, enhancing growth. A Morgan Stanley report expected that this would be a season of earnings upgrades for most FMCG companies post the strong results in Q2FY10.
However, going ahead, this could spur competition in the sector (leading to higher ad-spend and incentives like price-cuts etc.) which along with hardening input costs could pose significant risk to margins for most FMCG companies. It is here that ITC has a clear advantage as its bottom- line is derived mainly from businesses like cigarettes, hotels and agri (contributing over 100% of EBIT with the non-tobacco FMCG segment still incurring losses, as per a Morgan Stanley report).
Main advantage
The key to ITC’s resilience is its large portfolio of popular cigarette brands which have an estimated 80% market -share according to an HSBC research report. Its cigarettes business posted a distinct turnaround in FY10 after 2 years of shrinking volumes. Volume growth was about 8% in Q2FY10 as against 5-6% in the preceding quarter, according to HSBC, assisted by steady prices with no excise duty hikes.
Volume growth has proved resilient against several regulatory challenges, according to Morgan Stanley. This is significant as there is a high probability of a hike in value added taxes (VAT) on cigarettes to 20% by state governments, the report adds, but it believes that consumers have demonstrated reasonable price inelasticity to pass through price hikes so far. ITC recently effected a 5-10 % price hike in its premium brands. While the consensus analyst view is that it would not hurt volume growth but actual consumer behaviour bears watching.
Total net sales grew 14% y-o-y in Q2FY10 to Rs 2199.7 crore with cigarettes showing a sales growth of 21.45 and agri posting 19% growth in this period. FMCG was steady at 14% while hotel segment sales were down about 24%. PBT was up 25.5% boosted mainly by a 24% increase in cigarette segment earnings and included a sharp 128% increase in profits in the agri business. The hotel segment and FMCG continued to drag earnings down although FMCG saw some curtailing of losses this quarter (Rs 850 crore versus Rs 1166 crore in Q2FY09). Margins expanded for most segments led by by a 809 bps expansion in the agri business. Cigarettes margins expanded 134 bps y-o-y.
Growth estimates
Consensus analyst estimates see sales volume growth at around 7% after upgrades from around 5% levels. This is based on the fact that it has a dominant share of a market growing at about 5% which is likely to sustain as shift from other forms of tobacco usage to filter cigarettes is ongoing in India, according to HSBC. Net sales should grow at 12% according to Morgan Stanley estimates with EPS growth of about 16% in the next year.
ITC has marginally underperformed the Sensex by 0.5% and the BSE FMCG index by 0.7% in the last month despite stellar Q2FY10 results. It has played catch-up since, closing at Rs 268.75, up nearly 2% intra-day on 25 November 09. It trades at a P/E valuation of 21x and 18x consensus analyst FY11 and FY12 EPS estimates.