Excise duty increase has not dimmed ITC's prospects

Analysts expect price rises to offset duty hike on cigarettes and help maintain profit margin in FY14

Despite the Budget announcement of an 18 per cent rise in excise duty on cigarettes exceeding 65 mm in length (the second consecutive year of a rise in duty), against expectations of a 10 per cent rise, ITC’s stock fell only 0.7 per cent from its pre-Budget levels of ~295, mirroring the movement in the BSE FMCG (fast-moving consumer goods) index, which fell 0.75 per cent.

The fall is half the Sensex's 1.4 per cent decline during the same period, despite the likely impact of further price increases on volume growth, which have been under pressure for some time. According to analyst estimates, volumes grew at a compounded annual rate of 1.5 per cent during FY07-FY12 and 1-1.5 per cent year-on-year in the first nine months of this financial year.

The Street seems a little concerned about the duty increase. Analysts expect the company to pass on the rise in duty, as it has in the past. After Budget 2011-12 had raised the duty 21 per cent, the company had raised prices 16-17 per cent in FY13 (so far). They believe now, ITC would opt for a price rise of 13-15 per cent, which would help it maintain 18-20 per cent growth in overall earnings and 14-15 per cent segment growth in profit before interest and tax (PBIT) in FY14. The price rise would be sufficient to cover the impending increase in value-added tax (VAT) rates in forthcoming state budgets, they say.

On the flip side, the price increases are likely to impact cigarette volume growth in the near term. In his post-Budget note on the company, Spark Capital analyst Aashish Upganlawar said he expected volumes to fall two per cent in FY14. Gautam Duggad of Motilal Oswal Securities cut his volume growth estimate for FY14 from seven per cent to two per cent to factor in the impact of two consecutive years of substantial price rises. "This, along with the rise in surcharge from five per cent to 10 per cent, results in a three per cent cut in our earnings estimate for FY14 (for ITC)," he adds.

  However, analysts have not downgraded the stock. This is because despite volumes being subdued for long, ITC has been able to report strong PBIT growth. "ITC has strong pricing power in cigarettes---16.8 per cent compounded annual growth rate (CAGR) in PBIT, despite 1.5 per cent volume CAGR over FY07-12," says Duggad.

Adds Upganlawar, "While the sharp increase in taxation (both excise and VAT) has resulted in only a marginal increase in volumes through the past six years, ITC has attained consistent annual earnings growth of 18 per cent from the segment, led by price increases and better revenue mix (premiumisation)." This time, too, analysts expect price rises to help maintain the PBIT margin at 32-33 per cent.

Cigarettes account for 82 per cent of ITC's PBIT. Of the company's revenues from cigarettes, 97 per cent is accounted for by the over-65-mm category. Recently, the company expanded into the sub-65-mm segment. And, it has been successful in doing so, owing to its superior distribution network. "This could potentially accelerate investments towards the sub-65-mm segment. ITC had expanded its offerings in the sub-65-mm segment after the previous Budget. We expect further traction, given the excise arbitrage (excise differential per stick between the two categories---from 44 per cent to 53 per cent)," says Duggad. However, incremental gains in ITC's volumes and its financial performance are likely to be gradual.

Overall, ITC remains the top pick in the FMCG space due to strong pricing power in cigarettes and good earnings visibility. Improving profitability in the non-cigarette FMCG business is another positive. Losses in the non-cigarette FMCG business fell about half (to ~93 crore) in the first nine months of FY13 (down 48 per cent to ~24 crore in the quarter ended December), compared to the year-ago period. Analysts expect this business to break-even in FY14. Other major revenue contributors (namely, agri and paper) are also expected to record decent performances.

"With high comfort on consistently strong growth in earnings, we maintain ITC as a preferred pick in the FMCG sector," says Upganlawar.

Duggad says ITC remains insulated from competitive headwinds and raw material price fluctuations, though the excise duty rises more-than-adequately compensate for no volatility in raw materials in the core business.

Based on the average target price of about ~350, there is upside potential of about 20 per cent. At ~292, valuations are also reasonable (26 times the FY14 estimated earnings), providing a good investment opportunity.