ITC Limited. Overweight. 1Q FY13: Good earnings delivery led by healthy cigarette EBIT growth

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1 ITC Limited 1Q FY13: Good earnings delivery led by healthy cigarette EBIT growth Overweight ITC.BO, ITC IN Price: Rs Price Target: Rs Previous: Rs ITC reported good 1Q FY13 performance with in-line sales and better-thanexpected earnings. Net sales, EBITDA and PAT witnessed growth of 15%, 23% and 2 respectively. Robust cigarette EBIT growth led by pricing was the key earnings driver. We believe ITC should remain a core long-term holding given steady cigarette EBIT growth, improving profitability of other FMCG business, high FCF generation and potential for higher dividend payout. The stock has run up 26% YTD (trading close to the high end of its historical valuation band) and we would seek better entry points. In current uncertain markets, however, we see it as one of the better defensive holdings. Pricing continues to drive healthy cigarette EBIT growth. ITC reported 15% cigarette sales growth led entirely by pricing and estimated flat volume growth (better than our estimates). Pricing benefits and operating leverage aided margin expansion of 140bp y/y for cigarettes leading to robust 2 EBIT growth. We expect volume sluggishness to continue in the near term as consumers accommodate steep price increases made since Mar 12. We believe pricing will continue to support mid-to-high-teen EBIT growth for cigarettes over the medium term we estimate 17% cigarette EBIT CAGR over FY ITC has rolled out cigarettes with 64mm length at price points of Rs2-2.5/stick in some states (in test phase) and we would expect clear strategy on this front to pan out over next few months. Other FMCG continues to register healthy sales growth and reduction in losses. Sales growth of 23% and losses declined 49% y/y driven by better scale, price/mix growth and improved profitability across foods, stationary and personal care segments. We expect this trend to continue and expect other FMCG division to turn around in FY14 on profitability front. India Tobacco Latika Chopra, CFA AC J.P. Morgan India Private Limited Ritesh Gupta (91-22) ritesh.z.gupta@jpmorgan.com J.P. Morgan India Private Limited Ebru Sener Kurumlu (852) ebru.sener@jpmorgan.com J.P. Morgan Securities (Asia Pacific) Limited Price Performance Rs Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 ITC.BO share price (Rs) NIFTY (rebased) YTD 1m 3m 12m Abs 25.6% % 24.2% Rel 16.8% 2.5% % Moderate growth for hotels and agri business; Paper EBIT grows well. While the hotel division continues with disappointing performance owing to macro headwinds (sales up +1%, EBIT 49%), agri business had a subdued quarter (sales 1%, EBIT +9%) owing to lower demand and muted pricing for leaf tobacco exports. Paper business however benefited from better mix leading to 17% EBIT growth. ITC Limited (Reuters: ITC.BO, Bloomberg: ITC IN) Rs in mn, year-end Mar FY10A FY11A FY12A FY13E FY14E Revenue (Rs mn) 181, , , , ,183 Net Profit (Rs mn) 40, , , , ,243.2 EPS (Rs) Revenue growth (%) 16.3% 16.6% 17.2% 16.3% 16.9% EPS growth (%) 22.2% 21.4% 22.3% 16.5% 17.3% ROE 29.2% 33.2% 35.5% 36.1% 37.8% P/E (x) EV/EBITDA (x) Dividend Yield 0.7% % 2.5% 3. Source: Company data, Bloomberg, J.P. Morgan estimates. Company Data Shares O/S (mn) 7,830 Market cap (Rs mn) 1,953,083 Market cap ($ mn) 34,777 Price (Rs) Date Of Price 26 Jul 12 3mth Avg daily volume M - Avg daily Value ($ mn) NIFTY 5,110 Fiscal Year End Mar See page 10 for analyst certification and important disclosures, including non-us analyst disclosures. J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

2 Company Description P&L sensitivity metrics EBITDA EPS impact (%) impact (%) ITC is India's largest cigarette company Cigarette volume growth assumption with about 73% volume share and Impact of each 1% increase 1% 1% 85%+ value share. ITC also operates Cigarette price growth assumption other non-tobacco businesses such as hotels, paper, retailing, consumer Impact of each 1% increase 2.5% 2.5% products, and agri exports. Source: J.P. Morgan estimates. Revenue breakdown FY12 Agribusines s 15% Hotels 3% FMCG Others 14% Source: Company data. Paperboard s and packaging 11% EPS: J.P. Morgan vs. consensus Rs J. P. Morgan Consensus FY13E FY14E Source: Bloomberg and J.P. Morgan. FMCG Cigarettes 57% Price target and valuation analysis We raise our FY13 PAT estimate by ~2% driven by slightly highermargin growth assumption for cigarette division. We revise our sum-ofparts based Mar 13 price target to Rs260 from Rs235 for the stock. Our target EV/EBITDA multiple for the cigarette division now is 14x (earlier 13x), in line with the benchmark to global tobacco multiples adjusted for growth. Methodology Multiple (X) Per Share Cigarettes EV/EBITDA 14.0x 176 FMCG EV/Sales 3.5x 36 Hotel EV/EBITDA 13.0x 8 Paper EV/EBITDA 8.0x 16 Agri EV/EBITDA 7.0x 9 EV Net Cash 14 Equity Value 259 Source: J.P. Morgan estimates. Key downside risks to our earnings and PT are a substantial decline in volume growth for cigarettes, any business diversification that is substantially dilutive of earnings, and any legislative changes that impact cigarette demand. Table 1: India Consumer Valuations Price Mcap P/E (x) EV/EBITDA (x) Div. yield Rs US$ MM FY12 FY13E FY14E FY12 FY13E FY14E FY12 FY13E FY14E HUL , % 2.2% 2.4% ITC , % 2.2% 2.6% Colgate India 1,152 3, % 2.6% 3. Godrej Consumer 609 3, % % Dabur 117 4, % 1.5% 1.7% Nestle India 4,438 8, % 1.4% 2. United Spirits 745 1, % 0.4% 0.5% Marico* 195 2, % 0.5% 0.6% Emami* 492 1, % 1.5% GSK Consumer 2,676 2, % 1.5% 1.9% Source: Bloomberg, J.P. Morgan. * indicates non rated names. Priced as of Jul 26,

3 Cigarettes Impressive EBIT growth Cigarette sales growth of 15% y/y was better than our expectations entirely led by pricing. We estimated flat volume growth for the quarter. Product mix was largely stable. EBIT margins surprised positively, with margins expanding 140bp y/y driven by healthy pricing growth. EBIT growth as a result was robust at 2 y/y for cigarettes. ITC has rolled out cigarettes with 64mm length at price points of Rs2-2.5/stick in some states (in test phase) and we would expect clear strategy on this front to pan out over next few months. We believe pricing will continue to support mid-to-high-teen EBIT growth for cigarettes over the medium term we estimate 17% cigarette EBIT CAGR over FY Figure 1: Cigarette sales and growth trends Rs in mn, % Figure 2: Cigarette EBIT and growth trends Rs in mn, % 60,000 55,000 50,000 45,000 40,000 35,000 30,000 25,000 20, % 16% 14% 12% 8% 6% 4% 2% 20,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 25% 2 15% 5% Cigarette Sales Cigarette Sales growth Cigarette EBIT Cigarette EBIT growth Other FMCG: Healthy sales growth and loss reduction continues Other FMCG division posted strong sales growth of 23% y/y driven by product portfolio premiumisation and healthy volume growth across foods and personal care segments. ITC expanded its personal product range with launch of Vivel Summer Fair. Aashirvaad (wheat flour) portfolio continued to improve realizations as well as margins with higher contribution from premium variants Multi Grain and Select. In the Snacks segment, the company is introducing Tangles and new Bingo! variants into more markets after witnessing a healthy performance post launch. In the biscuits segment, Sunfeast saw good growth towards the premium end of the portfolio. Company also launched a new premium variant in biscuits during the quarter. 3

4 Profitability for the segment improved significantly with EBIT losses for other FMCG 2.6% of sales (-49% y/y) in a seasonally weak margin quarter. Margin improvement was driven by better scale, price/mix growth and improved profitability across foods, stationary and personal care segments. We expect this trend to continue and expect other FMCG division to turnaround in FY14E on profitability front. Figure 3: Other FMCG sales and growth trends Rs MM, % Figure 4: Other FMCG EBIT trends Rs MM, % 4 35% 3 25% 2 15% 5% Other FMCG Sales Other FMCG Sales Growth 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2, % -4% -6% -8% - -12% -14% -16% -18% -2 Other FMCG EBIT ,000-1,200-1,400 Other FMCG losses as % of sales 0 Hotels Sedate performance on weak macro Hotel division performance was sedate with sales growth of +1% y/y. Sales growth was weaker on account of persisting tough macro coupled with higher capacity creation on the supply side. EBIT saw a sharp decline of -49% y/y as margins fell to 11% (vs 22% in base qtr). Margins were impacted by lower utilization rates and preopening expenses related to Chennai Hotel which is yet to be commercialized. Company's new hotel at Chennai has been completed and is waiting for government approval to start operations. Construction for new properties in Kolkata and Gurgaon is progressing satisfactorily. Company also acquired a 99 year land lease in Colombo from Sri Lankan government to develop a hotel property. 4

5 Figure 5: Hotel sales and growth trends Rs in mn, % Figure 6: Hotel EBIT and growth trends Rs in mn, % 3 3,500 55% 1, ,000 2,500 2,000 1,500 1,000 35% 15% -5% -25% -45% -65% 1, Hotel sales Hotel sales growth Hotel EBIT Hotel EBIT growth Agri business Subdued performance Agri business results were weaker than expectations with flat revenue growth impacted by surplus leaf tobacco inventory and adverse commodity price parities. However, EBIT growth was 9% owing to a 90bp y/y expansion in margins helped by better realizations and favorable product mix for the rest of its portfolio. Figure 7: Agri-business sales and growth trends Rs MM, % Figure 8: Agri-business EBIT trends Rs MM ,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2, ,000 2,500 2,000 1,500 1, Agribusiness sales Agribusiness sales growth Agribusiness EBIT Paper: Healthy EBIT growth Paper segment s performance was good with subdued sales (+9% y/y) matched up by better margins (up 150bp y/y) leading to an EBIT growth of 17% y/y. Much of the sales growth was driven by improved mix. Company is setting up a paperboard machine at Bhadrachalam and a new carton line at Haridwar expected to be operational by end of FY13. 5

6 Figure 9: Paperboard sales and growth trends Rs in mn, % Figure 10: Paperboard EBIT and growth trends Rs in mn, % 3 25% 2 15% 5% 12,000 11,000 10,000 9,000 8,000 7,000 6,000 5,000 4, ,100 2,600 2,100 1,600 1, Paperboard Sales Paperboard Sales growth Paperboard EBIT Paperboard EBIT Growth 6

7 Figure 11: ITC: 1Q FY13 earnings summary Rs MM, YE Mar. Jun'11 Mar'12 Jun'12 Y/Y Q/Q Gross Income 84,508 96,377 96,942 15% 1% Net Sales Turnover 57,675 68,614 66,522 15% -3% Change in Stock (4,090) 3,124 (2,496) Raw Materials/ Packaging 27,191 24,917 28,262 4% 13% Staff Cost 3,885 3,323 4,125 6% 24% Other Expenditure 11,960 15,549 13,557 13% -13% Total Expenditure 38,945 46,913 43,447 12% -7% EBITDA 18,729 21,701 23,075 23% 6% Other Income 2,506 3,012 2,376-5% -21% Depreciation 1,665 1,880 1,948 17% 4% EBIT 19,571 22,832 23, % Interest % -7% PBT 19,370 22,684 23,366 21% 3% Current Tax 6,043 6,540 7,344 22% 12% Deferred Tax PAT 13,327 16,144 16, % Margin EBIDTA Margin 32.5% 31.6% 34.7% Net Margin 23.1% 23.5% 24.1% % of Sales Cost of Goods 40.1% 40.9% 38.7% Staff Cost 6.7% 4.8% 6.2% Others 20.7% 22.7% 20.4% Interest 0.3% 0.2% 0.2% Depreciation 2.9% 2.7% 2.9% Tax 10.5% 9.5% 11. Tax as % of PBT 31.2% 28.8% 31.4% Excise Duty 31.8% 28.8% 31.4% Source: Company 7

8 Figure 12: Segment-wise breakdown Segment Revenues Jun'11 Mar'12 Jun'12 Y/Y Q/Q FMCG Cigarettes 52,699 56,848 60,614 15% 7% FMCG Others 12,011 16,230 14,793 23% -9% Total FMCG 64,710 73,079 75,407 17% 3% Hotels 2,305 2,859 2,324 1% -19% Agri Business 17,071 14,142 16,914-1% 2 Paper and Packagin 10,113 10,329 11,056 9% 7% Others Total 29,490 27,330 30,294 3% 11% Total Segment Revenue 94, , ,700 12% 5% Less: Inter segment Revenue 12,197 7,044 11,135-9% 58% Total Sales 82,002 93,366 94,565 15% 1% Segment EBIT FMCG Cigarettes 15,767 17,579 18, % FMCG Others (763) (167) (388) -49% 133% Total FMCG 15,004 17,412 18,610 24% 7% Hotels % -68% Agri Business 1,571 1,056 1,714 9% 62% Paper and Packagin 2,270 1,958 2,647 17% 35% Others Total 4,354 3,842 4,623 6% 2 Total EBIT 19,358 21,254 23, % EBIT Margin (Gross Sales) Jun'11 Mar'12 Jun'12 FMCG Cigarettes 29.9% 30.9% 31.3% FMCG Others -6.4% % Total FMCG 23.2% 23.8% 24.7% Hotels 22.3% % Agri Business 9.2% 7.5% 10.1% Paper and Packaging 22.4% % Others Total 14.8% 14.1% 15.3% Total EBIT 20.6% 21.2% 22. Source: Company 8

9 ITC Limited: Summary of Financials Income Statement Cash flow statement Rs in millions, year end Mar FY11 FY12 FY13E FY14E Rs in millions, year end Mar FY11 FY12 FY13E FY14E Revenues 211, , , ,183 EBIT 70,497 83,930 98, ,349 % change Y/Y 16.6% 17.2% 16.3% 16.9% Depr. & amortization 6,560 6,985 7,557 8,606 EBITDA 77,057 90, , ,955 Change in working capital 737-4,868-2,462-3,600 % change Y/Y 18.3% % 18.7% Taxes EBIT 70,497 83,930 98, ,349 Cash flow from operations 53,327 60,156 76,892 89,250 % change Y/Y 19.4% 19.1% 17.4% 19.1% EBIT Margin 33.3% 33.8% 34.2% 34.8% Capex -13,419-22,476-14,579-14,286 Net Interest Disposal/(purchase) Earnings before tax 72,682 88, , ,983 Net Interest % change Y/Y 20.8% 22.4% 16.9% 18.2% Other -4,526 2, Tax -22,806-27,352-32,257-38,740 Free cash flow 39,908 37,680 62,312 74,964 as % of EBT 31.4% 30.7% % Net income (reported) 49, , , ,243.2 Equity raised/(repaid) 9,038 7, % change Y/Y 22.8% 23.6% 16.5% 17.3% Debt raised/(repaid) Shares outstanding 7,783 7,863 7,863 7,863 Other -4,222-2, EPS (reported) Dividends paid 38,182 34,435 49,736 58,779 % change Y/Y 21.4% 22.3% 16.5% 17.3% Beginning cash 54,963 62,346 71,822 84,399 Ending cash 61,401 70,773 84, ,584 DPS Balance sheet Ratio Analysis Rs in millions, year end Mar FY11 FY12 FY13E FY14E Rs in millions, year end Mar FY11 FY12 FY13E FY14E Cash and cash equivalents 62,346 71,822 84, ,583 EBITDA margin 36.4% 36.7% 36.8% 37.4% Accounts receivable 9,076 9,860 11,857 13,857 Operating margin 34.6% 36.1% 36.3% 36.7% Inventories 52,675 56,378 64,819 75,751 Net margin 23.6% 24.8% 24.9% 25. Others 17,656 18,311 18,311 18,311 Current assets 141, , , ,501 Sales per share growth 15.2% % 16.9% LT investments 15,633 19,533 19,533 19,533 Sales growth 16.6% 17.2% 16.3% 16.9% Net fixed assets 96, , , ,461 Net profit growth 22.8% 23.6% 16.5% 17.3% Total Assets 254, , , ,496 EPS growth 21.4% 22.3% 16.5% 17.3% Liabilities Interest coverage (x) Short-term loans Payables 43,821 47,358 55,333 64,665 Net debt to equity -38.5% -37.8% -39.8% -42.4% Others 41,807 44,869 44,869 44,869 Sales/assets Total current liabilities 85,628 92, , ,534 Assets/equity Long-term debt ROE 33.2% 35.5% 36.1% 37.8% Other liabilities 8,019 8,727 8,727 8,727 ROCE 46.6% 48.1% 49.3% 52.5% Total Liabilities 94, , , ,052 Shareholders' equity 159, , , ,444 BVPS Source: Company reports and J.P. Morgan estimates. 9

10 Analyst Certification: The research analyst(s) denoted by an AC on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an AC on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst's compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report. Important Disclosures Lead or Co-manager: J.P. Morgan acted as lead or co-manager in a public offering of equity and/or debt securities for ITC Limited within the past 12 months. Client: J.P. Morgan currently has, or had within the past 12 months, the following company(ies) as clients: ITC Limited. Client/Investment Banking: J.P. Morgan currently has, or had within the past 12 months, the following company(ies) as investment banking clients: ITC Limited. Investment Banking (past 12 months): J.P. Morgan received in the past 12 months compensation for investment banking ITC Limited. Investment Banking (next 3 months): J.P. Morgan expects to receive, or intends to seek, compensation for investment banking services in the next three months from ITC Limited. Company-Specific Disclosures: Important disclosures, including price charts, are available for compendium reports and all J.P. Morgan covered companies by visiting calling , or ing research.disclosure.inquiries@jpmorgan.com with your request. ITC Limited (ITC.BO, ITC IN) Price Chart Price(Rs) OW Rs120 OW Rs125 Oct 07 Jul 08 OW Rs100 Apr 09 N Rs125 N Rs139 OW Rs115 N Rs102.5 N Rs127 OW Rs157.5 OW Rs102.5 N Rs98 Jan 10 Source: Bloomberg and J.P. Morgan; price data adjusted for stock splits and dividends. Initiated coverage Jan 02, N Rs132.5 OW Rs153.5 OW Rs190OW Rs209 OW Rs217 OW Rs235 Oct 10 Jul 11 Apr 12 Date Rating Share Price (Rs) Price Target (Rs) 02-Jan-08 OW May-08 OW Jul-08 OW Oct-08 OW Jan-09 OW May-09 N Jul-09 N Oct-09 N Jan-10 N Mar-10 N Apr-10 N May-10 OW Jul-10 OW Oct-10 OW May-11 OW Sep-11 OW Jan-12 OW The chart(s) show J.P. Morgan's continuing coverage of the stocks; the current analysts may or may not have covered it over the entire period. J.P. Morgan ratings: OW = Overweight, N= Neutral, UW = Underweight Explanation of Equity Research Ratings and Analyst(s) Coverage Universe: J.P. Morgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] In our Asia (ex-australia) and UK small- and mid-cap equity research, each stock s expected total return is compared to the expected total return of a benchmark country market index, not to those analysts coverage universe. If it does not appear in the Important Disclosures section of this report, the certifying analyst s coverage universe can be found on J.P. Morgan s research website, 10

11 Coverage Universe: Chopra, Latika: Colgate-Palmolive (India) Limited (COLG.BO), Dabur India Limited (DABU.BO), GlaxoSmithKline Consumer Healthcare Limited (GLSM.BO), Godrej Consumer Products Limited (GOCP.BO), Hindustan Unilever Limited (HLL.BO), ITC Limited (ITC.BO), Jubilant Foodworks Ltd (JUBI.BO), Nestlé India Limited (NEST.BO), Pantaloon Retail (India) Ltd (PART.BO), Titan Industries Limited (TITN.BO), United Spirits Limited (UNSP.BO), Zee Entertainment Enterprises (ZEE.BO) J.P. Morgan Equity Research Ratings Distribution, as of July 6, 2012 Overweight (buy) Neutral (hold) Underweight (sell) J.P. Morgan Global Equity Research Coverage 45% 43% 11% IB clients* 51% 47% 34% JPMS Equity Research Coverage 44% 48% 8% IB clients* 7 62% 51% *Percentage of investment banking clients in each rating category. 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