ITC: A Hot Stock

ITC Limited Hold (Target Price: Rs 224) Market Data Price on reco. date (Rs) 161 (BSE) Mkt. Price BSE / NSE (Rs) 168 / 169 Change since reco.  4.3% 52-week High/Low (Rs) 196 / 140 NSE Symbol ITC BSE Code 500875 No. of shares 3762 m Free float 100.0% Market cap (Rs m) 605,682 Shareholding Category (%) Promoters 0.0 Banks, MFs and UTI 37.6 FIIs 12.7 Public 13.3 Others 36.3 Total 100.0 By this recommendation of HOLD, what we mean is that existing shareholders would be better off holding onto the stock with a long-term perspective. However, if an investor would like to BUY this stock, then the upside from the current levels is about 13.4% CAGR. Investors could take the investment decision based on this premise. Investment Rationale Multi growth drivers: ITC is moving in the right direction by de-risking its business model and entering new areas. The company has successfully invested strong cash flows from its cigarette business into growth businesses such as hotels, food s and rural retailing. Strong cash flows (around Rs.20 bn) had enabled ITC to establish a dominant position in the hotel and paper business. It has also successfully executed its various businesses to ensure that the firms ROE stays at a healthy 25%. On back of these parameters we estimate a 20% CAGR growth in earnings over the next 3 years. Near monopoly in cigarettes: Despite campaigns against smoking and punitive tax rates, ITC has managed to grow its core cigarette business at a CAGR of 9.9% during the period FY02 to FY07. ITC's profits from cigarettes tend to grow even in an adverse tax environment (9% YoY growth in 1QFY08 despite tax hikes). Net price realisations (net of all taxes) tend to outpace volume falls in a declining market, resulting in growth in net sales. In the 2007 budget, the excise duty on cigarettes was further hiked by 5%. Also, a 12.5% VAT by states governments has become applicable. ITC has passed on the increase in taxes by a ~20% effective hike in prices. This proves ITC's strong positioning in cigarettes in the domestic market, where it has a share of 72%. We believe ITC's dominance is unlikely to diminish in the medium term as it has the best brand recognition, distribution and portfolio of products across price points. Cigarette business continues to remain the mainstay of ITC, accounting for 66% of FY07 revenues. The company is looking at upgrading its cigarette units to beat competition from imports and contrabands. Currently, out of the total amount of tobacco produced in the country, around 48% is in the form of chewing tobacco, 37% as bidis and only 15% as cigarettes. In the rest of the world, production of cigarettes is 90% of total production of tobacco related products. Although the market is huge in absolute numbers, per capita consumption of cigarettes in India stands at approximately 1/10th the world average and this underlines the vast hidden potential. As disposable income increases, people might shift from bidis to cigarettes. Being the leading player in the segment, ITC is likely to be a big beneficiary of this change. We have factored in a modest 8% compounded rate of growth in revenues for the cigarette division for the next three years. It should be remembered that the same has grown at a CAGR of 10% between FY02 and FY07. Hotels: ITC is the second largest player in the hospitality industry in India, only trailing Indian Hotels (The Taj Group). This division continues to benefit from capacity expansion as well as the upturn in occupancy rates. This division displayed a staggering topline CAGR of 43% between FY02 and FY07. To strengthen its position and to ride the boom in hotels in India, the company consolidated operations by merging subsidiaries ITC Hotels and Ansal Hotels with itself during FY05. The company is likely to invest around Rs10 bn in the Bangalore, Chennai and Hyderabad hotels in the next 3 to 4 years. It is also constructing a resort at its golf course at Gurgaon and is looking for land in the city to set up a hotel. It also plans to set up a mid-sized three-star hotel in Chandigarh and two or three properties in state capitals and metropolises. The vision of the management is to have a hotel in every state capital. With 75 hotels (5,500 rooms) under the chain, ITC is expecting to add another 27 properties (3,000 rooms) under its management in the coming years. Recently, it had tied up with Starwood Hotels & Resorts to bring the latter's premium brand, the Luxury Collection to India. According to recent estimates of the WTTC (World Travel and Tourism Council), Indian tourism demand will grow at 8.8% CAGR over the next nine years (2006-15), which would place India as the second most rapidly growing tourism market in the world. However, addition to the room inventory over the next 2-3 years is not expected to be commensurate with the growth in demand. As per industry estimates, India will require around 120,000 hotel rooms over the next 3 years. Overall, the increased business and leisure related travel, strong room demand, and higher occupancies would help the players in the sector to sustain their pricing power. Paperboard - Expansion benefits: ITC is the leader in the domestic paperboards market having a share of 30% in value terms. It is also the only player in the premium value added paperboard segment. It has a market share of 77% in Cigarette Tissue segment, The paper segment provides synergies to its business as more than one-third of its paper production is used for internal consumption. This division has grown at a CAGR of 14% during the period between FY02 and FY07. The paper industry is capital intensive and prone to global cycles. The capital intensity of the business is bound to increase as environmental norms tighten. Although the overall paper and paperboard industry in India is growing at around 7%, the value-added paperboard segment continues to grow at a substantially faster pace of around 20%. ITC is making investments in the paper business to capitalize on trends in the industry. Over the next 2 to 3 years, the company plans to invest Rs 10 bn to expand its capacities. It is also in the process of doubling pulp capacity to 200,000 tonnes per annum, which would help it reduce dependence on the global pulp cycle and cut costly imports. We expect the paperboard segment to grow at a CAGR of 14% over the next three years, in line with its historical growth rates. Paper: Capacity addition (TPA) FY07 FY09E Coated and uncoated boards 320,000 400,000 Paper 30,000 30,000 Specialty paper 24,000 125,000 Total paper 54,000 155,000 Pulp 100,000 200,000 Non-cigarette FMCG: ITC has very cleverly used its distribution and procurement network to build its new consumer (FMCG) businesses. FMCG businesses Category Mkt size (Rs m) ITC share (%) Biscuits 50,000 9% Match sticks 12,000 10% Branded atta 12,000 52% Ready to eat 800 24% Confectionery 20,000 20% Since the launch of its ready-to-eat Kitchens of India brand in 2001, ITC has established itself in key FMCG segments like atta, ready-to-eat meals and biscuits through its Aashirvaad, Kitchens of India and Sunfeast brands respectively. The company is now looking to expand into new product categories. It is using its established procurement network to source wheat and other agri inputs at a price lower than the competition, also ensuring high quality control as a result of direct control over procurement. In four years, the company's turnover has touched Rs 17 bn from Rs 1 bn in FY03 in this segment Let us have a look at the company's future plans and prospects of each of the divisions in the non-cigarette FMCG segment. Foods: The product portfolio now comprises more than 100 distinct food products under five brands. In Biscuits (Sunfeast brand) ITC has seen robust growth and has captured a 9% market share of the Rs 46 bn biscuits sector. The company is constantly introducing innovations and variants within a category. ITC has recently launched its Bingo brand in the Rs.20 bn snack market. ITC is targeting 25% market share over next 2 years. The snack food market is growing at 30% annually. Staple Foods (wheat flour and salt) under the Ashirwad brand has been one of the key growth drivers in packaged foods. The branded atta enjoy 55 % market share of the Rs 10 bn organized market. ITC has successfully captured a market share of about 24% in the Rs 800 m ready-to-eat foods segment. It has also entered the branded spice market valued at Rs 4.5 bn and is aiming for a 20 % market share in the first year itself. Retailing: ITC is also a strong player in lifestyle retailing and has established its brands like Wills Lifestyle and John Players. ITC is targeting a 30% plus growth in its lifestyle retailing business by expanding its stores ITC's Expressions has emerged as the largest greeting card brand sold with 25% of the share in Rs 3 bn domestic greeting card market. It has launched stationery under the Classmate and paper Craft brands. The market size is estimated at Rs 6 bn and is growing at 10% per annum. It also controls 12% market share in Rs 10 bn matchbox market. It acquired WIMCO (through its subsidiary) to increase its market share. Personal care: ITC is also gearing up for the launch of a mass brand in the home and personal care space. The company has already set up a separate strategic business unit (SBU) for this purpose. Given its immense distribution strength, ITC shouldn't find it hard to make a successful entry into the Rs 80 bn home and personal care segment. However, it would face tough competition from the existing players. Though currently the segment is suffering a loss at the PBIT levels, we expect it to turn profitable in FY10. We expect the division to grow by 43% over then next three years, much lower than the 78% growth the segment achieved in the previous three years. Agri business: ITC is one of the largest exporter of agricultural commodities and has a significant presence in soya, wheat, rice and marine products. Currently, ITC sources 13 commodities and plans to enter the fruits and vegetable markets. ITC plans to increase exports of value-added aqua-products, processed fruit and organic products. Exports of leaf tobacco, nonbasmati rice and wheat are also expected to drive exports in the coming years. It also has tied up with Japanese trading house Marubeni for food business including exports of Indian beans. Currently, it contributes 13% (post inter-segment transfers) to the total revenues and we expect it to touch to 17% going forward. E Choupal- rural initiative: ITC's rural initiative is likely to be one of the key long-term growth drivers for the company in our view. ITC has built on its sourcing scale to establish an enabling infrastructure, called e-choupal. It also saves about 3% to 5% of the procurement costs. Started as a sourcing venture for ITC's non-cigarette FMCG business, e-Choupal is now undergoing transition to become a highly effective distribution channel and would be known as Choupal Sagar. There are over 6,400 E-choupals spread across 29,000 villages and reaching over 3 m farmers. ITC has also entered into collaboration with over 40 companies to sell seeds, pesticides, fertilizers, farm equipment, consumer product goods, finance and insurance. The company plans to expand this initiative to 100,000 villages and reach over 10 m farmers by 2010 and source a wider range of products like spices, cotton and vegetables. It is also planning to set up new small format stores in rural areas on the lines of its existing hypermarket chain, Choupal Sagar. The company would open 140 stores (currently 3 stores) in 54 towns in the next three-four years. Though currently, it is in an investment phase, we expect by 2011, the company would generate revenues from e- choupals.

Comparative Valuations

FY07/CY06 Unit ITC Altria GPI HUL Current price Rs 161 2813.8 1,270 199 Market cap US$ m 14,861 144,480 319 10,707 Revenues US$ m 3,017 101,407 186 2,952 EBDITA margin % 32.0% 17.7% 12.6% 13.6% Net profit margin % 21.8% 11.9% 11.6% 15.3% Return on capital employed % 33% 19% 130% 67% Return on equity % 26% 30% 21% 68% Price to earnings TTM, x 21.5 492.8 14.8 23.6 Price to book value TTM, x 5.8 199.3 3.1 16.1

Investment Concerns

Cigarette taxes: The domestic cigarettes industry has been facing pressures in the sphere of taxation and regulation with respect to advertisements. The government has increased excise duty by 5% and allowed the imposition of VAT by states. It is estimated that cigarettes are taxed 34 times higher than other tobacco products on a per kg basis. This results in low per capita consumption of cigarettes compared to that in neighboring countries, since around 61% of cigarette consumption comes from price-sensitive 'dual consumers,' i.e., those using cigarettes as well as other tobacco products. Also, there are more chances of excise duty on cigarettes rising than falling, as is the case internationally. To that extent, this star in the company's portfolio is under pressure. The domestic cigarette industry is also increasingly under threat from smuggled brands, which would now increase by the imposition of VAT. However, the sector is characterised by moderate competition on account of the strong brand loyalty. Further the union health ministry has stepped up its campaign against smoking in the recent past. Regulations have been passed against smoking in public places. Also globally, tobacco companies are in the eye on storm over health related issues and have been on the receiving end of penal action for damage claims. Though Indian consumers are not active on the libel side currently, this may change due to consumer activism. We have not factored in any negative impact on volumes due to these measures, as it is still early days.

Background

ITC is the largest cigarette company in India and has diversified into multiple businesses over the years. It commands around 70% of India's Rs 130 bn domestic cigarette market (value terms). Out of the top 10 cigarette brands in India, 6 belong to the ITC stable. The growing awareness of the harmful effects of tobacco has resulted in ITC focusing on de-risking its revenue profile (like any other international player in the last 25 years). Consequently, it merged the paperboards subsidiary with itself and invested in growing the hospitality, retailing, packaged foods and IT businesses. The company has emerged as the second largest luxury hotel chain after Indian Hotels. In packaged foods, its product range includes ready-to-eat (Kitchens of India), staples (Aashirvaad Atta and Salt), confectionery (Mint-O and Candyman) and biscuits. ITC has also entered into garment retailing. Other initiatives include greeting cards (20% market share), safety matches and incense sticks. Also it took the e-Choupal initiative to reach Indian villages where nearly two-thirds of the country's population lives. Started as a sourcing venture for ITC's non-cigarette FMCG business, e-Choupal is now undergoing transition to become a highly effective distribution channel and would be known as Choupal Sagar.

Industry Prospects

The Indian tobacco industry is unlike most other countries. Inspite of being the second largest producer of tobacco in the world after China, it holds a meager 0.7% share of the US$ 30 bn global trade in tobacco, with cigarettes accounting for 85% of the country's total tobacco exports. Per capita consumption of cigarettes in India is merely a tenth of the world average. In India, three major cigarette players dominate the market, primarily ITC with 72% market share, Godfrey Phillips with 13% and VST with 8% share of the market. The company is also present in hotels, paper, agri business and retail venture. The overall paper and paperboard industry in India is growing at around 7%, while the hospitality industry of the country is at a high growth pace due to favourable sector scenario. Currently, the size of the snack food market is estimated to be Rs 45 bn of which branded players account for Rs 20 bn. The snack food market is growing at 30% annually.

Risk Analysis

Sector:ITC has diversified interests across various sectors. Besides being a leader in cigarette business, it is gaining market share across its various other segments like paper, hotels and retailing. The company is moving in the right direction by de-risking its business model and entering new areas. ITC has successfully invested strong cash flows Seeing the diversified nature, we assign a medium rating of 5. Sales:ITC earned average revenues of US$ 1.9 bn m between FY03 and FY07 and revenues to the tune of nearly US$ 2.8 bn in FY07. Further, during FY07 to FY09, the company is expected to generate average annual revenues of US$ 4 bn. These are sizeable figures and hence, we assign a low-risk rating of 8 to the stock. Current ratio:ITC's average current ratio during the period FY03 to FY07 has been 1.3 times. This indicates that it is comfortably placed to pay off its short-term obligations. We assign a medium risk rating of 5. Debt to equity ratio:A highly leveraged business is the first to get hit during times of economic downturn, as companies have to consistently pay interest costs, despite lower profitability. We believe that a debt to equity ratio of greater than 1 is a high-risk proposition. ITC being a debt free company, we have assigned a low risk rating of 10. Long term EPS growth:ITC has grown its net profits at a CAGR of 17.8% in the past five years. Further, on the back of its strong position and increase in sales, earnings are expected to grow at a compounded rate of 13% during FY07 to FY10. As such, the rating assigned to the stock on this factor is 4. Dividend payout:A stable dividend history inspires confidence in the management's intentions of rewarding shareholders. ITC's average payout ratio has been 36% over the past 5 fiscals. Thus, we have assigned a low-risk rating of 8. Promoter holding:A larger share of promoter holding indicates the confidence of the people who run it. We believe that a greater than 40% promoter holding indicates safety for retail investors. There is no promoter holding in the company. We have hence assigned a high-risk rating of 1 to the stock. FII holding:We believe that FII holding of greater than 25% can lead to high volatility in the stock price. The FII holding in ITC, at the end of June 2007, stood at 12%. Based on our parameters, the rating assigned is 4. Liquidity:The average daily trading volumes of ITC in the last 5 years stand at 3,200,000 shares. This is high and hence the rating assigned is 10. Margin of safety:This is to determine the value of the stock relative to its price and the returns over a risk free rate. Margin of safety of a stock lies in its earning power, which is calculated as EPS divided by market price (reciprocal of P/E). Considering ITC's P/E of 21 times its trailing 12-month earnings, the earning power is 3.5%. This is still less than the yield on 10-year government paper. Thus, the rating assigned is 1. Considering the above parameters, the total ranking assigned to the company is 56. This makes the stock a medium-risk investment from a long-term perspective.

 

Risk Matrix

High Risk Medium Risk Low Risk Rating (1 to 3) (4 to 6) (7 to 10) Sector High Medium Low Sales (US$ m) < 500 501 - 1,000 > 1,000 Current Ratio (x) < 1 1 - 2 > 2 Debt to equity ratio (x) > 1 0.5 - 1 < 0.5 Long term EPS growth (%) < 10 10 - 20 > 20 Dividend Payout (%) < 15 15 - 25 > 25 Promoter holding (%) < 25 25 - 40 > 40 FII holding (%) > 25 10 - 25 < 10 Liquidity (Nos. '000) < 100 100 - 200 > 200 Margin of Safety (%) < 3 3 - 6 > 6 Final Rating < 30 30 - 60 > 60

Valuations

At the current price of Rs 161, the stock is trading at a earnings multiple of 15.8 times our FY10 estimates. We have valued ITC based on the sum-of-parts valuation method, and have used different valuation metrics to arrive at a fair value for each division. We have given a multiple of 17 times our estimated FY10 capital invested to the cigarette business. Paper is an asset-intensive global commodity. While paperboard (a predominant portion of ITC's sales) is relatively more insulated from global cycles, execution risks exist. We have given it a multiple of 1.4 times the capital employed. As far as the hotel segment is concerned we value it at 1.7 times the FY10 employed capital. Though the sector fundamentals look good, it requires huge investment and upside to the higher room rates is limited over the next few years due to higher competition. Agri business valued at 5.8 times the capital employed seeing the huge growth and e choupal benefits. ITC's FMCG business excluding cigarettes is still in aggressive investment mode and is unlikely to report profits until FY010E. We have valued it at 20 times its FY10 segmental earnings due to high growth rate and strong return profile. (Rs m) FY07 FY08E FY09E FY10E Revenues 123,693 147,791 175,695 210,891 PAT 27,000 29,443 32,959 38,591 EPS (Rs) 7.2 7.8 8.8 10.3 Price to earnings (x) 22.3 20.4 18.3 15.6 Price to book val. (x) 5.8 5.0 4.4 3.8 Sum of the parts valuation (FY10E) Valuation multiple Value (Rs m) Value per share (Rs) Cigarettes 17x cap.employed 510,143 136 Hotels 1.7xcap.employed 41,927 11 Paper 1.4xcap.employed 49,833 13 Agri 5.8x cap.employed 103,240 27 Non-FMCG 20x earnings 74,900 20 ITC's business value 780,044 207 Add: Cash & investments 60,068 16 Less: Debt 3,000 1 ITC's total value (FY10E) 843,112 224 Further we have added the cash and the investment per share and subtracted the debt the company is expected to have in FY10. We have arrived at a fair value of Rs.224 from a FY10 perspective and this translates into an upside of 13% CAGR from the current price. We thus recommend a 'HOLD' on the stock from a FY10 perspective. Financials at a glance (Rs m) FY07 FY08E FY09E FY10 Sales 123,693 147,791 175,695 210,891 Sales growth (%) 26.3% 19.5% 18.9% 20.0% Operating profit 39,565 44,309 49,957 58,723 Operating profit margin (%) 32.0% 30.0% 28.4% 27.8% Net profit 27,000 29,443 32,959 38,591 Net profit margin (%) 21.8% 19.9% 18.8% 18.3%   Balance Sheet Current assets 62,897 76,785 86,043 98,989 Fixed assets 56,109 57,515 64,363 70,393 Investments 30,678 36,948 43,924 52,723 Total Assets 149,683 171,247 194,330 222,104   Current liabilities 38,576 43,249 47,833 53,968 Net worth 104,371 120,270 138,068 158,908 Loan funds 2,009 2,500 2,700 3,000 Other liabilities 4,727 5,228 5,729 6,228 Total liabilities 149,683 171,247 194,330 222,104

Source: Equity Master : http://plethora-news.blogspot.com/2007_08_26_archive.html