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Valuation advantage for ITC
December, 08th 2011

Analysts prefer ITC to HUL but uncertainty about excise duty rise on cigarettes in coming Budget will limit substantial upside.

Though the two fast moving consumer goods (FMCG) giants, Hindustan Unilever (HUL) and ITC, reported better than expected financial performance in the September quarter, the former has done better (up 33 per cent) versus the latter (up 20 per cent) in the past year. While most of the outperformance by HUL has come since end-October, it has widened the valuation gap between the two.

Even as they are operating in different business segments, analysts are more positive on ITC than HUL. While HUL has been doing well for many quarters, with double-digit volume growth and steady margins, the relatively higher valuations (versus ITC), coupled with ITCs stronger earnings projections, are working in the latters favour.

Says a Sharekhan report: In addition to distortion in valuation, ITC provides better earnings visibility, given 21 per cent net profit CAGR (compounded annual growth rate) between FY11-13 (17 per cent for HUL). The core business of cigarettes is relatively price-insensitive and improved performance of the non-cigarettes business would result in better earnings growth over the long run. Adds Sameer Narang, HDFC Securities (institutional research), In the current economic environment, ITCs mix of inelastic (cigarettes) and growth businesses (foods) insulates it most from global uncertainties.

Steady cigarette volumes
The cigarettes division reported robust volume growth of eight per cent in the last quarter, despite a six per cent price rise, partly due to the lower base of the same quarter last year (volume fall of one per cent). ITC is also focusing on mix improvement, with long/kingsize filter cigarettes growing ahead of the portfolio.

Analysts expect the division to continue to do well and volume growth to remain robust on inelastic demand, strong brands in its portfolio, new launches and extensive distribution network.

...at least till the Budget
Uncertainty over a likely increase in excise duty, untouched in last years Union budget (for 2011-12), is a near-term risk. A few state governments such as Tamil Nadu, Kerala and West Bengal (the three forming 30 per cent of segment revenues) substantially increased VAT (value added tax) on cigarettes in the recent past. There is a strong likelihood of the excise duty being raised in the coming budget (for 2012-13).

Says a report by HDFC Securities (retail research), If the excise hike is significant (more than 10 per cent), then it could impact ITCs volumes for at least a few quarters in FY13, as a sharp hike in excise duty (average 18 per cent) in the FY11 Union Budget had led to decline in volumes in the first half of FY11.

Also, a delay in implementation of the Goods and Services Tax could increase the uncertainty on cigarette volumes in 2012-13.

The company has strong pricing power in cigarettes, which forms 57 per cent and 80 per cent of total revenues and profit before interest and tax (PBIT), respectively. In the last quarter, despite the price rise, cigarette revenue jumped 14 per cent (gross) and the PBIT margin improved 120 basis points (a percentage point is 100 bps). 

STEADY GROWTH
(Rs  crore) FY11 % change*

FY12E

% change* FY13E % change*
Net sales 21,468 16.8 24,544 14.3 28,378 15.6
Operating profit 7,454 18.3 8,455 13.4 9,862 16.6
Net profit 4,988 22.8 5,839 17.1 6,748 15.6
EPS (Rs ) 6.4 22.8 7.5 17.1 8.7 15.6
* y-o-y    E: estimates , Standalone  financials        Source: Company, analysts' reports


Other businesses to fuel growth

The companys other businesses, namely the non-cigarettes FMCG (branded packaged foods, personal products, education, stationery, apparels), agri-division (led by product mix improvement) and paper (new unit of 100,000 tonnes per annum expected to commission in 2012-13) should grow at a robust rate in coming years. Losses in the non-cigarettes FMCG business are likely to reduce further in the coming quarters and the business is expected to turn profitable by end-FY13.

However, headwinds (economic slowdown domestically and internationally, slow discretionary demand and supply additions) exceed tailwinds (rupee depreciation, capacity expansion) for the hotels business in the medium term, say analysts.

Valuations attractive
A key argument in favour of ITC is its business being relatively less sensitive to volatile commodity prices and the rupees depreciation against the dollar, which has been a bane for many companies, adding pressure to input costs.

Besides, the valuation gap between HUL and ITC has widened significantly in recent monthsit is now at levels not seen since December 2009. The one-year forward price to earnings multiple for HUL has shot up from 27 times to 34 times (historic average of 26 times), while for ITC it has come down from 24.5 times to 23 (average of 21 times). While HUL at Rs 397 is almost close to analysts target price (of Rs 400), ITC at Rs 205 still has the potential to provide an upside of at least 10 per cent (average target price of Rs 223) in the medium term.

 
 
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