Research firms CLSA and Credit-Suisse have come out with their reports on ITC. According to them ITC, which has been an underperformer on concerns of VAT implementation and subsequent impact on cigarette volume, will outperform now on expectations of increase in cigarette volumes and earnings growth.
Both research firms have raised their target price on ITC. CLSA is bullish on the stock and has recommended a 'buy' on it with a target of Rs 184, which implies 20% potential upside and Credit-Suisse has recommended 'outperformer' rating with a target of Rs 188, which implies 22% potential upside.
CLSA report on ITC:
Volume surprise likely
ITC has underperformed the market by 24% YTD on the concerns of VAT implementation and subsequent impact on cigarette volume and earnings growth. We believe that the current stock price already factors in the worst and cigarette volumes and earnings growth will likely surprise on the upside. We have reduced our FY08 cigarette volume drop assumption from 7.5% earlier to 3% now and raised earnings by 6%. Our new target price of Rs184/share offers an 20% upside and we upgrade the stock to a BUY (U-PF earlier).
Underpeformance is now behind
The stock has underperformed the market by 40% over the last 12 months and by 24% YTD on the concerns of VAT implementation. Then it was the concerns on whether the industry / ITC would be able to pass on the tax increases. Once ITC (and also the industry) effected nearly 18-20% weighted average price increase, passing on the entire tax hike, which in turn lead to concerns on volume growth. We believe that ITC will likely surprise on the positive on this front.
Cigarette business ebit will likely surprise on the positive
Our initial feedback, which now stands corroborated by the results of VST Industries (3rd largest cigarette manufacturer with 8% market share), indicates that cigarette volume degrowth is turning out to be much lower than our initial expectation of 7.5%. We have lowered the cigarette volume drop to 3% and upgraded earnings by 6%. Additionally, savings on entry tax (which now becomes VATable) will bring in a positive surprise on the margins.
Target price raised to Rs184/share; upgraded to 'BUY'
Our 12-m target price of Rs184 per share (earlier Rs 150) is based on sum of parts. The key reason for the target price upgrade is the 6% increase in earnings and upward revision in our target cigarette business PE to 17x, due to more confidence on cigarette volume trend. Cigarette business accounts for 70% of sum of parts. With the target price offering 20% upside we upgrade the stock to BUY (U-PF earlier).
Risks to our recommendation
The key risks to our recommendation remains more increase in VAT rates (currently 12.5%) the next year, a step-up in capex – particularly on the paper business. On the upside, as the state government of Uttar Pradesh joins VAT, the taxation in the state may go down from existing 33% to the usual 12.5%. Also the company has already stepped up the dividend payout to 50% and we do not see any risk to that despite a rising capex.
Credit-Suisse report on ITC:
Steady growth, low expectations
Event:
We initiate coverage on ITC with an OUTPERFORM rating and a target price of Rs188, which implies 22% potential upside.
View:
ITC's cigarette profits tend to grow even in an adverse tax environment. Furthermore, net price realisations tend to outpace volume falls in a declining market, resulting in net sales growth. However, total costs fall, as most costs are linked to sales volume, resulting in margin expansion. ITC has effected a price rise of some 20%, which should result in about a 9.4% rise in net realisations. We expect EBIT margins from cigarettes to increase 150 bp and absolute EBIT to grow 6% in FY08E, resuming doubledigit growth thereafter (10.5% p.a. from FY08-10E). Paper should benefit from pulp capacity expansion, while supply-demand in the hotel business remains conducive to profitable growth. Its foods business is likely to turn profitable by early FY09, although entry into the HPC business is expected to drag down segmental profitability. We expect EPS to grow 14.8% p.a. from FY07-10E and ROE to remain steady at about 25%, despite high investments.
Catalyst:
In our view, the market is excessively focused on short-term volume growth in cigarettes, or the lack of it, and would be positively surprised by segmental profit growth. We believe that consensus is for underestimating the extent of a net realisation rise in the cigarette business.
Valuation:
ITC has underperformed the market by 41% in the past 12 months and now trades at 19.3x FY08E, which is at a 10% premium to the broader market. We set a sum-of-the-parts (SOTP) fair value of Rs 188, based on Rs 110 for cigarettes (16.5x FY09E cigarette earnings).
Key risks comprise a further cigarette tax hike and cyclicality in other businesses.
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