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MOSL: ITC (Buy) - Excise duty hike sharp but not unmanageable - Near term volume disruption




Motilal Oswal Securities Ltd.


11 Jul 2014





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ITC: Excise duty hike sharp but not unmanageable; Near term volume disruption; key overhang behind; reiterate as top pick (ITC IN, Mkt Cap USD45.3b, CMP INR343, TP INR400, 17% Upside, Buy) Weighted average 22% excise duty hike for ITC In its FY15 budget, Government increased excise duty of Cigarettes by 11-72% across various slabs, with the sharpest 72% hike in 64mm segment. As per our calculations, weighted average excise duty increase for ITC works out to 22%. It will require 11% price hike to offset the impact. This is the third consecutive year of high double digit excise duty increase, though unprecedented in its magnitude (23% and 18% hike in FY13 and FY14). However, we believe the quantum of increase in current budget is benign, if viewed in the context of the demand by Health Minister to disproportionately raise excise duty to INR3.5/stick. Near term disruption in volumes We expect ITC to take a weighted average 16% price hike to pass on the impact of excise duty increase and maintain its 15% Cig EBIT growth trajectory. The sharp 72% excise hike in 64mm segment (10% volume contribution for ITC in our view), which acted as a consumer recruiter and prevented any sharp volume decline post excise duty increases in FY13 and FY14, will impact Cig volumes in FY15. Current 64mm price points of INR2.5-3 will become less lucrative and hence will shift towards INR4, in our view. Thus, we model for 3.3% volume decline in FY15 v/s our earlier assumption of 2% growth. ITC will have the challenge of migrating 64mm consumers to higher price point, post the sharp excise duty increase. Demonstrated track record of up-trading consumers We draw comfort from ITC’s demonstrated track record of migrating consumers from non-filter to filter segment in FY09. Post the 3x-5x excise duty increase in Non-Filter segment in FY09, ITC vacated the non-filter portfolio which used to contribute 20% of its then Cig volumes and still arrested the Cig volume decline to 2.9%. We expect ITC to implement the price hikes in 64mm in a phased manner to prevent any sharp volume backlash. We see greater impact for players like VST who derive 50%+ volumes from 64mm. We note that, barring FY02, increase in excise duty did not impact the Cigarette EBIT growth. In FY02, ITC’s Cigarette EBIT grew only 6% post an 8.5% volume decline, after 15% excise increase. In the recent past, even in years of higher increase in Cig excise duties (FY11, FY13, FY14), the Cig EBIT growth of ITC remained robust in 17-20% band. Reiterate as top pick; best earnings visibility plus valuations at discount to sector Despite the expected near term Cig volume weakness, we believe ITC has the requisite brand strength and pricing power to navigate the challenges posed by sharp excise duty increase in 64mm segment. We expect Cig volumes to stabilize in 2HFY15. Incrementally, profitability of non-Cig FMCG is also improving and delivered maiden annual positive EBIT in FY14. At 25.9x FY15E and 22.3x FY16E EPS, it trades at a discount of 16% to sector P/E, which we believe is unwarranted given the best earnings visibility that it offers in our universe. We maintain a Buy with a target price of INR400 (27x FY16E EPS).

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