Buy ITC For Target Price Of Rs. 360 (60%+ Upside From CMP Of Rs. 220): HDFC Sec

Holding steady…

ITC clocked in-line performance despite continued macro challenges. ITC’s performance was in sync with other FMCG companies. ITC-Cig/ITC-FMCG growth was at 5/6% vs. HUL/Dabur/Colgate/Marico posted domestic growth of 4/6/4/-1% in 3QFY20. ITC’s cig/FMCG performance was very much comparable to other FMCG cos for the past many quarters. Despite that, stock has de-rated over the last 12 months. We believe de-rating is unwarranted when the co is consistently showing quality earnings. We value ITC on SoTP basis (link to table) and arrive at a TP of Rs 360 (implied P/E of 25x). Maintain BUY.

HIGHLIGHTS OF THE QUARTER

 Cig. val/vol growth was 5/2% (10/5.5% in FY19, 10/7.5% in 3QFY19) was in-line with estimates. 8th consecutive quarter of positive volume growth vs. -4% CAGR over FY12-18. Volume growth moderated vs. FY19 owing to heavier base and impact from slowdown.

 Cig. EBIT grew by 6% (6.5% CAGR over FY15-19) vs. exp. of 8% growth. Cig. EBIT margins expanded by 60bps owing to (1) Gradual price hikes (~3%) and (2) Higher in-house manufacturing of capsule cig. Capsule cig is driving the growth for ITC and industry, it contributes 13% mix for ITC. Margin pressure was the key concern on the street in FY19 that has reversed in 9MFY20 (100bps expansion). We model 7% cig EBIT CAGR over FY20-22E.

 Non-cig business grew by 7% (est 9%. FMCG biz growth of 6% was in-line with our estimates FMCG posted EBITDA growth of 48% with EBITDA margin of 7.7%.

Hotels/Agri/Paper revenue grew by 22/9/1% with EBIT growth of 45/7/1%. Non-cig EBIT grew by healthy 11% (11% average in the last 12 quarters, 7% over FY14-19).

 GM was flat at 62% while employee/other expense grew by 6%/flat resulting in 7% EBITDA growth (11% in FY19 and 7% CAGR over FY15-18). APAT (at 25% tax rate) growth was 18% to Rs 37.8bn (est Rs 37.6bn).

STANCE

Stable taxes in FY19 accelerated cigarette volume growth to 5.5% vs. -5% CAGR during FY15-18. EBIT growth also accelerated to 9% as compared to 7% CAGR during FY15-18. Yet company could not enjoy re-rating as investors have flocked towards ITC’s peers (HUL, Dabur and Britannia etc.). Rather cigarette business saw de-rating (>20% fall, based on assigning fair valuation to other segments) over the last 12-months.

We expect cig valuation will recover owing (1) Continuation of stable taxes, (2) EBIT margin expansion and (3) Pickup in rural market. We believe cigarette valuation will recover to its average of 18x EV/EBITDA (still lower than 25x for Colgate which is similar wrt market leadership, vol growth trajectory and pricing power).

Other catalyst in the business is FMCG, better margin traction will also offer better value for ITC. We continue to believe that valuation discount will narrow down.