ITC managed a healthy 17% Ebit (earnings before interest and taxes) growth in cigarettes, as top-line growth came in higher than expected on a strong revival in volumes to 2% YoY growth. Margins continue to improve, driven by (i) further rise in prices, (ii) strong mix uptrading and (iii) improved scale efficiencies with the recovery in volumes. We expect the trend to accelerate, with further price hikes, continued uptrading and a drop in input costs.
FMCG top line grew 24% YoY and losses fell to Rs 736 m. Though top-line growth was higher than estimated, losses were also higher. This, we believe, is due to higher expenditure behind new launches, like Noodles, that have been rolled out nationally after positive response from test markets. We expect losses to continue to decline on stabilisation and scale efficiencies, despite continued new launches.
Agri surprised, with 18% sales and 36% Ebit growth, led by strong trade in value-added commodities like soya and coffee, and margin gains from the falling cost of leaf tobacco. In Papers, growth was weak, as pre-delivery of cigarette paper and packaging in Q2 in anticipation of shutdowns in the December quarter corrected itself. Hotels disappointed with 14% sales and 16% Ebit growth, despite healthy occupancy, at 68%, and a 10% rise in average room rates. Rising costs are hurting Hotel margins.
We expect ITC to maintain reasonably strong earnings growth momentum in FY11-12e. With the December quarter performance, we are now confident of cigarette business doing well, despite high tax increases. Steep price hikes are offsetting weak volumes to result in healthy top-line growth and better margins.
FMCG losses continue to decline, despite new category launches. Paper and Agri business are expected to sustain healthy top line growth and improving margins on structural improvement in profitability, riding on mix improvement and price hikes.
We also like ITC for its relative immunity to the stiff competition being witnessed in other FMCG categories. ITC has, in fact, managed to improve its market share by 100 bp in both soaps and shampoos over the last year. Also, ITC is set to benefit from improving discretionary spending, especially by urban consumers, as its Hotels and Retail businesses are direct beneficiaries.
ITC is currently trading at 25x (times) FY11e and 21x FY12e. This is in line with its last five-year average. ITCs premium to Sensex, at 16%, is lower by 20% vs its last five-year average. We believe the earnings outlook for ITC is improving, especially in cigarettes, which are seeing a revival in volume growth and improved profitability across all its business segments.
We maintain our multiple for ITC to 24x FY12e to peg it at a 20% premium to last five-year average to reflect improved earnings growth potential and structural re-rating of the stock, given increased confidence about ITCs ability to weather the steep hike in taxes for cigarettes. This, on an EPS of Rs7.8 for FY11E, gives us our PO (price objective) of Rs 190, implying 13% upside potential from current levels. A dividend yield of 3% further adds to the risk/reward ratio.
Bank of America Merrill Lynch