ITC’s Q4FY16 cigarette volume growth of ~0.5% y-o-y was in line with our estimate but significantly ahead of consensus estimate of de-growth of 2-4% y-o-y. Cigarette Ebit grew 11% y-o-y after four consecutive quarters of midsingle-digit growth. The recent length reduction of certain cigarette brands from 69mm to 64mm keeping their price same should help protect margins. We now expect a 10% price hike only in the relatively price inelastic Gold Flake portfolio in RSFT and DSFT segments over the next 6 months. This should help ITC deliver 2-3% volume growth and hence 12-13% cigarette Ebit growth in FY17. On the regulatory front, we believe the larger graphical health warning (GHW) shouldn’t impact volumes as ~80% cigarettes are sold loose. We expect only 9-10% excise duty hike as we believe the only successful way of curbing tobacco consumption is ‘gradually’ making it unaffordable over long periods of time. Reiterate Buy (target price R415, 26% upside).
Cigarette volumes grow ~0.5% y-o-y: ITC reported net sales of R101 bn (+10% y-o-y), in line with our estimate. Cigarette net sales increased 10% y-o-y, implying cigarette volume growth of ~0.5% y-o-y. Other FMCG sales grew +5% y-o-y (2% below expectations) hit by price deflation and weak macro. Gross margin expanded 27bps y-o-y to 60.9% due to lower commodity prices and premiumisation across businesses. Ebitda margin expanded by 136bps y-o-y to 36.3% helped lower employee and other expenses. PAT grew +6% y-o-y to R24.9 bn, impacted by higher tax rate.
Cigarettes – volume growth after 11 quarters: ITC’s cigarette volumes for Q4FY16 grew by ~0.5% y-o-y, ahead of consensus, which was building in a 2-4% volume decline. As we have been reiterating, following the weak performance in Q1FY16, when cigarette prices were up ~26% y-o-y, cigarette volume growth has been improving since Aug’15. Cigarette Ebit grew by 11% y-o-y, in double-digits after four consecutive quarters of mid-single digit growth, driven by volume growth and margin expansion of ~80bps y-o-y to 65%. Cigarette mix remained stable q-o-q with over 20% of sales volumes coming from the DSFT segment. Following the reduction in length of Capstan cigarettes from 69mm to 64mm in Oct’15, the proportion of DSFT cigarettes increased in the overall mix. However, this reduction in length is not margin dilutive as the price of Capstan cigarettes hasn’t been reduced although at 64mm it attracts lesser excise duty.
Where do we go from here?
Following the 10% excise duty hike, ITC has taken two measures in March 2016:
Increased the price on KSFT cigarettes by ~13% y-o-y,
Reduced the length of Berkeley, Flake and Silk cut cigarette from 69mm to 64mm, keeping their price the same.
Recent channel checks suggest that due to the relative price inelasticity of demand for KSFT cigarettes, the recent price hikes have been absorbed by consumers. Also, despite the reduction in length of some brand of 69mm cigarettes their volume growth hasn’t tapered. The length reductions result in an increase in net realisation per stick by ~20% as the consumer pays the same price for the cigarette despite a lower excise duty for 64mm cigarettes. Hence, the length reductions help ITC offset the 10% increase in excise duty and avoid margin dilution.
Price hikes needed only in Gold Flake portfolio in RSFT and DSFT: We believe ITC now needs to take a 10% price hike only in its premium Gold Flake branded cigarettes in the RSFT and DSFT segments. Given the relative price inelasticity of demand of these cigarettes, we expect these price hikes to be absorbed by consumers without a reduction in volumes. We expect this price hike by ITC in 2HFY17.
Price hike in KSFT and Gold Flake RSFT & DSFT, and length reduction of majority of cigarette brands in RSFT segment to 64mm should help ITC deliver 2-3% y-o-y cigarette volume growth and
12-13% y-o-y cigarette Ebit growth. We believe the larger Graphical Health Warning (GHW) shouldn’t impact volumes as ~80% cigarettes are sold loose.
FMCG business—weak rural demand pulls down growth: This segment reported only 5% y-o-y sales growth, impacted by weak rural demand, price deflation and pipeline correction in its stationery business. Despite the start-up costs related to new categories this segment reported Ebit of R708m. Most categories witnessed GM expansion driven by lower input costs and better product mix. Performance of the FMCG business was as follows:
Biscuits: ‘Mom’s Magic’ continued to gain market share, helping drive overall market share gain in biscuits for ITC. Sunfeast Bounce continued to gain market share in the creams segment and remains the largest selling brand.
Personal products: Growth was led by premiumisation of products; faced price deflation and high competitive intensity.
Packaged foods: Yippee! Noodles continued to do well, ITC spent extra on A&P for this brand; Aashirvaad atta continued to gain market share.
Education and stationery products: This segment undertook a pipeline correction ahead of its important quarter, which impacted top-line growth.
Hotels—Revenue growth increases due to better occupancy: The hotels business delivered sales growth of 5% y-o-y due to better room occupancy rate and strong growth in the F&B segment. However, profitability was impacted by lower room rates, impact of Chennai floods and gestation costs of the recently commissioned ITC Grand Bharat, Gurgaon.
Agri business: Over FY16, revenue was impacted by lack of export opportunities in wheat, soya, coffee and leaf tobacco. Export of wheat was impacted by lower international prices and poor quality due to unseasonal showers. Soya trading opportunities were constrained due to unfavourable pricing in view of surplus crop output in major origins. Leaf tobacco exports from India were impacted due to soft demand arising out of higher levels of uncommitted stocks and decline in global cigarette volumes.
Paperboards, paper & packaging: Sales growth was impacted by lower FMCG and cigarette category sales.