>ITC (MOTILAL OSWAL)

ITC has underperformed Sensex by 45% in CY09 (YTD). With Budget being just a month away expectations of steep increase in excise duty are doing the rounds. Cigarettes contribute 42% to sales and 87% to PBIT of ITC. The company has been facing headwinds on the regulatory front for the last two years, with the imposition of VAT (12.5%) and 5% increase in excise duty in FY08, followed by a sharp increase in excise duty on non-filter cigarettes (391% increase on
micros; 140% increase on plains) in FY09. ITC has discontinued non-filter cigarettes (19.4% of FY08 volumes). Consequently, volume growth of 7.1% in FY07 has decline to minus 3% in FY09.

■ Pictorial warnings unlikely to impact volumes: From 31 May 2009, it has become mandatory to display pictorial warnings on cigarette packs. However, as the pictorial warning is required only on one side of the cigarette pack to the extent of 40% of pack size, the consumer will not be able to see the warning if the retailer displays the back side of the pack or if the pack flap is open. Cigarette volumes are unlikely to be impacted due to the implementation of pictorial warnings. ITC will take a one-time hit of Rs150m-200m on replacement of cylinders for packing material.

■ Industry expects 6-8% excise duty increase in FY10 budget: Cigarette industry expects 6-8% increase in excise duty for FY10, which would result in 2-3% volume growth (v/s 4.5% decline in FY09). However, higher increase in excise duty would result in lower volume growth. We believe that fiscal constraints might force the government to propose a double-digit increase in excise duty. We don't rule out higher excise increase on filter cigarettes as this segment had not seen any excise increase in FY09.

■ Stock has reacted negatively to large excise hikes in the past: ITC’s stock price has reacted negatively to sharp increase in duties in the past. The stock declined by 6.1% in 2005 (10% excise increase after a gap of three years) and 17% in 2007 (imposition of 12.5% VAT and 5% increase in excise).

■ We currently factor in 7.5% increase in excise and 4% volume growth: We are currently factoring in 4% increase in cigarette volume and 7.5% increase in excise duty. Double-digit excise duty increase will be viewed negatively by the markets, in our opinion. Expanding margins by increasing prices will not be an easy option in FY10 as cigarette prices have increased by over 25% in the last two years. Maintain Buy with target price of Rs200.

To see full report: ITC