Tuesday, December 20, 2011

>ITC: High FCF growth, robust pricing power; raise to Buy

Source of opportunity
ITC has corrected by 8% over the last 30 days, underperforming the sector by 4% and now trades 1SD below the sector aggregate on a 12-month forward P/E. We believe the correction has been led by broader market weakness and concerns on taxation given fiscal challenges. We view this as an entry opportunity since ITC enjoys tremendous pricing power which will help mitigate higher taxes and is not fully factored into the present stock price. We raise ITC to Buy with a revised 12-month target price of Rs232 (from Rs201) as we believe ITC is well protected in the current uncertain environment given improving cash returns and visibility of margins.

We expect ITC to continue to show robust yoy volume growth of 8+% in 2HFY12 as seen in 1Q-2QFY12. ITC enjoys strong pricing power, with key brands seeing retail price increases at a 9% CAGR over the past 5 years against inflation of 6.5%. For FYTD ITC has increased prices by 3% (6% yoy) allowing it leverage to balance increases in taxation. We believe ITC is least affected by input cost inflation or INR depreciation in our coverage.

ITC trades at FY13E P/E of 20.2X compared with 25.1X for the sector. We raise FY12E-14E EPS by 1%-7% to factor in higher volumes for the cigarette business. Our 12m TP is set at 24X FY13E EPS, backed by Director’s Cut analysis. We raise our target multiple from 22X to factor in (1) increased cash generation and higher dividend payout ratio, (2) increased pricing power owing to strong brand portfolio and limited competition, and (3) improvement in CROCI to 50% in FY13E from 39% in FY11. We expect ITC cash surplus to increase to Rs61 bn in FY13E from Rs39 bn in FY11.

Key risks
(1) Increase in VAT rates over 20% by states and significant excise hikes,
(2) Stringent anti-smoking legislation, 
(3) Sustained FMCG losses.

To read the full report: ITC