>ITC: Best pre-budget return in the stock since 2006

ITC's stock has appreciated by 4.2% over the past two months, and is the best pre-budget returns since 2006. This performance is being partly driven by the strong stock market rally since end December 2011. There are expectations of a double digit increase in excise duty on cigarettes given the fiscal constraints of the Central government. However, ITC has given negative returns (after budget) only on two occasions in the past eight years; as the company has managed to pass on the increased duties given the superior pricing power. We believe that any correction in the stock price will provide a good entry point. Maintain Buy. Expect double-digit hike in excise duty; VAT to increase in a few states: There is high probability of double-digit hike to combat the inflation impact. However, very sharp excise increase looks unlikely as revenues suffer due to decline in volumes. Out of the 6 six states that have announced budgets, only Bihar and J&K hiked the VAT. There seems little incentive to increase VAT beyond 20% as differential taxes promote cigarette smuggling from neighboring states. However we expect another 100-150bp increase in the VAT rate (currently 18.5%).


ITC's price increases are ahead of hikes in duty and taxes: Increases in excise duty has a cascading impact on taxes as VAT is imposed at post-excise cigarette rates. We estimate that ITC needs to increase cigarette prices by 2.3% for every 5% increase in excise duty to maintain realizations/stick. The price increase required to neutralize the impact of a 1% VAT rate increase is ~0.8%. ITC has been hiking prices at a rate higher than the increase in duties and taxes. We note that excise duty declined from 55% of sales in FY06 to 44.5% in FY12.


ITC's cigarette segment's EBIT grew 15% even during bad times: ITC's cigarette segment posted 16.8% EBIT growth in FY11 and is expected to register ~20% growth in FY12. The company has been calibrating its price hikes and volume growth to grow its cigarette EBIT by 15% CAGR since 2003 due to its strong pricing power. It increased prices by ~6% in FY12 so far. We estimate the cigarette business to register 15.2% EBIT CAGR post FY12. A lower-than-expected hike in excise duty and higher volume growth could result in higher growth.


Non-cigarette segments' EBIT up 26% in 9MFY12; outlook positive: We expect non-cigarette EBIT to grow at 20% over FY12-14 led by (1) gradual reduction in the FMCG losses, (2) 14% EBIT CAGR in paperboard led by capacity expansion, (3) recovery in hotels, and (4) 15% EBIT CAGR in Agri business led by gains from new leaf tobacco facility in Mysore. We estimate 17% PAT CAGR over FY12-14. The stock trades at 22.5x FY13E EPS of INR9.2 and 19.2x FY14E EPS of INR10.8. Buy.


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