Tobacco: Excise Hike Will Be An Opportunity To Buy "Battleships"

November 24, 2011
Tobacco
THEMATIC
Excise hike will be an opportunity to buy Battleships

As is the norm in India, in the run-up to the budget, excise hike worries linger over tobacco stocks. Our analysis shows that whilst an excise hike may have negative newsflow based effects on the stocks, their earnings should hold up in the face of such hikes. We are BUYers in ITC and VST and believe that excise related newsflow may give better entry levels. Both ITC and VST are on Ambits Good & Clean 3.0: Battleships list.
Expect 15% excise hike for cigarettes: Excise hikes on tobacco have a long term relationship with the wholesale price index (WPI). This relationship points to a 15% excise hike for tobacco in FY13. Our analysis suggests that cigarette volumes are unlikely to decline in FY13 even if such an excise hike was implemented by the Government. However, in the new segment 59mm filters introduced in the FY10 budget, we do not see strong volume growth even in FY13, unless excise is reduced from Re0.69/stick to Re0.30/stick. Hike expected soon does it make a difference? Just three months before the Union Budget is presented in February 2012, an interim excise hike on tobacco may not seem obvious especially when such a hike is unprecedented. However, industry sources have, for some time, believed in the likelihood of such a hike. Moreover, this month ITC has taken an average 4% price hike on its portfolio by moving its key brands (Capstan, Scissors, Berkeley, Wills Flake Filter) from `25 to `28-`30 for a pack of 10 sticks. These price hikes are likely in anticipation of an excise hike. In this note we analyse two scenarios a 15% excise hike: (a) effective December 1, 2011; and (b) effective March 1, 2012. Our analysis suggests that in both the scenarios, earnings estimates of ITC and VST will be unaffected.
Exhibit 1: No impact on EPS if excise hike is effected pre or post budget
Scenario a hike effective Mar 1 EPS (in `) ITC VST FY12E 8.0 85.2 FY13E 9.9 96.9 Scenario b hike effective Dec1 FY12E 8.0 85.2 FY13E 9.9 97.0
Analyst contacts
Anand Mour
Tel: +91 22 3043 3169 anandmour@ambitcapital.com
Shariq Merchant
Tel: +91 22 3043 3246 shariqmerchant@ambitcapital.com
ITC Limited
CMP: Target Price (1 Year): Previous TP: Upside/Downside (%) EPS (FY13E): Variance from consensus (%):
BUY
`193 `239
`220
24% `9.9 9%
Stock Information
Mkt Cap: 52-wk H/L: 3M Adv: Beta: `1,503bn/US$28.7bn `216/148 `1,561mn/US$30mn 0.8
VST Industries
CMP: Target Price (1 Year): Previous TP: Upside/Downside (%): EPS (FY13): Variance from consensus (%):
BUY
`1,100 `1,505 NA 37% `96.9 NA
Source: Ambit Capital research, Company
Japan Tobacco (JTI)s exit is a small positive for ITC and VST. Since September 2011 JTI has stopped manufacturing in India and has exited the Indian cigarette industry. JTIs product had an annual volume of about 250mn sticks (priced at `25 for a pack of 10 sticks) and was sold in Kerala. Hence both VST and ITC will stand to gain. We are BUYers of ITC and VST. We expect ITCs earnings to grow at a CAGR of 24% over FY11-FY13, with cigarettes EBIT CAGR of 19%. Further, we believe the FMCG business will breakeven by 4QFY13, driven by profitability in the foods portfolio. We raise our valuation from `220 to `239. We expect VST to report earnings CAGR of 26% over FY11-FY13E, driven by cigarettes volume CAGR of 7% and realization CAGR of 9% over the same period. Despite being a smaller player, VSTs strength is its competitive position in the entry level 69mm (regular size filters, RSFT) segment. We initiate on VST with a DCF valuation of `1,505 (37% upside, 15.5x FY13 earnings relative to a 5year average of 8.8x earnings).
Stock Information
Mkt cap: 52-wk H/L: 3M ADV: Beta: `17bn/US$325mn `1,484/569 `38bn/US$0.7mn 0.6
Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
Please refer to disclaimer section on the last page for further important disclaimer.
Tobacco
CONTENTS
SECTOR
A 15% excise hike on cigarettes..................................................... 3 Structural changes in excise structure impact volumes.................. 4 Does an excise hike make a difference? ....................................... 6 Porter analysis ............................................................................. 10 Relative valuation ........................................................................ 11
COMPANIES
ITC Limited ................................................................................... 13 VST Industries .............................................................................. 27
Ambit Capital Pvt Ltd
Tobacco
A 15% excise hike on cigarettes

History suggests a strong relationship between the wholesale price index (WPI) and the excise hike on cigarettes in India (87% correlation over the last 15 years as shown in exhibit 1). Using this relationship and assuming 9% WPI for FY12 and 7% for FY13 (as 2011-12 YTD inflation is 9.6%, and last 3 years average inflation was 7%) indicates a 15% excise hike for cigarettes in FY13.
Exhibit 1: Specific excise duty on cigarettes adjusts for inflation over a multi-year period
FY94-FY97 WPI Excise hike 8.4% 8.7% FY97-FY01 5.2% 6.5% FY01-05 4.7% 3.7% FY05-FY09 5.7% 4.9% FY09-FY13E 7.3% 7.6%
Source: Ambit Capital research, Industry
Inflation-adjustment of taxation on cigarettes is a global phenomenon. The paper The Economics of Tobacco and Tobacco Taxation in India (M Govinda Rao, Rijo John, R Kavita Rao, James Moore, RS Deshpande, Jhumur Sengupta, Sakthivel Selvaraj, Frank Chaloupka and Prabhat Jha, March, 2010) points out While both specific and ad valorem taxes have been periodically raised, there is no annual systematic inflation-adjusted increase built into the process. Without an inflation-adjusted increase to specific tobacco taxes, some or all tobacco products will become relatively cheaper from year to the next.
Exhibit 2: Trend of specific excise duty on cigarettes and WPI in India
350 300 250 200 150 100 FY94 FY96 FY98 FY00 FY02 FY04 FY06 FY08 FY10 FY12E WPI Indexed Excise Indexed
Source: Industry, Ambit Capital research, Note: FY94=100 (indexed for WPI and specific excise duty on cigarettes).
Whilst our analysis points towards a 15% hike in excise, what it cannot tell us is when this hike will come in the February 2012 Union Budget or before that? Cigarette industry sources believe that the latter possibility is more likely.
Tobacco
Structural changes in excise structure impact volumes

Exhibit 3: Plains volume has moved to micros
3,000
Volume (mn/month)
Exhibit 4: Wills Navy Cut saw volume loss to Wills Flake

1000 800 600 400 200 0 FY91 FY95 FY99 Wills Navy Cut (LHS) Wills Flake Filter (RHS)
800 700 600 500 400 300 200 100 0 FY03
Volume (mn/month)
2,500 2,000 1,500 1,000 500 0 Plains FY95 FY08 Micros
Source: Ambit Capital research, Industry. Plains = 69mm non filter cigarettes, Micros = 59mm non filter cigarettes.
Empirical evidence suggests there is risk of downtrading from the 69mm segment (82% of industry volume) to the 59mm segment if excise is reduced on 59mm from Re0.69 a stick to Re0.30 a stick.
In FY94, excise on the 59mm non-filters (micros) segment was reduced by 50%. Between FY95 and FY08, micros volume grew at 9% CAGR while 69mm non-filters (plains) volume declined at 5% CAGR. Similarly, Wills Flake Filter in the 69mm segment has seen growth since FY98 coinciding with a decline in volume in Wills Navy Cut in the 74mm segment.
Exhibit 5: The 59mm segment has not found takers so far

0.28% 0.26% 0.24% 0.22% 0.20% 0.18% 0.16% 0.14% 0.12% 0.10% Volume contribution of 59mm segment to industry
Q1FY11
Q2FY11
Q3FY11 Q4FY11 % of industry
Q1FY12
Q2FY12
A new segment 59mm filters was introduced in FY11 in the wake of industrys demand (rejected by the Government) for an excise slab for a Re1 entry level cigarette (as non-filter cigarettes were made unviable due to the 142%-388% excise hikes in FY09). However, this new 59mm filters segment has not garnered volumes as:
With a retail price of `1.50, this segment generates just 23% gross margins compared with the 36%+ margins for other segments for ITC; and Consumers do not find the proposition attractive enough to downtrade from higher price points.
Tobacco Hence the cigarette industry continues to demand a viable Re1 entry level cigarette. We do not see any reason for the Government to accept this demand now. However, it is likely that the specific duty on the 59mm segment is retained at Re0.69 per stick. Even then, we do not see the 59mm segment finding takers, as the lowest viable price point will be `1.75 per stick, assuming 36% gross margin contribution (which is ITCs minimum margin in its other segments).
Exhibit 6: Margin profile of each segment for the Indian cigarette companies
Segment 59mm 69mm Premium 69mm MKFT KSFT
MRP per pack of 10 sticks (`) 15 25 38 44 49
Typical gross margin% 23 36 58 46 37
Moreover, the risk of cannibalization from the 69mm to the 59mm segment means that companies will have to generate 40% higher sales of 59mm stock to compensate for the loss of sales in the 69mm segment to match absolute margins. This is a daunting task. For this reason, we do not see the 59mm segment becoming a significant segment even in FY13, and hence we see no big risk in the shape of the demand structure for the cigarettes industry.
Tobacco
Does an excise hike make a difference?

The Union Budget for FY2011 did not hike the excise rates for tobacco products. The existing excise structure for cigarettes in India is along the lines of exhibit 7.
Exhibit 7: Current excise structure on cigarettes
Segments Kings Mini Kings RSFT Plains Micros Bingo Filters
Source: Ambit Capital research
Excise/1,000 sticks (in `) 2,018 1,517 998 1,517 689 689
Size 84mm 74mm 69mm 69mm 59mm 59mm
Type Filters Filters Filters Non filters Non filters Filters
However, with the Government facing growing fiscal pressure, the cigarette industry is too soft a target for the Government to ignore in the coming budget. Moreover, there is a growing body of opinion in the cigarette industry that the excise hikes may actually be implemented before the Union Budget on February 28, 2012.
Exhibit 8: Specific excise levy hikes on cigarettes imposed in previous Union Budgets
Segment Kings Mini Kings RSFT Bingo Filters Plains Micros Filter/Non -filter Filters Filters Filters Filters Non-Filters Non-Filters Length 84mm 74mm 69mm 59mm 69mm 59mm 1% 1% 11% 11% 5% 5% 6% 6% 142% 388% 0% 0% 2004-05 1% 1% 1% 2005-06 11% 11% 11% 2006-07 5% 5% 5% 2007-08 6% 6% 6% 2008-09 0% 0% 0% 2009-10 0% 0% 0% 2010-11 20011-12 11% 11% 18% NEW 11% -18% 0% 0% 0% 0% 0% 0%
Source: Ambit Capital research, Industry, *2011-12: as of now
In November 2011, ITC took an average 4% price hike on its portfolio by moving its key brands (Capstan, Scissors, Berkeley, Wills Flake Filter) from `25 to the `28`29 range for a pack of 10 sticks. ITC appears to have implemented these price hikes in anticipation of an excise hike.
Exhibit 9: Recent price increases by ITC
Brand Scissors Berkeley Wills Flake Filter Capstan Navy Cut RSFT Average Portfolio Price Hike
Old MRP in `/ pack of 10 sticks 25 25 25 25 25
New MRP in `/ pack of 10 sticks 29 28 28 28 28
% price hike taken by ITC 16 12 12 12 12 4.00
As a result of these price hikes, ITCs presence in the `2.50 segment reduces from 35% of its portfolio to merely 2% of the portfolio. Only 5% of ITCs volume is now contributed by `1.50-`2.50 price point per stick. With ITCs price ladder moving up, `2.50 becomes a natural price point for VST Industries.
Tobacco
Exhibit 10: ITC's portfolio ladder
Price point per stick > ` 5.0 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 Segment KSFT KSFT MKFT Premium RSFT RSFT RSFT RSFT RSFT MSFT ITCs key brands post recent hike Classic, India Kings Gold Flake Kings Wills Navy Cut Gold Flake Filter, Gold Flake Premium NA Bristol, Scissors, Capstan, Berkeley, Wills Flake Filter, Wills Flake Premium Flake Excel Ft Silk Cut Flake Standard
Considering the uncertainty regarding the timing of excise hikes, we look at two scenarios in this note:
A 15% excise hike effective December 1, 2011; A 15% excise hike effective March 1, 2012.
Impact of excise hikes on ITCs portfolio

Exhibit 11: If excise hike of 15% is effective Mar 1, 2012
ITC cigarettes Volume change Price change EBIT growth EBIT margin ITC's EPS (in `)
Exhibit 12: If excise hike of 15% is effective Dec 1, 2011

ITC cigarettes Volume change Price change EBIT growth EBIT margin ITCs EPS (in `)
FY12 6.0% 5.5% 19.8% 31.2% 8.0
FY13 1.0% 14.0% 17.9% 31.9% 9.9
FY12 4.7% 8.3% 20.9% 31.0% 8.0
FY13 4.5% 12.0% 17.2% 31.1% 9.9
Our analysis suggests ITCs EPS of `8.0 for FY12 and `9.9 for FY13 will not be impacted whether the excise hike is taken in December 2011 or in February 2012:
ITC has already taken a 4% price hike in November 2011 on the popular RSFT (69mm) brands, which are relatively price elastic. Thus, any impact on volume decline is going to be visible over the next six months irrespective of the excise hike. ITC will take price increases on its other brands gradually in case of interim excise hike, immediately post the excise hikes in order to pass on the increased tax burden, thereby negating any impact on the earnings.
We highlight the sensitivity of price-volume matrix on ITCs cigarettes EBIT growth:
Tobacco
Exhibit 13: Sensitivity of price-volume matrix on ITC's FY13 cigarettes EBIT (assuming excise hike from Mar1, 2012)
ITC cigarettes % EBIT growth 10.0 10.4 10.8 11.2 Price change (FY13 v/s FY12) 11.6 12.0 12.4 12.8 13.2 13.5 13.9 14.3 14.7 15.1 15.5 15.9 16.3 16.7
Volume change in % (FY13 v/s FY12) -4.6 (6) (5) (3) (2) (1) 0 1 3 4 5 6 7 9 10 11 12 13 15 -3.5 (4) (2) (1) 0 1 2 4 5 6 7 8 10 11 12 13 15 16 17 -2.3 (1) 0 1 2 3 5 6 7 8 10 11 12 13 15 16 17 18 19 -1.2 1 2 3 4 6 7 8 9 11 12 13 14 16 17 18 19 21 22 0.0 3 4 5 7 8 9 11 12 13 14 16 17 18 19 21 22 23 24 1.2 5 6 8 9 10 12 13 14 15 17 18 19 20 22 23 24 26 27 2.3 7 9 10 11 13 14 15 16 18 19 20 22 23 24 25 27 28 29 3.5 10 11 12 14 15 16 17 19 20 21 23 24 25 27 28 29 30 32 4.6 12 13 14 16 17 18 20 21 22 24 25 26 28 29 30 32 33 34 5.8 14 15 17 18 19 21 22 23 25 26 27 29 30 31 33 34 35 37
The above table highlights:
A price hike has a higher impact on EBIT growth than volume growth: A 1% price hike swings EBIT growth by 3%, whereas a 1% volume growth swings EBIT growth by 2% We expect ITC to take a 14% price hike in FY13 and garner 1% volume growth to achieve 18% EBIT growth in cigarettes. Higher pricing actions will be upside risks to our estimates.
Impact of excise hikes on VSTs portfolio

Exhibit 14: If excise hike of 15% is effective Mar 1, 2012
VST Volume change Price change EBIT growth EBIT margin VST's EPS (in `)
Exhibit 15: If excise hike of 15% is effective Dec 1, 2011

VST Volume change Price change EBIT growth EBIT margin VST's EPS (in `)
FY12 10.5% 4.0% 54.0% 11.1% 85.2
FY13 4.0% 14.0% 15.0% 10.9% 96.9
FY12 8.0% 7.5% 54.0% 11.0% 85.2
FY13 6% 10.5% 15.0% 10.9% 97.0
Our analysis suggests VSTs EPS of `85.2 for FY12 and `96.9 for FY13 will not be impacted whether the excise hike is taken in December 2011 or in February 2012. In fact, with ITC taking price hikes on its `2.50 price point segment, VST is in a position to take 25% price hikes on 78% of its volume portfolio. Thus, any excise hike by the Government will see an immediate price increase by VSTs portfolio to negate the impact of the excise burden. We highlight the sensitivity of price-volume matrix on VSTs EPS:
Tobacco
Exhibit 16: Upside/downside risks to VSTs FY13 EPS (assuming an excise hike effective March 1, 2012)
VSTs EPS growth (%) Price change (FY13 v/s FY12) 11.4 12.0 12.6 13.3 13.9 14.5 15.2 15.8 16.5 17.1 Volume (FY13 v/s FY12) in % (2.7) (19) (14) (9) (4) 1 7 12 17 22 27 (0.4) (15) (10) (5) 1 6 11 16 22 27 32 1.8 (11) (6) 0 5 10 16 21 26 32 37 4.0 (7) (2) 4 9 15 20 26 31 36 42 6.2 (3) 2 8 13 19 25 30 36 41 47 8.4 1 6 12 18 23 29 35 40 46 52 10.7 5 10 16 22 28 34 39 45 51 57 12.9 8 14 20 26 32 38 44 50 56 62 15.1 12 18 24 30 37 43 49 55 61 67 17.3 16 22 29 35 41 47 53 59 66 72
The above table highlights:
Price hike has a much higher impact on EBIT growth than volume growth: A 1% price hike swings EBIT growth by 7.5% whereas a 1% volume growth swings EBIT growth by 2% We expect VST to take a 14% price hike and garner 4% volume growth to achieve 14% EPS growth in FY13. However, higher pricing actions will be upside risks to our estimates as the company has room to take about 20% price hikes (78% of its volume comes from the `2 price point, which can move to `2.5 price point without facing any significant competitive risks)
Japan Tobacco (JTI)s exit is small positive for ITC and VST
Since September 2011, JTI has stopped manufacturing in India and has exited the Indian cigarette industry. JTIs product, primarily Gold Coast Filter, with an annual volume of about 250mn sticks (priced at `25 for a pack of 10 sticks) was sold in Kerala. Hence both VST and ITC (through their brands Moments and Duke respectively) will stand to gain in Kerala.
Tobacco
Porter analysis
Exhibit 17: Porter analysis of the Indian cigarettes industry
Bargaining power of suppliers

LOW
Bargaining power of buyers

LOW
Tobacco is the key raw material, which is procured locally by auction. Tobacco prices are influenced by global demand and supply Tobacco is processed and stored for a year, so does not cause volatility to companys margins.
The addictive power of the product gives the manufacturers obvious pricing power. Furthermore, consumers tend to be loyal to their favourite brands Volume growth can see some impact if price hikes are steep and come relatively frequently
Competitive intensity
MEDIUM
ITC dominates the Indian cigarettes industry with ~78% volume market share Entry of Marlboro through Godfrey Phillips distribution created some competitive ripples in the market, but has stabilized for now
Barriers to entry
HIGH
Threat of substitution
MEDIUM
FDI in tobacco manufacturing is banned in India. As advertisement of cigarettes is banned in India, it acts as a barrier for new brands before they become successful A licence for additional cigarette manufacturing capacity has not been granted by the Government for more than five years.
Only 15% of tobacco consumed in India is in the form of cigarettes Chewing tobacco has seen growth of 15%-20% CAGR over last 20 years. However, with the ban on plastic packaging, the risk from chewing tobacco is reducing. For lower priced cigarettes, beedi is a viable substitute
Improving
Unchanged
Deteriorating
10
Tobacco
Relative valuation
Relative valuation
Price Mcap Div Sales yield CAGR (%) (%) FY11 (FY11-13) EV/sales FY12 FY13 EBITDA CAGR (%) (FY11-13) EV/EBITDA FY12 EPS CAGR (%) P/E FY12 FY13
(Local (US$bn) Currency) Indian companies ITC VST Industries HUL Nestle Mean Median International companies Imperial Tobacco British American Tobacco Philip Morris Altria Group Japan Tobacco Mean Median 2,287 2,923 72 28 375,500 36.4 90.8 125.2 56.6 48.8 193 1,101 390 4352 29.8 0.3 16.2 8.1
FY13 (FY11-13)
2.3 4.1 1.8 1.4 2.4 2.0 4.2 4.1 3.7 5.6 2.1 3.9 4.1
17.3 13.5 16.0 22.2 17.3 16.7 -26.3 5.1 7.4 0.8 1.3 -2.4 1.3
5.9 2.5 3.6 5.6 4.5 4.6 3.8 4.2 4.1 3.9 1.7 3.5 3.9
5.0 2.1 3.1 4.6 3.8 3.9 3.7 4.0 4.0 3.8 1.7 3.4 3.8
23.2 29.3 21.7 27.6 25.4 25.4 4.1 6.4 10.8 6.9 11.4 7.9 6.9
16.5 8.5 25.3 28.1 21.1 23.7 9.2 11.1 9.8 9.5 7.6 9.4 9.5
13.3 6.9 20.7 21.4 16.8 19.4 8.8 10.4 9.4 9.0 6.9 8.9 9.0
23.8 25.5 20.9 25.1 23.8 24.5 22.6 21.3 16.1 7.4 35.0 20.5 21.3
24.1 12.9 33.6 42.7 28.6 29.2 11.1 15.1 14.9 13.5 18.0 14.5 14.9
19.6 11.4 27.8 32.7 23.1 24.0 10.2 13.7
12.6 14.3 12.9 13.7
Note: For December year ending companies, FY12 and FY13 pertain to CY11 and CY12 respectively; Source: Bloomberg, Ambit Capital research
ITC is trading at 19.6x FY13 earnings, a 15% discount to its peer group Indian FMCG companies, despite having comparable 24% EPS CAGR over FY11-FY13. Considering ITCs strong growth trajectory and dominant position in the cigarette industry, we believe this is not justified. VST is trading at 11.4x FY13 earnings, a 51% discount to its Indian FMCG companies despite having higher EPS CAGR of 26% over FY11-FY13. Considering its improving earnings trajectory, the new-found competitive advantage of leading in the entry level cigarettes segment, we believe the discount will narrow down.
Exhibit 18: Cross cycle P/E bands for ITC

300 250 200 150 100 50 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11
Exhibit 19: Cross cycle P/E bands for VST

1,600 15x Price 10x
30x 25x 20x 15x
1,400 1,200 1,000 800 600 400
5x
Price
200 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11
11
Tobacco
ITC has traded at a median multiple of 22x one-year forward earnings since April 2006. Given 24% earnings CAGR expected over FY11-FY13 and that the FMCG business appears likely to breakeven in 4QFY13, the stock is likely to rerate. VST has traded at a median multiple of 9x one-year forward earnings since April 2006. Given 26% earnings CAGR expected over FY11-FY13 and its competitive dominance in the entry level cigarettes, this stock too is likely to rerate.
Exhibit 20: Cross cycle EV/EBITDA for ITC
250 200 150 100 50 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11
Exhibit 21: Cross cycle EV/EBITDA for VST

20x
1500 1300 10x
15x 10x 8x
1100 900 700 500
Price
7x 5x 3x
Price
300 100 Apr-06
Apr-07
Apr-08
Apr-09
Apr-10
Apr-11
12
Consumer Goods
November 24, 2011
ITC
Bloomberg: ITC IN EQUITY Reuters: ITC.NS
BUY
Accounting: GREEN Predictability : GREEN Earnings Momentum: GREEN UPDATE

Anand Mour
Tel: +9122 3043 3169 anandmour@ambitcapital.com
Armour plated protection

We do not see the forthcoming excise hike impacting ITCs earnings. Despite factoring in an excise hike of 15%, we expect ITCs cigarettes PBIT to grow at 19% CAGR during FY11-FY13. We remain BUYers with a revised target price of `239 (previous TP `220). Cigarettes FY11-FY13 EBIT CAGR of 19%: ITCs cigarettes EBIT grew at a CAGR of 14% between FY02-FY09 and at 17% CAGR between FY09-FY11. We expect this CAGR to rise to 19% over FY11-FY13, driven by 3.5% volume CAGR (FY09-FY11 was 2%) and 10% realization CAGR (FY09-FY11 was 12%). Expect FY11-FY13 cigarette volume CAGR of 3.5%: 1HFY12 saw about 8% volume growth (versus 2% from FY00-FY11), with the King Size Filter (KSFT) segment growing at above 30%. We expect cigarette volumes to grow at 3.5% CAGR between FY11-FY13, driven by faster growth in: (a) less price sensitive king size brands (15% of ITCs volumes); and (b) premium Regular Size Filter (RSFT) brands (29% of ITCs volumes). The rise in growth of the less price sensitive segments will be driven by a broader shift in the B2C space where across the market we see sales of premium products grow at an accelerating rate as demographics and urbanization ally with rising incomes to push aspirational consumption. This trend is supported by the narrowing price differential of KSFT and premium RSFT brands compared with popular RSFT brands (51% of ITCs volumes): Price gap of KSFT brands to popular RSFT brands narrowed from 2.29x in FY91 to 1.85x in FY12, and is expected to reduce to 1.75x in FY13. Price gap of premium RSFT to popular RSFT brands narrowed from 1.52x in FY91 to 1.45x in FY12 and is expected to reduce to 1.40x in FY13.
Shariq Merchant
Tel: +91 22 3043 3246 shariqmerchant@ambitcapital.com
Recommendation
CMP: Target Price (12 months): Previous TP: Upside (%) EPS (FY13E): Change from previous (%) Variance from consensus FY13 (%) `192 `239
`220
24 `9.9 8 9
Stock Information
Mkt cap: 52-wk H/L: 3M ADV: Beta: BSE Sensex: Nifty: `1,503bn/US$2,8734mn `216/148 `1,561mn/US$29.8mn 0.8 15,700 4,706
Stock Performance (%)

1M Absolute Rel. to Sensex -5.2 1.2 3M -4.9 -0.0 12M 13.0 33.3 YTD 11.6 35.1
Expect FY11-FY13 average realization CAGR of 10%: We expect the realization CAGR of 8% over FY00-FY11 to be sustained as: (a) The Government is likely to keep hiking excise rates to deal with the weakened fiscal position; (historically, ITCs prices have grown broadly in line with excise hikes); (b) On its mass segment brands (eg. Wills Flake Filter, Scissors Ft, Berkeley Ft and Capstan Ft), ITC raised prices by 12%-16% in November 2011. We expect the firm to do the same for its premium brands (Gold Flake Kings, Gold Flake Premium etc). Valuation: We expect FY11-FY13 EPS CAGR of 24% (FY00-FY11 EPS CAGR of 18%) driven by EBIT CAGR rising to 19% (FY02-FY11 EBIT CAGR of 15%). Furthermore, we expect the FMCG segment to report losses of `1,171mn in FY13 and breakeven in 4QFY13. Assuming WACC of 12.6% and terminal growth of 4%, our DCF model values the stock at `239, implying 24x FY13 EPS (5-yr average multiple is 22x).
Exhibit 1: Key financials (` mn)
Year to January Operating income (` mn) EBITDA (` mn) Adjusted PAT (` mn) Adjusted EPS (`) RoE (%) P/E (x) EV/EBITDA (x)
Source: Company, Ambit Capital research
Performance (%)
25,000 20,000 15,000 10,000
Sensex ITC
250 200 150 100
Nov-10 Mar-11 Jul-11 Nov-11
1-year P/E or EV/EBITDA

31 27 23 19 15 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11 ITC 1 Year Fwd PE
FY09 FY10 FY11 FY12E FY13E 156,119 181,532 211,676 248,954 291,160 48,585 60,740 71,534 88,661 108,547 32,636 40,610 49,876 61,979 76,468 4.2 5.2 6.4 8.0 9.9 25.3 29.2 33.2 35.7 37.4 45.8 36.8 30.0 24.1 19.6 25.4 20.0 17.2 14.4 11.9
PE
Median
Source: Bloomberg, Ambit Capital research
Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.
Please refer to the Disclaimers at the end of this Report.
ITC
Company Financial Snapshot

Profit and Loss (` mn)
Net sales Optg. Exp(Adj for OI.) EBIDTA Depreciation Interest Expense PBT Tax Adj. PAT Profit and Loss Ratios EBIDTA Margin % Adj Net Margin % P/E (X) EV/EBIDTA (X) Dividend Yield (%) FY11 211,676 131,953 79,723 6,560 481 72,682 22,806 49,876 33.8 23.6 30.0 20.6 2.3% FY12E 248,954 151,658 97,295 6,880 461 89,954 27,976 61,979 35.6 24.9 24.1 16.5 2.0% FY13E 291,160 172,426 118,733 7,313 436 110,984 34,516 76,468 37.3 26.3 19.6 13.3 2.4%
Company Background
Incorporated in 1910, ITC is the largest cigarette player in India with about 78% volume market share and 87% value market share. Whilst cigarettes account for 59% of the companys gross revenues, the company has successfully diversified to other FMCG (13% of revenues), agri business (14% of revenues), hotels (3% of revenues) and paperboards (11% of revenues). British American Tobacco (BAT) owns over 31% stake in the company. The company is professionally managed and headquarted in Kolkata.
Balance Sheet (consolidated) (` mn)

Total Assets Net Fixed Assets Current Assets Other Assets Total Liabilities Networth Debt Current Liabilities Deferred Tax Balance Sheet Ratios ROE % ROCE % Net Debt/Equity Equity/Total Assets P/BV (X) FY11 254,172 96,785 101,840 55,547 254,172 159,533 992 85,628 8,019 33.2 31.6 0.0 0.9 10.0 FY12E 295,413 102,860 127,006 65,547 295,413 187,341 992 98,971 8,108 35.7 34.1 0.0 1.0 8.6 FY13E 345,303 108,776 160,980 75,547 345,303 221,651 992 114,440 8,219 37.4 35.9 0.0 1.0 7.2
Cash Flow (consolidated) (` mn)

PBT Depreciation Tax Change in Wkg Cap Others CF from Operations Capex Investments CF from Investing Debt Dividends Others CF from Financing Change in Cash FY11 72,682 6,560 22,806 (4,254) 168 52,351 (11,831) 1,722 (10,109) (85) (40,015) 9,028 (31,072) 11,170 FY12E 89,954 6,880 27,976 830 90 69,778 (12,955) (10,000) (22,955) (34,170) (34,170) 12,653 FY13E 110,984 7,313 34,516 1,690 111 85,582 (13,230) (10,000) (23,230) (42,158) (0) (42,158) 20,194
Segmentwise PBIT breakdown for ITC (FY11)

Paperboards, Paper & Packaging, Agri 12 Business, 8 Hotels, 4 FMCG, -4
Cigarettes EBIT margin trajectory

35% 30% 25% 20% 15% 10%
Cigarettes, 81
Cigarettes EBIT Margin trajectory
5% 0% FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11
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ITC
Cigarettes PBIT to grow at 18%-19% CAGR trajectory

Exhibit 1: Cigarettes PBIT growth trajectory inching up
20% 17% 14% 11% 8% 5% 2% -1% FY03 FY05 FY07 FY09 FY11 Cigarettes PBIT Growth (YoY)
Exhibit 2: Cigarettes PBIT margin growing consistently

35% 30% 25% 20% 15% 10% 5% 0% FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11
Cigarettes EBIT Margin trajectory
Even under either scenario of a 15% excise hike occurring effective December 1, 2011 or March 1, 2012, we foresee ITCs cigarettes PBIT maintaining its growth trajectory of 19% over FY11-FY13. While cigarettes PBIT margin has moved up from 21.1% in FY02 to 29.1% in FY11, we expect it to expand further to 31%-32% in FY13. 19% CAGR growth in cigarettes PBIT is to be driven by: 3.5% volume CAGR (FY09-FY11 was 2%); and 10% average realization CAGR (FY09-FY11 was 12%).
Expect FY11-FY13 cigarette volume CAGR of 3.5% The company has seen volume CAGR of around 2% over FY00-FY11. However, in 1HFY12, the company has seen about ~8% volume growth with the kingsize segment (KSFT) volume growing above 30%. Going forward we expect the cigarette volumes to grow at a 3.5% volume CAGR between FY11-FY13. This uplift in volume growth is likely to be driven by faster growth in: (a) less price sensitive king size brands (account for 15% of ITCs volumes); and (b) premium RSFT brands (account for 29% of ITCs volumes).
Exhibit 3: Cigarettes volume grew at 2% CAGR over FY00-FY11
10% 8% 6% 4% 2% 0% -2% FY01 -4% -6% -8% -10%
Source: Ambit Capital research, Industry, Company
Exhibit 4: Contribution of premium brands increased from 12% in FY91 to 44% in FY11
55% 45% 35% 25% Volume contribution to KSFT and Premium RSFT
Cigarette Volume Growth (YoY)
FY03
FY05
FY07
FY09
FY11E FY13E
15% 5% FY91 FY94 FY97 FY00 FY03 FY06 FY09 FY12 KSFT and Premium RSFT
Source: Ambit Capital research, Industry, Company
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ITC
Aggregate volume of premium portfolio KSFT brands (Gold Flake Kings, Classic etc.) and premium RSFT brands (Gold Flake Filter, Gold Flake Premium) have grown at 9% CAGR over the last 21 years. Their contribution has increased from 12% in FY91 to 44% in FY11. This trend in growth of premium brands is driven by: Concerted focus of ITC to premiumise its portfolio to improve margins. Consumers preference for these premium brands. Price gap of the KSFT brands to the popular RSFT brands narrowing from 2.29x in FY91 to 1.85x in FY12, and is further expected to reduce to 1.75x in FY13. Price gap of the premium RSFT brands to the popular RSFT brands narrowing from 1.52x in FY91 to 1.45x in FY12, and is further expected to reduce to 1.40x in FY13.
We expect the trend to continue and on a conservative basis, expect the volume of premium brands to grow by 7.5% CAGR over FY11-FY13. In the remaining portfolio, which is the largely popular RSFT segment (i.e. the midpriced RSFT segment which accounts for 51% of ITCs volumes), we expect volume to grow at 0.4% CAGR over FY11-FY13. ITCs non premium portfolio that includes non filters (now less than 1% of the total portfolio as the 142%-388% excise hikes in FY09 made non-filters unattractive for consumers), has grown at 0.4%-0.6% CAGR over the last 21 years. Owing to migration of non-filter smokers to the popular RSFT, ITCs mid-priced RSFT brands grew by more than 45% in FY09, but the growth has slowed down to 0.4% CAGR in the last 2 years as the entry level RSFT (dominated by VST as gross margins are very low at 20% compared to ITCs benchmark margin of 36% across segments) is witnessing strong growth. In 1HFY12, VSTs volume grew at 10%.
Expect FY11-FY13 average realisation CAGR of 10% The company has seen realisation CAGR of around 8% over FY00-FY11. Ahead, we expect this realization CAGR to be broadly sustained as: (a) The Government is likely to keep pumping up excise rates to deal with its weakened fiscal position; historically, ITCs prices have grown broadly in line with excise hikes.
Exhibit 5: ITCs average realization hike has generally exceeded the excise hike
18% 16% 14% 12% 10% 8% 6% 4% 2% 0% FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 ITC's average realisation hike Specific duty excise hike FY11
Source: Company, Ambit Capital research, Industry
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ITC
The above chart highlights ITCs average realisation hike has always been higher than the weighted average excise hike for the company: In FY06, the average realization hike was at 4%, compared with the 10% excise hike as the average ad valorem local taxes during that year was reduced from 5.5% to 2.9%. In FY09, average realization increased by 13% despite the excise hike on the filters segment, due to premiumisation as contribution of the lower-priced non filters declined from 18% to less than 1%.
We expect ITC to take an average realisation CAGR of 10% over FY11-FY13. ITC has taken 12%-16% price hikes on its less expensive brands (eg. Wills Flake Filter, Scissors Ft, Berkeley Ft and Capstan Ft) in November 2011. We expect 10% average price hike on its KSFT brands (Gold Flake Kings, Gold Flake Premium etc.), 13% average price hike on its premium RSFT brands (Gold Flake Filter, Gold Flake Premium), 11% price hike on its minikings brand, Wills Navy Cut and 16% average price hike on its other RSFT brands portfolio (Bristol, Silk Cut, Navy Cut RSFT, Wills Flake Premium etc.)
Exhibit 7: Further price hike potential for ITC
Segment KSFT Minikings Premium RSFT Other RSFT Weighted average price hike in FY13 expected Price hike % Contribution expected to volume 10% 11% 13% 16% 14% 15% 5% 29% 51% 100%
Exhibit 6: Price hikes taken in November 2011 by ITC

Brand Scissors Berkeley Wills Flake Filter Capstan Navy Cut RSFT Average Portfolio Price Hike New MRP Old MRP in in `/pack `/pack of 10 sticks of 10 sticks 25 25 25 25 25 29 28 28 28 28 % Price hike taken 16% 12% 12% 12% 12% 4.00%
Source: Ambit Capital research, Company, Industry
FMCG to breakeven by 4QFY13

Exhibit 8: ITCs FMCG gets 63% of revenues from foods Exhibit 9: Expect FMCG to breakeven by 4QFY13
FMCG breakup (FY11),
0% FY04 FY06 FY08 FY10 FY12E -15% -30% -45% -60% -75% -90% PBIT (Rs mn) ROCE (%)
(1,000) (2,000) (3,000) (4,000)

Foods, 63%
Non Foods, 37%
(5,000) (6,000)
The Foods portfolio, which contributed 63% of ITCs other FMCG business has broken even in FY11. Revenues of ITCs foods portfolio has achieved scale its revenue of `28,941mn in FY11, was higher than similar revenues of GSK Consumer (`24,308mn in CY10) but lower than that of Nestle (`63,766mn in CY10).
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ITC
In each category of the foods portfolio, the company maintains a strong top three leadership positions. In the Noodles category, the newest category for the company, it has already achieved 10% market share (second only to Nestles Maggi). We, therefore, believe that the company need not spend significantly more than the competition on advertisement and promotion in its overall food category that is likely to make industry comparable margins. Discussions with various industry experts suggest that ITC can make 6% EBIT margin in its portfolio by FY13.
Exhibit 10: EBIT margins of other foods companies (FY11)
Company EBIT margin
Britannia GSK Consumer Nestle

5.7% 19.6% 18.3%
Exhibit 11: ITCs foods portfolio is well diversified

Portfolio Mix (FY11), Sunfeast, 39% Others, 27%
Exhibit 12: Foods portfolio to drive profitability of FMCG

Category FY13 EBIT margin
Biscuits Atta Wafers/confectionery/others Average foods portfolio
6% 5% 8% 6%
Aashirvaad, 34%
Source: Ambit Capital research, Company, Industry Biscuits comparable to Britannia (6%); confectionery comparable to Perfetti (6%); wafers comparable to Balaji Wafers Private limited (12.5%) discussed with industry experts for understanding typical margins in other categories
Of the remaining 37% of its other portfolios, ITCs personal care portfolio is a leading loss-maker due to the brand building spends. The company has already achieved 5% market share in the soaps and shampoos segment, according to industry experts. But the company has recently forayed into skin care. We expect the advertisement spends to moderate in the personal care categories. Conversation with trade channels suggests that ITCs trade spend has moderated over the past 12 months, with respect to soaps and shampoos. We expect the next categories wherein ITC is likely to enter to be the fast-growing deodorants, hand and body lotion, which are the high margin categories. With the foods portfolio achieving 6% EBIT margin and brand building spends in the non-foods portfolio moderating, we expect the FMCG segment to breakeven for ITC in 4QFY13.
Exhibit 13: FMCG business quarterly revenue and EBIT expectations
2,000 1,500 1,000 500 Q1FY11 Q3FY11 Q1FY12 Q3FY12 Q1FY13 Q3FY13 FMCG Revenue
20 (20) (40) (60) (80) (100) FMCG PBIT
18
ITC Exhibit 14: Key assumptions and estimates

ITC Profit and loss assumptions We expect cigarettes volume to continue to grow despite the likely price hike in FY13, driven by strong growth in 1.0 KSFT and premium RSFT brands. The company could see 3.5% volume CAGR over FY11-FY13. The company has always taken price hikes higher than 14.0 the realisation increase, with an intention to improve segment EBIT margins 15 We expect 15% increase in excise for FY13 291,160 17.0 185,474 With the company enjoying natural pricing power, the 63.7 company is able to increase gross margins with price increases that are higher than the excise hikes 108,547 37.3 Higher gross margins to result in higher EBITDA margins 31.1 Tax rate to remain around 31%-31.5% 76,468 26.3 76,468 FY10 FY11 FY12E FY13E Comments
Cigarettes volume growth (%,YoY)
7.2
(2.8)
6.0
Cigarettes realisation growth (%, YoY) Average excise growth (%, YoY) Net income (` mn) Net income growth (%, YoY) Gross profits (` mn) Gross margin (%) EBITDA EBITDA margin (%) Tax rate (%) Adjusted net profit (` mn) Net profit margin (%) Reported PAT (` mn) Balance sheet Capital expenditure (` mn) Average inventory days Average debtor days Average current liability days Average net working capital (excl. cash) Cash flow Cash flow from operations (` mn)
6.7 0 181,532 16.3 111,459 61.4 60,740 33.5 32.5 40,610 22.4 40,610
18.0 15 211,676 16.6 130,411 61.6 71,534 33.8 31.4 49,876 23.6 49,876
5.5 0 248,954 17.6 156,553 62.9 88,661 35.6 31.1 61,979 24.9 61,979
14,092 62 207 179 (21)
7,980 62 234 197 (11)
12,063 62 234 197 (10)
12,296 We are building in about `12bn capex every year 62 We expect inventory days to be maintained 233 We expect debtor days to be maintained 197 We expect the current liabilities days to be maintained (11)
80,601
52,351
69,778
With working capital days being broadly maintained, 85,582 operating cash flow growth will be strengthened by margin improvement Free cash flow generation to remain strong as strong 72,352 growth in CFO and moderate capex (`12bn) will drive FCF (36,279)
Free cash flow (` mn) Dividend payout (` mn) Source: Ambit Capital research
67,859 (38,182)
40,520 (34,435)
56,823 (29,405)
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Segmentwise analysis
Exhibit 15: Segmentwise breakup
Gross segmental sales FMCG - Cigarettes FY09 151,151 FY10 172,830 FY11 198,276 FY12E 221,646 FY13E 255,226 Assumptions Volume CAGRof 3.5% and average realisation CAGR of 10% to drive growth Foods portfolio contributing 63% of the portfolio expected to benefit from the packaged foods growth. Personal care products like soaps and shampoos is expected to drive its market share from 5% currently to 6% Growth to be driven by occuapancy. Expect addition of 600 rooms in 4QFY12. Expect agri to maintain growth driven by tobacco, coffee etc Expect value added paperboard segment to maintain growth at 18-20%.
FMCG - Others
30,140
36,417
44,824
53,655
64,288
Hotels Agri business Paperboards, Paper & Pkging Total YoY Gr (%) Gross seg sales FMCG - Cigarettes FMCG - Others Hotels Agri business Paperboards, Paper & Pkging Total PBIT FMCG - Cigarettes FMCG - Others Hotels Agri business Paperboards, Paper & Pkging Total PBIT margin (%) Cigarettes FMCG Hotels Agri Paperboards Total Source: Ambit Capital research
10,203 38,460 28,220 258,173
9,108 38,621 32,336 289,313
10,774 47,480 36,669 338,022
11,902 57,627 43,789 388,620
14,544 69,170 51,736 454,964
9.3% 20.0% -7.3% -0.6% 19.4% 9.1%
14.3% 20.8% -10.7% 0.4% 14.6% 12.1%
14.7% 23.1% 18.3% 22.9% 13.4% 16.8%
11.8% 19.7% 10.5% 21.4% 19.4% 15.0%
15.1% 19.8% 22.2% 20.0% 18.1% 17.1%
41,838 (4,835) 3,162 2,562 5,086 47,813
49,381 (3,495) 2,166 4,478 6,843 59,373
57,668 (2,976) 2,666 5,663 8,192 71,213
69,086 (2,280) 3,022 6,624 10,071 87,404
81,469 (1,171) 4,327 7,955 12,158 106,480
Margin improvement to be driven by increase in premium portfolio from 44% in FY11 to 47% in FY13 Portfolio mix improvement and foods portfolio to drive decline in FMCG losses Expect the hotels margins to continue to expand driven by higher revenue growth and cost optimisation Expects marins to marginally moderat from the highs of FY11 Mix improvement led by growth in value added products to drive the margin expansion
27.7% -16.0% 31.0% 6.7% 18.0% 18.5%
28.6% -9.6% 23.8% 11.6% 21.2% 20.5%
29.1% -6.6% 24.7% 11.9% 22.3% 21.1%
31.2% -4.3% 25.4% 11.5% 25.0% 22.5%
31.9% -1.8% 29.8% 11.5% 26.9% 23.4%
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ITC
Absolute valuation
Given the cash generative nature of the companys main business, we use a 3stage DCF for ITC: Stage 1 (FY13-15): revenue and PAT CAGR of 20% and 19% respectively. RoE moves from 38.2% in the beginning of the period to 39.4% at the end of the period. Stage 2 (FY16-20): revenue and PAT CAGR of 17% and 17% respectively. RoE moves from 39.5% in the beginning of the period to 39.8% at the end of it. Stage 3 (FY20 onwards): we use a perpetuity growth rate of 4%.
Our model discounts the companys free cash flows using a weighted average cost of capital (WACC) of 12.6%. With conservative assumptions around sales and earnings as highlighted in the note earlier, our model gives a valuation of `239 per share i.e. a 24% upside from the current level with cash profiles shown below. We have taken perpetuity growth of 4% for ITC, compared to 3% for VST, primarily as we believe other business of ITC will drive additional growth.
Exhibit 16: FCF v/s RoE profile
80000 70000 60000 50000 40000 30000 20000 10000 0 FY04 FY06 FY08 FY10 FY12E ROE Free Cash Flow to the firm 40% 38% 36% 34% 32% 30% 28% 26% 24% 22% 20%
Exhibit 17: FCF assumptions

PV of FCF for forecasting period (FY14-FY19) (` mn) Terminal value (` mn) Enterprise value (` mn) Less: net debt/ (cash) at 31st March 2012 (` mn) Implied equity value (` mn) Fully diluted equity shares (mn)
Implied equity value (`/share)
505,897 1,237,971 1,743,868 (99,640) 1,843,508 7,738

239
Scenario analysis
Exhibit 18: ITCs EPS scenario
FY13 Base Case Bull Case Bear Case
EPS (in `.) Cigarettes volume change (YoY) Cigarettes realisation hike (YoY) FMCG PBIT (` mn) DCF Valuation
9.88 1% 14% (1,171) 239
10.24 4% 14% 508 252
9.35 -4% 14% (1,843) 223
In our base case, we are building in 1% cigarettes volume growth in FY13 with 14% average realization hike and FMCG losses of `1,171mn. However, in our bear case, if the company is not able to sustain volume growth (4% volume decline), with FMCG losses also higher at `1,843mn, we estimate ITCs EPS at `9.35. Assuming the WACC of 12.6% and terminal growth of 4%, our DCF model suggests a value of `223. In our bull case, as we assume the volume trajectory to remain robust at 4%, and the FMCG business to report a profit of `508mn an EPS of `10.24 is likely. Assuming WACC of 12.6% and terminal growth of 4%, our DCF model suggests a value of `252.
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ITC
Relative valuation analysis

Exhibit 19: Relative valuation
Price Mcap Div yield % Sales CAGR % EV/SALES FY12 FY13 EBITDA CAGR (FY11-13) EV/EBITDA FY12 EPS CAGR % P/E FY12 FY13 (local (US$mn) currency) Indian companies ITC VST Industries HUL Nestle Mean Median International companies Imperial Tobacco British American Tobacco Philip Morris Altria Group Japan Tobacco Mean Median 2,287 2,923 72 28 375,500 36.4 90.8 125.2 56.6 48.8 4.2 4.1 3.7 5.6 2.1 3.9 4.1 -26.3 5.1 7.4 0.8 1.3 -2.4 1.3 3.8 4.2 4.1 3.9 1.7 3.5 3.9 3.7 4.0 4.0 3.8 1.7 3.4 3.8 4.1 6.4 10.8 6.9 11.4 7.9 6.9 9.2 11.1 9.8 9.5 7.6 9.4 9.5 8.8 10.4 9.4 9.0 6.9 8.9 9.0 22.6 21.3 16.1 7.4 35.0 20.5 21.3 11.1 15.1 14.9 13.5 18.0 14.5 14.9 12.6 14.3 12.9 13.7 10.2 13.7 193 1,101 390 4352 29.8 0.3 16.2 8.1 2.3 4.1 1.8 1.4 2.4 2.0 17.3 13.5 16.0 22.2 17.3 16.7 5.9 2.5 3.6 5.6 4.5 4.6 5.0 2.1 3.1 4.6 3.8 3.9 23.2 29.3 21.7 27.6 25.4 25.4 16.5 8.5 25.3 28.1 21.1 23.7 13.3 6.9 20.7 21.4 16.8 19.4 23.8 25.5 20.9 25.1 23.8 24.5 24.1 12.9 33.6 42.7 28.6 29.2 19.6 11.4 27.8 32.7 23.1 24.0 FY11 (FY11-13) FY13 (FY11-13)
Note: For December year ending companies, FY12 and FY13 pertain to CY11 and CY12 respectively; Source: Bloomberg, Ambit Capital research
ITC is trading at 19.6x FY13 earnings, 15% discount to its peer group Indian FMCG companies, despite having comparable 24% EPS CAGR over FY11-FY13. Considering ITCs strong growth trajectory and dominant position in the cigarette industry, we believe this discount is not justified.
Exhibit 20: Cross cycle P/E bands for ITC
300 250 200 150 100 50 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11
Source: Bloomberg, Ambit Capital research;
Exhibit 21: Cross cycle EV/EBITDA for ITC

250 30x 25x 20x 15x 150 100 50 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11
Source: Bloomberg, Ambit Capital research;
20x
200
15x 10x 8x
Price
Price
ITC has traded at a median multiple of 22x one-year forward earnings since April 2006. Given 24% earnings CAGR expected over FY11-FY13 and the FMCG business likely to breakeven in 4QFY13, the stock is likely to re-rate.
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ITC
Ambit v/s Consensus

As shown in the table below, our forecasts are ahead of consensus at the EPS level for FY12 by 3.7% and by 8.6% for FY13 due to a combination of cigarettes. The EBIT growth of 19.8% for FY12 and 17.9% for FY13 are assumed in our model and also FMCG losses reducing to `2,280mn for FY12 and to `1,171mn for FY13. This increases our estimates for net worth and hence our book value is also above consensus estimates.
Exhibit 22: Ambit v/s consensus
Ambit EPS (`) Consensus Gap
FY12E FY13E
BVPS (`)
8.01 9.88 24.20 28.60
7.80 9.10 23.90 27.80
3% 9% 1% 3%
FY12E FY13E
Explanation for our flags on the cover page

Segment Accounting Score GREEN Comments
The company in the past has shown high levels of cash conversion, efficient working capital management and is professionally managed. The company has high pricing power in its cigarettes business and has consistently see margin expansion in the segment. Further, FMCG losses are declining as mentioned by the company. Hence, visibility of earnings is very high. The company has reported 18% CAGR in its PAT over the last eleven years, 17% CAGR over the last five years, 17% over the last three years and 22.9% growth in its PAT in 1HFY12
Predictability Earnings Momentum

GREEN GREEN
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ITC
Balance sheet
Year to January (` mn) FY09 FY10 FY11 FY12E FY13E
Shareholders' equity Reserves & surpluses

Total net worth
3,774 133,576
137,351 0
3,818 136,826
140,644 0
7,738 151,795
159,533 0
7,738 179,603
187,341 0
7,738 213,913
221,651 0
Minority Interest Preference share capital Debt Deferred tax liability

Total liabilities
0 1,776 8,672
147,798
0 1,077 7,850
149,571
0 992 8,019
168,543
0 992 8,108
196,442
0 992 8,219
230,863
Gross block
Net block
105,587
72,719
119,679
81,424
127,658
83,451
139,721
89,526
152,018
95,442
CWIP
Investments
12,141
28,378
10,090
57,269
13,334
55,547
13,334
65,547
13,334
75,547
Cash & equivalents Debtors Inventory Loans & advances Other current assets Total current assets Current liabilities Provisions Total current liabilities
Net current assets
10,310 6,687 45,997 16,450 2,154 81,597 29,741 17,295 47,036

34,561 0 147,798
11,263 8,581 45,491 13,061 2,884 81,279 34,991 45,499 80,491

788 0 149,571
22,432 9,076 52,675 14,181 3,475 101,840 44,579 41,048 85,628

16,212 0 168,543
35,086 10,388 60,286 16,230 5,017 127,006 50,693 48,277 98,971

28,035 0 196,442
55,280 12,127 70,383 18,948 4,241 160,980 57,978 56,462 114,440

46,540 0 230,863
Miscellaneous
Total assets
Income statement
Year to January (` mn) Operating income FY09 156,119 FY10 181,532 FY11 211,676 FY12E 248,954 FY13E 291,160
% growth Operating expenditure

EBITDA
11.9% 107,534
48,585
16.3% 120,792
60,740
16.6% 140,141
71,534
17.6% 160,293
88,661
17.0% 182,612
108,547
% growth Depreciation
EBIT
10.3% 5,494
43,091
25.0% 6,087
54,653
17.8% 6,560
64,975
23.9% 6,880
81,781
22.4% 7,313
101,234
Interest expenditure Non-operating income Adjusted PBT Tax

Adjusted PAT/ Net profit
183 5,349 48,257 15,622

32,636
648 6,147 60,153 19,543

40,610
481 8,188 72,682 22,806

49,876
461 8,635 89,954 27,976

61,979
436 10,186 110,984 34,516

76,468
% growth Extraordinaries Reported PAT / Net profit Minority Interest Share of associates
Adjusted consolidated net profit Reported consolidated net profit
4.6% 0 32,636 0 0
32,636 32,636
24.4% 0 40,610 0 0
40,610 40,610
22.8% 0 49,876 0 0
48,762 48,762
24.3% 0 61,979 0 0
56,943 56,943
23.4% 0 76,468 0 0
67,681 67,681
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ITC
Cash flow statement

Year to January (` mn) FY09 FY10 FY11 FY12E FY13E
EBIT Depreciation Others Tax (Incr) / decr in net working cap

Cash flow from operations
48,441 5,494 3,038 (15,622) (4,084) 37,268 (17,397) 968 (16,429) (369) (16,299) 437 (16,231) 4,608 10,310 19,870
60,801 6,087 (1,469) (19,543) 34,725 80,601 (12,741) (28,891) (41,633) (698) (44,517) 7,200 (38,015) 953 11,263 67,859
73,163 6,560 (313) (22,806) (4,254) 52,351 (11,831) 1,722 (10,109) (85) (40,015) 9,028 (31,072) 11,170 22,432 40,520
90,415 6,880 (371) (27,976) 830 69,778 (12,955) (10,000) (22,955) (34,170) (34,170) 12,653 35,086 56,823
111,420 7,313 (325) (34,516) 1,690 85,582 (13,230) (10,000) (23,230) (42,158) (0) (42,158) 20,194 55,280 72,352
Capex (Incr) / decr in investments Other income (expenditure) Others

Cash flow from investments
Net borrowings Issuance of equity Interest paid Dividend paid Others

Cash flow from financing
Net change in cash Closing cash balance

Free cash flow
Ratio analysis
Year to January FY09 FY10 FY11 FY12E FY13E
EBITDA margin (%) EBIT margin (%) Net profit margin (%) Dividend payout ratio (%) Net debt: equity (x) Working capital turnover (x) Gross block turnover (x) RoCE (%) RoIC (%) RoE (%)
31.1 31.0 20.9 49.9 0.01 5.2 1.6 23.7 22.7 25.3
33.5 33.5 22.4 109.6 0.01 10.3 1.6 27.6 27.1 29.2
33.8 34.6 23.6 80.2 0.01 24.9 1.7 31.6 30.8 33.2
35.6 36.3 24.9 55.1 0.01 11.3 1.9 34.1 34.3 35.7
37.3 38.3 26.3 55.1 0.00 7.8 2.0 35.9 38.2 37.4
Valuation parameters
Year to January FY09 FY10 FY11 FY12E FY13E
EPS (`) Diluted EPS (`) Book value per share (`) Dividend per share (`) P/E (x) P/BV (x) EV/EBITDA (x) EV/EBIT (x)
4.2 4.2 17.7 1.8 45.8 10.9 29.7 14.9
5.25 5.25 18.2 4.9 36.8 10.6 24.0 12.0
6.4 6.4 20.6 4.5 30.0 9.4 20.6 20.2
8.0 8.0 24.2 3.8 24.1 8.0 16.5 16.2
9.9 9.9 28.6 4.7 19.6 6.7 13.3 12.9
25
ITC
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26
Consumer Goods
November 24, 2011
VST Industries
Bloomberg: VST IN EQUITY Reuters: VSTI.NS
BUY
Accounting: GREEN Predictability : AMBER Earnings Momentum: GREEN INITIATING COVERAGE

Anand Mour
Attacking at the entry gate
VST, the third largest cigarette company in India with 8.5% Tel: +9122 3043 3169 volume share, is benefiting from its dominance of the lowest anandmour@ambitcapital.com price point in the cigarettes industry. The company has seen Shariq Merchant volume growth at 6.6% CAGR over the last 2 years (compared Tel: +9122 3043 3246 with 2.1% for ITC). In 1HFY12, the company saw 10.7% volume shariqmerchant@ambitcapital.com growth (ITC: 8.5%). Despite taking a 3% price increase in Recommendation September, VST continues to benefit from strong volume growth CMP: in 2HFY12. We initiate coverage with a BUY with a TP of 1,505.
Competitive position: STRONG Change to this position: IMPROVING
Target Price (Period): Upside/Downside (%) EPS (FY13): Change from previous (%) Variance from consensus (%)
`1,100 `1,505 NA 37% `96.9 NA NA
Competitive advantage at entry level price points VST enjoys a Previous TP:
volume share of 61% in the `2/stick price point and 46% in the `2.50/stick price point segment in the Indian cigarettes industry. Entry level cigarettes in India will continue to benefit from the switches from the other forms of tobacco to cigarettes as education, per-capita income and urbanization of consumers increases. Increase in bidi (a local Indian smoke) prices at a higher rate compared to cigarettes prices over the last one year has also benefited VSTs volume trajectory. volume growth at about 11% (against 7% growth in FY09-FY11), driven by the `2/stick price point brands. We expect VSTs cigarettes volume to sustain a CAGR of 7% over FY11-FY13, which will likely be driven by its competitive position in the entry level cigarettes. VSTs volume growth will get an additional boost if bidi prices continue to rise at a faster pace. Bidi prices have increased by 33% over the past year, due to the higher prices of tendu leaves. Discussions with bidi traders suggest that bidi volumes have declined by 30%+ in the last three years.
Stock Information
`17bn/US$325mn `1,484/569 `38mn/US$0.7mn 0.6 15,700 4,706 52-wk H/L: 3M ADV: Beta: BSE Sensex: Nifty:
Volume growth trajectory to remain robust 1HFY12 saw cigarettes Mkt cap:
Stock Performance (%)

1M Absolute Rel. to Sensex -11.4 3M -6.6 12M 79.0 99.3 YTD 74.9 98.3 -17.9 -11.5
Dividend payout to remain high VST has no specific capex fund

requirement, and so pays out about 85% of its PAT as dividends. We expect VST to maintain a dividend payout of 85%-90%, and expect DPS to be `62 for FY12 and `75 for FY13. Stock offers 5.6% dividend yield on our FY12 est. Valuation: We expect FY11-FY13 EPS CAGR of 26% (FY04-FY11 EPS CAGR of 19%) driven by cigarette volume growth of 7% (FY04-FY11 volume CAGR of 1%). Assuming WACC of 13.7% and terminal growth of 3%, our DCF model values the stock at `1,505, implying 37% upside and 15.5x FY13 EPS (5-yr historic average multiple is 8.8x). The key catalyst for VST will be higher-thanexpected volume growth (we expect 7% CAGR over FY11-FY13). We initiate with a BUY stance. VST is on our Strategy teams list of 36 Battleships stocks.
Exhibit 1: Key financials (` mn)
Year to March Operating income (` mn) EBITDA (` mn) EBITDA (%) EPS (`) RoE (%) RoCE (%) P/E (x)
Performance (%)
25,000 20,000 15,000 10,000
Sensex
1600 1300 1000 700 400

VST Inds
Nov-10 Mar-11 Jul-11 Nov-11
1-year P/E or EV/EBITDA

FY09 3,811 826 21.7 31.9 20.9 21.7 34.5 FY10 4,722 824 17.5 48.2 30.6 32.0 22.8 FY11 5,784 1,364 23.6 61.5 37.1 39.1 17.9 FY12E 6,428 1,925 29.9 85.2 47.9 50.4 12.9 FY13E 7,454 2,281 30.6 96.9 51.2 53.8 11.4
16 13 10 7 4 Apr-06 VST Industries 1 Year Fwd PE
Apr-07
Apr-08
Apr-09
Apr-10 Median
PE
Source: Bloomberg, Ambit Capital research
Ambit Capital and / or its affiliates do and seek to do business including investment banking with companies covered in its research reports. As a result, investors should be aware that Ambit Capital may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the only factor in making their investment decision.
Please refer to the Disclaimers at the end of this Report.
Apr-11
VST Industries
Company Financial Snapshot

Profit and Loss (` mn)
Net sales Optg. Exp(Adj for OI.) EBIDTA Depreciation Interest Expense PBT Tax Adj. PAT Profit and Loss Ratios EBIDTA Margin % Adj Net Margin % P/E (X) EV/EBIDTA (X) Dividend Yield (%) FY11 5,784 4,188 1,597 244 1,353 402 950 23.6% 16.4% 17.9 12.2 4.1% FY12E 6,428 4,302 2,125 205 1,920 605 1,315 29.9% 20.5% 12.9 8.5 5.6% FY13E 7,454 4,973 2,481 295 2,185 688 1,497 30.6% 20.1% 11.4 6.9 6.8%
Company Background
Incorporated in 1930, VST Industries is the third largest player in the Indian cigarettes industry. VST has about 8.5% volume market share in India and owns iconic brands such as Charms and Charminar. Key states for VST are Andhra Pradesh, West Bengal, Kerala and Chattisgarh. British American Tobacco (BAT) owns 32.16% stake in the company, another 25.95% is owned by Bright Star Investments Pvt. Ltd. and 8.45% is owned by ITC Limited and its subsidiary Russell Credit Limited. The company is professionally managed and its headquarters is in Hyderabad.
Cash Flow (consolidated) (` mn)
Balance Sheet (` mn)

Total Assets Net Fixed Assets Current Assets Other Assets Total Liabilities Networth Debt Current Liabilities Deferred Tax Balance Sheet Ratios ROE % ROCE % Net Debt/Equity Equity/Total Assets P/BV (X) FY11 7,677 1,393 4,575 1,710 7,677 2,988 4,819 (139) 37.1 39.1 FY12E 8,645 1,218 5,717 1,710 8,645 3,263 5,520 (139) 47.9 50.4 FY13E 9,828 1,010 7,108 1,710 9,828 3,643 6,324 (139)
1 6.4
1 6.0
PBT Depreciation Tax Change in Wkg Cap Others CF from Operations Capex Investments CF from Investing Change in Equity 51.2 Debt 53.8 Dividends CF from Financing 1 Change in Cash 5.7
FY11 1,353 244 402 (75) (91) 1,178 324 (193) (131) 808 808 226
FY12E 1,920 205 605 (123) 1,643 150 (150) 1,113 1,113 381
FY13E 2,185 295 688 (193) 1,986 150 (150) 1,346 1,346 490
Portfolio breakup by volume VST operates at lower price points, where ITC does not have a focus
Price point/stick 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 Above 5.0
Volume market share at specific price points highlights VSTs leadership at entry level price points
70% 60% 50% 40% 30% 20% 10% 0% 1.5
Industry 1% 11% 4% 46% 0% 23% 5% 9% 2%
ITC 0% 3% 2% 46% 0% 29% 6% 12% 3%
GPI 0% 16% 4% 79% 0% 0% 1% 0% 0%
VST 2% 78% 20% 0% 0% 0% 0% 0% 0%
61% 46% 32% 19% 3% 2.0 VST ITC 2.5 36%
28
VST Industries
Competitive advantage at entry level price points

VSTs key competitive advantages in a market dominated by ITC (79% volume market share for ITC v/s 8.5% for VST), are: Iconic brands Charms and Charminar which are particularly strong in the Southern and Eastern regions of India (~17% volume market in those regions) and which have a strong presence at the entry level price points in the cigarette market (for example, 61% market share at the `2/stick price point). Whilst VSTs market share in the `1.50/stick segment is modest at 32%, in the `2/stick segment, VST is dominant. The `2/stick segment accounts for 11% of sales in the Indian market by volume and 6% by value. In this segment, ITCs Silk Cut and Duke are the only meaningful competition that VST faces and it is in this segment that VST continues to see very strong volume growth (16% in 1HFY12). Following ITCs recent price hikes (in November 2011), VST is dominating the `2.50/stick price point segment as well. In fact with recent price hikes by ITC, `2.50 becomes the natural pricing zone for VST. Therefore, if required in the wake of a hike in excise duty, VST is now in a position to take 20% price hikes, by increasing prices from `2/stick to `2.50/stick. Distribution: VST has a strong distribution network in its area of operations. The company has 600 distributors and a reach of more than 0.6mn retail outlets directly. In comparison, ITC with the strongest distribution network, reaches 2mn retail outlets directly. The company is strengthening the depth of its distribution network by expanding further in the areas of its higher strengths such as Andhra Pradesh, West Bengal etc. Buoyed by the success, visible in terms of volume growth, the company will continue to thrust its distribution reach to drive revenue growth.
Exhibit 1: Portfolio breakup, volumewise VST operates at lower price points, where ITC, others, have no focus
Price point/stick 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 Above 5.0 Industry 1% 11% 4% 46% 0% 23% 5% 9% 2% ITC 0% 3% 2% 46% 0% 29% 6% 12% 3% GPI 0% 16% 4% 79% 0% 0% 1% 0% 0% VST 2% 78% 20% 0% 0% 0% 0% 0% 0%
Exhibit 2: Volume market share at specific price points highlights VSTs leadership at entry level price points
70% 60% 50% 40% 30% 20% 10% 0% 1.5
61% 46% 32% 19% 3% 2.0 VST ITC 2.5 36%
29
VST Industries
Volume growth trajectory to remain robust

In FY09, the companys volumes declined by 19% as the non-filters, which contributed 58% to VSTs volume, became unviable due to the 142%-388% excise levy on non-filters in FY2009. Since FY09, the companys leadership position has shifted to the low-priced 69mm (Regular size filters, RSFT) segment and this entrylevel segment has enabled the company to grow faster than the cigarettes market. Between FY09-FY11, VSTs cigarette volumes have grown at a CAGR of 6.6%, compared to ITCs 2.1% and Godfrey Phillips 3.6% volume CAGR for the same period.
Exhibit 3: VSTs volumes have picked up since FY09
70% 60% 50% 40% 30% 20% 10% 0% 1.5
Source: Ambit Capital research.
Exhibit 4: Bidi prices have risen sharply over last 1 year

190 180 170 160 150 140 130 120 110 100
n0 Ap 8 r- 0 Ju 8 l- 0 Oc 8 t- 0 Ja 8 n0 Ap 9 r- 0 Ju 9 l- 0 Oc 9 t- 0 Ja 9 n1 Ap 0 r- 1 Ju 0 l- 1 Oc 0 t- 1 Ja 0 n1 Ap 1 r- 1 Ju 1 l- 1 Oc 1 t- 1 1
61% 46% 32% 19% 3% 2.0 VST ITC 2.5 36%
Ja
Bidi
Cigarette
Source: Ambit Capital research, WPI Price Index.
In 1HFY12, VSTs volumes have grown by 10.7%, and our channel checks suggest that volume growth continues to remain strong in the current quarter despite the company taking a 25% price hike on Charminar Special, which contributes 10% to the companys volume. This strong volume growth is supported by: (a) VSTs strong brand and competitive position in the `2 segment; and b) rising bidi prices. As the chart above suggests bidi prices have increased by 33% over the past year, thereby making cigarettes comparatively affordable. We strongly believe that cigarettes will continue to see strong volume growth, with VST being the biggest beneficiary, if the cigarette-bidi price differential continues to narrow. Therefore, we expect VST to garner 4% volume growth with 14% price hikes in FY13 over FY12, as its competitive advantage of dominating the lowest price point sustains.
30
VST Industries
Expect earnings to grow at 26% CAGR over FY11-FY13E

During FY11-FY13, the company is likely to grow its EBITDA at a CAGR of 29% and PAT at a CAGR of 26%. The key drivers to the growth will be 7.2% volume CAGR and 8.9% average realization CAGR for the same period.
Exhibit 5: EBITDA growth v/s EBITDA margin
70% 60% 50% 40% 30% 20% 10% 0% -10% FY08 FY09 FY10 FY11 FY12E FY13E 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0%
Exhibit 6: Cigarette vol. growth v/s realization growth

60% 50% 40% 30% 20% 10% 0% FY09 FY10 FY11 FY12E FY13E 15% 10% 5% 0% -5% -10% -15% -20% -25%
EBITDA Growth
EBITDA Margin (RHS)
Realisation growth
Source: Company, Ambit Capital research.
Volume growth (RHS)
Source: Company, Ambit Capital research.
As the company operates at the lowest price point of the 69mm RSFT segment, the company gets a natural price ladder with ITCs pricing decisions. Any change in industry dynamics with ITC not taking price hikes in the competitive brands, despite an excise hike will therefore be a key risk for VST. However, in our opinion, the probability of such an event (i.e. of ITC not taking price hikes) remains low.
Dividend payout
The company has for a long time now been a free cash flow generator and has seen improving trends in dividend payout. With no major capex planned, the company has raised its payout to almost 90% of net income. We expect this payout to be maintained, with dividend yield for FY12 expected at 5.6% at the current market price (`1,101).
Exhibit 7: Dividend v/s dividend payout
80 70 60 50 40 30 20 10 FY04 FY06 FY08 FY10 FY12E Dividend payout Dividend per share
Exhibit 8: CFO v/s operating cash flow payout

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2,500 2,000 1,500 1,000 500 FY05 FY07 FY09 FY11 FY13E Operating Cash Flow Operating Cash Flow Payout 120% 100% 80% 60% 40% 20% 0%
31
VST Industries
Accounting analysis
High dividend payouts (dividend payout/reported PAT was 88% in FY09, 87% in FY10 and 85% in FY11) has resulted in an improving RoE profile for the company. VST now has the best RoEs in this industry, despite having lower profit margins than ITC.
Exhibit 9: Dupont analysis
Company/metric VST Industries ITC Godfrey Phillips British American Tobacco (UK) Peer group median (ex-VST) Divergence with peer group median
RoE % FY09 21 24 18 37 24 (3) FY10 31 29 17 37 29 2 FY11 37 31 21 33 31 6
PAT margin % FY09 13 21 10 8 10 3 FY10 16 22 8 7 8 7 FY11 16 24 10 7 10 6
Asset turnover FY09 1.7 1.1 1.6 1.2 1.2 0.4 FY10 2.0 1.2 1.7 1.5 1.5 0.5 FY11 2.3 1.3 1.6 1.6 1.6 0.8
Financial leverage FY09 1.0 1.1 1.2 3.8 1.2 (0.2) FY10 1.0 1.1 1.2 3.4 1.2 (0.2) FY11 1.0 1.1 1.3 2.9 1.3 (0.3)
While the debtor days for the company are lowest in the sector, the companys increasing inventory days (131 days in FY11) are a cause for concern. While the storage of raw tobacco structurally leads to high inventory days, the rising trend is discomfiting. Management says that the high inventory pertains to a specific export order (`800mn), adjusting for which the inventory days stand at 106 days. However, even that is a high figure. AMBER FLAG.
Exhibit 10: Working capital cycle analysis
Company/metric VST Industries ITC Godfrey Phillips British American Tobacco (UK) Peer group median (ex-VST) Divergence with peer group median CFO as % of EBITDA Average debtors days FY09 65 77 28 88 77 (29) FY10 87 133 39 82 82 26 FY11 86 73 87 86 86 (26) FY09 4 16 9 16 16 (12) FY10 7 15 11 16 15 (8) FY11 9 15 11 15 15 (6) Average YoY change in CFO inventory days as % of EBITDA (bps) FY09 FY10 FY11 FY10 FY11 101 101 98 28 98 2 121 92 97 29 92 29 131 85 82 29 82 49 2,203 5,599 1,125 (613) 1,125 4,971 (30) (5,951) 4,787 380 380 (5,210)
The company fares well on a check of advances given to related parties. We did not come across any loans and advances given to related parties by the company.
Exhibit 11: Loans and advances analysis
Loans and adv as a % of net assets 6% 8% 12% 7% 8% -2%
% of loans and adv to related parties 0% 2% 1% 3% 2% -2%
Loans and adv to related parties as a % of net assets 0% 0% 0% 0% 0% 0%
The company has not provided for any bad debts. Since the Indian business is based on cash, with minimal credit given to buyers, the debtors on the books essentially pertain to the export business. However, a distinction can be made between ITCs (5%) and VSTs (0%) provisions, as ITCs debtor provisions pertain to the other businesses in which it is present.
32
VST Industries
Exhibit 12: Analysis of debtor provisions
As % of gross debtors FY09 VST Industries ITC Godfrey Phillips British American Tobacco (UK) Peer group median (ex-VST) Divergence with peer group median
FY10 0% 5% 1% 3% 3% -3%
FY11 0% 5% 1% 2% 2% -2%
As % of gross debtors o/s for more than 6 months FY09 FY10 FY11 0% 47% 64% NA 47% -47% 0% 0% 0% NA 0% 0% 0% 0% 0% NA 0% 0%
0% 6% 2% 3% 3% -3%
While FY11 tax rates were broadly in line with historical averages, FY10 tax rates were lower due to a high amount of deferred tax reversal. We expect the companys tax rates to sustain at around 31% in the foreseeable future.
Exhibit 13: Tax expenses as a percentage of PBT
Company VST Industries ITC Godfrey Phillips British American Tobacco (UK)
Standalone FY10 24.0% 32.5% 29.3% NA FY11 29.8% 31.4% 31.2% NA
Consolidated FY10 NA 32.6% 29.5% 27.5% FY11 NA 31.8% 31.3% 28.4%
Contingent liabilities as a percentage of net worth stood at 15% as per FY2011 disclosures, and in our opinion, appear reasonable.
Exhibit 14: Contingent liabilities
Particulars In respect of Land disputes In respect of taxes In respect of labour cases Total disclosed disputed liabilities
FY10 (` mn) 10 15 2 27
FY11 (` mn) 389 1 391
As a % of net worth (FY11) 0% 15% 0% 15%
While the FY09 and FY10 depreciation rates were in line with that of peers, the FY11 rate is higher due to an impairment loss of `12.7mn on Time Share Rights on a certain property in Southern India and accelerated depreciation of `28.7mn on revision of the useful life on certain assets.
Exhibit 15: Depreciation analysis
Average depreciation YoY change in rate depreciation rate (bps) FY09 FY10 FY11 FY10 FY11 6.6% 5.4% 8.3% 6.4% 6.4% 0.2% 6.9% 5.2% 7.9% 7.0% 7.0% -0.2% 8.5% 5.2% 8.6% 7.4% 7.4% 1.1% 27 (19) (40) 67 (19) 46 163 (7) 74 33 33 130
33
VST Industries
Key assumptions and estimates

Exhibit 16: Key assumptions and estimates
FY10 Profit and loss assumptions FY11 FY12E FY13E Comments
Cigarettes volume growth (%, YoY)
4.5
8.7
10.5
4.0
We expect cigarettes volume to continue to grow, as the company continues to occupy the entry level price point in the 69mm segment. In FY11, the company saw 8.7% volume growth despite an 18% increase in prices. To pass on a 15% excise hike, we expect the company to take a 14% price increase. Even though the company is in a position to take about 20% price increase, we expect to see prices rise by 14% as the company will leave room for retailer to make additional margin on stick sales. We expect a 15% increase in excise for FY13 See above
Cigarettes realisation growth (%, YoY) Average excise growth (%, YoY) Sales (` mn)
Sales growth (%, YoY)
3.2
18.0
4.0
14.0
0 4,722
23.9
15 5,784
22.5
0 6,428
11.1
15 7,454
16.0
Gross profits (` mn)
2,103
2,931
3,619
4,357 With the company enjoying natural pricing power driven by its leadership at the entry level price points, the company will be able to increase gross margin, with price hikes higher than excise hike. (Gross margins: FY08: 60%, FY09: 53%, FY10: 45%) Expect trade promotion costs to increase in FY13 to support volume growth in the wake of price increases
Gross margin %
44.5
50.7
56.3
58.5
EBITDA (` mn)
EBITDA margin %
824
17.5
1,364
23.6
1,925
29.9
2,281
30.6
PBT (` mn)
PBT margin % Tax rate (%)
980
20.8 24.0
1,353
23.4 29.8
1,920
29.9 31.5
2,185
29.3 31.5
Tax rates likely to remain at 31.5%
Net profit (` mn)

Balance sheet assumptions
745
950
1,315
1,497
Capital expenditure (` mn) Average inventory days Average debtor days Average current liability days Average net working capital (excl. cash)
Cash flow assumptions
221 137 11 236 (77)
323 147 8 233 (68)
150 147 8 233 (68)
150 140 8 223 (65)
No specific project planned, only regular capex of `150mn Expect inventory days to remain stable (and high) Expect debtor days to remain stable (and low) We expect the current liabilities days to be maintained
CFO FCF Dividend payout (` mn) Change in cash

715 480 540 (74)
1,178 854 808 226
1,643 1,493 1,113 381
1,986 1,836 1,346 490
34
VST Industries
Absolute valuation
Given the cash generative nature of the companys main business, we use a 3stage DCF for VST: Stage 1 (FY13-15): revenue and PAT CAGR of 14.5% and 12.8% respectively. RoE moves from 51% in the beginning of the period to 55% at the end of it. Stage 2 (FY16-20): revenue and PAT CAGR of 9% and 9% respectively. Stage 3 (FY20 onwards): We use a perpetuity growth rate of 3%.
Our model discounts the companys free cash flows using a weighted average cost of capital (WACC) of 13.7%. With conservative assumptions around sales and earnings as highlighted in the note earlier, our model gives a valuation of `1,505 per share i.e. 37% upside from the current level with cash profiles as shown below.
Exhibit 17: FCF v/s RoE profile
1,000 900 800 700 600 500 400 300 200 100 FY06 FY07 FY08 FY09 FY10 FY11 FY12E FY13E Free Cash Flow to the firm (Rs mn) ROE (%) 55% 50% 45% 40% 35% 30% 25% 20%
Exhibit 18: FCF assumptions

PV of FCF for forecasting period (FY14- FY20) (` mn) Terminal value (` mn) Enterprise value (` mn) Less: net debt/ (cash) at 31st March 2013 (` mn) Implied equity value (` mn) Fully diluted equity shares (mn) Implied equity value (`/share)
10,210 10,160 20,370 (2,870) 23,240 15.4 1,505
Scenario analysis
Exhibit 19: VSTs EPS scenario
FY13 Cigarettes volume change (YoY) Cigarettes realisation hike (YoY) EPS in FY13 (in `) DCF valuation (in `)
Base case 4% 14% 96.9 1,505
Bull case 6% 18% 127.0 1,942
Bear case 0% 14% 89.6 1,404
In our base case, we build in 4% cigarettes volume growth in FY13 with 14% average realization hike. However, if the company sees flat volume with 14% realization hike, in our bear case, VSTs EPS will be `89.9. Maintaining WACC of 13.7% and terminal growth of 3%, our DCF model values the stock at `1,404, even which offers an upside of 27% from current level and 7% lower from our base case target price. Our bull case estimates the volume trajectory to remain robust at 6% growth with average realisation hike of 18%, resulting in an EPS of `127. Maintaining WACC of 13.7% and terminal growth of 3%, our DCF model values the stock at `1,942, which offers an upside of 76% from current level and 29% lower from our base case target price.
35
VST Industries
Relative valuation analysis

Exhibit 20: Relative valuation
Price Mcap Div yield % FY11 Sales CAGR % (FY1-13) EV/SALES FY12 FY13 EBITDA CAGR % (FY11-13) EV/EBITDA FY12 EPS CAGR % P/E FY12 FY13 (local (US$mn) currency) Indian companies VST Industries ITC HUL Nestle Mean Median International companies Imperial Tobacco British American Tobacco Philip Morris Altria Group Japan Tobacco Mean Median 2,287 2,923 72 28 375,500 36.4 90.8 125.2 56.6 48.8 4.2 4.1 3.7 5.6 2.1 3.9 4.1 (26.3) 5.1 7.4 0.8 1.3 (2.4) 1.3 3.8 4.2 4.1 3.9 1.7 3.5 3.9 3.7 4.0 4.0 3.8 1.7 3.4 3.8 4.1 6.4 10.8 6.9 11.4 7.9 6.9 9.2 11.1 9.8 9.5 7.6 9.4 9.5 8.8 10.4 9.4 9.0 6.9 8.9 9.0 22.6 21.3 16.1 7.4 35.0 20.5 21.3 11.1 15.1 14.9 13.5 18.0 14.5 14.9 12.6 14.3 12.9 13.7 10.2 13.7 1,101 193 390 4352 0.3 29.8 16.2 8.1 4.1 2.3 1.8 1.4 2.4 2.0 13.5 17.3 16.0 22.2 17.3 16.7 2.5 5.9 3.6 5.6 4.5 4.6 2.1 5.0 3.1 4.6 3.8 3.9 29.3 23.2 21.7 27.6 25.4 25.4 8.5 16.5 25.3 28.1 21.1 23.7 6.9 13.3 20.7 21.4 16.8 19.4 25.5 23.8 20.9 25.1 23.8 24.5 12.9 24.1 33.6 42.7 28.6 29.2 11.4 19.6 27.8 32.7 23.1 24.0 FY13 (FY11-13)
Source: Ambit Capital research, Bloomberg. Note: For December year ending companies, FY12 and FY13 pertain to CY11 and CY12 respectively.
VST is trading at 11.4x FY13 earnings, a 51% discount to Indian FMCG companies despite having higher EPS CAGR of 25.5% over FY11-FY13. Considering VSTs improving earnings trajectory, and its competitive advantage in the entry level cigarettes segment, we believe VSTs discount to Indian FMCG will narrow going forward.
Exhibit 21: VST: 1 year fwd P/E bands
1,600 1,400 1,200 1,000 800 600 400 200 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11 5x Price 10x 15x
Exhibit 22: VST: 1 year fwd EV/EBITDA

1500 1300 1100 900 700 500 300 100 Apr-06 5x 3x Price 7x 10x
Apr-07
Apr-08
Apr-09
Apr-10
Apr-11
VST has traded at a median multiple of 9x one-year forward earnings since April 2006. Given 26% earnings CAGR expected over FY11-FY13 and its competitive dominance in the entry level cigarettes, the stock is likely to re-rate going forward.
36
VST Industries
Ambit v/s Consensus

There are no consensus estimates available for this stock
Exhibit 23: Explanation for our flags on the cover page
Segment Accounting Score GREEN Comments
The company in the past has shown high levels of cash conversion, efficient working capital management and low levels of loans and advances and contingent liabilities. While the company enjoys strong presence in the entry level cigarette category, it does not enjoy strong pricing power as it follows the market leader, ITC. Though we have a fairly clear view on its future cash flows, the dependence on the excise structure and ITCs pricing prompt us to give VST an AMBER FLAG Considering the low level of competition in the price point where it is present and the high volume growth being witnessed, earnings momentum remains healthy for VST.
Predictability
AMBER
Earnings Momentum
GREEN
37
VST Industries Balance sheet

Year to March (` mn) FY09 FY10 FY11 FY12E FY13E
Shareholders' equity Reserves & surpluses

Total net worth
154 2,240
2,395
154 2,319
2,474
154 2,490
2,644
154 2,693
2,847
154 2,843
2,998
Minority interest Preference share capital Debt Deferred tax liability

Total liabilities
(85)
2,309
(125)
2,349
(139)
2,506
(139)
2,708
(139)
2,859
Gross block
Net block
2,492
1,254
2,713
1,326
3,036
1,524
3,186
1,469
3,336
1,324
CWIP Investments Cash & equivalents Debtors Inventory Loans & advances Other current assets Total current assets Current liabilities Provisions Total current liabilities
Net current assets
54 1,930 137 49 1,343 130 5 1,663 2,050 542 2,592

(929)
68 1,903 64 145 1,791 146 2 2,147 2,555 540 3,095

(949)
69 1,710 290 128 2,356 166 2 2,942 2,932 808 3,739

(798)
69 1,710 671 142 2,618 185 3,615 3,258 897 4,155

(540)
69 1,710 1,102 158 2,909 205 4,373 3,620 997 4,617

(244)
Miscellaneous
Total assets
2,309
2,349
2,506
2,708
2,859
Income statement
Year to March (` mn) Operating income FY09 3,811 FY10 4,722 FY11 5,784 FY12E 6,428 FY13E 7,454
% growth Operating expenditure

EBITDA
12.1% 2,985
826
23.9% 3,897
824
22.5% 4,420
1,364
11.1% 4,502
1,925
16.0% 5,173
2,281
% growth Depreciation
EBIT
-1% 158
668
0% 179
646
65% 244
1,120
41% 205
1,720
18% 295
1,985
Interest expenditure Non-operating income Adjusted PBT Tax

Adjusted PAT/ Net profit
69 737 245
492
334 980 235

745
232 1,353 402

950
200 1,920 605

1,315
200 2,185 688

1,497
% growth Extraordinaries Reported PAT / Net profit Minority Interest Share of associates
Adjusted consolidated net profit Reported consolidated net profit
-15.7% 126 618 618 618
51.3% (124) 621 621 621
27.6% 950 950 950
38.4% 1,315 1,315 1,315
13.8% 1,497 1,497 1,497
38
VST Industries Cash flow statement

Year to March (` mn)
EBIT Depreciation Others Tax (Incr) / decr in net working capital Cash flow from operations Capex (Incr) / decr in investments Other income (expenditure) Others
Cash flow from investments FY09 FY10 FY11 FY12E FY13E
737 158 87 (245) (203)

534
980 179 (155) (235) (54)

715
1,353 244 (91) (402) 75

1,178
1,920 205 (605) 123

1,643
2,185 295 (688) 193

1,986
(212) (304) 92
(234) (27) (208)
(324) (193) (131)
(150) (150)
(150) (150)
Net borrowings Issuance of equity Interest paid Dividend paid Deferred Tax
Cash flow from financing
(542) 7
(535)
(540) (40)
(580)
(808) (14)
(821)
(1,113) (1,113)
(1,346) (1,346)
Net change in cash Closing cash balance

Free cash flow
91 46
322
(74) 137
480
226 64
854
381 290
1,493
490 670
1,836
Ratio analysis
Year to March (%)
EBITDA margin (%) EBIT margin (%) Net profit margin (%) Dividend payout ratio (%) Net debt: equity (x) Working capital turnover (x) Gross block turnover (x) RoCE (%) RoIC (%) RoE (%)
FY09
FY10
FY11
FY12E
FY13E
21.7 19.3 12.9 110.1 (2.6) 1.5 21.7 20.4 20.9
17.5 20.7 15.8 72.5 (2.6) 1.7 32.0 22.4 30.6
23.6 23.4 16.4 85.0 (3.3) 1.9 39.1 23.2 37.1
30.0 29.9 20.5 84.6 (5.3) 2.0 50.5 26.5 47.9
30.6 29.3 20.1 89.9 (12.3) 2.2 53.8 27.1 51.2
Valuation parameters
Year to March (` mn)
EPS (`) Diluted EPS (`) Book value per share (`) Dividend per share (`) P/E (x) P/BV (x) EV/EBITDA (x) EV/EBIT (x)
FY09
FY10
FY11
FY12E
FY13E
31.9 31.9 155.1 30.0 34.5 7.1 20.4 22.9
48.2 48.2 160.2 30.0 22.8 6.9 20.5 17.3
61.5 61.5 171.2 45.0 17.9 6.4 12.2 12.3
85.2 85.2 184.4 62.0 12.9 6.0 8.5 8.5
96.9 96.9 194.1 75.0 11.3 5.7 6.9 7.2
39
VST Industries
Institutional Equities Team

Saurabh Mukherjea, CFA Research Analysts Aadesh Mehta Anand Mour Ankur Rudra, CFA Ashvin Shetty Bhargav Buddhadev Chandrani De, CFA Chhavi Agarwal Dayanand Mittal Gaurav Mehta Hardik Shah Krishnan ASV Nitin Bhasin Pankaj Agarwal, CFA Parita Ashar Puneet Bambha Rakshit Ranjan, CFA Ritika Mankar Ritu Modi Shariq Merchant Sales Name Deepak Sawhney Dharmen Shah Dipti Mehta Pramod Gubbi, CFA Sarojini Ramachandran Production Sajid Merchant Kausalya Vijapurkar Praveen Mascarenhas Production Editor Database (022) 30433247 (022) 30433284 (022) 30433251 sajidmerchant@ambitcapital.com kausalyavijapurkar@ambitcapital.com praveenmascarenhas@ambitcapital.com Regions India / Asia India / Asia India / Europe India / Asia UK Desk-Phone (022) 30433295 (022) 30433289 (022) 30433053 (022) 30433228 +44 (0) 20 7614 8374 E-mail deepaksawhney@ambitcapital.com dharmenshah@ambitcapital.com diptimehta@ambitcapital.com pramodgubbi@ambitcapital.com sarojini@panmure.com Industry Sectors Banking / NBFCs FMCG Technology / Education Services Automobile Power / Capital Goods Metals & Mining Construction / Infrastructure Oil & Gas Derivatives Research Technology / Education Services Banking Construction / Infrastructure / Cement NBFCs Metals & Mining / Media / Telecom Power / Capital Goods Mid-Cap Economy Cement Consumer Desk-Phone (022) 30433239 (022) 30433169 (022) 30433211 (022) 30433285 (022) 30433252 (022) 30433210 (022) 30433203 (022) 30433202 (022) 30433255 (022) 30433291 (022) 30433205 (022) 30433241 (022) 30433206 (022) 30433223 (022) 30433259 (022) 30433201 (022) 30433175 (022) 30433292 (022) 30433246 E-mail aadeshmehta@ambitcapital.com anandmour@ambitcapital.com ankurrudra@ambitcapital.com ashvinshetty@ambitcapital.com bhargavbuddhadev@ambitcapital.com chandranide@ambitcapital.com chhaviagarwal@ambitcapital.com dayanandmittal@ambitcapital.com gauravmehta@ambitcapital.com hardikshah@ambitcapital.com vkrishnan@ambitcapital.com nitinbhasin@ambitcapital.com pankajagarwal@ambitcapital.com paritaashar@ambitcapital.com puneetbambha@ambitcapital.com rakshitranjan@ambitcapital.com ritikamankar@ambitcapital.com ritumodi@ambitcapital.com shariqmerchant@ambitcapital.com Head of Equities (022) 30433174 saurabhmukherjea@ambitcapital.com
40
VST Industries
Explanation of Investment Rating

Investment Rating Expected return (over 12-month period from date of initial rating) >5% <5%
Buy Sell
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Tobacco: Excise Hike Will Be An Opportunity To Buy "Battleships"

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Tobacco: Excise Hike Will Be An Opportunity To Buy "Battleships"

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November 24, 2011

Excise hike will be an opportunity to buy Battleships

Source: Ambit Capital research, Company

Ambit Capital Pvt Ltd

A 15% excise hike on cigarettes

Source: Ambit Capital research, Industry

Ambit Capital Pvt Ltd

Structural changes in excise structure impact volumes

Exhibit 4: Wills Navy Cut saw volume loss to Wills Flake

800 700 600 500 400 300 200 100 0 FY03

2,500 2,000 1,500 1,000 500 0 Plains FY95 FY08 Micros

Exhibit 5: The 59mm segment has not found takers so far

Q3FY11 Q4FY11 % of industry

Source: Ambit Capital research, Industry

Ambit Capital Pvt Ltd

MRP per pack of 10 sticks (`) 15 25 38 44 49

Typical gross margin% 23 36 58 46 37

Ambit Capital Pvt Ltd

Does an excise hike make a difference?

Excise/1,000 sticks (in `) 2,018 1,517 998 1,517 689 689

Size 84mm 74mm 69mm 69mm 59mm 59mm

Type Filters Filters Filters Non filters Non filters Filters

Source: Ambit Capital research, Industry, *2011-12: as of now

Old MRP in `/ pack of 10 sticks 25 25 25 25 25

New MRP in `/ pack of 10 sticks 29 28 28 28 28

% price hike taken by ITC 16 12 12 12 12 4.00

Ambit Capital Pvt Ltd

Source: Ambit Capital research, Industry

Impact of excise hikes on ITCs portfolio

Exhibit 12: If excise hike of 15% is effective Dec 1, 2011

FY12 6.0% 5.5% 19.8% 31.2% 8.0

FY13 1.0% 14.0% 17.9% 31.9% 9.9

FY12 4.7% 8.3% 20.9% 31.0% 8.0

FY13 4.5% 12.0% 17.2% 31.1% 9.9

We highlight the sensitivity of price-volume matrix on ITCs cigarettes EBIT growth:

Ambit Capital Pvt Ltd

The above table highlights:

Impact of excise hikes on VSTs portfolio

Exhibit 15: If excise hike of 15% is effective Dec 1, 2011

FY12 10.5% 4.0% 54.0% 11.1% 85.2

FY13 4.0% 14.0% 15.0% 10.9% 96.9

FY12 8.0% 7.5% 54.0% 11.0% 85.2

FY13 6% 10.5% 15.0% 10.9% 97.0

Ambit Capital Pvt Ltd

Source: Ambit Capital research, Industry

The above table highlights:

Ambit Capital Pvt Ltd

Bargaining power of suppliers

Bargaining power of buyers

Ambit Capital Pvt Ltd

19.6 11.4 27.8 32.7 23.1 24.0 10.2 13.7

12.6 14.3 12.9 13.7

Exhibit 18: Cross cycle P/E bands for ITC

Exhibit 19: Cross cycle P/E bands for VST

30x 25x 20x 15x

1,400 1,200 1,000 800 600 400

200 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11

Source: Ambit Capital research

Ambit Capital Pvt Ltd

Exhibit 21: Cross cycle EV/EBITDA for VST

1100 900 700 500

300 100 Apr-06