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Cigarette volumes improving gradually; EBIT growth still uncertain

* ITC’sreported EBITDA was in line with our estimates as better-thanexpected Cigarettes and Paper and Packaging sales were offset by weaker than anticipated EBIT margins in Cigarettes, FMCG– Others, and Hotels.

* Cigarette EBIT was up 36.7% YoY in 1QFY22 on a weak base (38.8% decline in 1QFY21). However, it was still 16.2% lower than 1QFY20 levels, and there is little indication of segmentalEBIT growth returning to over 10% levels anytime soon.

* In the FMCG – Others segment, we believe the rise in commodity costs poses a risk to segmental EBIT margin improvement in FY22, especially given the likely impact on 2QFY22 as well.

* Continued sub-par growth in EBIT in the mainstay Cigarettes biz and tepid underlying cigarette volumes act as deterrents for a valuation re-rating. Thus, ITC’s valuation of ~15x FY23E appearsfair. Maintain Neutral.

Sales above expectations; margins disappoint

* ITC’s 1QFY22 net revenue was up 37.1% YoY to INR122.2b (est. INR114.2b), EBITDA grew 50.8% YoY to INR39.9b (in-line), PBT increased 28.4% YoY to INR40.2b (est. INR44.4b), and adj. PAT rose 28.6% YoY to INR30.1b (est. INR33.2b).

* Overall gross margins contracted 310bp YoY to 52.6% in 1QFY22, while the EBITDA margin expanded 300bp YoY to 32.7%.

* Cigarette volumes are likely to have grown ~31% YoY (est. +22%). The volume decline in the base quarter was 37%. Cigarette net sales grew 34.2% YoY to INR43.8b. EBIT in Cigarettes grew 36.7% YoY to INR32.2b on a weak base (est. 44.6% growth YoY to INR34.1b), but declined 16.3% v/s 1QFY20 levels. In the base quarter (1QFY21) EBIT had declined 38.8% YoY to INR23.6b. EBIT margin for the Cigarettes biz expanded 130bp YoY to 73.5%

* Net sales for FMCG –Others grew 10.4% YoY to INR37.3b in 1QFY22. EBIT in FMCG – Others grew 38.3% YoY to INR1.7b.

* Revenue for the Agri / Paperboards, Paper, and Packaging business was up 9.2%/54.2% YoY. Revenue for Hotels surged 464% YoY on a very weak base.

* Other income was down 52.2% YoY to INR4.3b due to lower market yields and treasury corpus.

Valuation and view

* There is no material change to our EPS forecasts after the 1QFY22 results.

* As highlighted in our detailed note in Dec'20, with the Cigarettes business likely to contribute over 82% to ITC's overall EBIT even in FY23E (from 85% in FY20), there is no material reduction in the dependence on this segment – which is beset by concerns of a) weak EBIT growth for several years now, b) the overhang of a possible GST increase going forward, and c) ESG-related issues over tobacco, leading to a reduction in valuation multiples.

* With PBT growth over FY20–23E (6.9% CAGR) likely to remain similar to growth in the preceding five years (6.6% CAGR), valuations of 14.8x FY23E, although cheap, are fair considering the concernsstated above. A dividend yield of 5.7– 6.1% is expected over the next two years, in line with that of other global cigarette players.

* Despite valuing ITC at a 10% premium to the global peer average and rolling forward to Sep’23 multiples (targeting 15x Sep'23E EPS), the upside on our TP of INR225/share is limited. Maintain Neutral.

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