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Higher sales from leaf tobacco impacted margins

VST Industries reported Q3FY23 performance below our estimates; Revenue grew 5.2% to Rs3.4bn, while EBITDA/PAT cut by 13.2/4.5% due to higher sales from leaf tobacco exports. We estimate cigarette volume decline of ~3.0%, due to high base along and also consumer shift, buying more of RSFT cigarettes (Rs10/ stick). Gross margin fell by 583bp to 47.3% due to (1) higher raw material cost - tobacco +10% and paper & filter +12% on the back of global supply chain shortage (2) product mix, and (3) higher sales from leaf tobacco. EBITDA margin cut to 27.3% (-581bp) on account of higher employee cost (+7.3%) & other expenses (+3.7%) while trade promotion cost remained flat. Management indicated, despite challenging macro condition and changing consumer preferences to RSFT, VST need to ramp up its offering in the core markets UP/Bihar in addition to AP/Telangana. Further, rising input RM/PM could weigh high on margins in Q4 in our view. Considering weaker Q3, we cut earnings and retain BUY rating, with a revised DCF-based TP Rs4,026 (implying 18.3x avg. FY24E/FY25E EPS). Flat volumes as VST’s portfolio is skewed towards DSFT; industry grew 15.0%

VST’s Q3FY23 revenues grew 5.2% to Rs3.4bn on the back of consumer shift towards RSFT cigarettes (Rs10/ price per stick) reflecting ~3.0% volume decline. Further, high inflation weighed on weaker demand in key states such as UP/Bihar. Management guided that cigarette industry grew ~15.0% driven by consumer up-trade and premiumsiation as lot of demand moved up to >Rs10price band where VST has only one brand to compete. In Q3 Leaf tobacco exports grew 60.0% to Rs1.0bn as company received large orders due to lower international prices. We believe slower than industry growth may force VST to redraw its growth strategy driven by, (1) ramp up its offering in RSFT segment, (2) network expansion in newer states, and (3) focus on premium brand ‘Total’ and better trade visibility.

Gross margins fell by 583bp due to global supply chain shortage resulted higher COGS

Gross margins fell by 583bps to 47.3% vs 53.1% last year due to higher raw material cost along with inferior product-mix and also higher sales from leaf tobacco during the quarter. On the back of global supply chain shortages VST faced sharp inflation in key raw material such as FCV tobacco (+10.0%) and paper & filter(+12.0%). That said, EBITDA margin cut by 581bps to 27.3%, also coupled with higher employee cost (+7.3%) and other operating exp. (+3.7%) while trade promotions cost remained flat. We reckon cost saving measures undertaken by VST may sustain, though in the medium term packaging material (paper and cartons) appears to be inflationary. Management expects margin pressure to continue for next 2-3 quarters on the account of higher inflationary pressure

Valuation and risks We 

We note, VST deliberately chose to expand direct coverage by investing feet-on-the-street, trade visibility and cut wholesale discounts to strengthen consumer perception for ‘Total’ brand as trade pushed volumes by discounting price. Though improved consumer mobility has resulted in pick-up demand, yet unexpected rural slow-down in north impacted volumes to some extent. We believe growing demand for value segment could provide strong tailwinds to VST however higher raw material cost could pose challenge for margin recovery in the near term. Considering weaker than estimated Q3, we have cut earnings for FY23E/24E by 8.3%/2.8% respectively. We retain Sell with revised DCF-based TP of Rs4,026 (implying 18.3x avg. FY24E/FY25E EPS). Risks to our call include sharp increase in any form of taxation and disruption in supply chain.

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