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Cigarette volumes grew at 8.0%; margin slipped

Godfrey Phillips (GP) reported Q2FY24 revenues ahead of our estimates, though margins declined sharply; Revenue grew 13.7% while EBITDA dropped by 5.4%. Tobacco segment gross revenues grew 16.7%, driven by 8% growth in cigarette volumes and 17% growth in leaf tobacco exports to Rs3.7bn. Non-tobacco (TFS+Funda Goli) grew 4.3%. GP’s performance was driven by, (1) clear focus on strengthening core cigarette business, (2) expanded distribution for Marlboro led to 33% contribution, (3) strong exports of leaf tobacco and (4) launch products to attract new users. Gross margin declined by 380bp to 42.4% due to higher RM inflation coupled with higher exports of leaf tobacco and cigarettes. EBITDA at Rs2.2bn cut by 5.4% due to higher other exp. (+27.1%) and employee cost (+15.8%) settling EBITDA margin at 18.8% (-379bp). GP has strong focus on RSFT segment, yet expanded footprint for TFS (152 stores) to reflect lowering of losses. With weak 1HFY24 profits, we cut our earnings and retain BUY, with a revised DCF-based TP Rs2,530 (implying avg. of 13.8x avg. of FY25/26E EPS).

Cigarette net sales/volumes grew at 14.9%/8.0% led by Marlboro; TFS growth was muted

In Q2FY24 GP’s net sales grew 13.7% to Rs11.5bn, driven by 8.0% growth in cigarette volumes yet it saw 17% rise in cut and unmanufactured tobacco exports. With closure of chewing business, GP has clear focus on driving cigarette business coupled with expanded distribution saw 1HFY24 cigarette volume growth at 22.8% led by Marlboro portfolio which grew +27% in volumes. Marlboro franchise now make up 33% contribution led by strong growth in ‘MarlboroCompact’ priced at Rs10. Management said growth was led by, (1) normalised consumer activities, (2) higher demand in core markets J&K/MH/ Guj/Raj, (3) faster growth in Marlboro, (4) growing reach for ‘Focus’ brand and ‘Stellar’ in south, and (5) 24Seven (TFS) including ‘Goli’ grew 4.3% to Rs1.2bn. GP saw strong recovery in footfalls in TFS and stores/kiosks stood at 152.

Higher share of unmanufactured tobacco sales cut gross margin by 380bp

In Q2, GP’s gross margin declined to 42.4% (-380bp), led by 17% growth (Rs3.3bn) in cut and unmanufactured tobacco exports and also sharp increase in prices for leaf tobacco and cigarette packaging prices. EBITDA at Rs2.2bn declined 5.4% due to higher other expenses (+27.1%) and employee cost (+15.8%); EBITDA margin slipped to 18.8% (-379bp). With 19.2% EBIT margin for tobacco business, losses in TFS retail business dropped at Rs172.7mn. We expect operating leverage and higher contribution margin from prepared foods to lift profitability for TFS in Q3.

Management expects sustained growth momentum, as long-term growth drivers are intact

We reckon GP’s growth strategy is driven by (1) focusing on new markets to capture shift in demand towards value-for-money cigarettes, (2) reinforcing partnership with Phillip Morris, acting as key growth engine, (3) strengthening export markets, and (4) capitalizing on fast-growing TFS business. We expect cigarette industry to effect price increase across portfolio in 2HFY24 given rising RM/PM prices. Though steady dividend income from associate company would aid PAT.

Valuation and risks

In line with our argument, cigarette industry witnessed strong volume growth in FY23 and GP saw premiumsiation (Marlboro) and higher sales in RSFT segment, and the trend would continue in FY24 as well. We believe strong tailwinds for RSFT segment and also Marlboro entry into the DSFT segment (64mm). With increased footprint for TFS we expect operating leverage to drive profitability, yet cut losses. We remain hopeful on rural recovery which could provide strong tailwinds for GP. Considering pressure on margin and stable income from associate, we cut earnings for FY24E/25E by 2.6/2.1% and introduce FY26E and retain BUY with a revised DCF-based TP Rs2,530 (implying 13.8x avg. FY25E/FY26E EPS). Risk: sharp increase in taxation and higher competition.

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