ITC cigarette margins impacted by timing of certain expenses: Jefferies

ITC's 3Q16 results were operationally in-line with expectations, as cigarette margins were impacted by timing of certain expenses. Low single-digit decline in cigarette volumes was better than beaten-down expectations and likely indicates a bottoming out of demand.

Key Takeaway
 
ITC's 3Q16 results were operationally in-line with expectations, as cigarette margins were impacted by timing of certain expenses. Low single-digit decline in cigarette volumes was better than beaten-down expectations and likely indicates a bottoming out of demand. A revival in overall consumption trends should kick start cigarette volume recovery for ITC in due course, in our view. Maintain Buy.
 
Cigarettes - demand weak but steady: ITC’s cigarette revenues grew c.6% YoY (-2% vs est) while profits grew c.3% YoY (-6% vs est), as the segment saw an unprecedented margin drop. Demand trends, although weak, were steady as the volume decline was limited to low single-digits, better than ests. Pricing has been weaker this year given the muted demand environment, but product mix trends were steady and the shift to smaller cigarettes (DSFT) has had no impact on margins. The mgmt attributed the margin decline in 3Q to timing of certain operating/marketing expenses, and indicated that underlying profit growth was healthy. Nevertheless, we lower our FY16E EBIT forecast by c.1% to factor in weaker 3Q, but keep FY17E and 18E mostly unchanged.
 
FMCG – impacted by deflation and inventory correction: FMCG revenues grew c.7% YoY, c.4% below est. Overall demand continued to be weak, especially in rural markets. Price deflation and channel corrections in the stationery business further impacted growth. Noodles business, however, has recovered well this Q. The underlying growth in the segment was close to double digits. The segment has reported profits in 2H of each year for the past 2 years – likely driven by timing of marketing expenses. We cut our revenue est. by c.3% over FY16-18E given the muted demand environment, but forecast small profits for the segment inline with recent trends.
 
Other segments - mixed performance: Paper segment revenues grew c.5% YoY while profits increased c.13% YoY, led by a richer product mix and lower input prices. However, weak demand aside, this category continues to be under pressure from increased imports from China and ASEAN countries. The hotels and agri business faced pressure on pricing and demand this quarter.

Valuation/Risks
We lower our FY16-18E EPS est. (~3%) and SOTP-based TP mainly to account for higher tax rates. Our TP now stands at Rs381/share (25x FY17E cig profits). Near term earnings are likely to be weak, but we believe we are nearing the bottom of the weak demand cycle. Maintain Buy. Risks: a) Severe slowdown; b) adverse taxation.