Buy ITC; target Rs 203: Motilal Oswal

Research firm Motilal Oswal has maintained buy rating on ITC with target price of Rs 203. The buoyant macro outlook for ITC prompts to revise EPS estimates for FY08 to Rs 7.8 (Rs 7.5 earlier) and for FY09 to Rs 9.3 (Rs 9).

Motilal Oswal report on ITC:

New FMCG - turnaround likely by 2010

New FMCG comprises ITC's fastest growing businesses, which includes Processed Foods, Lifestyle Retailing, Greetings, Stationery, Matchboxes and contributes 9% to the topline. Food products contribute 62% to new FMCG products with brands such as Sunfeast, Kitchens of India, Aashirvaad and Mint-o. ITC has emerged as the third largest player in the Rs 45 billion biscuit industry and is a market leader in branded atta (52% share of the organized market). The company markets more than 100 SKUs and plans to enter new product segments. It is currently growing by more than 40% per annum in the Biscuit category and expects to maintain the trend. ITC has forayed into Rs 20 billion (30% CAGR growth) snack food segment with the launch of Bingo range of potato chips and finger snack foods. The product has been launched in 160 flavors and is expected to scale up at a fast pace.

Lifestyle retailing under the Wills Lifestyle and John Players brands has entered the fast growth lane. With expected growth of 20% in the domestic branded garments industry, this division is likely to grow by 25-30% ahead.

We expect school books and the stationery business to emerge as the next growth driver, once the company commissions its own writing paper unit. The division, which is expected to clock sales of over Rs 1 billion in FY07, has established brands like Classmate and Paper Craft. The division has gross margins of 20% and holds immense scale-up potential once in-house paper availability increases. We estimate 46% CAGR in sales over FY07-FY09 and 32% CAGR reduction in losses over next two years. We expect the new FMCG businesses to turnaround in FY10 with an EBITDA of Rs 980 million.

Paperboard & specialty packaging - set to enter the fast lane

The company has emerged a leader in Paperboard and Specialty Packaging, with growing focus on high-value packaging solutions for consumer goods and pharmaceuticals. The company is in the process of increasing paperboard capacity by 90,000 tonnes. Additionally, plans are underway to set up a writing & printing paper unit and an ECF (elemental chlorine-free) pulp capacity, each of 100,000t p.a., at Bhadrachalam. The ECF pulp capacity will enable the company to overcome its dependence on imported pulp thereby improving profitability. ITC appears well placed, as the area under its forestation scheme will increase to 100,000 hectares by FY10.

ITC's paperboard business has been recording steady 19% EBITDA CAGR over the past five years. With long-term outlook for the paper division being positive, we expect the share of high-end paperboard and consumer stationery products to rein in enhanced profits. Also, the new unit will enable increased sale of value-added products.

Choupal Sagar - giving rural India a taste of organized retailing:

Choupal Sagar - a rural hypermart, is an extension of ITC's rural distribution strategy. It is already operating 21 Choupal Sagars across three states - Uttar Pradesh, Madhya Pradesh and Maharashtra. The setting up of eight more Choupal Sagars is already in an advanced stage, with operations expected to commence in the next 1-2 quarters. The company plans to increase this number to 40 in the next 12 months and 100 in the next three years. ITC has positioned Choupal Sagar as a one-stop shop for warehousing of agri-produce, a fuel station, healthcare, soil testing, banking, food court and tractor servicing. The Sagars will also sell agri-inputs, apparel, grocery, durables, toys, music etc. with Uttam Quality, Sahi Jaankari, and Kam Daam. The company has tied up with a client, Merubeni - Merubeni and ITC will work together to explore new products and opportunities - whereby ITC will gain from Merubeni's expertise in setting up strong supply chain processes and warehouses ('backend'). We expect ITC to commission up to 40 Choupal Sagars by FY09, which should yield annual sales of Rs 2 billion.

Hotels - limited headroom

Earnings of ITC's hotel business currently reflect the gains from higher occupancy rates and average room rates (ARRs) prevailing in the hotel industry. For FY07, the division has reported 25.8% increase in topline and 27.7% increase in EBITDA. ITC plans to add 1,100-1,200 rooms in three new properties at Bangalore, Chennai and Hyderabad. Construction of the Bangalore property is underway while the company is yet to begin construction at its Chennai property. While we have positive expectations with regard to ARRs in the Hyderabad property, we believe ARRs in Bangalore are expected to soften post-FY2008 owing to the new properties going on stream. We expect the growth rate to slow down due to limited headroom for increasing occupancy. We expect ARR to increase by 15%-20% in the next two years but margins to decline, as the new properties begin operations in FY09. Having taken into account rupee appreciation, we expect hotels to report 16.7% CAGR in sales and 12.5% CAGR in EBITDA over FY07-FY09.

20% PAT CAGR likely post FY08

We expect ITC to post steady growth in the coming few years. We estimate sales and PAT growth at 19.7% and 17.2% over FY07-FY10. The sales and PAT growth post FY08 is expected to be above 20% as the impact of VAT imposition on cigarettes will be likely over by 2008. We expect sharp growth in paper business post FY08 and expect new FMCG businesses to turnaround by 2010.

Valuations attractive; Buy

The stock has underperformed the BSE Sensex in the past one year by 39% owing to uncertainty of cigarette volumes over VAT imposition. Given the company's strong free cash flows, popular brands, market leadership in key businesses and the immense potential offered by its e-Choupal initiative, we remain positive on the stock. We maintain Buy, with an SOTP-based target price of Rs 203, a 33% upside.