ITC acquires paperboard unit of BILT- a neutral
event: ITC has established a dominant position in the value-added paperboard segment in
India with the acquisition of a 65,000-tonne facility for Rs 2.33 bn. The overall market
size for value added paperboard in India is about 250,000 tonne. ITC would now account for
more than 80% of this market and would thus have some pricing power for its overall
business. The current pricing for paperboard is at lower than import parity pricing and to
that extent there is a leeway to improve the product price depending on the demand
elasticity.
As per the terms of the deal, there are six bullet payments
of equal size beginning in year 0 and then at the end of every year until year five. The
NPV of the deal using a cost of capital of 13% for ITC works out to Rs 1.8 bn. Operating
at a steady state, the acquired unit should be able to generate sales of Rs 1.9 bn-2 bn
and earn 15-20% EBIT margins, without factoring in much upside from pricing. As such, in
theory the acquisition should be able to generate enough cash flows to pay back the cost
of acquisition over the five-year time frame. We believe this acquisition does not mean
any increase in outlay for capital expenditure for ITC and will be within the Rs 6 bn
guidance for annual capex.
Limited impact on overall corporate profitability:
The impact of the acquisition, as we have assumed in
our earnings model, is limited. Our EPS for FY05E and FY06E have increased by 1.2% each.
We have not altered our capex projections and believe it will be capped within Rs 6 bn
annually. We have assumed that in FY05 ITC can utilise 70% of the acquired capacity and
80% in FY06. There would likely be upside if ITC delivers a higher utilisation rate.
Investment thesis:
We rate ITC Buy/low risk (1L). Our positive call on the
stock is premised on a recovery for the core cigarette business as well as cyclical
recoveries for its hotels and paperboard businesses. ITC is building a strong portfolio of
non-cigarette consumer businesses, which we believe will help valuations over a longer
term. We have received positive feedback from trade channels about ITC’s recent
initiatives in the food business. With price and volume leadership for the cigarette
business, ITC has demonstrated significant ability to expand it operating profits. While
the issue of investment in non-consumer businesses has been crapped with limited
investments, we believe a rising dividend payout ratio could help valuations. While BAT is
committed to developing ITC’s business in India, it will be very difficult for it to
get a controlling stake in this company unless facilitated by the government. With a rural
recovery in the offing, ITC looks set to be a beneficiary as half of its cigarette volumes
are derived from the rural economy.
Valuation
Our target price for ITC is Rs 950 based on about 13.5x
FY04E EPS, a 10% premium to sensex valuations. The company is investing in the
non-cigarette consumer businesses and the growth of this segment should help rating
multiples. We believe ITC can trade at 8-10xEV/EBITDA, which is at the lower end of its
historical trading band. The company has tremendous brand equity for its core cigarette
brands and will likely get a premium over the broader market. Our target price of Rs 950
is based on 8.5xEV/FY04E EBITDA.
Near-term market volatility and short-term trading patterns
may cause the Expected Total Return to become temporarily misaligned relative to the
hurdle for this stock’s fundamental rating, as defined under our current system.
Risks
We rate ITC ‘Low Risk’ as the company
operates in branded businesses and has witnessed low volatility in its earnings. It has
steadily increased its earnings over the years and we believe the dominance in its
categories will allow it to continue this trend.
With much of its earnings coming from the tobacco segment,
the most important risk for ITC is controls on the business and the taxation policy of the
government. Being perceived as a sin (read "unhealthy") industry, the stock
attracts negatives such as environmentalist action as well as limited investment
opportunities.
Another significant risk to the company is the dilution in
capital efficiency from investments being committed to non-tobacco businesses, some of
them being global cyclicals and others economy cyclicals. Risks could emerge from any
acquisition that the company announces in these capital-intensive businesses.