FMCG - Cigarettes... set for high decadal growth - ICICI Securities

India's unique tobacco consumption pattern is set for rapid change driven by a secular decline in beedi consumption and more regulatory concerns on chewing tobacco, thereby benefitting cigarette consumption. We believe the cigarette market should witness strong growth in the current decade, with substitutes declining and the 64mm segment playing a strong role in recruiting new smokers. Our analysis suggests the industry can see a 5-8% CAGR increase in the number of smokers over the next 10 years. We analyse in detail the sources and the drivers of this growth in this report. We initiate on ITC and VST with a strong BUY.

Opportunity for cigarette consumption volumes to grow 5-8% CAGR over the next 10 years: While cigarette consumption volume has grown at a CAGR of 1% over the last 2 decades, we believe the Indian cigarette industry has an opportunity to grow at 5-8% CAGR in volume terms through the current decade. Though the industry has seen flat volumes over the past four years, there has been a clear polarisation trend - KSFT (King Size Filter, 84mm) volumes growing at 16% CAGR, and economy RSFT (Regular Size Filter, 69mm, priced to make gross margin contribution of 15-25%) volumes growing at 25% CAGR. We believe an aggressive launch of the 64mm category can provide the volume impetus. Our analysis suggests the cigarette industry can see 5-8% volume CAGR driven by shift from other forms of tobacco over the next 10 years. We analyse the sources of this growth: 1.5-2.0% is the natural growth in the number of cigarette smokers in line with the population trend, while the rest being shift from beedi (hand-rolled Indian traditional cigarette) and gutkha (tobacco-laced areca nut pieces).

- Expect aggressive launch of 64mm cigarettes soon: Though cigarette companies have only soft-launched variants of 64mm cigarettes in the past three months, we learn that consumer acceptance for the category runs high. We expect an early and aggressive launch of 64mm sticks to capture >10% market volume by FY14. Our analysis shows the current price point of some 64mm brands do not make it conducive for companies to go aggressive, so we expect revised prices for nationwide launch. We emphasise that though the 64mm category offers huge opportunities for volume growth, as this segment will make lower absolute gross margin contribution per stick, ITC will accelerate its launch plans only after ensuring that it maintains average absolute gross margin contribution in the overall portfolio, for which the price proposition for 64mm needs to be revised.

- Expect ITC to take further price increases by Oct'12: We expect ITC to take 3-4% further price hikes on its cigarettes portfolio by Oct'12. This additional price hikes along with the ones taken post the Union Budget and 1% volume growth in FY13E will enable the company's cigarette segment to report 20% EBIT growth during the year. Further, these price hikes shall also increase feasibility of the 64mm category.

- Initiate with strong BUY on ITC and VST: As we expect 64mm to charge the cigarettes consumption volume over the next 10 years, we believe both ITC (leader in the cigarettes industry) and VST (strong position in the economy filters segment) shall stand to gain. We expect VST to redesign its portfolio to capture the economy segment of 64mm at Rs2 price point. We expect ITC's earnings to grow at 22.1% CAGR and VST's at 24.2% CAGR over FY12-FY15. We initiate with a strong BUY on both ITC - trading at 17.9FY15E, and VST - trading at 9.8xFY15E, with target price of Rs306 and Rs2,302 respectively based on FY14 earnings.

Source : Equity Bulls

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