Godfrey Phillips India Ltd.

(GPIL)

(CMP: Rs. 2288.2) Changing gears could lead to a re-rating

CMP (Rs.) 2288.2 Price Target (Rs.) 2584

Q4FY11 Result Update

HDFC Sec Scrip code GODPHIEQNR Company Background Industry Cigarettes

June 17, 2011

Recommended Action Existing investors can hold, fresh investors could add on dips in the price band of Rs. 2122-2215

Time Horizon 1-2 quarters

Incorporated in 1936, the K. K. Modi group promoted Godfrey Phillips India Ltd. (GPIL) is the second largest player in the Indian cigarette industry. The company owns some of the most popular cigarette brands in the country like Four Square, Red and White, Jaisalmer, Cavanders and Tipper. Over the years, GPIL has set its own benchmarks in innovation with revolutionary brands like Stellar, the first slim cigarette and I-gen, the first euro norm cigarette in India. The companys products are distributed over an extensive India wide network of more than 500 distributors and 800,000 retail outlets. With the Corporate Office in Delhi, the Company has offices over 8 locations in India. GPIL has two major stakeholders, one of India's leading industrial houses - the K. K. Modi Group, which holds 46% stake and one of the world's largest tobacco companies, Philip Morris Inc, US (PMI), which holds 25.1%. Nationally, GPIL enjoys ~12-13% market share in cigarettes in terms of volume and 11-12% share in value. GPILs plants are situated at Andheri (Mumbai) and Baramati and the plant located at Guldhar (Ghaziabad) is owned by GPILs wholly owned subsidiary, International Tobacco Company Ltd. The companys business can be categorized into two segments, i) Cigarettes & Tobacco products and ii) Tea & Related Products. The cigarettes & tobacco products segment accounts for 91.5% (in FY11) of GPILs total revenue. The balance is contributed by diverse businesses like Tea, Confectionery, Chewing Products, Cosmetics and Retail (included under Tea & Related products). GPIL has four wholly owned subsidiaries (direct) namely International Tobacco Company Ltd, Chase Investments Ltd, City Leasing & Finance Co Ltd and Manhattan Credits Finance Ltd. The other indirect subsidiaries include Kashyap Metal & Allied Industries Ltd (66.23%), Unique Space Developers Ltd. (66.67%), Gopal Krishna Infra & Real Estate Ltd. (66.67%) and Rajputana Infra Corp Ltd. (66.23%). All the direct & indirect subsidiaries have been incorporated in India. International Tobacco Company manufactures cigarettes on behalf of GPIL, which account for 57.6% of GPILs total sales quantity of cigarettes. GPIL pays manufacturing charges to International Tobacco for manufacturing on its behalf, which is netted off in the consolidated accounts. None of the other subsidiaries have started generating the revenues. GPILs Q4FY11 results were impressive & better than our estimates. Given below is a brief overview of the same.

Q4FY11 Results Review (Standalone)

Y-o-Y GPILs net sales grew by 30.6% to Rs. 4580.3 mn [Q4FY10: Rs. 3505.9 mn] on the back of strong performance by Cigarettes & Tobacco products business, which grew by 31.1%, thus contributing 91.9% to GPILs total net sales. Tea & related products also reported decent growth of 15.6%. The operating profit jumped up sharply by 281.8% to Rs. 870.2 mn [Q4FY11: Rs. 227.9 mn], while OPM improved by 1250 bps Y-o-Y to 19%, mainly due to decline in the advertisement & sales promotion expenses (down 4.3% Y-o-Y) & marginal growth in the material cost (4.8% Y-o-Y). However, higher other expenses (up 60% Y-o-Y) restricted further margin expansion. Segment-wise, Cigarettes & Tobacco products business PBIT increased significantly by 250.3% Y-o-Y, while the PBIT margins improved by 1177 bps Y-o-Y to 18.8%. Tea & Related products segment reported marginal profit of Rs. 3.1 mn as compared to a loss of Rs. 21.7 mn in Q4FY10. Lower effective tax rate (down 88 bps Y-o-Y to 31.7%), higher other income (up 111.8% Y-o-Y) & relatively lower growth in depreciation cost (up 34.1% Y-o-Y) boosted the PAT, which increased by 294.4% to Rs. 563.2 mn [Q4FY10: Rs. 142.8 mn]. PAT margins improved significantly by 823 bps Y-o-Y to 12.3%. EPS for the quarter stood at Rs. 54.2 vs. Rs. 13.7 in Q4FY10.

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Q-o-Q Sequentially, the results were decent on the revenue front and impressive on profit front. The net sales grew by 9.9%, supported by robust growth of 10.7% Q-o-Q reported by Cigarettes & Tobacco products. However, Tea & Related products segment sales declined by 6.2% Q-o-Q. The operating profit growth was much better at 59.5%, while the OPM improved by 591 bps Q-o-Q from 13.1% in Q3FY11 on the back of 21.6% decline in the Advertising & Sales promotion expenses. The benefit of lower effective tax rate (down 73 bps Q-o-Q) was offset by decline in the other income & other operating income (down 7.4% & 31.3% Q-o-Q respectively) and higher depreciation expense (up 30% Q-o-Q). PAT grew by 50%, while the PAT margins improved by 329 bps Q-o-Q from 9% in Q3FY11.

FY11 financial overview: (Consolidated) [Marginal difference between standalone & consolidated financials]
The net sales grew by 15.8% Y-o-Y to Rs. 16024.5 mn [FY10: Rs. 13838.7 mn] on the back of robust performance by both its segments viz; Cigarettes & Tobacco products & Tea & Related products. The operating profit grew by 62% to Rs. 2473.2 mn [FY10: Rs. 1526.7 mn], while the OPM improved by 440 bps to 15.4% mainly on the back of decline in the material cost (down 1.8%). However, higher effective tax rate (up 173 bps to 31.3%) & decline in the other income (down 48.8%) put some pressure on PAT, which increased by 44.4% to Rs. 1661.3 mn [FY10: Rs. 1150.7 mn]. PAT margins improved by 170 bps to 10.4%. EPS for FY11 stood at Rs. 159.7 vs. Rs. 110.6 in FY10. GPIL announced dividend of Rs. 35 per share for FY11 vs. Rs. 25 in FY10.

Quarterly & Yearly Financials: (Standalone)

(Rs. in Million) Particulars Gross Sales Excise Duty Net Sales Other Operating Income Other Income Total Income Total Expenditure Raw Material Consumed Stock Adjustment Purchase of Finished Goods Employee Expenses Advertising & Sales Promotion Other Expenses PBIDT Interest PBDT Depreciation Q4FY11 8365.3 3785 4580.3 53.3 50.4 4684.0 3710.1 1132.7 9.8 628.6 371.9 573.2 993.9 973.9 25.9 948.0 123 Q4FY10 6795.7 3289.8 3505.9 67.0 23.8 3596.7 3278.0 942.9 2.8 744.0 232.4 599.0 756.9 318.7 15.1 303.6 91.7 VAR [%] 23.1 15.1 30.6 -20.4 111.8 30.2 13.2 20.1 250.0 -15.5 60.0 -4.3 31.3 205.6 71.5 212.3 34.1 Q3FY11 7869.9 3700.6 4169.3 77.6 54.4 4301.3 3623.7 1094.3 72.6 466.3 342.3 731.5 916.7 677.6 27 650.6 94.6 VAR [%] (Q-o-Q) 6.3 2.3 9.9 -31.3 -7.4 8.9 2.4 3.5 -86.5 34.8 8.6 -21.6 8.4 43.7 -4.1 45.7 30.0 Q2FY11 7232.5 3537.8 3694.7 73.1 84.1 3851.9 3021.8 1086.4 -144.1 347.3 344.7 525.4 862.1 830.1 25.9 804.2 98.9 Q1FY11 7105.5 3525.3 3580.2 91.0 26.7 3697.9 3266.3 1084.5 9.7 415.4 329.0 589.3 838.4 431.6 19.7 411.9 83.5 FY11 30573.2 14548.7 16024.5 295.0 215.6 16535.1 13621.9 4397.9 79.7 1857.6 1387.9 2419.4 3479.4 2913.2 98.5 2814.7 400.0 FY10 26076.6 12237.9 13838.7 239.8 412.8 14491.3 12409.3 3564.8 -95.3 2982.3 1058.6 1978.5 2920.4 2082.0 69.0 2013.0 339.1 VAR [%] 17.2 18.9 15.8 23.0 -47.8 14.1 9.8 23.4 -183.6 -37.7 31.1 22.3 19.1 39.9 42.8 39.8 18.0
2

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PBT Tax (DT & FBT) Reported Profit After Tax EPS (Rs.) Equity Face Value OPM (%) PATM (%)

825.0 261.8 563.2 54.2 104 10.0 19.0 12.3

211.9 69.1 142.8 13.7 104.0 10.0 6.5 4.1

289.3 278.9 294.4 294.4 0.0 0.0 192.3 201.9

556.0 180.5 375.5 36.1 104 10 13.09 9.01

48.4 45.0 50.0 50.0 0.0 0.0 45.2 36.5

705.3 211.0 494.3 47.5 104.0 10.0 18.21 13.38

328.4 101.1 227.3 21.9 104.0 10.0 8.8 6.3

2414.7 754.4 1660.3 159.6 104.0 10 15.0 10.4

1673.9 490.1 1183.8 113.8 104.0 10.0 10.3 8.6

44.3 53.9 40.3 40.3 0.0 0.0 45.2 21.1

(Source: Company, HDFC Sec)

Quarterly & Yearly Segmental: (Standalone)

(Rs. in Million) Particulars Revenue from Operations Cigarettes & Tobacco Products Tea and related products Profit/Loss Before Interest and Tax Cigarettes & Tobacco Products Tea and related products Less: Interest Other Un-allocable Expenditure Add: Other Income Net Profit/Loss Before Tax PBITM (%) Cigarettes & Tobacco Products Tea and related products Capital Employed in Segment Cigarettes & Tobacco Products Tea and related products Unallocated Net Assets/Liabilities Total Capital Employed Q4FY11 4633.6 4258.1 375.5 803.9 800.8 3.1 25.9 0 47 825.0 17.3 18.8 0.8 6923.5 6708.1 215.4 979 7902.5 Q4FY10 3572.9 3248.2 324.7 206.9 228.6 -21.7 15.1 0 20.1 211.9 5.8 7.0 -6.7 5913.4 5631.7 281.7 751.8 6665.2 17.1 19.1 -23.5 30.2 18.6 VAR [%] 29.7 31.1 15.6 288.5 250.3 71.5 133.8 289.3 Q3FY11 4246.9 3846.4 400.5 537.1 535.4 1.7 27 0 45.9 556 12.6 13.9 0.4 6542.3 6297.5 244.8 1220 7762.3 5.8 6.5 -12.0 -19.8 1.8 VAR [%] (Q-o-Q) 9.1 10.7 -6.2 49.7 49.6 82.4 -4.1 2.4 48.4 Q2FY11 3767.8 3429.2 338.6 598.8 608.8 -10 25.8 0 132.3 705.3 15.9 17.8 -3.0 7256.0 7008.2 247.8 130.8 7386.8 Q1FY11 3671.2 3395.7 275.5 380.8 391.5 -10.7 19.7 32.7 0 328.4 10.4 11.5 -3.9 6512.9 6295.7 217.2 379.6 6892.5 FY11 16319.5 14929.4 1390.1 2320.6 2336.5 -15.9 98.4 0 192.5 2414.7 14.2 15.7 -1.1 6923.5 6708.1 215.4 979 7902.5 FY10 14078.5 12869 1209.5 1347 1414.6 -67.6 68 0 394.9 1673.9 9.6 11.0 -5.6 5913.4 5631.7 281.7 751.8 6665.2 17.1 19.1 -23.5 30.2 18.6 VAR [%] 15.9 16.0 14.9 72.3 65.2 44.7 -51.3 44.3

(Source: Company, HDFC Sec)

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Yearly Financials: (Consolidated)

(Rs. in Million) Particulars Gross Sales Excise Duty Net Sales Other Operating Income Other Income Total Income Total Expenditure Raw Material Consumed Stock Adjustment Purchase of Finished Goods Employee Expenses Advertising & Sales Promotion Other Expenses PBIDT Interest PBDT Depreciation PBT Tax (DT & FBT) Reported Profit After Tax Minority Interest & Profit / Loss in Assc. PAT (net of minority interest & profit / loss in Assc.) EPS (Rs.) OPM (%) PATM (%) FY11 30573.2 14548.7 16024.5 271.8 206.7 16503 13551.3 4397.9 79.6 1857.6 1578.3 2419.4 3218.5 2951.7 99 2852.7 439.2 2413.5 754.8 1658.7 -2.6 1661.3 159.7 15.4 10.4 FY10 26076.6 12237.9 13838.7 213.5 403.8 14456 12312 3564.8 -95.7 2982.3 1191 1978.5 2691.1 2144 69.1 2074.9 375.6 1699.3 502 1197.3 46.6 1150.7 110.6 11.0 8.7 VAR [%] 17.2 18.9 15.8 27.3 -48.8 14.2 10.1 23.4 -183.2 -37.7 32.5 22.3 19.6 37.7 43.3 37.5 16.9 42.0 50.4 38.5 -105.6 44.4 44.4 39.9 19.6

(Source: Company, HDFC Sec)

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Conclusion
GPILs FY11 results were much better than our estimates with sales growing at a robust rate with the profitability & margins improving significantly over FY10. Despite regulatory hurdles like pictoral warnings, ban on smoking in public places and burdensome tax structure, the company has maintained its growth momentum in cigarettes business. The company has successfully responded by reiterating collective representation, product customization, diversification and geographical expansion. In FY11, the Cigarettes & Tobacco business grew by 16% despite a significant hike in the excise duty on cigarettes in Union Budget FY10-11. We feel that going forward, pictoral warnings are unlikely to impact cigarette volumes. Further, cigarettes demand being largely inelastic, GPIL would not find it very difficult to pass on any excise hikes in future to the consumers and the impact on volumes could be only for the short term. Further, in Union Budget FY12, there was no hike in excise duty on cigarettes, which is positive for GPIL & could improve the cigarette volumes in FY12. GPIL has been able to have an access to the flagship brand of PMI Marlboro post alliance with PMI. It has also got access to PMIs technology. The Marlboro portfolio has seen a growth rate of over 30% since this strategic arrangement. With the expansion of retail outlets and launch of new variants, we expect this brand to continue to grow at a decent rate over the next few years, which could boost GPILs revenues & profits. To reduce its dependance on cigarettes business, which is largely government regulated, GPIL has diversified into other business like Tea, Cosmetics, Confectionery, and Retail. The company has also forayed into Chewing products category by launching Pan Masala brand Pan Vilas. GPL is scaling up these businesses (reported under Tea & Related products) rapidly by making large investments and expects Tea and Pan Vilas products to be the new growth drivers over the next few years. In FY11, the segment reported good growth in sales (14.9%) and surprisingly the segment loss reduced much faster than our expectations (from Rs. 67.6 mn in FY10 to Rs. 15.9 mn in FY11). Infact in Q3FY11 & Q4FY11, the segment reported marginal profit of Rs. 1.7 mn & Rs. 3.1 mn respectively, thus witnessing a turnaround. We expect the topline of other businesses to grow at a robust pace & losses (PBIT) to reduce further in FY12. Infact after reviewing H2FY11 profitability, we feel that the segment could breakeven on PBIT front in FY12. Once the segment starts adding to the bottomline, GPILs margins could improve further. Recently, the Supreme Court banned the sale of tobacco, gutka & pan masala in plastic pouches from March 01, 2011. While this could impact GPILs production & sales of pan masala (in Chewing Products category) in near term until the company is ready with new packaging, the non-availability of chewing tobacco products could indirectly encourage more smoking of cigarettes, thus boosting its cigarettes business. In April 2011, KK Modi Group announced an organizational restructuring with the setting up of a family council to ensure promoter interests in its businesses while roping in ex-IOC Chairman Sarthak Behuria to steer the corporate functioning. The move is part of its strategy to become a $5bn group in terms of market capitalisation in the next 5 years to be fuelled by growth in domestic & global markets. The Corporate Executive Committee under the stewardship of Behuria would be responsible for driving the group's portfolio strategy, support growth aspirations of the various operating companies. It would also work to make transformational moves and accelerate GPILs international expansion via organic and inorganic means. This organizational restructuring could lead to faster decision-making and GPIL could get better valuations going forward We feel that GPIL would comfortably surpass our net sales & profit projections for FY12. Hence we are raising our Net Sales, Operating & PAT estimates by 2.6%, 8.5% & 15.6% respectively. Margins are likely to improve over FY11 on the back of lower raw material cost as a % to net sales over the next two years. This is mainly because of GPILs increasing focus on mid to high-end cigarette brands and foray into larger regular filter market. Revised EPS is likely to be Rs. 184.6 vs. our original projection of Rs. 159.6. At CMP of Rs. 2288.2, GPIL trades at 12.4xFY12E EPS, which is at a huge discount to ITC. Considering its sound business model, its ability to generate strong cash flows in cigarettes despite regulatory hurdles & high tax burden and diversification into new business, which are not prone to government intervention, we feel that GPIL deserves to trade at better valuations. Further the Indian market offers better scope in terms of likely increase in cigarettes volume growth due to demographic factors and also due to the absence of consumer litigation in India. This makes us believe that GPIL should trade at a premium to its global cigarette peers going forward. The company has been able to generate strong cash flows over the last three years and is expected to improve it going forward. Moreover, GPILs Market Cap / Sales for FY12E stand at 1.3x, which further makes the valuation attractive. GPIL reportedly has paid Rs. 120 mn as advance tax for first instalment for FY12 (in June 2011) vs. Rs. 60 mn paid last year. In our Stock Note dated April 27, 2011, we recommended investors to buy Godfrey Phillips India Ltd. at Rs. 1935.6 & to average it on dips in the price band of Rs. 1755-1835 for sequential price targets of Rs. 2234 & Rs. 2394 over the next 2 quarters. Thereafter, the stock touched a low of Rs. 1900 on May 20, 2011 & subsequently met our first price target on June 15. Taking into account strong FY11 performance, upgrading of FY12 projections and possibility of the stock getting re-rated, we are accordingly revising our second price target upwards to Rs. 2584 (14xFY12E EPS). Hence we recommend existing investors to hold this scrip, while fresh investors could buy it on declines in the price band of Rs. 21222215 (11.5-12xFY12E EPS) for the above mentioned price target over the next one to two quarters.

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Financial Estimations: (Consolidated)

(Rs. in Million) Particulars Net Sales Operating Profit PAT (Adjusted) EPS (Rs.) OPM (%) NPM (%) PE
* Act - Actual; OE - Original Estimates; RE - Revised Estimates

FY08 9029.3 1474.1 1243.4 119.6 16.3 13.8 19.1

FY09 11320.9 1505.4 1085.5 104.4 13.3 9.6 21.9

FY10 13838.7 1526.7 1150.7 110.6 11.0 8.3 20.7

FY11E 15658.2 2124.3 1396.4 134.3 13.6 8.9 17.0

FY11 (Act) FY12 (OE) FY12 (RE) 16024.5 2473.2 1661 159.7 15.4 10.4 14.3 17653.2 2603.9 1660 159.6 14.8 9.4 14.3 18107.7 2824.8 1919.4 184.6 15.6 10.6 12.4

(Source: Company, HDFC Sec Estimates)

Analyst: Mehernosh Panthaki (mehernosh.panthaki@hdfcsec.com) RETAIL RESEARCH Tel: (022) 3075 3400 Fax: (022) 2496 5066 Corporate Office
HDFC Securities Limited, I Think Techno Campus, Building - B, "Alpha", Office Floor 8, Near Kanjurmarg Station, Opp. Crompton Greaves, Kanjurmarg (East), Mumbai 400 042 Phone: (022) 3075 3400 Fax: (022) 2496 5066 Website: www.hdfcsec.com Email: hdfcsecretailresearch@hdfcsec.com
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