ITC

Investors can consider booking profits in ITC shares, as the stock valuations (30 times trailing earnings, at Rs 254) seem to have outpaced the medium-term growth prospects. Forays into businesses less profitable than the core tobacco business and the likely moderation in growth rates for tobacco are the primary reasons for the recommendation.
CIGARETTES
ITC holds close to 70 per cent of the domestic market for cigarettes with the segment’s contribution to the topline averaging 65 per cent and profits 85 per cent for the four years ended March 2009. With strong pricing power to pass on excise duty hikes, operating margins have averaged a healthy 25 per cent, much higher than rivals such as Godfrey Philips. In-house production of cartons, filters and paper, coupled with efficient raw tobacco procurement, have made ITC a highly integrated player.
While the implications of the GST tax regime are unclear, further increase in taxes appear unlikely, given that current rates are already stiff. Despite ITC’s dominance in the cigarette business, challenges remain.
Under the current taxation structure , licensed products are at a disadvantage to smuggled or unlicensed low-end filter cigarettes and the grey market. This restricts the potential for uptrading, with fewer consumers being able to make the jump from beedis and chewing tobacco to filter cigarettes, but facilitates the reverse. That is one reason why cigarettes account for just 14 per cent of tobacco consumption in India.
The government’s efforts at creating awareness through a public smoking ban and graphic images may so far not have had a big impact on tobacco products. However, the broader consumer trend towards health and wellness is a negative for long-term growth in cigarettes.
All said, ITC may remain the market leader in the cigarette business, growing in high single-digits in terms of volumes. ITC’s ‘mindshare’ among consumers, not to mention a distribution system that will require years to replicate, is going to be hard to dent by rivals such as Philip Morris and Godfrey Philips. Over the medium term, the business is likely to remain the major cash cow, continuing to fund efforts to diversify into other businesses.
Non-cigarette FMCG
To diversify its revenues and profits, ITC has charted several forays into consumer products such as garments, confectionery, consumer staples, bakery products, snacks and stationery products.
However, the new businesses do have a long gestation period and establishing a market share has required big investments in advertising and distribution. The non-cigarette FMCG business showed a loss margin of 12.7 per cent on sales of around Rs 1,600 crore for the half year ended September 2009.
In the FMCG business, ITC has over the past couple of years moved from segments such as matches, snacks and consumer staples such as atta into the more highly competed soaps and personal products.
While ITC does enjoy a competitive edge in bakery products or consumer staples by virtue of its well established agri-product supply chain, the same cannot be said of the soap or personal products segments that are more brand-driven and far more saturated. Building a brand reputation in this business may entail high spending, considering well-entrenched competitors such as HLL, Colgate Palmolive and P&G whose operating margins range between 13-16 per cent.
The early signs for ITC’s biscuit brand, Sunfeast, and snack brand, Bingo, have been encouraging with estimates of its market share at 11 to 13 per cent. But, here again, well endowed incumbents such as Britannia, Parle, Pepsico’s Frito Lay have moved zealously to guard their turf.
While ITC has managed to win share in Round one of the battle, the business may continue to call for high investment and features lower margins (between 9 and 12 per cent).
HOTELS
One segment with the profit margins to give tobacco a run for its money is hotels. ITC operates 100 hotels under four brands generating close to Rs 1,100 crore of business in FY-09 and an average segmental profit margin of 35 per cent over the four financial years ended 2008-09, in line with the industry averages. Business slipped by over 20 per cent between FY-08 and FY-09 on account of the deteriorating business conditions, coupled with the terrorist attack.
Here, ITC’s focus on the premium and business travel segment, ensures that the strong signs of recovery across the economy will translate into better occupancy over the medium term. The company may be well-poised to capitalise on expected demand growth by virtue of being an early mover and an established brand.
paper and packaging
This segment generated revenues of over Rs 2,800 crore in FY-09 with internal sales accounting for 41 per cent and operating margin has averaged around 19 per cent for the last four years. Growth expectations are similar between 7 and 15 percent for various products.
AGRIBUSINESS
The agribusiness segment, procures rice, soya, coffee, wheat, tobacco, potatoes for trading and internal consumption.
ITC’s much-admired e-choupal, which is part of this segment, essentially provides information to farmers, procures directly from them and also doubles up as a mechanism for distribution of FMCG products and other services. For now, operating margin in this segment tends to swing quite sharply with the commodity prices and is likely to remain on the lower single-digit figures. In the half-yearly FY-10 results the segment saw a spike in segment margin to 14 per cent on the back of several commodity prices rising significantly from the lows in the second half of FY08.
ITC’s balance-sheet generates annual operating cash flows of about Rs 3,200 crore, allowing the company to make sizeable investments over the medium term into its diversification forays.
But even the winning outcome, with higher market share and volumes in non-cigarette businesses, is likely to leave ITC with lower net profit margins and lacks the dominance that it currently enjoys in tobacco. The size of the moat surrounding the ITC fortress is likely to shrink over the medium term
via BL