Robust cash flows in the cigarette business is helping ITC improve its revenue mix and build businesses that will help sustain growth rates.
ITC has seen headwinds in the cigarette business in last two years led by changes in regulations and tax structure. While excise duties were increased by 6 percentage points and value-added tax of 12.5 per cent was imposed on cigarettes in FY08, duties on non-filter cigarettes were hiked in 2008-09 budget. About three months back, smoking in enclosed public places was also banned. But, these moves have not prevented ITC from investing in its businesses, which also include hotels, paperboards and FMCG products.
Notably, and going forward, even as the recent terror attacks may play a spoilsport for its hotel business, ITC’s consolidated numbers are expected to grow at a healthy pace. This will be driven by growth in the cigarette business, improvement in non-tobacco FMCG businesses and volume expansion in the paperboards business.
FMCG-Cigarettes
Three out of every four cigarettes consumed in India are from the ITC stable. These are sold under domestic brands like Wills, Gold Flake, India Kings and Scissors besides, foreign brands like State Express 555 and Benson & Hedges, which are owned by BAT, UK (owns 32 per cent stake in ITC).
Over the last few years, regular changes in the tax structure and regulations have not only made cigarettes expensive, but have also threatened to lower consumption. The hike in duties on non-filter cigarette in the 2008-09 budget saw the company discontinue its non-filter cigarette sales (about 20 per cent of volumes). Such moves have impacted overall cigarette volumes of ITC, which analyst say were down 2-3 per cent in H1 FY09 (similar trend expected for FY09).
Positively, cost control measures, judicious price hikes and efforts to upgrade consumers to filter-based cigarettes has paid off; topline was up 10.6 per cent and profit was up 9.2 per cent during H1 FY09. In fact, profit margins were up in Q2FY09 at 55.6 per cent (54.9 per cent in Q2 last year). The recent ban on smoking in enclosed public places, too, hasn’t impacted sales in any meaningful manner.
Going forward, analysts say that margins should increase marginally due to better product mix, price hikes effected in Q2 and lower expenses (which ITC had incurred in an effort to upgrade customers to filter cigarettes). Also, the mandate of putting ‘pictorial signs’ indicating the harmful effects of smoking on the cigarette packs (from June 2009) is unlikely to have any visible impact on the ITC’s sales; partly due to the fact that about 70 per cent of cigarettes sold in India are in loose format.
More From This Section
Overall, analysts expect cigarette volumes to grow between 2-5 per cent in FY10. In short, the company’s cash cow (cigarette) should continue to generate money, which can be use for investing in other businesses.
FMCG- Others
Many of the non-tobacco FMCG businesses like processed foods, personal care and apparels have high growth potential due to low per capita consumption and under-penetrated markets. For ITC, a low base suggests that growth rates should be ahead of the industry average. But, since quite a few of these businesses are in the nascent stage of development they will continue to incur losses.
ITC forayed into snack foods (‘Bingo’ potato chips) in March 2007 and in soaps and shampoos (‘Fiama Di Wills’, ‘Vivel Di Wills’ and ‘Superia’) in September 2007. Since early 2007, it has launched many products/variants and increased spending on advertising and promotions.
These product development expenses are largely responsible for the increase in losses, more so in the last three quarters. Against a loss before interest and segment of Rs 264 crore in FY08, the same stood at Rs 239 crore in H1FY09. With most of the product launch expenses through and consumer response healthy (Bingo’s share at 16 per cent of potato chips market), the H2 FY09 is likely to be better (estimated loss of Rs 150 crore) with further improvements expected in FY10.
In processed foods, margins are seen improving due to the easing of commodity prices (wheat, vegetable oils) and as businesses like snack foods gain further scale. Analysts say that the increasing thrust on high margin products (like cream biscuits, as against low-priced glucose biscuits) will also help spur margins. Overall, ITC inherently also enjoys the advantage of direct sourcing of tobacco leaf and other agri-commodities from farmers, which help control costs and quality in its businesses including processed foods, which includes staples, biscuits, ready-to-eat foods and snack foods.
In the lifestyle retailing (apparel) business, which sells apparels under brands like Wills Lifestyle and John Players, margin pressure is also expect to ease as ITC is expected to renegotiate rentals in light of the subdued real estate market.
| BUSINESS MIX | ||||
| in Rs crore | FY06 | FY07 | FY08 | CAGR(%)5-year |
| GROSS REVENUES | 17,701 | 21,110 | 23,670 | 14.8 |
| FMCG-Cigarettes | 11,330 | 12,834 | 13,826 | 9.5 |
| FMCG-Others | 1,013 | 1,689 | 2,511 | 87.2 |
| Hotels | 783 | 986 | 1,100 | 41.6 |
| Agri Business | 2,678 | 3,501 | 3,868 | 18.5 |
| Paperboards & Paper | 1,896 | 2,100 | 2,364 | 15.2 |
| Share of cigarette (%) | 64 | 60.8 | 58.4 | - |
| EBIT | 3,237 | 3,861 | 4,364 | 15.5 |
| FMCG-Cigarettes | 2,709 | 3,172 | 3,634 | 13.6 |
| FMCG-Others | -172 | -202 | -264 | NA |
| Hotels | 258 | 351 | 411 | 109.9 |
| Agri Business | 91 | 124 | 129 | 9.0 |
| Paperboards & Paper | 351 | 417 | 453 | 14.9 |
| Net Profit | 2,235 | 2,700 | 3,120 | 17.9 |
| Share of cigarette (%) | 83.67 | 82.15 | 83.28 | - |
Paper, Paperboards & Packaging
This business, which supplies packaging and printing solutions to many industries, has consistently delivered EBIT margins of 18-19 per cent in the last five years. However, in the last few quarters, margins have been under pressure due to high input costs (coal, power), and recently, due to higher depreciation on new capacities. Notably, with the company’s pulp facility stabilising (120,000 tonne per annum-TPA), coal prices down and small price hikes effected, margins should improve going forward. That apart, volume growth should improve led by contribution from new capacities (100,000 TPA). Since this business accounts for about 10 per cent each of revenues and profits, the impact on ITC’s numbers should be positive.
Hotels
With the hotel industry witnessing subdued times, prospects for ITC’s hotel business is unlikely to be very different. In fact, revenue growth has ranged at just 12-14 per cent in the last year-and-a-half. Although profit growth was better at 18 per cent during the same period, it slipped to just 4 per cent in Q2FY09. This business, which operates 90 properties (over 6,000 rooms), will see a new super deluxe hotel each coming up in FY10 (Bangalore) and FY11 (Chennai), which along with other expansions should help improve volumes.
Agri
Although a visible contributor to revenues (16 per cent), which accrue from trading of tobacco leaves and agri commodities, its contribution to profits has been small at 3-5 per cent. While these have improved recent to 5.7 per cent in H1FY09, thanks to better tobacco leaf prices, expect them to hover at 4-5 per cent in the medium-term.
| GROWING STRONGER | |||
| in Rs crore | FY08 | FY09E | FY10E |
| Net sales | 13,948 | 16,532 | 19,941 |
| OPM (%) | 31.6 | 30.0 | 29.5 |
| Net profit | 3,110 | 3,423 | 3,988 |
| EPS (Rs) | 8.3 | 9.1 | 10.6 |
| PE (x) | 20.5 | 18.6 | 16.0 |
| * Standalone numbers; E: Analysts estimates | |||
Investment rationale
ITC’s move into various non-tobacco FMCG businesses and expansion of its e-Choupal network are seen as steps towards building long-term sustainable growth drivers. And ITC, which has an annual cash flow of over Rs 4,000 crore from operations, funding these initiatives will not be an issue. Interestingly, ITC has well integrated operations in many of its businesses, including tobacco, foods, paper and agri, which is a big positive in the long-run. Meanwhile, in light of the improving prospects for the FMCG businesses (cigarette and others), which together contribute about 60 per cent to revenues and 75 per cent to profits; ITC’s consolidated performance should remain healthy. At Rs 169.30, the stock is trading at 16 times its estimated FY10 earnings, and can deliver 20-22 per cent returns in the next one year.