ITC: Dousing the smoke

Government risk is one reason why ITC valuation is low

The government order on the 17-year old excise case against ITC came as a surprise, but the damage has been adequately reflected in its share price.

The company had won the long pending appeal in the Supreme Court in September 2004 against an excise charge of Rs 800 crore (Rs 32 per share), which had led to a jump of Rs 37 in its share price on the day of the ruling.

The government order on Monday, which overruled the Supreme Court decision, led to a fall of Rs 38 in ITC's share price. ITC had deposited an amount of Rs 350 crore (Rs 14 per share) between April 1996 and January 1997 with the government, which will now not be refunded.

In addition, the company would have to pay Rs 450 crore (Rs 18 per share) in a month's time. The net impact would be lower since the payment would be a tax-deductible expense. In any case, the impact is fully represented in the share price especially since it's one-off in nature.

In comparison, the Supreme Court ruling last month against state governments imposing luxury tax would have a much bigger impact. ITC had made a provision of Rs 1,669 crore as on December 31, 2004, relating to these disputed state taxes, which had been stayed by the court.

This favourable ruling means that ITC needn't provide for these taxes anymore. With the cash on ITC's books being adequate to cover the existing contingent liability (in the worst case scenario that the company has to actually pay the entire amount), a higher proportion of future cash flows can be utilised to make dividend payouts.

Nonetheless, Monday's government ruling further proves that policy makers have a big say as far as the fortunes of cigarette makers go. It's no wonder ITC trades at around 15 times FY06 earnings despite a consistent record of strong growth.

ONGC

ONGC was the main beneficiary of higher oil prices in the last quarter, and the sharp improvement in its performance for the third quarter was hardly surprising. Net profit has grown 103 per cent to Rs 3493.32 crore.

Average crude realisations, pegged at $ 41 per barrel in the last quarter, have grown approximately 51 per cent on y-o-y basis.

As a result, net sales have grown 67.46 per cent to Rs 12103.53 crore in the December quarter. Other income too has grown 32.85 per cent due to improved interest and treasury income.

ONGC has also seen its share of subsidy losses rise, as per the formula worked out earlier with oil marketing companies (OMCs).

Subsidy losses in Q3 FY05 amounted to Rs 1,332.02 versus Rs 973 crore in the earlier quarter.

In the previous fiscal, upstream companies had provided their share of subsidy losses for the June and September quarter to OMCs only in the December quarter. ONGC's nine-month subsidy losses in FY05 have amounted to Rs 3,114.19 crore versus Rs 1,535.68 crore.

A larger turnover has helped to offset this growing subsidy burden "" operating profit grew 66.7 per cent to Rs 6,286.36 crore in the last quarter but operating profit margins were more or less steady at 52 per cent.

In spite of widely expected good results, concerns over the company's subsidy burden have led to this stock remaining flat over the last 4 weeks.

Going forward, the firmness in global crude prices is expected to help ONGC keep its net realisations buoyant. And this should help it to more than offset the rising subsidy burden on the company.

Dr Reddy's Labs: aggressive growth ruled out

Dalal Street had already factored a weaker performance from Dr Reddy's Laboratories, and the stock has fallen about 17 per cent over the last 4 weeks.

As expected, the company has reported a 90 per cent drop in net profit to Rs 4.34 crore in the December quarter. On a consolidated basis, the performance was even worse. Surging research and development costs, and marketing expenses coupled with a 4.9 per cent drop in net sales in the last quarter, have been responsible.

Net sales have fallen due to weakness in its API business "" API income has fallen 29.7 per cent in the last quarter, largely due to a fall in revenues at its European operations. European API sales declined on account of intense competition that led to a fall in sales of ramipril ( medication for the cardio-vascular segment).

To the company's credit, it has grown the generics business 73.5 per cent to Rs 61.33 crore largely by diversifying its markets overseas.

The company has also faced rising costs in the last quarter "" R&D costs have jumped 37.7 per cent to Rs 69.05 crore, while selling expenses too have grown 32 per cent.

With the company aggressively widening its client base overseas, a rise in marketing expenses is logical. The upshot: operating profit declining 88.28 per cent and operating profit margins fell 1260 basis points to 1.76 per cent.

Going forward, a rapid reversal in the company's performance is not anticipated. R & D costs are expected to remain high on a y-o-y basis in the next few quarters. Also as the company has not had any major generic launch for a long time, aggressive sales growth is also more or less ruled out.

With contributions from Mobis Philipose & Amriteshwar Mathur