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ITC: All around improvement

Jan 22, 2005

Performance summary
Tobacco major, ITC, reported 11% growth in its December quarter net sales. Its profit growth however, was much better at 18% YoY, owing to operating margin expansion of over 1%. Overall, the company has clocked nearly 16% topline as well as bottomline growth in the first nine months of FY05.

(Rs m) 3QFY04 3QFY05 Change 9mFY04 9mFY05 Change
Gross sales 29,946 32,427 8.3% 87,329 98,256 12.5%
Net Sales 16,234 17,952 10.6% 45,885 53,080 15.7%
Expenditure 10,316 11,196 8.5% 27,667 32,369 17.0%
Operating Profit (EBDITA) 5,918 6,756 14.2% 18,218 20,711 13.7%
EBDITA margin (%) 36.5% 37.6% 39.7% 39.0%
Other income 418 512 22.6% 1,687 1,789 6.0%
Interest (net) 72 182 154.3% 166 412 147.9%
Depreciation 598 699 16.8% 1,791 2,080 16.2%
Profit before Tax 5,666 6,387 12.7% 17,948 20,008 11.5%
Tax 1,859 1,898 2.1% 5,890 6,041 2.6%
Profit after Tax/(Loss) 3,807 4,489 17.9% 12,058 13,966 15.8%
Net profit margin (%) 23.5% 25.0% 26.3% 26.3%
No. of Shares (m) 247.6 248.1 247.6 248.1
Diluted Earnings per share (Rs)* 61.5 72.4 64.9 75.1
Price to earnings ratio (x) 18.4
*(annualised)

What is the company's business?
ITC commands about 70% of India's Rs 120 bn domestic cigarette market (value terms). Out of the top 10 brands in India, 6 belong to ITC. The growing awareness on harmful effects of tobacco as well as the government's punitive tax policy forced ITC to move towards de-risking its revenue profile. Consequently, it merged the paperboards subsidiary with itself and invested in growing the hospitality, retailing, packaged foods and IT businesses. The ITC group has emerged as the second biggest luxury hotel chain after Indian Hotels. In packaged foods, its product range includes ready to eat (Kitchens of India), staples (Aashirvaad Atta and Salt), confectionery (Mint-O and Candyman) and biscuits. ITC has also entered into garment retailing and has 42 Wills Lifestyle stores. Other initiatives include greeting cards (20% market share), safety matches and incense sticks.

What has driven performance in 3QFY05?
Sales: Cigarettes (78% of 9mFY05 revenues) grew by a decent 5% during the quarter. However, this performance pales in comparison to the 11% growth growth it witnessed, both in the September quarter and the first half of the year. The company's FMCG business (comprising of retailing, foods, agarbattis, greeting cards etc.) grew by a strong 72%, but growth seems to be slowing down for this business. The revenues from this business had almost doubled in the June quarter. Hotels business benefited from capacity expasion, as well as the upturn in the industry's occupancy rate and grew by over 36% YoY in 3QFY05. The performance has also to be viewed in the context that the industry is coming out of a bad trough. Paperboards (12% of revenues) clocked a strong 24% growth led by continued shift to speciality paperboards and capacity augmentation. The company's agri business (13% of sales) clocked 6% growth. This business had grown by a strong 39% in the June quarter.

Turnover snapshot
(Rs m) 3QFY04 3QFY05 Change 9mFY04 9mFY05 Change Sales mix
Cigarettes 23,023 24,195 5.1% 68,777 74,990 9.0% 77.7%
Others 885 1,522 71.9% 2,151 3,894 81.0% 4.0%
Total FMCG 23,909 25,718 7.6% 70,927 78,884 11.2% 81.8%
Hotels 706 958 35.6% 1,773 2,268 27.9% 2.4%
Paperboards, paper & packaging 3,141 3,908 24.4% 9,180 11,536 25.7% 12.0%
Agri business 3,781 4,016 6.2% 11,123 12,639 13.6% 13.1%
Total turnover 31,537 34,599 9.7% 93,004 105,327 13.3% 109.2%
Less: Inter segment revenues 2,010 2,684 33.6% 7,361 8,859 20.3% 9.2%
Gross sales 29,528 31,915 8.1% 85,642 96,468 12.6% 100.0%

ITC grew by 8% at the gross sales level during the quarter. But increasing contribution of non-tobacco businesses to revenues (up from 19.7% in 9mFY04 to 22.3% in 9mFY05) has led to a decline in the percentage of excise burden on gross turnover (down from over 47.5% last year to 46.0% in 9HFY05). Thus, net sales growth was faster than gross sales.

PBIT as a % of sales
(Rs m) 3QFY04 3QFY05 9mFY04 9mFY05
Cigarettes 22.2% 23.2% 22.8% 23.0%
Others -42.5% -26.8% -52.7% -32.5%
Total FMCG 19.8% 20.2% 20.5% 20.3%
Hotels 15.9% 27.9% 7.7% 19.3%
Paperboards, paper & packaging 19.0% 19.5% 19.0% 19.6%
Agri business -0.3% 5.2% 6.0% 7.4%
Total PBIT 17.2% 18.6% 18.4% 18.7%
Margins: At the PBIT level, cigarettes saw an expansion in margins (up 1%). Hotels too saw margins improve considerably over last year. Infact, all of ITC's key business segments improved their profitability during the quarter as well as 9mFY05. The company's FMCG businesses like food processing, garment retailing, greeting cards, incense/match sticks etc. saw a reduction in their losses, thus aiding the overall margin expansion.

Cost break-up
as % of sales 3QFY04 3QFY05 9mFY04 9mFY05
Material cost 36.8% 36.4% 34.3% 35.7%
Staff cost 5.6% 5.4% 6.0% 5.5%
Other exp. 21.1% 20.6% 20.0% 19.7%
Total expenses 63.5% 62.4% 60.3% 61.0%
Net profit: The company's increasing capex on hotels and paperboards capacity has led to higher depreciation provisioning. Interest costs too seem to have risen on account of higher debt levels. However, higher operating margins, as well as an other income fillip has led to profits outpacing topline growth.

Over the last five quarters
3QFY04 4QFY04 1QFY05 2QFY05 3QFY05
Net sales growth (YoY) 10.6% 23.8% 24.2% 13.1% 10.6%
Cigarette value growth (YoY) 6.8% 7.1% 10.8% 11.2% 5.1%
Excise as % of gross sales 45.8% 43.1% 46.1% 47.2% 44.6%
OPM (%) 36.5% 28.6% 39.3% 40.2% 37.6%
Net profit growth (YoY) 17.7% 19.7% 16.3% 13.5% 17.9%

What to expect?
At Rs 1,379 the stock trades at 18.4 times annualised 9mFY05 earnings and market cap. to gross sales of 2.6x. Though the company has reported 1HFY05 EPS numbers that are above our FY05 estimates, we would like to maintain the same owing to the fact that its agri exports business has shown signs of volatility in the past. Slowly but surely, ITC's other businesses are coming of age, with improving profitability. The merger of ITC Hotels will also increase the non-tobacco revenues. Overall, we are enthused by ITC's performance and believe that the company's non-tobacco initiatives are on track.

The recent Supreme Court ruling on state level luxury taxes is a positive for tobacco companies in general and ITC in particular. The company has also had success in courts over past excise claims. All this is likely to free up its cash flows in the future, which may nudge the management towards higher dividend payouts. Our target price on ITC remains unchanged at Rs 1,635 over the medium term.

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