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ITC: Paradigm shift

Feb 22, 2005

ITC is a name synonymous with the Indian tobacco industry. With a 70% market share in the cigarette category backed by a wide range of brands, ITC is the undisputed leader. Out of the top 10 brands in India, 6 belong to ITC. The company has been in the news recently, first because of the excise relief from the Supreme Court (Rs 8 bn) and consequently, the anguish over the central government's order of paying up Rs 4.5 bn. In this article, we take a look at the business journey of ITC over the years. Background
Though the first six decades of the company's existence were primarily devoted to the growth and consolidation of the cigarettes and leaf tobacco businesses, the Seventies witnessed the beginnings of a corporate transformation. The company's multi-business portfolio encompasses a wide range of businesses like cigarettes & tobacco, hotels, information technology, packaging, paperboards & specialty papers, agri-exports, foods, lifestyle retailing and greetings & stationery. Though the company is diversified, the core business i.e. cigarettes contributed almost 72% of revenues in FY04.

The non-tobacco shift!
The share of cigarettes out of the total tobacco offtake declined from 21% two decades ago to 14% currently, despite the FMCG industry in India clocking a CAGR of 8% during this period. High government taxes on cigarettes is a key cause of concern for ITC, which amount in excess of 130% of the net value of the product. If one looks at the broader numbers, it is both an opportunity and a threat (India per capita consumption of cigarettes is 119 sticks per annum as against the world average of 1,267 sticks per annum). Then, why ITC diversified?

The answer to this question lies in understanding what is happening in the global markets. Companies like Phillip Morris are under intense regulator and public scrutiny with respect the health impact of cigarette consumption (law suits are a common phenomenon). In such a highly 'regulated' sector, from ITC's standpoint, it is important not to put all eggs in one basket. Therefore, the case of diversification into hotels, paper boards and so on.

The journey so far…
Although, cigarettes have grown at a decent CAGR of 7% over the last 5 years, agri-products grew at a rate of 23% during the same period. Paper and printing related revenues grew at a CAGR of 46%. But, the most astounding growth was witnessed in new businesses like branded clothes and other FMCG products that grew by 237% on a CAGR basis (albeit on a lower base). Hotel's, which currently is on top of their priority list, grew by 21% in this period. This clearly shows that ITC's new businesses are showing promising prospects.

In FY00, the contribution of cigarettes to total EBIT (earnings before interest and tax) was 87% and today it constitutes 78% of the total pie and this figure is slowly expected to go down in time to decline. Paperboards, that contributed 5% in FY02, now contribute 10% to the profits. Other FMCG businesses although yet eating into the overall profitability will soon be profitable given ITC's strong supply chain. The hotel's division also has been performing well and in revenue contribution terms, has outperformed other segments in 9mFY05.

The changing revenue mix…
( Rs m) FY03 % total FY04 % total 9mFY05 % total
FMCG - Cigarettes 87,640 73.7% 92,303 72.4% 74,990 71.2%
FMCG - Others 1,092 0.9% 3,042 2.4% 3,894 3.7%
Hotels 1,934 1.6% 2,575 2.0% 2,268 2.2%
Agri Business 16,581 13.9% 17,088 13.4% 12,639 12.0%
Paperboards, Paper and Packaging 11,629 9.8% 12,533 9.8% 11,536 11.0%
Total 118,876 100.0% 127,540 100.0% 105,327 100.0%

As can be seen from the table below, cigarettes comprise a major chunk of the profits (92%). This, the company has utilize to fund its other businesses, which over a period of time, is likely to contribute in a significant manner. Having said that, the reliance on the core business will continue for the next three years at least.

PBIT snapshot
(Rs m) FY03 % total FY04 % total 9mFY05 % total
Cigarettes 19,235 90.7% 20,333 92.0% 17,279 87.9%
Others -1,224 -5.8% -1,744 -7.9% -1,267 -6.4%
Total FMCG 18,011 84.9% 18,590 84.1% 16,012 81.5%
Hotels 101 0.5% 325 1.5% 438 2.2%
Paperboards, paper & packaging 2,263 10.7% 2,299 10.4% 2,262 11.5%
Agri business 841 4.0% 898 4.1% 939 4.8%
Total PBIT 21,215 100.0% 22,111 100.0% 19,651 100.0%

So, where to from here?
One may argue that cigarette will still be the mainstay of ITC's backbone. We agree totally! However, to de-risk its revenues, it has diversified into other businesses and the performance, so far, has been encouraging.

But consider the following facts.

The paperboards division:  ITC Bhadrachalam that was merged into ITC in FY01 and is offering more value added products by absorbing state-of-the-art technology. With the acquisition of BILT's 65,000 tonnes paperboard capacity, as well as its own plans to increase capacity by 75,000 tonnes, we believe that ITC will benefit from economies of scale going forward (but how the pulp prices will behave remains to be seen).

ITC Hotels has gained the 2nd position in the Indian hospitality industry dethroning EIH (the Oberoi Group), an old player. The FMCG division, though still nibbling away the profits, has improved in terms of profitability and we expect this business to be value accretive in the coming years. Through E-choupal, ITC has built significant competitive edge and the agri-exports division is likely to clock robust growth going forward.

What to expect?
At the current market price of Rs 1,277, the stock trades at 15.4 times our FY05 estimated earnings. Given the expansion plans, especially in the hotel's and paper business, we remain optimistic about ITC's long-term growth prospects.

We had re-iterated our BUY view on the stock in January 2005 at Rs 1,255 with a target price of Rs 1,635 with a two to three year view. We maintain our view on the stock.

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