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ITC: Not quite injurious!
May 25, 2007

Performance summary
Tobacco major, ITC, reported a decent performance for the March quarter and full year FY07. While the topline has grown by 26.3% YoY in FY07, the net profits have gone up by 20.8% YoY. The margins have however declined by 200 basis points due to higher raw material costs. The management has declared a dividend of Rs 3.10 per share (face value Re1).

Rs(m) 4QFY06 4QFY07 (%) Change FY06 FY07 (%) Change
Net sales 27,845 34,663 24.5% 97,906 123,693 26.3%
Expenditure 19,820 25,360 28.0% 64,631 84,129 30.2%
Operating profit (EBDITA) 8,024 9,303 15.9% 33,274 39,564 18.9%
EBDITA margin (%) 28.8% 26.8%   34.0% 32.0%  
Other income 746 1023 37.1% 2861 3365 17.6%
Interest 97 1 -0.99482 120 34 -72.0%
Depreciation 862 922 7.0% 3324 3629 9.2%
Profit before tax 7,812 9,403 20.4% 32,692 39,266 20.1%
Extraordinary item 4 -   (450) -  
Tax 2,138 2,897 35.5% 9,889 12,267 24.1%
Profit after tax/(loss) 5,679 6,506 14.6% 22,354 26,999 20.8%
Net profit margin (%) 20.4% 18.8%   22.8% 21.8%  
No. of shares (m) 3,762 3,762   3,762 3,762  
Diluted earnings per share (Rs)*         7.2  
Price to earnings ratio (x)         23.4  
* 12 months trailing earnings

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 the company 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 largest 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 FY07?
‘Non cigarette’ led growth: ITC reported a decent topline performance with a growth of 26% YoY, driven by the non-cigarette FMCG businesses, agri-business and the hotels business. While cigarette continued to contribute 60% of the revenues in FY07, its share has come down from 64% in FY06. The non-cigarette portfolio grew by 33.1% during the year.

Revenue mix
(Rs m) 4QFY06 4QFY07 (%) Change FY06 FY07 (%) Change
Cigarettes 28,827 32,940 14.3% 113,297 128,337 13.3%
% of revenues 60.9% 59.3%   64.0% 60.2%  
Others 3,057 4,985 63.1% 10,135 17,044 68.2%
% of revenues 6.5% 9.0%   5.7% 8.0%  
Total FMCG 31,884 37,925 18.9% 123,432 145,381 17.8%
% of revenues 67.4% 68.2%   69.7% 68.2%  
Hotels 2,633 3,044 15.6% 7,833 9,857 25.8%
% of revenues 5.6% 5.5%   4.4% 4.6%  
Paperboards, paper & packaging 4,755 5,334 12.2% 18,957 21,001 10.8%
% of revenues 10.1% 9.6%   10.7% 9.9%  
Agri business 8,040 9,287 15.5% 26,784 36,913 37.8%
% of revenues 17.0% 16.7%   15.1% 17.3%  
Total turnover 47,312 55,589 17.5% 177,006 213,151 20.4%
Less: Inter segment revenues 3,112 2,876 -7.6% 14,763 18,102 22.6%
Gross sales 44,200 52,714 19.3% 162,243 195,050 20.2%

Cigarette: The company continues to maintain its leadership position in the cigarette industry with a 13% YoY growth for the year. The strategy of value addition yielded impressive results, with cigarette sales volumes posting a growth of over 7% during the year. The cause for concern, however, remains the severe taxation and regulatory milieu for cigarettes in India. Excise duty rates on cigarettes were increased for the second successive year. However, while duty rates on cigarettes went up in excess of 6% in the Union Budget 2007, the same were left unchanged in respect of most of the other tobacco products. Moreover, with effect from 1st April 2007, cigarettes have been brought under the ambit of Value Added Tax by the States at a rate of 12.5% on invoice price, without a reduction/set off in excise duties collected in lieu of State level sales tax. This may hamper the volumes in the coming quarters.

Branded Packaged Foods: This division continued to expand rapidly with sales recording an impressive growth of 68% YoY over the previous year. ITC now has more than 150 distinct food products under 6 brands. In the Staples category, ‘Aashirvaad Atta’ continued to retain its market leader position with 52% market share amongst national branded players. Sales in the biscuit category grew 55% YoY. The company launched new variants in the biscuit segments. It also expanded its production capacity by adding facilities at two more locations. Value added products and improving product mix helped the company in neutralising the impact of an unprecedented increase in input costs. ITC also did well in the confectionery category, registering a strong growth of 51% YoY. The business added incremental capacity during the year to meet the enhanced business volumes. In the ready to eat segment, the company successfully introduced 12 new products in the domestic markets. Also, exports of products were scaled up during the year. The company is increasing its capacity in the foods segment, as it provides a huge opportunity in the face of growing income and changing consumer lifestyle.

Hotels: The segment continued with its strong performance led by higher tourist inflow, better room rates and improved occupancies. The segment grew by 26% YoY in FY07. ITC also entered into a collaboration with Starwood Hotels & Resorts through a new franchise agreement. As per the agreement, ITC-Welcomgroup will have an exclusive partnership with Starwood to bring in its premium brand, ‘The Luxury Collection’, to India. This will help the company command higher room rates and add to the revenues.

Paperboards, Specialty Paper & Packaging: This segment recorded a growth of 10.8%YoY during the year in terms of sales. Production during the year touched 390,458 MT as compared to 365,819 MT in FY06. Sales of value added paperboards (VAP) grew by 15% YoY to touch 139155 MT. ITC is the leading provider of value added paperboard packaging in the country. The company’s strategy is to improve the product mix and it has lined up various expansion plans. 2 major capacity augmentation projects comprising (a) a 90,000 TPA paperboard machine and (b) a 100,000 TPA paper machine for manufacturing uncoated paper including branded copier grades is on track. Also, a new facility at Haridwar was completed during the year, adding manufacturing capacity both in the paperboard cartons and flexibles segments. These investments would help the company improve its revenue mix.

Agri business: This business grew by 38% YoY led by higher sales of soya and rice exports and leaf tobacco. Leaf tobacco exports during the year grew by an impressive 21% by value to touch an all-time high. The contribution from this division has gone up to 17% from 15% in FY06. Also the e-choupal network was further scaled up during the year and currently comprises 6,400 choupals reaching out to over 3.5 m farmers in 38,500 villages. ITC has plans to extend the E-Choupal initiative to 15 states in total across India, with 20,000 Echoupals covering 10 m farmers over the next few years

Others: The matchstick and stationery business continued performing well during the year. The Company’s Lifestyle Retailing business grew by 52% YoY during the year under review in both the premium and popular segments. The export segment also registered strong growth during the year. The management continues to be bullish on the retailing business.

Cost break-up
As a % of net sales 4QFY06 4QFY07 FY06 FY07
Total Cost of goods 45.2% 45.5% 40.7% 43.5%
Staff Cost 5.2% 4.7% 5.5% 5.1%
Other Expenditure 20.8% 23.0% 19.8% 19.4%

Lower margins: ITC’s operating margins declined by over 200 basis points (2%) in FY07. The company’s raw material costs as a percentage of sales increased to 43.5% (40.7% in FY06). Also, the company is investing heavily in augmenting capacities and brand building. While the PBIT margins of cigarettes, hotels and agri business have improved, paperboard segmental margins have remained stable. The company’s move to diversify its business and reduce its dependence on cigarettes business is also paying off as the share of cigarettes to the total PBIT is reducing.

PBIT margin trend…
(% of segmental revenues) 4QFY06 4QFY07 FY06 FY07
Cigarettes 22.1% 22.5% 23.9% 24.7%
Others -13.9% -9.7% -17.0% -11.9%
Total FMCG 18.7% 18.3% 20.6% 20.4%
Hotels 37.1% 38.5% 32.9% 35.6%
Paperboards, paper & packaging 16.5% 18.2% 18.5% 19.8%
Agri business 1.1% 0.9% 3.4% 3.3%
Total PBIT 16.5% 16.5% 18.3% 18.1%

Bottomline picture: Inspite of lower interest costs, ITC witnessed a dent of 100 basis points in its net profit margins during FY07, primarily due to the operating margin contraction. Excluding the exceptional item (one off assistance to contract manufactures) to the tune of Rs 450 m, the net profits have grown by 18.4% YoY. Our estimates were in line with the company’s performance.

What to expect?
At the current price of Rs 168, the stock is trading at a price to earnings multiple of 23.4 times its 12-months trailing earnings. The strong performance of the non-cigarette business is positive for the company. With duties on cigarettes increasing, the volumes could be impacted to a certain extent. Hence, lower dependence on this segment would benefit the company in the long term. We derive comfort from the fact that the company has been able to run its other businesses rather successfully and are positive on the company from a long-term perspective. Valuations from a medium term perspective though, look stretched.

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