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ITC: A feather in the cap - Views on News from Equitymaster

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ITC: A feather in the cap
May 29, 2006

Performance summary
As compared to a single-digit growth in cigarette revenues in the last two years, ITC's core business in FY06 grew at a commendable rate of 13% YoY (growth was much higher in 4QFY06). Even as the core business was growing, the fact that the company was able to ramp up revenues in other key business divisions i.e., paper boards, hotels and agri-exports, is a vindication of its scalability. Even as operating margins were lower in FY06, led by higher other income, PBT grew by 22% YoY in FY06. Excluding the extraordinary items, the actual growth in net profit was 24% YoY in FY06.

(Rs m) 4QFY05 4QFY06 Change FY05 FY06 Change
Net Sales 21,771 27,845 27.9% 76,395 97,905 28.2%
Expenditure 15,139 19,820 30.9% 48,469 64,632 33.3%
Operating Profit (EBDIT) 6,632 8,024 21.0% 27,926 33,274 19.2%
Operating Profit Margin (%) 30.5% 28.8%   36.6% 34.0%  
Other Income 593 746 25.8% 2,358 2,861 21.3%
Interest (net) 13 97 665.9% 424 119 -71.9%
Depreciation 897 862 -4.0% 3,129 3,323 6.2%
Profit before Tax 6,315 7,812 23.7% 26,731 32,692 22.3%
Extraordinary income/(expense) 3,543 4 -99.9% 3,543 (450) -112.7%
Tax 2,141 2,138 -0.2% 8,360 9,888 18.3%
Profit after Tax/(Loss) 7,718 5,679 -26.4% 21,914 22,354 2.0%
Net profit margin (%) 35.4% 20.4%   28.7% 22.8%  
No. of Shares (m) 3,741 3,755   3,741 3,755  
Diluted Earnings per share (Rs)         6.0  
P/E Ratio (x)         30.7  

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 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.

Segment revenue
(Rs m) 4QFY05 4QFY06 Change FY05 FY06 Change
Cigarettes 25,035 28,827 15.1% 100,025 113,297 13.3%
Others 1,740 3,057 75.7% 5,634 10,135 79.9%
Total FMCG 26,775 31,884 19.1% 105,659 123,432 16.8%
Hotels 1,810 2,633 45.5% 5,773 7,834 35.7%
Paperboards, paper & packaging 4,117 4,755 15.5% 15,653 18,957 21.1%
Agri business 5,162 8,040 55.8% 17,801 26,784 50.5%
Total turnover 37,864 47,312 25.0% 144,886 177,007 22.2%
Less: Inter segment revenues 2,521 3,112 23.5% 11,390 14,763 29.6%
Gross sales 35,344 44,200 25.1% 133,496 162,244 21.5%

Other businesses also gain momentum: The fact that hotel revenues in FY06 have grown by 36% YoY is no surprise to us. The growth was led by a combination of factors including full operation of the Mumbai property, higher occupancy rates leading to higher room revenues. The growth in agri business has to be viewed in light of a 6% YoY fall in revenues in FY05 and to that extent, the growth is exaggerated. Consequent to this growth, the contribution of this business to revenues has increased from 12% in FY05 to 15% in FY06. Growth in paperboard revenues has to be viewed in light of enhanced capacity utilisation at the Kovai unit and capacity addition to the tune of 75,000 TPA.

Margins - A mixed bag: While operating margins contracted in FY06, it has be borne in mind that the company has been investing heavily towards capacity augmentation and new product launches across business segments. What is important, however, is that ITC was able to expand PBIT margins by 30 basis points (0.3%) in FY06. While cigarette margins were influenced by price hikes, with bulk of the capacity expansion in the paperboard business focused at the premium segment, margins have expanded. PBIT margins of ITC is comparable with the industry leaders (with a pan-India presence) in the hotel sector and we believe that further expansion is possible in FY07.

PBIT margin trend…
(% of segmental revenues) 4QFY05 4QFY06 FY05 FY06
Cigarettes 22.4% 22.1% 22.9% 23.9%
Others -39.4% -13.9% -34.7% -17.0%
Total FMCG 18.4% 18.7% 19.8% 20.6%
Hotels 31.4% 37.1% 24.4% 32.9%
Paperboards, paper & packaging 13.1% 16.5% 17.9% 18.5%
Agri business 0.5% 1.1% 5.4% 3.4%
Total PBIT 16.0% 16.5% 18.0% 18.3%

Extraordinary effect: Net profit was higher last year owing to reversal of tax provisions to the tune of Rs 1.4 bn. Excluding this and other miscellaneous items, the growth in net profit in FY06 actually stands at a healthy 24% YoY. While the company's performance at the topline level was 8% higher than our estimates, at the net profit, it was marginally lower owing to extraordinary items.

Over the last few quarters: As is evident from the table below, the cigarette division has been recording higher growth in revenues in the last few quarters, broadly in line with the increase in demand for FMCG products in this period. While margins have softened, we continue to have a cautious view on the same going forward. This is because while the cigarette business contributed to 64% of revenues in FY06, at the PBIT level, the contribution was higher at 84%. By hiking indirect duty for organised players, the expected shift from 'bidis' to cigarettes is likely to be much slower than expected. The core business, in our view, will continue to face issues on the indirect tax front, both at the central and the state level.

Over the past few quarter…
(YoY change) 3QFY05 4QFY05 1QFY06 2QFY06 3QFY06 4QFY06
Net sales growth 10.6% 15.7% 18.6% 25.6% 27.9% 27.9%
Cigarette value growth 5.1% 6.4% 12.0% 7.2% 19.1% 15.1%
EBDITA margin 37.6% 30.5% 36.5% 37.6% 34.4% 28.8%
Net profit growth 17.9% 99.3% 20.1% 17.8% 24.7% 35.9%

What to expect?
At Rs 183, the stock is trading at a price to earnings multiple of 20.7 times our estimated FY08 earnings, which means that the margin of safety is lower. However, we are confident of the fact that the company will be able to grow revenues in double digits in the next three to five years. Though medium-term valuations are high, if one has a long-term horizon, ITC should have a place in one's portfolio.

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