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ITC: No smoking zone!

Jul 13, 2005

ITC has come to be a synonym for cigarettes in India, with 6 out of the top 10 brands coming from the company's stable. People usually associate ITC only with cigarettes, often forgetting that the company has other businesses as well. The company, however, did understand the risk of being in a regulated sector and expected the government intervention to increase over time. Considering this risk, the company forayed into the paper manufacturing business two decades ago, which was targeted at backward integration as well as de-risking its business model. In this article, we take a look at ITC's Paperboard division and leave cigarettes alone for a change(!).

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 now 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 continues to contribute almost 75% of revenues.

The non-tobacco shift!
The share of cigarettes out of the total tobacco offtake has 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 (which amount in excess of 130% of the net value of the product) is a key cause of concern for ITC, If one looks at the broader numbers, it is both an opportunity and a threat (India's per capita consumption of cigarettes is 119 sticks per annum as against the world average of 1,267 sticks per annum).

Then, why did ITC diversify? The answer to this question lies in understanding what is happening in the global markets. MNC companies like Phillip Morris are under intense regulatory and public scrutiny with respect to 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.

Paperboards & Speciality papers
With the acquisition of BILT's 65,000 tonnes paperboard capacity, as well as its own plans to increase capacity by 75,000 tonnes by FY06, we believe that ITC will benefit from economies of scale going forward (the behavior of pulp prices however remains to be seen).

ITC's paperboard unit at Bhadrachalam is the largest and most contemporary paperboards manufacturing facility in the country and accounts for over 80% of the company's total installed paperboard capacity of 325,000 tonnes. This segment of the company supports some of the biggest brands in India. We see them on every supermarket shelf and retail outlet, straddling all carton consuming segments including foods, beverages, pharma, personal care, durable goods, etc. ITC's clientele includes the likes of Nestle, HLL, Colgate, Dabur and Barista.

This division has grown at a CAGR of 15% during the period between FY02 and FY05, outperforming the company's cigarettes business' growth (7%) during the same period twice over. The future of this segment is promising and will see growth and profitability because of economic upturn and better product mix that will help margins improve. The company is also increasing its capacity to 400,000 tonnes by FY06. We expect this segment to grow at a CAGR of 6%-7% and value added paperboards to clock 15%-20% growth.

How the numbers stack up for this division?
As can be seen from the table below, the contribution of the paperboards division to total revenues stood at 11.7% in FY05, up from 9.8% in the previous fiscal. Also, ITC Bhadrachalam is one of the most energy efficient paperboards producers in the globe and more than 95% of the energy consumed by the unit is generated internally. It is also the largest exporter of coated paper in India, with nearly 20% of its production being exported to 40 countries.

Paperboard business: Past performance
(Rs m) FY02 FY03 FY04 FY05 CAGR
Revenues 10,310 11,629 12,533 15,653 14.9%
PBIT 1,622 2,263 2,299 2,800 20.0%
PBIT margin % 15.7% 19.5% 18.3% 17.9%  
% of total Sales 9.9% 9.8% 9.8% 11.7%  

The range of paperboards includes cast and coated paper used in the pharma industry, virgin boards used by FMCG companies, greeting cards and premium cosmetics and Cupstock used for soaps, ice creams and beverages.

Thus, to conclude, while we expect the cigarette business to remain the mainstay of ITC's backbone in the future, its other businesses, especially paperboards and hotels, are likely to contribute greater to the overall growth. At the current price of Rs 1,745, the stock is trading at a price to earnings multiple of 19.8 times its FY05 earnings, which we believe is at the higher end of the spectrum from a medium term perspective.


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