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ITC: Merger concerns

Sep 6, 2001

Cigarette giant ITC has called a board meeting on September 21 2001, to consider a merger with its paperboard subsidiary, ITC Bhadrachalam. The proposed merger is expected to bring synergies in ITC’s operations as the company uses part of the paper and paperboard manufactured by ITC Bhadra. ITC Bhadra, a Rs 5.3 bn company, has earnings of Rs 349 m as on FY01. The company’s size is just 12% of ITC’s total size. ITC along with its wholly owned subsidiary Russell Credit holds a 61% stake in ITC Bhadra. ITC Bhadra has incurred losses in the past three years (Rs 1.8 bn cumulative loss). The company’s financials in the past three years were affected by volatile paper prices. The paper prices showed some improvement in the second half of FY01, which fueled the earnings growth of the company. ITC’s Chairman has already indicated an expansion plan of Rs 15 bn for this paper product subsidiary.

ITC Bhadra’s financial ratios are not as encouraging as ITC’s. The company’s operating margins at 20% are almost half compared to 40% margin of ITC. This is likely to impact ITC’s future operating margins and consequently earnings quality. We have attempted to analyse the financial performance and valuations of both the companies and arrive at a merger ratio.

Comparative financials
(Rs m) ITC ITC Bhadra Combined
Net sales 42,042 5,344 47,386
Operating profits 16,878 1,050 17,928
Profit after taxes 10,063 349 10,412
OPM 40.1% 19.7% 37.8%
NPM 23.9% 6.5% 22.0%
Number of shares (m) 245.4 113.5 250.8
FDEPS (Rs) 41.0 3.1 41.5
Book value/share (Rs) 144.0 37.5  

The outlook for the paper industry is not very encouraging; this could further affect the earnings growth of ITC Bhadra, consequently the merged entity. ITC’s decision to invest Rs 15 bn in this business only indicates low returns on investments (ROCE) going forward. ITC recorded a ROCE of 26%, as on FY01 as against 9% at ITC Bhadra. While the merger would add 26% to ITC’s fixed assets, its contribution to revenues would be 11% and to profits would be just 3%. This is likely to affect the valuations of ITC’s stock. Weakening cigarette demand and threat of smuggled cigarettes will also contribute in trimming the earnings growth of the merged entity.

  • ITC: Double Whammy

    Comparative Valuations
    Particulars ITC ITC Bhadra
    Market Price (Rs) 753.2 47.5
    PER (x) 18.4 15.4
    Price/Book value (x) 5.2 1.3
    Market Capitalisation 184,843 5,389
    Market Cap/Sales (x) 4.4 1.0

    We have arrived at the merger ratio of about 1 share of ITC for every 20 shares of ITC Bhadra. While ITC’s stock would under-perform the market considering this merger ratio, shareholders of ITC Bhadra are likely to benefit till the price is adjusted. ITC’s diversification into hotels and retailing also raises concerns, as returns in these businesses are relatively less than the returns on its tobacco business.

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