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ITC Vs Gallaher: Tobacco giants… - Views on News from Equitymaster
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ITC Vs Gallaher: Tobacco giants…
Dec 19, 2005

Despite the incidence of health problems, a growing number of class-action lawsuits and rising prices of tobacco products, consumers still find tobacco products entirely seductive. This makes us believe that there are real fortunes to be made, especially in our country. In this article, we compare Gallaher, one of the market leaders of UK, with our very own ITC, to give a broader perspective and the available potential in our country.

About Gallaher
Established in 1857 and headquartered in UK, Gallaher Group Plc commands a 40% market share in UK, and is engaged in the manufacture, marketing and distribution of tobacco and tobacco related products worldwide. It offers various brands of cigarettes, cigars, and hand rolling and pipe tobacco products and snuff’s. In addition, the company operates a distribution business in certain Continental European markets, which includes the sale of tobacco and non-tobacco products, such as food and prepaid phone cards, and sales through cigarette vending machines.

Gallaher was spun off in 1997 from Fortune Brands, because of a flurry of tobacco-related lawsuits in the US. The company, along with other firms, is fighting the European Union's ban on tobacco advertising (scheduled to start in 2006). The company has a European joint venture with R.J. Reynolds and has also partnered with Indonesian tobacco maker, Sampoerna International, to sell the ST Dupont Paris luxury cigarette brand in Russia.

(INR m) CY00 CY01 CY02* CY03 CY04 CAGR
Gross sales 356,280 486,115 715,870 723,840 764,240 21.0%
Less :- Excise duty 273,184 318,400 408,080 414,355 425,515 11.7%
excise as a % of sales 76.7% 65.5% 57.0% 57.2% 55.7%  
Net Sales 83,096 167,715 307,790 309,485 338,725 42.1%
Expenditure 48,384 127,155 257,810 251,885 280,245 55.1%
EBITDA 34,712 40,560 49,980 57,600 58,480 13.9%
Operating margin % 41.8% 24.2% 16.2% 18.6% 17.3%  
Net profit after Tax(Loss) 19,888 19,680 22,015 23,520 24,080 4.9%
Net profit margin % 23.9% 11.7% 7.2% 7.6% 7.1%  
EPS (Rs) 31.4 30.4 31.4 30.3 35.6  
P/E ratio (x)         19.9  
1 Sterling Pound = 80 Indian Rupees
* CY02 onwards accounting policy changed

About ITC
ITC commands about 70% of India’s Rs 130 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 its hospitality, retailing, packaged foods and IT businesses. Consequently, 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.

(INR m) FY01 FY02 FY03 FY04 FY05 CAGR
Gross sales 88,270 99,820 111,940 120,400 135,850 11.4%
Less :- excise duty 44,750 47,810 51,590 53,450 57,100 6.3%
Excise as a % of sales 50.7% 47.9% 46.1% 44.4% 42.0%  
Net Sales 43,520 52,010 60,350 66,950 78,750 16.0%
Expenditure 25,160 31,550 37,120 41,100 48,470 17.8%
EBITDA 18,360 20,460 23,230 25,850 30,280 13.3%
Operating margin % 42.2% 39.3% 38.5% 38.6% 38.5%  
Net profit after Tax(Loss) 10,060 11,900 13,710 15,390 18,370 16.2%
Net profit margin % 23.1% 22.9% 22.7% 23.0% 23.3%  
EPS (Rs) 41.0 48.1 55.4 64.3 90.0  
P/E ratio (x)         24.2  

As can be seen from the above tables, Gallaher has grown at a faster pace than ITC. However, it must be noted that in CY02, the UK major had changed its accounting policy resulting in an immediate revenue boost. One of the reasons for the slow growth and ITC being only about 23% of the size of Gallaher is because chewing tobacco has been a tradition in India for centuries. Of the total amount of tobacco produced in the country, around 48% is in the form of chewing tobacco, 38% as bidis and only 14% as cigarettes.

Major Brands
Gallaher ITC
Benson & Hedges India Kings
Silk cut Goldflake
Mayfair Navycut
Sobranie Bristol
Dorchester Wills

As can be seen from the above tables, Gallaher has grown at a faster pace than ITC. However, it must be noted that in CY02, the UK major had changed its accounting policy resulting in an immediate revenue boost. One of the reasons for the slow growth and ITC being only about 23% of the size of Gallaher is because chewing tobacco has been a tradition in India for centuries. Of the total amount of tobacco produced in the country, around 48% is in the form of chewing tobacco, 38% as bidis and only 14% as cigarettes.

Thus, bidis, snuff and chewing tobacco (such as gutka, khaini and zarda) form the bulk (86%) of India's total tobacco production. In the rest of the world, production of cigarettes is 90% of total production of tobacco related products. Also, the per capita consumption of cigarettes in India is merely a tenth of the world average. This unique tobacco consumption pattern is a combination of tradition and more importantly, the tax imposed on cigarettes over the last 2 decades.

In contrast in the United Kingdom, around 75% of the smoking community have cigarettes, while the rest either have cigars or a pipe. Gallaher also makes Hamlet cigars, Amber Leaf hand-rolled tobacco and Condor pipe tobacco, thus offering all type of tobacco products under the sun.

Just to put things in perspective, while around 73% of ITC’s revenues come from its core business, over 90% of Gallaher’s revenues come from cigarettes and hence excise duty as a percentage of gross sales is higher in the case of latter. Thus, the margins for ITC (38.5% in FY05) are much higher as compared to Gallaher (17.3% in CY04). It must be noted here that ITC’s hotel’s division margins are amongst the highest in the industry at 35%+ levels.

What to expect?
Despite high government intervention and campaigns against smoking along with high tax rates, ITC has managed to grow its portfolio and going forward, we expect it to outperform its peers. As disposable incomes increase, people might shift from bidis to cigarettes and hence there lies a huge potential to convert, and being the No. 1 player in the segment, ITC is likely to be a big beneficiary of this change.

Further, the company has emerged as the second largest player in the hospitality industry in India, behind Indian Hotels (The Taj Group). This division continues to benefit from capacity expansion as well as the upturn in the industry's occupancy rate. This division displayed a staggering CAGR growth of 53% between FY02 and FY05 and we expect it to grow the fastest going forward. Also, margins for this business (around 25%) are the highest in the company's portfolio. ITC has 5,200 rooms, of which 3,200 are owned while the rest are managed properties. The company plans to open new hotels in Bangalore, Chennai and Hyderabad in the next 3 to 5 years. With this expansion, the company's rooms under management will increase by 750. Thus, to conclude, we expect the cigarette business to remain the mainstay of ITC’s backbone in the future. However, its other businesses, especially paperboards and hotels, are likely to contribute greater to the overall growth.

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