ITC: Hold and track investment plans

Recommendation: Hold and track investment plans

Suresh Krishnamurthy

IN THE wake of a fairly good performance in the fiscal year to date, fresh investments can be contemplated in the ITC stock with a long-term perspective.

But there may be a downside in the near-term, especially in the first quarter of the next year coinciding with the Budget blues.

While on the one hand, there could be fair capital appreciation over the long-term, on the other, if ITC diversifies into the airlines sector, further downside can be expected. In fact, shareholders would be better off divesting their holdings if the company firms up plans to invest in the airlines sector. ITC again performed creditably in the second quarter of 2000-01. Profits rose close to 22 per cent over the corresponding previous period on the back of a 9 per cent increase in revenues. Compared to the first-quarter ended June 2000, sales fell marginally, while profits rose 4 per cent.

In its mainstay cigarette business, that accounts for close to 90 per cent of the revenues, ITC has had to deal with a difficult situation over the last couple of years. Rising incidence of taxes and the ban on smoking in public places in several States have affected volume growth. But ITC has managed to sustain the rising trend in profitability.

Cigarettes: Volumes slip again

Top-line growth was helped by enhanced hotel revenues in the second quarter. When the first quarter financial performance was announced, ITC remarked about the continuing trend in the recovery of cigarette volumes. However, volumes appear to have slipped again.

Compared to June 2000, the net sales growth was negative, and of gross income marginal. Also, the net sales growth was about 13 per cent in the quarter-ended June 2000 over the corresponding previous period. For the quarter-ended September 2000, the net sales growth slackened to around 6 per cent compared to September 1999.

Given the buoyancy in exports and rising hotel occupancy, the slowing cigarette sales seems to have reined in the topline growth. That the growth has slackened is not surprising. The impact of the 7 per cent rise in cigarette prices, effected towards the end of the previous quarter, was felt in this quarter. Also, the impact of slowing agricultural and manufacturing production on consumer consumption.

Changing product-mix

Evidently, ITC has been able to sustain profit growth through cost control. The interest cost burden, which ballooned due to the support provided by ITC to its erstwhile subsidiary, ITC Bhadrachalam Finance, in 1998, is declining. Interest costs in both the first and second quarters fell to 27 per cent over the corresponding previous period. This gave profit growth a boost.

However, the major prop came from operating profit margins which rose 43 per cent this year compared to 38 per cent last year. The rising OPM reflects the changing product mix in favour of premium varieties. ITC has been claiming much success in its efforts to improve the product mix in favour of premium cigarettes -- a class that offers better margins and is less elastic to price hikes.

Sustainability, in question

Despite the robust profitability growth achieved by ITC in the last few quarters, a big question mark hangs over its ability to register profit growth of around 20 per cent if cigarette sales volume remain sluggish. There does not appear to be much scope for an improvement in the OPMs. Also, further declines in the interest cost appear unlikely. In this backdrop, sustaining this profitability trend beyond the next quarter without any revival in the offtake of cigarettes appears a challenging proposition for ITC.

It is perhaps time for the investments made by ITC to pay off to compensate for the flat trends in the cigarette business. ITC has invested more than Rs 1,000 crore in its subsidiaries -- ITC Hotels and ITC Bhadrachalam. This apart, it has also ploughed back a significant proportion of its earnings into its own hotel properties. Investments in hotels and paper businesses are showing signs of paying off and may, indeed, contribute to profit growth in the coming years. However, it is still too early to count the chickens. ITC's foray into the retail, greeting cards and IT sector is also in the nascent stage.

Near-term uncertainty notwithstanding, ITC's valuations from a long-term perspective appear attractive. The stock trades at a price-to-earnings multiple of less than 20 times its annualised earnings for the quarter-ended September 2000. Even after adjusting for the management quality which has, in the past, thrown nasty surprises, and the risks of investing in a company highly sensitive to taxes and government regulation, the valuations appear attractive.