ITC: Book profits, Re-enter at lower levels

Recommendation: Book profits, Re-enter at lower levels

Suresh Krishnamurthy

THE favourite refrain of many bulls when asked about the impact of excise duty hikes on ITC is that it is no longer only a cigarette company but has interests across diversified segments such as paper, hotels and real-estate.

In this backdrop, would consolidation of accounts reveal a much different picture than one can get by viewing the accounts of ITC alone?

The answer is that the consolidated picture still reveals ITC to be heavily dependent on its cigarette business. However, the non-cigarette business is growing at a faster much pace compared to the cigarette business and therein perhaps lies the confidence behind the assertion of those bulls. Still, it remains a predominantly cigarette company.

ITC has invested heavily in companies such as ITC Bhadrachalam, ITC Hotels, ITC Infotech and Russel Credit. Companies such as ITC Hotels have, in turn, invested in hotel properties such as Srinivasa Resorts, Ansal Hotels and Fortune Park. These factors indicate that consolidation of accounts may be a better guide for analysing the growth prospects of ITC. For this purpose, the accounts of ITC and its subsidiaries for the year ended March 2000 were consolidated.

The consolidated accounts did reveal the strength of the ITC group but, interestingly, not the full picture. This is because investments in associates such as ITC Filtrona, Surya Tobacco, International Travel House, Adyar Property Holding still continue to be valued at cost. The economic value of these investments is still not getting reflected in the consolidated financial statements because the accounting standards allow companies to state their value at cost.

Better income growth beyond ITC

The consolidated ITC is not much larger than the cigarette company -- the total sales of the group is Rs 8,600 crore against ITC's Rs 7,950 crore. ITC's paper and hotels businesses are small while it is yet to take up real-estate development on any significant scale. The contribution of cigarettes to the total group revenues continues to be a significant 80 per cent.

At the net level also, the consolidated profits were Rs 715 crore against ITC's Rs 725 crore. This is a clear indication that ITC's investments are yet to pay off. For instance, ITC Bhadrachalam, which has taken up a large part of the total investments, was a loss-making company as of March 2000.

These are absolute figures and what is of interest is the rate of growth. Thus, sales at the group level grew at 7 per cent compared to ITC's 5 per cent. The profits for the year ended March 2000 rose at 33 per cent compared to 17.5 per cent of ITC. This is quite significant. For, it means while ITC's investments may not be paying off yet, there has been considerable improvement in their profitability.

This suggests that in evaluating ITC in future, it is important to look at how the subsidiaries are performing. Importantly, the turnaround in the fortunes of ITC's investments continued this financial year ended March 2001 also. ITC Bhadrachalam Paperboards, which made a Rs 32-crore loss in the year ended March 2000, would close this year with a sizeable profit.

Also, while ITC Hotels' profitability has been stagnating, it did not pull down the profitability of the group because of the improved performance of ITC and ITC Bhadrachalam.

A more leveraged balance-sheet

At the balance-sheet level, the consolidated financial statements indicate a group that is relatively more leveraged compared to ITC alone. While there is only a marginal increase in the shareholder funds, the debt of the group is almost twice that of ITC's. The higher financial leverage will have implications for stock valuation.

However, here also, what is significant is that compared to the year ended March 1999, the leverage of the group has declined quite significantly. The group's debt as a proportion of shareholder funds is down from 66 per cent to 36 per cent, a rather steep drop. This mainly due to the repayment by ITC of loans it had taken to tide over the difficulties imposed by the failure of its erstwhile subsidiary, ITC Classic Finance. The repayment of these loans has significantly reduced the leverage of the group.

Even more significant is the size of investments at the group level, at Rs 684 crore, including Rs 350 crore invested in the .001 per cent ICICI preference shares redeemable in April 2018. The value of this investment is practically the present value of the sum receivable on maturity which would be close to 5 per cent of the sum invested.

On the other hand, many of the investments in associates are valued at cost. Whether the fair value of these investments would compensate for the money put in ICICI is not known. To this extent, ITC's financial statements continue to be opaque.

The valuation angle

With regard to profitability ratios since ITC's subsidiaries are still not performing well, the return on net worth and return on capital ratios at the group level are lower than that calculated using ITC's financial statement alone. Reflecting the lower profitability, the interest coverage ratios are also lower.

Both the earnings per share and the book value per share are only marginally higher. In the case of book-value per share, it needs to be considered that the bulk of the investments at the group level of Rs 684 crore is still taken at cost basis. The fair value could be a lot different which, in turn, would affect the book value per share.

Overall, the financial statements of ITC alone would have provided a sufficiently meaningful picture for evaluating the investment prospects of its stock till now. Even for the period till December 2000, the per share earnings of ITC was quite close to the consolidated EPS. However, going forward, the consolidated picture may be a better guide if the investments in ITC Bhadrachalam and ITC Hotels start doing well.

With respect to valuation, the stock continues to trade at around 21 times its consolidated earnings for the period ended December 2000 taking into account the share of profits in ITC Bhadrachalam and ITC Hotels. The next financial year may prove difficult in all the three major businesses. The other businesses are too small to make any substantial difference.

Importantly, any downturn in the profit growth of the cigarette business could hit the company hard as that business contributes most significantly to the bottomline. These factors suggest that for now the stock continues to be overvalued and to reap any significant gains investors may have to remain invested for a considerable period of time. Investors in this backdrop can consider booking profits in the stock and re-enter at lower levels.