Investment focus - ITC: Book profits

A strong show in cigarettes and shrinking losses in the FMCG business have sharply expanded the price-earnings multiple for the ITC stock over three years. Its price-earnings multiple has jumped from 22 times trailing earnings in 2009 to 33 times now. The stock now trades on par with Dabur India, Marico and Godrej Consumer based on current year’s profit estimates. This is despite ITC’s FMCG business carrying higher risks and offering poorer growth prospects than these players. Investors should book profits in the stock.

For one, optimism about the company’s latest numbers seems overdone. ITC reported a 20 per cent growth in net sales and a 21 per cent rise in net profit in the September quarter. This was aided by a 320-point expansion in cigarette margins and a 26 per cent sales growth in FMCGs with reduced losses. The sustainability of both these numbers can be questioned. Cigarette margins have been driven entirely by recent price hikes (about 12 per cent in August/September 2012), even as volumes have stayed flat. It is volumes rather than realisations that decide the quality of earnings in the FMCG space and it remains to be seen if volumes hold up at increased prices.

For the medium term, investors are pinning their hopes on ITC’s recently launched 65 mm cigarettes at lower price points. But this segment may not offer the pricing power or the 60 per cent-plus margins that ITC’s current cigarette portfolio enjoys. Two, harsher regulatory curbs on the cigarette business, in the form of plain packaging or further taxes remain a big risk to the company’s prospects over the medium term. Though ITC has poured substantial capital into its diversification bid in the last three years, cigarettes remain its key money-spinner.

For the half year ended September, cigarettes brought in 49 per cent of ITC’s sales and 81 per cent of its net profits. These numbers have scarcely budged in the past three years. Three, in the FMCG business, the company has managed to build scale but without matching the profit margins of even much smaller players in the sector.

With annual sales of Rs 6,300 crore, ITC’s FMCG business is already larger than Dabur’s and half the size of Hindustan Unilever’s. Yet while rivals manage pre-tax profit margins of 14-15 per cent, ITC’s FMCG business sport pre-tax losses of about Rs 140 crore a year. This could be because two-thirds of ITC’s FMCG business is made up by packaged foods such as biscuits, atta and noodles, which offer lower margins and limited pricing power compared to segments like personal products.

For now, ITC may also continue to face margin pressures from high agri-commodity inflation. .Fortunes of ITC’s paperboard and agri-business segments are cyclical. ITC does have ambitious investments plans for its hotel segment, but excess capacity, especially in luxury hotels, may depress returns in the near term.

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