ITC: Cigarettes fail to light up show

While price rises in cigarette business and lower costs helped improve profitability, valuations leave little room for error

Though ITC missed the Street's expectations on sales growth for the June quarter, it was just able to meet the profit forecast. Also, analysts say, revenues, which rose 10.5 per cent to Rs 7,411 crore, were largely driven by realisation gains of 16 per cent in the cigarettes business. In fact, they estimate cigarettes volumes to have fallen two per cent and see it as a key disappointment as the Street was factoring in a one-two per cent growth.

Abneesh Roy, fast-moving consumer goods (FMCG) analyst at Edelweiss Securities, says, "The 64-mm cigarettes have done well and contributed five per cent to overall cigarette volumes. However, the (overall) cigarettes volumes came in lower. FMCG sales growth, too, came in lower than our expectations of 22-23 per cent. This weakness was driven by biscuit, soap and shampoo segments."

Higher realisations, with benign (6.8 per cent) rise in total expenses over June 2012, led to a 225-basis-point surge in Ebitda margin to 37.7 per cent, higher than the Street expectations of 35.3 per cent and provided impetus to net profit.

After the results on Thursday, the scrip fell 4.6 per cent, against the 1.4 per cent fall in the Sensex. Since the stock had rallied strongly in the past two-three weeks (and has outperformed the Sensex since January), part of Thursday's fall could be attributed to profit booking.

While some analysts say the June quarter may be a blip in terms of weakness in cigarette volumes and expect volumes to pick up and drive ITC's earnings, others are a bit sceptical.

Nillai Shah, FMCG analyst at Morgan Stanley, wrote in a post-results note on ITC, "This was the ninth consecutive quarter of 18-per cent-plus EBIT (earnings before interest and tax) growth for the cigarettes division. Margin expansion was driven by a combination of price increase, product-mix improvement, lower marketing expenses and relatively benign commodity costs. For FY14, we expect a relatively benign 30-basis-point expansion (in margins). We reiterate our 'overweight' position on ITC and recommend investors add to positions on today's weakness."

However, Ritwik Rai, FMCG analyst, Kotak Securities, says, "ITC's revenues came in below our expectations, primarily on account of weaker sales growth in the cigarette and other FMCG segments. Net sales growth of cigarettes at 7.1 per cent (versus the estimated 10 per cent) represents a 20-quarter low. Results show growing stress on demand, and pose a question mark on the extent of price inelasticity that cigarettes command."

Rai says in this context ITC's valuations are demanding. He adds that growth of the company's key segments has moderated significantly and the likelihood of positive earnings surprises in the near-term is low. Hence, Rai maintains a negative stance on the stock.

Before the results, of the 13 analysts polled by Bloomberg in July, 10 were bullish and the rest neutral on ITC. The average target price of Rs 366.31 a share, however, suggests a mere two per cent upside from Thursday's closing price of Rs 359. This also suggests there is little room for further disappointment.

The stock's fortunes though could improve if cigarette volumes pick up and profitability in non-cigarettes FMCG business improves.

The other FMCG segment, which delivered its first-ever operating profit of Rs 12 crore in the March 2013 quarter, posted a loss of Rs 19 crore in the June 2013 quarter. The management attributes these losses to significant business development, brand-building and other promotional costs. Revenue growth of 18.4 per cent (Rs 1,745 crore) in this business was also the lowest since June 2011 quarter. Analysts expect the trend to be weak in the near term.

"Weakness in other FMCG business should continue for another quarter and could witness some pick-up from the second half of this financial year driven by good monsoons", says V Srinivasan, FMCG analyst at Angel Broking. However, most analysts expect this segment to report profit for FY14.

Among other businesses, hotels continued to be under stress, with sales growing 7.5 per cent to Rs 250 crore and EBIT falling 66 per cent to Rs 9 crore. The company's Chennai property, ITC Grand Chola, inaugurated in September 2012, continues to pull down the segment's margins. Paper business' EBIT, too, continued to be under pressure due to higher wood prices and declined five per cent to Rs 252 crore. But, analysts expect paper margins to recover over the next few quarters. These two businesses account for a sixth of the revenues and less than 10 per cent of profits, and consequently had little impact on overall performance.

Positively, good traction in tobacco and wheat exports helped the agriculture business (about 30 per cent of the revenues), which reported a sales growth of 29.4 per cent to Rs 2,189 crore and an EBIT growth of 16.3 per cent to Rs 199 crore, and supported overall earnings.