ITC: Concern over cigarette business profitability

Lower tax rate aided third quarter earnings; focus will now shift to the Budget

Akin to its peers, the cash crunch arising from the note ban impacted ITC’s results for the December 2016 quarter (Q3). However, even as results were in line with expectations, the key worry is whether ITC’s cigarette business growth will see a recovery. This is critical given the pressures in the business and the fact that it still accounts for more than 80-85% of the company’s profits.

Consider this: The cigarettes business continued to grapple with the tightening regulatory noose amid the note ban-driven demand pressures. Most of the 2% growth in this business was led by price hikes even as most analysts estimate that cigarettes’ volumes have fallen by low single digits. In fact, this segment's profits grew at a subdued pace of 1.7% in Q3 — the lowest in over 10 quarters. This indicates that the company has been careful with the quantum of price hikes (so as not to hurt volumes) and is only gradually passing on the higher tax burden to customers. 

With the adoption of larger pictorial warnings on cigarette packs, it has also likely impacted demand. While analysts’ view on the note ban impact on demand is mixed, it needs to be seen how the March 2017 quarter pans out. What’s worse, the Budget could raise duties on cigarettes as well.

ITC’s fast moving consumer goods (FMCG) segment, seen as a key growth engine, also saw the weakest revenue growth in 10 quarters (up 3.4 per cent). Although this was largely on expected lines, demand weakness coupled with rising input costs across most sub-categories pulled down its profitability. The segment reported a loss of Rs 20 crore in Q3 versus a profit of Rs 19 crore in the year-ago period. Some of this pressure can also be attributed to ITC's continued investments in innovation and brand-building initiatives in the FMCG business. Again, the March quarter performance will be a key factor to watch.

Among others, its hotels business reported a strong performance on both revenues and earnings, because of higher average room rates and healthy traction in food and beverage sales.

A lower tax rate provided a leg up to ITC’s overall earnings, which was slightly ahead of Street expectations. Because of this, the ITC scrip hit a new 52-week high of Rs 266.7 on Friday but ended the session down 2.8% at Rs 257.5. Part of the weakness can be attributed to profit-booking in the counter, while some of it is due to the muted show in cigarette and FMCG segments. While GST should benefit players such as ITC in the longer run as it will provide a level-playing field with unorganised players and so will implementation of mandatory licensing for non-tobacco products, an increase of more than 10% in excise duty on cigarettes in the Budget will hurt sentiment.