D Street wary as ITC's high cigarette volume growth came at cost of profit

Analysts believe gradual price hikes will help sustain decent growth in cigarette volumes

Even as ITC posted a better-than-expected performance for the September quarter (Q2), led by strong cigarette volumes, its share price fell 2.3 per cent to close at Rs 280.65 on Friday. Analysts say that the Street seems unsure if ITC can sustain the strong volumes, which have partly come at the cost of profits.   

In Q2, while ITC's gross revenue grew a healthy 14.7 per cent year-on-year to Rs 110.9 billion versus analysts' estimates of Rs 107 billion, net profit was up 12 per cent to Rs 29.5 billion as against expectations of Rs 28 billion as per Bloomberg poll of analysts. 

Importantly, volumes in its key cigarette business grew by six per cent year-on-year, the best in at least 13 quarters, and came at the upper end of growth expectations of 3-6 per cent. The question is whether ITC can deliver satisfactory volume growth going ahead without hurting profits in this business.

The Q2 cigarette volume growth was supported by a favourable base, besides the absence of price hikes and regulatory blows (no upward tax revision recently). Going ahead, too, the next few quarters should see volumes grow at a healthy pace, aided by a favourable base effect (flat to negative volume growth in the previous three quarters). Since competitive intensity from smuggled cigarettes was high and volumes had been muted, ITC had been selective in raising prices. Analysts expect the pricing trend to continue because any sharp increase could hurt volume growth as market share could tilt towards unorganised players.  

The flip side is that the absence of price hikes, along with the Kerala floods and change in product mix, weighed on its Q2 profitability, say analysts. The cigarette business, which accounts for around 85 per cent of ITC's operating profit, saw earnings before interest and tax (Ebit) grow by just 8.7 per cent versus revenue growth of 10.4 per cent, on a year-on-year basis. Analysts were estimating an Ebit growth of as much as 12 per cent.

"Price hike is necessary to improve profitability. But, we believe ITC would take price hikes gradually and in select markets to not to hurt volume growth significantly," says Nitin Gupta, an analyst at SBICAP Securities, who also expects about four per cent volume growth in coming quarters. In this backdrop, the Street would keep an eye on the mix of volume and profit growth in cigarettes going ahead.

Positively, ITC's investments in non-cigarette businesses such as FMCG, hotels and paper products are yielding returns, as seen in Q2. The share of non-cigarette revenue in the past one year has improved to 57-58 per cent from 46-47 per cent. Further, as profitability improves, its share in earnings should also go up. Analysts believe that this augers well for ITC's overall earnings and that the current stock valuation offers a good buying opportunity.