Positive Smoke Signals

The ITC scrip has always been the darling of speculators. But it has not disappointed the long-term investor either. And now, even though its price has fluctuated wildly, ITC remains a technical favourite and most analysts still recommend a buy because they expect the stock to cross Rs 850 by December. Is all this faith justified?

Look at the way the scrip has moved. In spite of problems of excise and FERA, the stock has been on an upward spiral since November 1996 when its price was Rs 244 . In June 1997 at a price of Rs 562, valuations appeared rather stretched. But the stock has moved relentlessly upwards since then also, outperforming the market by gaining 37 per cent against a Sensex fall of 17 per cent. This is an indication of the long term iew that investors are willing to take on the company and its prospects. The Smart Investor takes a look.

 

But why are both punters and investors bullish on the scrip?

Says Anand Tandon, managing director, Stewart and Mackertish Securities, ITC has strong fundamentals and is also highly liquid. Any stock that falls in this category turns volatile as it offers easy entry and exit. Other scrips which fit the bill like Castrol and State Bank of India too witnessed such volatility. The scrip will continue to be volatile for some time providing enough trading opportunities.

For the longer term (about a year) Tandon says, Having outperformed the index for so long, the surprise element is missing from the price movement. The scrip should however touch Rs 850 at least by December 1998 on the basis of its very strong fundamentals.

Says another Mumbai-based analyst who did not wish to be quoted, I am expecting the scrip to touch Rs 900 by the year-end. This positive sentiment is echoed by practically everybody. However, after the current bull run which saw the scrip touching Rs 802, there seems to be a consensus that the scrip would witness a small correction.

Fundamentals of the scrip

Says an analyst with Stewart and Mackertish Securities, A cigarette company shells out roughly 50 per cent of its gross sales as excise. ITC maintains a gross margin (net sales less raw material and manufacturing expenses) of almost 50 per cent. This gives it a phenomenal operating leverage. A 0.1 per cent increase in gross margins will add Rs 30 crore to the bottomline. It is for this reason that the company is able to put in a sterling performance in spite of being in an almost stagnant market. (Because of the unusually high incidence of excise, the cigarette market has been growing at 2-3 per cent annually. In fact, the share of cigarettes in total tobacco consumption has fallen from 23 per cent in 1971 to 19 per cent today.)

How is ITC able to maintain its margins?

Says Kannan V, analyst with ICICI Asset Management Company, It is because of its tremendous pricing power and control over key inputs. Cigarette consumption particularly in the premium segment is driven by brand loyalty and is relatively price inelastic. ITC is the market leader in all the cigarette segments with some very strong brands and it has a virtual monopoly in the premium segment. In the longs segment, its Wills Navy Cut has absolutely no competition with a 100 per cent market share; in the Kings category

its India Kings, Classic and Gold Flake are very strong brands. The only effective competition in this category is from imported brands and Godfrey Philips Four Square. ITC is therefore able to effect price hikes in the premium segment (longs and kings) without impacting volumes much. Any non excise related hike in prices has a direct impact on the bottomline.

Says Kannan, Consumption in the non premium categories is price elastic specially in micros. Therefore pricing power in these segments for any player is low. For ITC, the lower segments are therefore significant for the volumes that they offer.

... very strong distribution

ITC's dominance of the market with a 68 per cent market share (up from 63 per cent in 1993) is attributable in a large measure to its strong distribution network. ITC has penetrated the innermost parts of the country with a network of over 600 wholesalers in over 3,500 cities and over 10,000 villages in India. No other cigarette company has a reach as far as that of ITC.

...controls key inputs

ITC is uniquely placed in the cigarette industry from the perspective of controlling key inputs. This has been achieved through a spate acquisitions --Indian Leaf Tobacco Company (ILT) and Tribeni Tissues. Tobacco, which is the largest input is dominated by the ILT division of ITC which feeds VST also. ITC has a key role in tobacco pricing, crop size and research and development efforts which give ITC a head start.

The cigarette paper market is dominated by the Tribeni Tissues division of ITC which supplies to all cigarette majors. Cigarettes are packed in paper board cartons supplied by ITC Bhadrachalam Paperboards Ltd. Essentially, ITC is vertically integrated while competition is not.

Can ITC replicate its success story for long?

Over the last two years, the number of households in the upper income groups have grown faster than in the low income group. This shift is expected to only grow stronger in the years to come. ITC with a near complete domination of the premium segment will be able to increase volumes even while increasing prices (for the premium segment).

With reference to the half year results an industry observer says, Higher disposable income, aggressive marketing efforts and moderate excise hikes have helped to push the regular filter smoker up the value chain to the longs and kings segment (compare growth rates in columns 3 and 4 in the table Changing product mix and ITC has made the most of this shift. This trend is likely to continue and is beneficial for ITC as its Bingos (cheapest cigarettes) are priced on a marginal cost basis and any reduction in its volumes will actually result in increase in overall profitability.

ITCs dominant presence in all the segments of the market ensures that the company is the biggest beneficiary of any shift in consumption patters which will take place. However, if legislation banning advertising is implemented, the rate of shift in consumer preference towards the premium segment could be impacted.

... modernisation to improve margins

ITC has drawn up a Rs 800 crore expansion cum modernisation plan wherein the capacity at the Bangalore plant, which will manufacture the foreign brands to be introduced in India, will be enhanced to 100 million sticks per day (62 million presently) at a cost of Rs 300 crore. The remaining Rs 500 crore will be spent on modernising the existing units. This modernisation cum expansion will enable the company to meet international quality standards. Also, this will result in better operating margins.

... restructuring to improve margins

After a spate of diversifications, the ITC management has taken a conscious decision to concentrate on four core areas -- tobacco, hotels, packaging and printing and paper. ITCs earlier diversifications had masked the extremely high profitability of its tobacco business, which will now get fully reflected in the bottomline. Since there will not be any drags because of unprofitable businesses, margins should improve further.

Hotels are being developed as a second line of defense. Though hotels are a cyclical and capital intensive business, they are profitable in the long term -- ROCE in 1996-97 (a recession year) for EIH and IHCL was 29 and 26 per cent respectively. ITC's has the advantage of an existing upmarket brand --Welcomegroup.

....industry positives

Cigarettes constitute 18 per cent of the tobacco market in India as compared to 85 per cent globally, offering huge potential for growth. Excise duty which determines the consumption of the cheaper cigarettes is already too high and is expected to be inflation linked in the near future. Thus excise duty is not expected to hinder volume growth in the future.

Other concerns

....domestic competition

The other cigarette majors namely VST, GPI and GTC are either plagued by management problems (GTC) or have a regional focus (VST). None of the players have the financial clout or the network so critical for the business -- ITC spent Rs 190 crore on advertising and sales promotion in 1996-97. ITC therefore has almost a walk over situation in the market.

...the foreign threat

Foreign brands with their premium image do pose a threat to ITC in its premium segment. ITC's distribution and world class manufacturing facilities should be able to restrict the foreign brands. Also, access to BATs international brands like 555 and Benson and Hedges will help eat away at the foreign cigarette pie, effectively reducing the impact that the foreign cigarettes would have on ITC.

...pending litigation

ITC's FERA violations have been estimated at $100 million. The actual liability, say analysts, can go up to a maximum of 5 times the actual violation. Its excise liability is estimated at Rs 900-950 crore. Of this the company has already made a payment of Rs 350 crore, reducing its effective liability to Rs 500 crore. Thus the total liability of the company is approximately Rs 900 crore. Given the time that any such case takes to be resolved, market watchers are not unduly worried about the contingent liability.

How does ITC compare with the other fast moving consumer goods (FMCG) heavyweights?

FMCGs are good defensive scrips particularly in the kind of uncertain markets that we are living through. ITC trades at an unjustified discount to the FMCG sector given its position of strength and huge growth potential.

ITC is thus one of those scrips which while presenting excellent trading opportunities, is also a good long term buy. Investors are advised to buy at declines.