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Profitable Puffs

The government’s reluctance to allow foreign cigarette brands means that ITC will remain a cash cow…

Gold Flake Premium, Navy Cut, 555, Ashirvaad, Sunfeast, Candyman, Bingo, Aashirvaad, Wills Lifestyle, Fiama di Wills and Vivel — these are some of the more than 30 brands owned by the Rs 21,000 crore cigarette to FMCG behemoth, ITC Ltd. Each of these brands, from Gold Flake to Aashirvaad atta, occupies its own distinct place in the Indian consumer’s mind. Traditionally a cigarette company, ITC has moved into many other businesses as it seeks to put its cigarette profits to good use. In each of the businesses it has entered, the competition has had to give way. In fact, today ITC commands so much financial muscle that if it announces its foray into any business, the news rattles the incumbents.

Sources of moat
A government-mandated moat. Whatever its reasons, health or ideology-related, the Indian government is reluctant to allow foreign cigarette majors such as a Rothmans or a Benson & Hedges to come into India and start manufacturing and sale s. ITC’s other Indian competitors are too weak and small to offer effective competition. So between bidis at the lower end of the market and imported cigarettes at the premium end, ITC has a large chunk of the cigarette market to itself.
A smoky affair. Cigarette smokers smoke — no matter the health risk — and they will continue to do so. The smokers know this and so does ITC.
ITC understands the addictive nature of its product better than anyone else. For a long time now, ITC has monopolised Indian smokers. Even today it has an estimated 85 per cent market share.
It has further cemented its position by establishing a powerful distribution network that covers more than 20 lakh retail outlets. So strong is its hold over the market that it promptly collects payments from retailers for the goods it sells to them, something that few other companies can afford to do.
Moreover, no other player has the financial strength to invest Rs 1,000 crore over the last six years on technology and products.
The best part of being in this business is that ITC can raise its price without unduly worrying about consumers bolting to a competitor. Two things work in the company’s favour. One, as cigarette smokers will tell you, they are addicted to their brand and will not shift to another just because its price went up by a couple of bucks. Second, customers don’t have too many choices here in India.
Deep pockets. Cigarette is a big money spinner that throws out a lot of cash. In FY11, for instance, cigarettes yielded a return on capital (before taxes) of more than 180 per cent. All that cash needs to be put to good use. After diversifying into hotels, paper, branded apparel and agriculture, among others (all of which it still is present in), ITC decided to foray into the Indian FMCG business.
FMCG foray. The current market for FMCG goods in India is estimated at Rs 29,000 crore. The prospect of being a significant player in this vast market was too alluring for a deep-pocketed player like ITC to pass up. The company entered into the FMCG space in 2001. Revenues from this business are now near the Rs 4,500 crore mark and it accounts for 17 per cent of ITC’s net revenues.
In this short period ITC has managed to grab significant market share from competitors. In biscuits, its share is estimated at 11 per cent. In atta it has decimated HUL’s Annapurna atta, taking the leadership position in the organised atta market. Bingo chips is estimated to have cornered 9 per cent. In soaps ITC has captured 6 per cent of the market, and in shampoos its share is estimated at a little less than 3 per cent.
What makes ITC’s FMCG foray different? Can you think of many companies that can afford to splurge over Rs 2,000 crore just to position themselves in a business? That’s ITC’s cumulative losses in the FMCG space in the last 10 years. Losses are diminishing with each passing year: in FY11 they stood at `331 crore, down 12.8 per cent compared to the previous year.
Being present in the Rs 29,000 crore Indian FMCG business is a high stakes proposition. The company knows that it is up against competition that has taken over a century to build its brands (like Britannia) or players deeply entrenched in the Indian psyche (like HUL). This battle for market share will not be decided in a hurry.
ITC has set its goals high. From being totally absent from this space only 10 years ago, it now wants to be number one in this space (displacing HUL). Getting to the summit will take many years, huge investments and patience — all of which ITC is willing and able to put in.

What could cause moat to be breached
In its cigarette business, ITC doesn’t face a serious threat from any of the domestic players. The only international player that could pose a threat to ITC could be Philip Morris of Marlboro fame. Philip Morris is much bigger than ITC. It is present in India through its stake in Godfrey Philips. However, it will take a number of years even for this global major to acquire the distribution reach that ITC has built up across India. Battling against an interest play like ITC will also require massive deployment of resources.

Growth drivers
Still many puffs left. According to ITC, 48 per cent of the adult male population in India consumes tobacco. Of this only 10.3 per cent smokes cigarettes (16 per cent smoke bidis while 33 per cent consumes smokeless tobacco). Thus, there is a lot of scope to improve the penetration of cigarettes.
Even if rising health awareness eventually leads to fewer people taking up the stick in future, the sheer scale of opportunity leaves enough room for ITC to multiply its revenues. Growth will also come from the conversion of bidi smokers to cigarettes. Currently the consumption of bidis outpaces cigarettes by 10 times. Big opportunity here.
Other growth drivers. ITC has a host of other non-cigarette businesses that bring in about half of its revenues (albeit at a lower profitability). All of them, with the exception of FMCG, are doing well.
Its agri business (contributes 18.5 per cent to topline) saw sales growing 23 per cent in FY11. Profits were up 26 per cent, driven by higher soya sales.
Paperboard (topline contribution 13.6 per cent) saw sales grow 14 per cent in FY11 while profits were up 20 per cent. In this segment, ITC is the market leader with a value market share of about 26 per cent.
Hotels (topline contribution of 4 per cent) saw an improved business environment, which helped the company post revenue growth of 18 per cent in FY11. Profits were up 23 per cent. ITC Gardenia, launched in Bangalore, added around 20 per cent to the company’s total room count and made money for the company in the first full year of operation itself.

Concerns
Price hikes could deter uptrading. The string of price increases taken by the company means that the price of the cheapest cigarette in ITC’s stable (excluding micro filters) is now 10 times the price of a bidi. That is a huge price differential for any bidi consumer and may dissuade him from uptrading.
When will FMCG business break even? Analysts following ITC are of the consensus view that its FMCG business may break even by FY13. New product launches like Yippee Noodles and aggressive brand building activities for gaining market share, as in shampoos, may however push the break even date further ahead.
Delay in GST implementation. Currently the VAT on cigarettes differs from state to state. Gujarat, for instance, has a VAT of 25 per cent on cigarettes. Rajasthan has set it at 40 per cent, Maharashtra at 20 per cent, Himachal Pradesh at 16 per cent, and so on. A uniform GST will be positive for ITC as it will rationalise the taxation rate across the country. Implementation of GST has been delayed a number of times. It is now expected that it will be rolled out in FY12. If it isn’t, then individual states may continue to hike VAT arbitrarily.

Financials
For the financial year FY11, ITC reported a 17.5 per cent growth in revenues at Rs 21,167 crore. PAT came in 22.8 per cent higher at Rs 4,987.6 crore. During the quarter ended March 2011, cigarette volume declined 2 per cent which was attributed to pipeline corrections. ITC took an overall price hike of 5 per cent in February 2011. The FMCG (non cigarette) business grew 17 per cent y-o-y. Improving sales and better mix resulted in margin expansion to the extent of 180 basis points (y-o-y) in this segment.

Valuation
At the current market price, ITC trades at 30 times its FY11 earnings. This is higher than its five-year median PE of 25.3. Over the last five years, the company’s EPS has grown at a compounded annual rate of 16.71 per cent, which gives it a PEG ratio of 1.79. Thus the stock is trading in the expensive zone. Wait for it to correct before you buy.