ITC: time to tap into margins for growth

It is tempting to conclude that ITC Ltd is caught in a bad situation. Its cigarettes business is barely growing, its fast-moving consumer goods (FMCG) business is no longer the growth driver it used to be, and a weak business environment has hit its paper business. Even agricultural commodity trading revenues have declined because of weak trading conditions. The hotels division has done relatively better in recent quarters, but is not a significant contributor to revenue.

ITC's broad strategy was to let the cigarettes business be the profitability driver, while the FMCG business would drive sales growth. That plan has come apart, at the moment.

In the September quarter, its sales declined 1.4% over a year ago, with the cigarettes business growing by just 1.6% while the FMCG business sales grew 7.1%. Excluding noodles from the FMCG basket, since the Maggi noodles issue has hit sales of all instant noodles, sales growth was a bit higher at 10%. This is lower than the June quarter's 12% growth.

There is one area, however, where ITC's flag flies high-the cigarette segment's profit margins. Even after all the tax hikes-the previous three fiscal years have seen excise on cigarettes increase by 98% and value added tax, or VAT, by 104% at a per unit level-this business still earned a segment profit margin of 68.7% in the September quarter. It is higher by 98 basis points over a year ago and by 1.7 percentage points sequentially. What's better, it is much higher than three years ago; it earned a 61.4% margin in the September 2012 quarter. A basis point is one-hundredth of a percentage point.

Taxes and margins rising together may seem anomalous. ITC has hiked prices to both recover tax increases and compensate for the decline in volumes. A better product mix, too, can contribute to higher margins. But better profitability has come at a price as sales growth has slowed considerably. ITC blames this partly on smuggled cigarettes eating into the share of the organized market.

As long as its other segments were contributing to sales growth, especially the FMCG business, one could pardon slow cigarette sales growth. When non-cigarette sales growth also crawls, then there is a problem. One could call this a temporary phase, with FMCG sales expected to improve soon. That could happen but low inflation may keep a lid on value sales growth.

Alternatively, ITC could also consider a situation where it settles for lower margins from the cigarettes business.Other consumer companies have sacrificed profitability in order to pep up sales growth levels.

ITC may still not need this option. It may hope that cigarettes are spared from duty hikes in the next budget. Another hope is that cigarettes are covered under the proposed goods and services tax, lowering the overall indirect tax incidence. Either of these developments (the second can have a bigger impact) will relieve some pressure on the company.

Leaving these hopes aside, it is time for ITC to focus on improving cigarette sales growth, even at the cost of slightly lower profit margins. It could be done either by price cuts or promotions, but it will mean lower profit margins per unit that can be made up by the resulting higher volume growth. That could mean higher profit growth, too, in absolute terms, even if margins turn soft.

The ITC stock fell on Friday by 4.3%. Operating profit grew by just 2% (margins improved still) while its net profit rose by 0.25%. A more proactive approach to attain better sales growth levels and, therefore, higher profit growth, may cheer investors up.

In arrangement with HT Syndication | MINT