Once a tobacco-only company, ITC has diversified itself with successful products. And the tobacco business isn’t doing badly either

For ITC, the country’s largest cigarette company, Budget 2010-11 has not brought any cheer. The tax on tobacco products has been raised: an excise duty hike of 18 per cent on 60-70 mm cigarettes and 11 per cent on others. At first glance, it appears that ITC’s margin will be hit hard. Growth also looks restricted given the government’s continuous efforts to curb smoking.

However, a closer look at ITC’s performance reveals that the concern about its margin is exaggerated. Also, its other business arms should drive growth if the cigarette business slows down (although there are no signs of it). Considering these factors, we reiterate our buy on ITC. We recommended the stock first in July 2009, when it was trading at Rs 217. Since then, it has gained about 20 per cent.

Business performance. ITC has managed to pass on the rising tax burden to its customers while maintaining a healthy growth rate. The margin of the company’s cigarette business, for example, rose from 22 per cent in fiscal year 2004 (FY04) to 27.67 per cent in FY09. The compounded annual growth rate (CAGR) of the cigarette business remained healthy over this period at over 10 per cent, which is comparable to the growth of the overall FMCG industry. It follows that the company can handle margin pressure in its cigarette business due to rising government taxes

However, the cigarette business is not the sole contributor to ITC’s topline. In FY09, non-cigarette products accounted for around 49 per cent of its net turnover. Its non-cigarette portfolio includes fast-moving consumer goods (FMCG), hotels, paperboards, specialty papers and packaging and agri-business. ITC has strong brands in each category, such as Bingo, Sunfeast, Ashirwad and Fiama Di Wills in FMCG, and ITC Hotel and WelcomHotel in the hotels category. In the paperboards business, ITC is the market leader.

Over the years, all of these segments have recorded healthy growth rates. For example, the FMCG segment (excluding cigarettes), has recorded a CAGR of 74 per cent in the last seven years.

Financial performance. ITC is strong on all financial parameters. The sales CAGR for the last five years stands at around 15 per cent, and profit after tax grew higher at 17 per cent. It has a low debt-to-equity ratio of 0.01. The cash flow has also increased: at the end of FY09, its cash balance was Rs 1,032 crore.

ITC’s hotel business was the only segment that was hit hard by the economic slowdown. However, the previous quarter (Q3FY10) results show that it is gaining traction. Overall, in Q3FY10, the company’s net sales and profit grew 18 per cent and 26 per cent y-o-y, respectively.

Investment rationale. As ITC’s non-cigarette portfolio is growing faster than its cigarette business, the company’s dependence on the cigarette business is declining. However, this is not to say that the cigarette business is stagnant. ITC’s other businesses are in the growth phase and growing faster than their respective industries. The company is investing heavily to ramp up its distribution and logistics channels and aggressively marketing for its products. Although these expenses are squeezing its margins, the positive impact of these investments should be reflected in margins in the coming quarters.

Besides, the stock of the company is attractively priced compared to its peers. At a price of Rs 259, its shares are trading 22 times the company’s annualised earnings per share. Since our first recommendation, the PE ratio has remained at the same level, which indicates that earnings have kept pace with the rise in share price. The company’s policy to pay regular dividends to its shareholders makes its shares even more attractive.