• The strategic fit that can be conceived for the merger is the use of paperboard made by ITC Bhadrachalam for manufacturing cartons and greeting cards by ITC.

• Amalgamation will result in addition of a business with comparatively lower profitability and asset utilisation ratios. It has a loss-making subsidiary BFIL Finance which can be a drag on ITC.

• The short-term outlook is negative, stable in the medium-term.
  
  

MORGAN STANLEY DEAN WITTER
Outlook Neutral

• ITC's sales and profits will increase by 11 per cent and 3.5 per cent and equity capital by 0.9 per cent.

• ROCE would fall 1.4 per cent.

• From ITC's future cash-flow perspective, the event does not change much as ITC's money was being used earlier too. We expect an initial negative reaction.

• Market rating outperformer.

• Price targets Rs 940.
  

SALOMON SMITH BARNEY
Do Not Panic

• Initial reaction was negative but subsequent analysis shows results are not shocking.

• Assuming 1:15 swap ratio, EPS is enhanced but capital efficiency ratios will decline marginally.

• Merger integrates the two entities and does not appear to alter business fundamentals of the core tobacco business.

• Except weakness in stock price over the short-term and view it as an opportunity to buy.

• Rating : medium risk. Price target : Rs.1000
  

The proposal to merge ITC Bhadrachalam with ITC Ltd has eroded nearly Rs 2500 crore in market capitalisation of the latter. The merger came as a complete surprise to the markets even though ITC, with a 60 per cent stake in the paperboard company, had been supporting it through loans and preference capital. While markets have so far given a thumbs down to the stock, some analysts believe that the concerns may have been overemphasised.

Markets have reacted negatively to the merger proposal due to lower profitability operations in the cyclical paperboard business. It would also be a cash guzzler in view of the company's Rs 1500 crore expansion plans.

However, with a nearly Rs 100 dip in the stock price, we believe that the impact of the merger has been built into the valuations and there may be no significant concerns now. The share swap ratio for ITC-B's shareholders is expected to be between 20:1 to 15:1, resulting in issue of 22 lakh to 30 lakh shares of ITC Ltd. This would result in an increase in ITC's equity by a mere 0.89 per cent to 1.22 per cent. With this marginal increase, impact on BAT's shareholding in ITC would be negligible. How BAT eventually reacts to the proposal is not known for the present.

Concerns on the merger were not entirely unwarranted. Prior to last fiscal, ITC-B had made cash losses for almost three years in a row. The paper industry was in a down-trend and pulp prices were witnessing a decline. Last fiscal was a good one for the paper industry and the company managed to show a 6 per cent net margin. The concern is over cyclical nature of operations and paper companies' dependence on import of pulp. ITC-B has tried to insulate itself by undertaking a massive forestry programme and setting up waste paper recycle plant. Nonetheless, susceptibility to global pricing remains.

After a good year of operations, ITC-B had operating and net margin of 27 per cent and 6 per cent compared with ITC's 40 per cent and 24 per cent, respectively. The ROCE and RONW at 9 per cent and 8 per cent for ITC-B and 25 per cent and 29 per cent for ITC respectively point to significant divergence in profitability of operations. With ITC's additional cash being deployed in ITC-B's capital expansion, its ROCE too would be hurt. However, profitability needs to be put in perspective vis-a-vis the size of operations. For the last fiscal, ITC-B had net sales of Rs 535 crore against Rs 4204 crore for ITC. Its operating profit was Rs 144 crore against Rs 1688 crore for ITC. The capital employed stood at Rs 825 for ITC-B was roughly 20 per cent of ITC's Rs 4330 crore. Thus, with capital about 20 per cent of ITC's, ITC-B netted sales equivalent to 13 per cent of ITC and operating profit equivalent to 8.5 per cent.

Based on last fiscal's figures, post-merger ITC's operating and net margins would decline by 200 basis points and 100 basis points, respectively. The ROCE and RONW would decline by a similar margin. In absolute terms, the sales of merged entity would go up by 11 per cent and earnings by about 3 per cent. Slightly higher absolute earnings would compensate a slightly lower ROE.

But a lower ROE definitely means marginally lower discounting. Besides, the growth in earnings would be lower than that of pre-merger ITC on account of low profit operations of ITC-B besides cyclicality of the business. We believe that this has already been built into the stock price now.

The impact of ITC-B's operations on ITC financials would have reflected in the consolidated accounts, which has become compulsory from the present fiscal. The merger would give one-time tax savings this year on account of accumulated losses of ITC-B. A large expansion plan of Rs 1500 crore would also give the necessary tax reprieve.