ITC's cigarette biz huffs and puffs, FMCG is burning cash

FMCG major ITC draws its investment clout from its cigarette business, which generates more than Rs 1,500 crore in pre-tax profit every quarter. However, investors and smokers, here’s some bad news for you: There is heightened global pressure on the cigarette industry with Australia, the UK, Canada and Russia taking stringent action that can cap cigarette sales and dilute brand franchise.

Cigarette valuations are under serious threat from legislative/regulatory tightening globally

Australia is starting to implement a ‘plain packaging’ norm (30 other countries are also contemplating a similar move) and there is a severe clampdown on cigarette sales in markets like Russia. Britain has hiked cigarette taxes by two times its historical average and Canada’s health warnings have also gotten stricter. Brokerage IDFC believes that “as regulatory concerns escalate, global majors will be derated and have a ruboff effect on ITC”. ITC makes most of its money from cigarettes and tobacco, which is then funnelled to FMCG products - which don’t bring in much margins.

Despite pricing power, ITC faces formidable challenges to grow volumes in the face of a structural rise in taxation

ITC’s woes don’t just end with this regulatory uncertainty.The increasingly disruptive tax environment for cigarettes in India resulted in a quarterly drop in tobacco product sales.

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[caption id=“attachment_416675” align=“alignleft” width=“380”]  he increasingly disruptive tax environment for cigarettes in India resulted in a quarterly drop in tobacco product sales.[/caption]

Uttar Pradesh, the country’s most populous state, in early July increased the value-added tax on cigarettes to 50 percent from 17.5 percent. The northern state contributes 5 percent of the company’s sales by value. ITC’s average VAT rate increased to 18 percent as more states followed suit. Since ITC generates about half its revenue from cigarettes, government curbs on tobacco use pose a challenge to sales. ITC’s volume growth has already suffered with cigarette volume CAGR at a disappointing 1.3 percent over the past five years.

The ban on chewing tobacco in five states in the past two months is another red flag for the industry. Prompted by loss of revenues after the ban on chewing tobacco, state governments are likely to increase taxation on cigarettes. Moreover, the 2012 Union Budget suggested that the government plants to implement an ad valorem excise structure on cigarettes which would limit ITC’s power to expand margins like it did in the past few years.

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FMCG unexciting despite ITC having pumped in Rs 4,000 crore

Third, ITC’s new businesses offer no consolation. IDFC believes ITC has ’not fired’ in non-cigarette FMCG business. It has not just lost Rs 2,500 crore, but has also not garnered even 15 percent share in any category, despite having strong distribution and investing huge capital (around Rs 4,000 crore). This dilutes the economic benefits of this space, it said.It continues to be a No 3 in biscuits despite having invested 10 years in this category. In soaps, ITC has been No 5, with market share remaining stagnant at 6-7 percent for the past two years. Has any other company invested such sums without creating a relevant share in any category?

“With 75 percent of capex set for asset-intensive segments and structural headwinds rendering the cigarette growth story illusory, we expect ITC getting into a prolonged de-rating.”

Hotels would remain a drag on the balance-sheet

In financial year 2012 ITC allocated more than 30 percent of its capex, or Rs 720 crore, for expanding the hotel chain at a time when the demand environment remains challenging as foreign tourist arrivals have slowed and domestic consumers look to cut on discretionary spend. “The segment will continue to be a capital guzzler and would bring down overall company return ratios as it expands. We believe hotels are strictly a price/book business and its limited value benefit to ITC is reflected by the valuation of its domestic peers,” said IDFC.

Like Reliance, ITC seems headed for a long period of underperformance with its core business under siege. Even though it has been trying to establish itself in the FMCG business for years, the business hardly generates much margins in comparison to its cigarette business.