ITC may have to add profits to consumer playbook

While core competence is a virtue that most investors cherish, diversification is one that can be useful, too. ITC Ltd’s consumer products business could be a case in point as its flagship cigarettes business is suffering from a punishing increase in taxes and harsh regulatory oversight. News of ITC’s plan to set up 20 new factories to make consumer products could be a sign of a bigger push.

Sharp annual price hikes in cigarettes have hurt sales growth, but cigarette margins are protected. In FY15, for example, annualized sales of cigarettes rose by 8.6%, but profit rose by 14.8%. That may seem good, but not for a business where sales have increased at a compounded rate of 15.4% between FY09-14 and profit by 18.7%. Though ITC’s segment profit margin is still an eye watering 67.4%, it is not pulling as much weight as it did earlier.

Its consumer products business’ growth, too, has hit a bump. In the initial years, it benefited from external factors such as a growing consumer market and a friendly tax policy—area-based excise and income tax exemptions. That is no longer the case. In FY15, the consumer business’ annualized sales rose by a mere 6.1%. Though it did report a small loss, this is not very significant considering the overall mandate of this business is to gain scale.

So where has it reached in terms of scale? In FY09, ITC’s consumer business had a revenue of Rs.3,006 crore, roughly 40% of the size of cigarette revenue. Five years later, this has increased to 52%. That may seem like a small increase. But compounded growth is a healthy 22%, which compares well with the 11.1% figure achieved by Hindustan Unilever Ltd, a rival it is most compared with. In absolute terms though, ITC’s consumer business revenue as a proportion of HUL’s is only 29%.

Thus, consumer products has done well, but ITC’s cigarettes business revenue, too, has increased, even if at a slower pace. And, its rivals have been doing OK, too. This brings us to the present. As things stand, cigarette profitability is healthy, but sales growth, and to a lesser extent, profit growth, too, is a challenge.That is likely to make it more difficult for ITC to grow beyond a certain point, in each category. So, scale may be a more difficult target than it was, say, a decade ago. Till the cigarettes kitty was overflowing, investors were a content lot, resting on the hope that some day the consumer business bets will pay off.

But the straining cigarettes business may change that. Slower profit growth also affects growth in cash generation. Investors may, therefore, expect the consumer business to do its bit for profit growth.

ITC’s own strategy, though unstated, has been to enter a number of categories, to begin with, build scale, and then identify the next big opportunity. Only time will tell if it is willing to shift gears.

Acquisitions are one way to go—it had acquired a few brands recently—to acquire scale. Having a more focused approach to its product portfolio may be another; getting rid of non-performing brands may hit size ambitions a bit, but may see profitability improve. A recent news report mentioned about analysts asking for a demerger of the consumer business. That seems premature talk at the moment, but a sign that investors are unlikely to remain content with the status quo.