Quick Take | ITC may have a new blend in its strategy pack

It’s that time of the year for ITC. Investors will be wondering if the government will sacrifice cigarettes at the altar of revenue growth by hiking taxes. But this year may see another conversation — around declining margins in its cigarettes business. The cigarettes division contributed to 45 percent of revenue and 84 percent of segment profit. Cigarettes are important for ITC’s sales growth and crucial for profit growth.

In the December quarter, the cigarette business’s margin declined over a year ago and sequentially too. Sales grew by 9.6 percent over a year ago while profit grew by 8.8 percent. In the September quarter too, margins declined year-on-year but improved sequentially.

It’s unusual for ITC’s cigarettes business to see a decline in profitability because of its position as a market leader and the pricing power it commands. In fact, a relatively calm period with no tax hikes in the previous Budget also meant it could have hiked prices to improve or protect margins. Why it did not do so is a question.

Now, it is possible that margins recover smartly in the next few quarters, making this conversation redundant. Or it may not. Let’s assume it does not and see what that could imply.

There may be a shift in ITC’s strategy on how it manages its cigarettes and consumer goods. Consumer goods contributed to 28 percent of sales, and between the two they account for three-fourth of overall sales. This may be part of how its new chief executive Sanjiv Puri wants to drive the company’s performance. Earlier, cigarettes would deliver thumping profit growth, while goods would aid sales growth.

The new strategy could look like this. Manage the cigarettes business for volume-led sales growth, with healthy margins though not at the cost of sales growth. At 70.1 percent, it’s higher than what a mass consumer business can deliver.

The consumer business was earlier swinging from losses to a slender profit, showing a volatile trend. Recent results show it delivering a consistent, albeit low, level of profits. ITC is even providing Ebitda numbers for this segment alone, perhaps trying to highlight its improving profitability. In the December quarter, it was up 42 percent over a year ago and rose sequentially too. The consumer segment’s margin is still low at 2.4 percent but that could easily improve.

ITC’s objective was to grow scale in each consumer product category, and then enter new categories. It would utilise cash from the cigarettes business and profitable consumer categories to fund this objective. Profit was not an immediate priority for the overall business.

That may have changed. A focus on the consumer business’s margins could help overall profitability improve. But growth could be held in check. In the December quarter, ITC’s consumer sales rose by 11.5 percent, lower than the 13 percent that market leader Hindustan Unilever achieved. There was a time when ITC’s growth would be streets ahead of HUL’s.

If indeed there is a shift in strategy, then both cigarettes and consumer will aim to deliver on sales and profit growth. As the consumer business margin improves from its single-digit levels, the blended margin will improve and so will earnings growth.

This can also shield, to an extent, ITC’s earnings from the vagaries that its cigarettes business is subject to. The government’s GST collections have been running below expectations. What easier way to boost them and strike a blow for public health, than to hike taxes on tobacco. That typically hurts volume growth due to the price hikes that follow.

Since September, bigger graphic warnings on cigarette packs have been implemented. While it’s too soon, these may affect volume growth in later quarters. An unfavourable product mix too was said to be one reason for lower margins.

The risk of an increase in taxes in February may be why ITC held back price hikes, despite tobacco costs increasing. Frequent price hikes could harm growth. If taxes are hiked, it will increase prices at one go. That may hurt volume growth in the near term.

Now, the threat from a higher tax rate is an immediate concern. But a vital trend investors should watch out for is how sales and profit growth in the two main businesses behave. If both deliver on sales growth and profit growth, though at different levels, then it will be a clear signal of a shift in ITC’s strategy.