A long road lies ahead of ITC Ltd. Its shares have risen by a mere 4.5% in the past year, while Hindustan Unilever Ltd’s (HUL’s) shares have gained by 22.5%. Its Q2 results indicate this gap may remain for some time to come.

Consider its cigarettes business, which contributed to 41% of sales and 85% of segment profit. Sales rose by 10.4% which was good, and while the company does not reveal volume numbers, analysts estimate volume growth at about 5-6%. Ordinarily, this should have been good. But then, its segment profit margin declined by 1 percentage point over a year, even though it rose by 1.8 percentage points sequentially. The company said that floods in Kerala damaged inventory and the shift to new graphics from 1 September resulted in higher costs. Why margins increased sequentially is unclear as also whether the entire decline in margins can be attributed to these events.

ITC’s FMCG business is doing well with sales growth at 12.8%, slightly higher than what HUL reported. But profits may have improved but remain very slender, as the company remains in investment mode in this business. Its other businesses, such as paper and hotels, have also seen stable margins sequentially.

The overall picture that emerges is one where ITC’s revenue rose by 7.3% over a year ago, while input costs declined by 1.7%. In fact, employee costs too declined by 1.7%. But it was tripped up by a sharp increase in other expenses, which rose by a fourth over a year ago. Other expenses include heads such as freight, advertising and losses from floods too would be included here.

Since the costs of floods and costs of changing graphics are one-time in nature, that should mean the cigarette business’ profitability should recover. Insurance may cover the lost stocks too. The impact of the new graphics on cigarette sales is a risk to watch out for.

Cigarettes and FMCG are the main engines of growth for ITC. Cigarettes appear to have shrugged off the effect of higher taxes in the new Goods and Sales Tax (GST) regime. Its sales growth has returned to more decent levels. The key risk here remains a further increase in taxes that will again deal a blow to volumes.

FMCG sales growth too looks healthy but margins remain a question mark. With ITC setting up a number of manufacturing units for this business, segment profits may not improve by much. In any case, ITC’s chief objective is to expand its market share and profits are secondary in importance. While margins have picked up a bit, they still remain thin.

ITC’s earnings rose by 11.9% over a year ago to 2,955crore, which is relatively low for ITC. That then explains the divergence in share price performance over HUL, whose earnings rose by 19.2% in the September quarter. Unfortunately for ITC’s investors, it is back to watching for the risk of an increase in indirect taxes in the coming quarters. If it is spared in 2018-19, then that should set the stage for a healthier growth in both volumes and profits from the cigarettes business.

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