Column

Not many companies have the luxury of being a monopoly in a sector in which most direct forms of advertising are banned. ITC is one such company. It has a near monopoly when it comes to selling cigarettes in India. And, that to an extent, it has the pricing power that has over the years ensured that it keeps growing at a steady pace quarter on quarter.

For the quarter ending June 30, 2010, the net profit of ITC went up by 21.8% to Rs 1,070.3 crore. This increase in profit was on the back of the operating profits (or the earnings before interest and taxes) of the cigarette business going up by 16% to Rs 1,305 crore. The operating profits of other divisions like hotels, paper and agri business also went up significantly to contribute to the overall increase in profits.

To its credit, the company realised well in time that, in order not meet the same fate as big western cigarette companies, it needed to diversify into other areas of businesses. And that it did by getting into agri business and foods, soaps and detergents big time.

The agri business, which concerns dealing in agri commodities such as rice, soya, coffee and leaf tobacco, is profit making. For the quarter ending June 30, the business made an operating profit of Rs 123.10 crore on a revenue of Rs 1,349.80 crore. This meant an operating margin of 9.1%.

The foods, soaps and detergents business of ITC, which forms a major part of the non-FMCG cigarette business, continues to lose money. For the June quarter, the non FMCG business lost Rs 89.25 crore, down from Rs 99.77 crore during the same period last year. Given the price pressures and competition from big existing incumbents like Hindustan Unilever, this is not surprising.
Over the years these new businesses have been contributing a significant portion of the revenue, and the company’s dependence on the cigarette business has been going down.

For this quarter, the cigarette business brought only 42.5% of the total net revenue, in comparison to 46.2% during the same period last year.

But what is worrying is that the cigarette business contributed 83.2% of the operating profit in the quarter. This is marginally lower than the 85.4% it contributed during the same period last year.

Given ITC’s near monopoly in the cigarette business in India, the kind of margins it enjoys are mind-boggling. The operating margin for the cigarette business during the quarter stood at 52.5%. Now compare that to the 9 odd percent margin enjoyed by the agri business.

This means all the cash being thrown by the cigarette business is being deployed at extremely low margins to build newer businesses.

The last year’s annual report of ITC makes a rather interesting point. Cigarettes have 15% share in the total tobacco consumption in India, but they contribute nearly 85% of taxes. In fact due to these high tax rates, the share of cigarettes as a proportion of tobacco consumption in India has fallen from 23% in 1972 to around 15% currently.

Governments over the years have penalised cigarette smokers and let other tobacco consumers like bidi smokers and gutka and pan masala eaters go free. Bidi production is largely a small scale industry in India and bidi smokers come from the lowest strata of the society. So no politician wants to charge punitive taxes on bidi, and make himself unpopular politically.

Given this logic, taxes on cigarettes in India are likely to go up in the years to come. This rules out any dramatic increase in revenues from the cigarette business. On the other hand ITC’s other businesses are nowhere close to earning the kinds of margins that its cigarette business does.

Over the years there has been talk of bidi smokers migrating to cigarette smoking, and now there is talk about more women starting to smoke as the economy progresses. Whether that happens, remains to be seen. In the meanwhile, it’s a real catch 22 situation for the company.