Investing in India: Should you buy ITC?

Indian cigarette maker ITC is one of India's great success stories. And now it's diversifying its business with an aggressive expansion plan into other growth sectors. But could it overreach itself? And should you buy this stock now amid market volatility?

ITC is the largest consumer goods company in India. Until a few years back, it derived more than 90% of its revenues from the sale of cigarettes and tobacco. But this is no longer the case.

Sure, ITC's cigarettes business is still the company's cash cow: indeed, the business generated Rs 57.6bn at an operating level in 2011 for the company. But rather than distributing excess cash as dividends, ITC has chosen to invest in the Indian growth story. Today, ITC's other businesses includes processed foods, apparel, hotels, paper and paperboards, and agri trading.

Moreover, ITC started a unique initiative in 2000, named e-choupal. Through this initiative, ITC links directly with rural farmers via the internet to source agricultural and aquaculture products. This programme coversfour millionfarmers in 40,000 villages across ten Indian states and provides ITC an unparalleled reach in the rural markets. On the one hand, the company is able to source its raw materials more economically than its competitors while on the other, it has a distribution channel in place, which it can use to sell its products.

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The future of the company

Cigarettes now contribute 52% of ITC's top line, a significant reduction. However, they still contribute 81% of its operating profits. This means that ITC's profitability is still largely dependent on its cigarettes business. Cigarettes make up 15% of tobacco consumption in India. The rest consists of chewing tobacco, gutkha (a powdery preparation of tobacco, paraffin and lime, among others) and beedis (a thin, south Asian cigarette filled with tobacco and wrapped in a leaf).

While the cigarettes business may be considered ITC's weakness, it is actually the company's strength. This business has shown tremendous resilience even in the face of a slowdown. ITC's cigarette volumes have grown by about 2.5% annually over the last five years in spite of higher taxes, graphical warnings on packs and increases in price.

Moreover, the ban on advertising cigarettes and expansion of cigarette manufacturing facilities has resulted in a monopoly for the existing players. As the largest in the sector, ITC is firmly positioned to take advantage.

And while cigarettes are the biggest contributor to the bottom line, the company is steadily building its other businesses. Over the last five years, ITC's non-cigarette fast-moving consumer goods (FMCG) business grew by 165%, while its paper and paperboards business grew by 84%. The hotel industry in India has faced headwinds in recent years due to the recession. Even so, ITC's hotel business grew by 10% over the last five years. And in the long run, the hospitality business in India has great prospects. With the Indian middle class increasing their disposable income, and growth in visits from foreign tourists, this sector is set to take off in fact, some estimates already suggest that India is short of about 100,000 hotel rooms.

ITC also trades agricultural commodities, including tobacco and soya. This has turned out to be a very promising business, thanks to the aforementioned e-choupal network. Over the last five years, this business has grown by 36% while its operating profit more than tripled over the same period.

There are plenty of challenges

With strong brands and a solid distribution network, ITC is poised to take advantage of India's consumption story. However, it does face certain challenges. The reliance on cigarettes to finance its growth is a potential weak point. The government is constantly introducing new legislation to curb cigarette consumption. So far, this hasn't had much impact on ITC's cigarette sales, but there's no guarantee that will continue.

ITC is also expanding aggressively. It plans to invest Rs 250bn over the nextten years in its FMCG, paper and paperboard and hospitality businesses. Considering the company clocked net sales of Rs 211bn in the financial year 2011, this is very ambitious expansion, which of course, carries execution risk.

Another concern to watch is succession. The driving force behind ITC's success has been its chairman, Yogesh Chander Deveshwar. He was appointed in 1996 and since then, the company's sales have grown from Rs 50bn to Rs 211bn, while its profits have grown from Rs 2.6bn to nearly Rs 50bn. Deveshwar is past retirement age now, but is continuing in his post, as the company has not managed to find a suitable successor. It remains to be seen when this will happen, and who ITC will appoint as its new chairman. Will that person be able to take Deveshwar's legacy forward? It's a risk investors should be aware of.

So should ITC be a part of your stock portfolio?

ITC (ITCG: Luxembourg) is a play on the Indian consumption story. Its brands and distribution network make it a formidable player in the Indian market. The company has deep pockets, is not afraid to take on competitors and is known to garner market share quickly in whichever business it enters. However, volatile economic conditions have seen investors park their money in defensive stocks, which has pushed up the price of ITC. We'd suggest putting the company on your watch list and buying when the opportunity arises to get it at cheaper valuations.

This article is taken from Equitymaster, an independent Indian equity research company.