Contribution of other businesses must accompany improved cigarette margins.

Hotels-to-tobacco major ITC’s cigarettes business brought about a positive surprise in the June 2007 quarter. Segment margin in cigarettes improved by nearly 150 basis points to 27.3 per cent, on the back of a 20 per cent price hike.

As a result, the stock was up 2.8 per cent on the bourses while the Sensex tumbled 3.4 per cent. The ITC stock has been an underperformer over the past year; it is at about the same levels, while the Sensex is up 42 per cent.

This was because analysts have been factoring a decline in cigarette volumes by 7-8 per cent this year because of the price hike to offset VAT, which would reduce demand.

In the June quarter, ITC’s net sales grew 16.7 per cent y-o-y, which is much lower than the 26.3 per cent growth in FY07.

However, the operating profit margin which had dipped 200 basis points y-o-y in the March 2007 quarter, improved by 700 basis points sequentially to 33.9 per cent and was marginally lower on a y-o-y basis. Net profit also improved 20 per cent y-o-y in the first quarter (Q1).

However, considering that ITC is aggressively pushing its non-cigarettes businesses, its growth at 18 per cent in Q1 is half of what it was in FY07.

Its paper revenues grew slowly by 5 per cent as one of its paperboard machine at Bhadrachalam was under planned shutdown for upgrade, but paper is not a high-growth business and revenues had grown 11.8 per cent last year.

Top line growth in hotels, FMCG-others and agri business was slower in Q1 than it was last year. Nor are these businesses turning hugely profitable - FMCG-others, which includes branded foods, lifestyle retailing, stationery & cards and safety matches, continue to be loss making.

The segment margin in hotels went up just 10 basis points y-o-y despite higher revenue per room and better F&B performance. The margin in agri business declined 40 basis points y-o-y to 3.8 per cent in Q1.

Analysts have now revised the cigarette volume decline to be lower at around 4 per cent this year. The turnaround in cigarettes margins may indicate that the worst is over for ITC, but its other businesses need to improve profitability. The stock trades at 21 times estimated FY08 earnings and 19 times FY09 earnings, and is unlikely to be an outperformer.