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ITC, Bhadrachalam merger for diversification, growth

Suresh Krishnamurthy

BL Research Bureau

THE proposed merger between ITC and ITC Bhadrachalam is to be viewed in the backdrop of ITC's conscious effort to de-emphasise its tobacco business. Indeed, the robust cash flows of ITC allows the company the opportunity to add businesses to its portfoli o and thus reduce the importance of the tobacco business.

The increased government and non-governmental activism against tobacco companies worldwide has made it necessary for these companies to diversify in order to manage risks. It is in this backdrop, ITC too had invested in industries such as hotels, IT, agr icultural exports, and retailing. The merger now gives a more concrete shape to such plans. The merger plan indicates that a large portion of the future cash flows will be invested in the paper industry.

In fact, in a recent speech, the Chairman of ITC, Mr. Y.C. Deveshwar, remarked that, ``The sterling turnaround has led your company to encourage ITC Bhadrachalam to embark on an ambitious growth plan entailing an investment of Rs 1,500 crore over the nex t five to seven years''.

Given the state of affairs at ITC Bhadrachalam, the company would have necessarily had to resort to outside financing for the expansion. At the same time, ITC is flush with cash and looking for avenues to invest. Since ITC is convinced about the growth p rospects in the value-added paperboards segment, the merger would address both these issues.

In the near-term, the merger has the potential to bestow substantial tax benefits to ITC. ITC Bhadrachalam has on its books accumulated losses to the extent of around Rs 125 crore at the end of March 2001. As per tax rules, the accumulated losses would b e much higher because of higher depreciation rates.

Calculation based on accretion to fixed assets suggests that the carry forward losses could be of the order of around Rs 300 crore.

For ITC whose profits are touching Rs 1,000 crore, this can bring down tax by around Rs 100 crore in this financial year itself. However, this would be only a one-time windfall. In addition, to the extent the paper division makes losses due to falling pa per prices, the benefits will be reduced.

There are also other justifications for the merger. The loss made by ITC Bhadrachalam is taken into account when the stock is valued at the bourses because the company is a 51 per cent subsidiary. However, while the losses of the subsidiary go to reduce the valuation of the company, it does not reduce the tax outflows of the company. Given that the earnings of subsidiaries have to be consolidated from this financial year, ITC might as well merge the company with itself. In addition, the sales tax on con sumption of ITC Bhadrachalam's products by ITC can also be avoided. This adds to the benefits flowing from the merger.

Overall, there are few justifications for the proposed merger. What the merger does not address is whether it makes sense for ITC to be in the paper business at all considering the low profitability. ITC is convinced that it makes sense. Judging by the stock price fall on Thursday, the stock markets don't seem to share the opinion.