Coming Revolution in Automotive Industry

 

Indian automotive industry is grappling with one change after another last few years:

1. Demonetisation in fag end of 2016 washing out sales in second half of year
2. BS IV norms implemented from April 2017,                                                               
3. GST implementation in July 2017 and associated changes at OEM and partners, 
4. Leapfrogging to BS VI from April 2020

and not to forget other things like historic high fuel prices, corona pandemic etc. etc.

Now new change like five year moved forward target of compulsory 20% ethanol blending is staring in ace of automotive industry.

And as if this was less, greenhouse gas reduction targets are pushing government to accelerate adaption of electric vehicles supported with FAME subsidies.

Adaption of EV presents biggest opportunity as well challenge for automotive industry it has seen after invention of IC engines. This era will be probably similar to the initial days of IC engines wherein lot many innovations took place, many new players came in and many perished (It is said in USA over 2000 automotive manufacturers were registered in last century and at the turn of century only 3 survived and they too were not in financially great shape)

Adaption of EV raises lot many unanswered questions few of which are:

1. Which technology to bet on - Hybrid, LI-ion batteries or hydrogen cells or ? 
2. Which chemistry to bet on in fast changing cutting edge battery technology               
3. Whether to make batteries (constituting ~ 40% of vehicle cost) in-house or outsource
4. How charging infra will develop - battery swapping or fast charging or something else
5. How to substitute lost aftersales revenues with EV adaption for both OE & channel

Also, earlier IC engine vehicles was monopoly of mechanical engineers, but EV will require many new competencies like electrical engineering for battery & motor, chemistry knowledge for Battery chemistry, power electronics and computer knowledge for Battery Management System.

This presents catch 22 situations for existing automotive players; if they take early stance but bet on wrong technology it will mean huge wasted investment and if they don’t, upcoming players will eat their lunch.

Probably stock markets are sensing these changes and today Tesla has become not only the most valuable automotive company in the world but also more valuable than the next six automakers combined.

One thing is for sure, next decade landscape of automotive industry will be much different than what it is today and will bring out some new hero's and zero's in automotive industry.

Musings on Nestle

This started as discussion with an investor friend and ended as a blogpost. We both are invested in nestle and agree that it is one of the bluest blue business but have different opinion on valuations. 

One of us, is worried about sharp run up in stock over last 2-3 years and feels that it may stagnate or derate, while other believes that these valuations are justified and reflect business pedigree, past returns and bright future.  

So, we decided to dig up past data and look at possible and plausible future scenarios. Following is summary of discussion which you may find useful if you are interested in Nestle. 

Nestle as Business (2001-20) 

Following graph tells last 20-year story on volumes, sales and earnings.

   

• Over last 20 years, volumes, sales and profits have grown with rate of growth in profit>revenue>volume.
• In first decade, there was good growth both in volumes and sales and margins expanded from 9% to 13%.
• In second decade, volumes stagnated but sales doubled and margins again increased from 13% to 16%.
• In 2015, Maggi crisis hurt both volumes and sales while earnings almost halved. 
• But Nestle fought back with vigour and regained its pre-crisis tonnage by 2018.
• Post 2017, low commodity prices helped Nestle to expand its operating margins.

Let's get into further details at product mix level:

• Milk products & nutrition segment was and is it's biggest segment in value terms contributing to almost half of it's sales.
• Prepared dishes & cooking aids segment (which includes maggi noodles) over last 20 years has doubled its share in overall volumes from 25% to 55% and largest in tonnage terms.
• Chocolates and confectionary segment did well in first decade but post 2010 volumes have stagnated.
• Coffee & Beverages segment is overall laggard with almost stagnant volumes over last two decades.

Nestle as Stock (2001-20)

Now let's look at stock & valuation front -                 

• Over last 20 years, stock has grown at healthy clip, with rate of growth of stock price>profit>revenue>volume.
• Till 2008 crisis stock prices moved in line with underlying sales and earning growth with stock trading 2-3 times sales or 25-30 times earnings.
• Post 2008 crisis valuations outpaced underlying business performance and increased to 5-6 times sales or 40-45 times earnings. 
• Till maggi crisis growth slowed down but stock kept moving higher helped by multiple expansion.
• During Maggi crisis, even though earnings were cut in half, stock though dropped but  retained its expensive looking valuations.
• Post crisis with a) maggi regaining its market share, b) increased earnings due to low commodity prices 3) renewed vigour in new product launches and d) capacity expansion plans led to stock almost trebling in span of 3 years. 

But all this is past, what matters as investor is how future unfolds with business and stock prices :

On business front - 

Sales growth will depend on a) overall sales growth in existing segment and customer acceptance of new launches  b) management execution and c) competitive response etc.

It will be interesting to see, whether last decade trend of volume stagnation continues or management with its many initiatives is able to reverse this trend. 

On positive side Nestle has huge product portfolio in its international stable and can bring those products in Indian market increasing its potential multifold.

Earning trajectory will depend on a) overall volume and sales growth, b) product mix and c) input  prices

In past, Nestle had grown its margin from 8% to 16%, lot will depend on whether it can continue this trend or margin revert back to mean.

On stock front - 

Stock Prices in long term depend on earning trajectory but in short term keep fluctuating based on investor perception about future business prospects and myriad other factors like overall market levels, cash flows, interest rates etc. etc.

On one side, stock seems to be running ahead of its fundamentals and trading at historically highest valuations and may stagnate as earnings backfill expectations (remember HUL's lost decade!)

But on other side, expensive looking valuations has been reality for long time and reflect business quality and future potential opportunities. Hence it makes sense to hold on even at expensive looking valuations. Past has taught me, if one gets in good business at attractive valuations, time to sell is almost never. 

One may get uncomfortable with lot of one side or other side discussion, when we try to peek into future...but future is inherently unpredictable, with many possible scenarios and as investor our job is to think of most likely scenario and its probability....with advance acceptance that we may be proven wrong.

I hope this discussion, leaves you with better understanding of Nestle's business & stock history over last 20 years, but probably more confused if you are looking for simple yes/no answer on future course of business or stock prices. 

Disclosure- I am not SEBI registered research analyst or investment advisor and blog is written more to educate myself and clarify thought process and should not to be construed as an investment advice. I hold Nestle stock and assume above discussion to be biased.   

Musings on ITC

ITC is one of those stocks, where most investors have strong opinion and rightly so. Some love to hate this stock, while there are others who love this hated stock. Discussion on ITC among investors bring out strong emotions. Fastest way to lose an investor friend is trying to have rational argument with him regarding ITC. 

Even with this background, let me try to enter these muddled waters and attempt to understand both sides of argument and try to work out approximate valuation for the business.

 Let’s look at why some investors love to hate ITC stock:

 

1. Worldwide there is growing trend of ESG investing. ITC with its mainstay of tobacco business, is anathema for  these investors, impacting institutional demand for ITC stock.

 

2. Concerns over capital allocation in general and hotel business in particular. Hotel business earns paltry return on capital, but management for some unexplainable reason keeps on pouring more and more capital in hotel business.

 

3. Management has awarded itself generous stock options. In last decade ESOP's  issued at subsidised prices have diluted earnings for other shareholders by 6-7%. 

 

4. British American Tobacco (BAT) owns 29.5% and Govt. of India controlled companies own 28% of stock. With no clear ownership, there is no pressure on management to pay attention to market signals.

 

5. Conglomerate discount with businesses as diverse as high return cigarette to low return hotel  businesses under common structure.

 

6. Fiscally constrained governments regularly keep on increasing taxes & cess affecting demand for cigarettes. Also, it carries regulatory risk due to sin nature of business.

 

7. ITC stock price is back where it was eight years ago (Meantime stock has given dividend of Rs. 50) 

 

But then, why some investors love this hated stock:

 

1. ITC stock is cheap on every valuation count and valuation gap becomes even more stark when compared to other FMCG companies which trade at historically high valuations.

 

2. Stock offers attractive and expected to grow dividend yield of 5.5% as compared risk free returns of 6%. 

 

3. Business earnings have more than doubled in last 6 years, making valuations attractive.

 

4. Business generates strong, steady and growing stream of cash flows, one of the highest in FMCG sector (Almost double that of fabled HUL which valued by market at more than 5L Cr)

 

5. Cigarettes as a product is highly addictive in nature and has inelastic demand, in past company has been able to pass on big tax increases to customers and also increase its profitability.

 

6. Over decade, ITC has built FMCG business with strong backward integration for which management has set an ambitious target of 1L Cr revenue by 2030.  FMCG margins are increasing both in absolute and percentage terms. When one extrapolates expanding margin, and juxtaposes with valuations of other FMCG companies, prospects are mouth-watering.

 

7. Recently, management has acknowledged poor stock performance and have indicated that it will  take steps to maximise shareholder value.

 

What is experience of International Tobacco businesses:

 

Let’s raise our sights from ITC, and look at international markets to understand what is happening with tobacco business and their valuations.    

 

We find international situation is much grimmer. After peaking in 2017, tobacco stocks as a group had a very difficult time in the past couple of years. Regulatory and consumer demand challenges continue to plague the group, making valuations very cheap and dividend yields high. 

Worldwide tobacco stocks are known for steady and high dividend pay-outs and high yields. For example,  

 

BAT stock offers dividend yield of 7-8% and stock prices trade at 2011 levels.

Philip Morris stock offers dividend yield of 6% and stock prices trade 2012 levels.

Imperial Brands trades at unbelievable dividend yield of 14% and stock price trades at 2004 level.

 

This is starker when we compare these yields with near zero bond yields in these markets. Reasons for undervaluation across world seem to have similar underlying reasons as they are in Indian market. Realising this most of these companies are at various stages of diversifying away from tobacco business.

 

Let’s make a attempt to find approximate value of the business:

 

Though there is lot of heated discussion about ITC’s attractive business and poor capital allocation; there is little discussion regarding approximately right valuation for the business other than comparing high level cash flows and P/E with other FMCG companies.

 

But, ITC is conglomerate of diverse businesses ranging from, stable and super profitable cigarettes business to cyclical and low returning hotel business. Hence, we will value different parts of  businesses by comparing with valuations of similar publicly traded businesses and then finally sum up all parts to reach overall valuation for ITC.

 

What follows is too simplistic and high level of valuations, but our aim here is to be approximately right than to be precisely wrong.  

 

a) Cigarettes Business:

 

This is most valuable part of the business generating extraordinary profits and free cash flows.

 

Let’s look at market valuation of few cigarette manufacturers listed in this space:

Company.	Sales.	Ebit.	Market Cap	Mcap /Ebit
VST Industries (Rs Cr)	1,200.	400	5,000.	13.2.
Godfrey Philips ( Rs Cr)	2,500.	430.	4,700.	11.0.
BAT ( Billion £)	25.98.	9.70.	60.00.	6.2.
Philip Godfrey (Billion $).	29.80.	10.44.	126.50.	12.1.

ITC generates revenue of 24,000 cr and Ebit of 16,000 cr. Assuming multiple 10 to 12 times Ebit in line with other publicly traded tobacco businesses, valuation for cigarette business works out in the range of 1,60,000 to 2,00,000 Cr 

 

b) FMCG Business:

 

FMCG business is still in nascent stage and have subdued profits due to investments being made in brand building, new products etc. Hence market cap to sales will be better matrix to value this business than usual P/E ratios etc.

 

Company	Sales (Rs Cr)	Mkt cap (Rs Cr)	Price/Sales
HUL	40,150.	5,00,984.	12.5
Nestle	12,741.	1,57,278.	12.3
Dabur	8,410.	87,019	10.3.
Britania	12,320.	90,000.	7.3
Godrej	9,900.	69,000.	7.0
Marico	7,075.	47,000.	6.6
Colgate	4,480.	37,148	8.3

Most similar large FMCG companies trade in valuation range of 7 to 12 times of sales.

As we are valuing ITC’s FMCG business which generates subnormal profit, by comparing it with other super profitable listed FMCG peers which seem to be generously valued by market. Some discount to these valuations needs to be considered.

 

ITC’s FMCG business with revenue of 13000Cr can be valued in range of 70,000 to 1,20,000 Cr

 

C) Hotels Business:

 

It is capital intensive business generating low ROCE of 3-4% and is usually valued comparing on EV/Ebit or per room basis to similar listed players.

 

Company	Ent . Value.	Ebit	EV/Ebit	Rooms (Nos)	Valuation/Room
Indian Hotels	15,941.	737.	22.	16,000.	1.00.
EIH	5,057	222.	23.	4,500.	1.12.

 

ITC Hotels with Ebit of 425 Cr and room inventory of 10,000 Rooms can be valued in the range   of 9,000 to 10,000 Cr

 

D) Paper Business:

 

Paper is cyclical and capital intensive business and better valued with EV/Ebit basis.

JK Paper with Net worth- 2400Cr generates revenue of 3100 Cr and Ebit of 830Cr and valued by market at Enterprise Value is 3300 Cr or EV/Ebit ~ 4

 

ITC Paper with its Net worth - 6000Cr generates revenue of 4500Cr and Ebit -1300 Cr, and can be valued in the range of 6,000 to 8,000 Cr

 

E) Agro Business:

 

Though not strictly comparable but similar business here is KRBL, which buys basmati rice from farmers and sells in domestic and international markets. KRBL with Net worth of 3,150Cr and generates revenue of 4,000Cr and Ebit of 772Cr and is valued at enterprise value of 6200 Cr

 

On comparable basis, ITC Agro business with net worth of 3362 and generating revenue of 5900 Cr and Ebit -830 Cr. It can be roughly valued in the range of 6,000 to 8,000 Cr

 

F) Cash and liquid investments :

 

Over and above ITC is cash rich company and even after paying generous dividends holds cash and liquid investments worth approx. 20,000 Cr

 

Business	Valuation (Rs cr)
Segment	Lower end	Upper end
Cigarettes	1,60,000	2,00,000
FMCG	70,000	1,20,000
Hotel	9,000	10,000
Paper	6,000	8,000
Agri.	6,000	8,000
Cash & CE	20,000	20,000
Total	2,71,000	3,66,000

 

With 1,230 Cr shares outstanding, fair value of the stock works out in the range of Rs. 220 to 300 per share.

 

Thus, ITC stock seems to be undervalued by 10 to 40% to fair valuation of its underlying businesses. But, it is not as cheap as direct comparison on P/E & cash flow with other FMCG companies suggests.

 

What is range of likely outcome ?

 

Bull case is 

 

1. Management stops pouring money in low ROCE business like hotels.

2. FMCG business grows in line with ambitious revenue targets and starts generating attractive FMCG like returns.

3. Management considers spinning off different business reducing conglomerate discount.

4. Cigarette continues to generate high returns due to inelastic demand nature of business.

5. Government rationalises tax structure reducing share of illicit imported cigarettes.

5. ESG investing wave wanes off over period of time.

 

And bear case is

 

1. ESG trend continues growing making institutional money wary of investing in tobacco stock.

2. FMCG business is not able to grow and or doesn’t generates expected attractive returns.

3. Management keeps pouring money in low quality business like hotel etc.

4. SUTTI investments are liquidated in market increasing supply depressing stock prices.

5. Higher taxation and stricter regulatory regime for tobacco or worst case ban on smoking.

6. Reducing cigarette consumption in health-conscious youth in line with global trend.

 

Few recent welcome changes are –

 

1. Recently management has acknowledged stock underperformance and has expressed willingness to explore options to maximise shareholder value

2. Recent change in dividend policy to distribute 80-85% of PAT as dividend, this should allay some concerns over capital allocation.

3. FMCG business margins are increasing every year both in absolute and percentage terms.

Considering above what conclusion one can draw ?

 

Intrinsic value of the business is decided by free cash flows generated by it over its lifetime and ITC generates loads of free cash flow. For lifelong holder of business, it will generate great rewards in terms of dividends.

 

But, markets price stocks not only by fundamentals of the business but also by demand and supply for its shares. To move price of large cap business like ITC, institutional demand is necessary and increasing trend of ESG investing is big headwind for this to happen.

 

It seems likely that ITC may become high dividend yield stock like other international tobacco stocks but realisation of capital gains will depend on FMCG performance, management actions on capital allocation, to unlocking shareholder value and most importantly ESG impact on institutional fund flows. 

 

 

 

 

Disclosure: I am not SEBI registered advisor or research analyst. Above discussion is to clarify my own understanding and shared to get constructive feedback if any. Do not consider this article as a recommendation to buy or sell a stock. Please seek advice from your investment advisor before making any investment decisions. I hold ITC stock in my portfolio and have vested interest in the stock. Consider me biased and take my discussion with bucketload  of salt.