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.