12 September 2020

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.

 

CompanySales (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/EbitRooms (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.

33 comments:

  1. Demerging FMCG business looks like the best option to unlock value.

    ReplyDelete
    Replies
    1. FMCG still in nascent stage. Demerger May happen but doesn’t seems probable in near future.

      Delete
  2. A fair and unbiased write-up which neither a bull not a bear would find fault with. 👌🏼

    ReplyDelete
  3. Beautifully written and explained.

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  4. By demerging, FMCG will loose it's moat from tobacco unit. IMO FMCG still needs some more time and funds before o it becomes as profitable as other FMCG

    ReplyDelete
  5. Very detailed and unbiased analysis
    Nice work...thanks

    ReplyDelete
  6. Good one Manish ji. I really think ITC is undervalued

    ReplyDelete
  7. Excellent Write up, very clear and crisp, detailed and unbiased analysis

    ReplyDelete
  8. A good insight and future view... I have good portion of investment in ITC.

    ReplyDelete
  9. Really well written and excellent analysis, crisply explained without complex models. A great template for an investor to articulate before making an investment decision. Keep blogging.

    ReplyDelete
    Replies
    1. Thank you Mahendra....it’s due to your prodding to publish it. Otherwise it was private musing.

      Delete
  10. One point is add is management is saying in Hotel business they are moving to asset lite model

    ReplyDelete
    Replies
    1. That will be good as it may improve returns on capital. Let’s hope they don’t put more money in hotels.

      Delete
  11. The way you have put forth your knowledge/study Manish, is sheer brilliance. So keep enlightening us.

    ReplyDelete
  12. Very well articulated Manish ji. Really appreciate your way of putting things in prospective.... My buying price is 155. Holding for next 5 years without any expectation. Itc is brand even in hotel segment n their properties are very prime.

    ReplyDelete
    Replies
    1. Hotel is Brand and properties are prime... ITC is in this business since 40 years..but returns have been suboptimal.

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  13. Itc won't be out of the tobacco sector but a better way would be to slowly turn around the hotels and divest them either into REIT's or to other hotel groups and slowly get itself into alcohol business. As alcohol has a rising trend in India and isn't considered as bad as tobacco while still earning superior margins. If the ESG funds aren't going to invest in the company then better make it more stronger and attractive for other share holders. Itc with its reach can really make this happen and could be a great competitor to Kingfisher / McDowells

    ReplyDelete
  14. Agree with your wonderful analysis of undervalued stuff but not sure why is Institution investors shying away with the stock?
    Also sunset tobacco industry has over weightage on the stock which predominantly seems to be one the reason of its bearishness.

    ReplyDelete
    Replies
    1. You have answered yourself. ESG trend is big headwind for ITC

      Delete
  15. Very good analysis...I have put 20% of my networth in ITC (ar Rs 200) ... Long run, it will do well...Undervaluation will continue for sometime...ITC has to do the following to get better valuations -

    1) Hotels business is a vanity business..they need to hive this
    2) FMCG - do well in higher value addeded products (like perfumes, Dairy and Snacks ) - not Ashirwad Atta - even if you sell ~100000 Cr you will not make more than 2-3% margin

    3) Due to lack of a promoter and serious institutional overseeing, executive compensation is very high in FMCG biz...Managers who generate 4-5% margins need not get paid like Google executives (95+ % real margin).

    ReplyDelete
  16. Tobacco profits are like a goldmine for ITC and never going to decrease much.
    It is difficult to create a brand in FMCG and market it.
    The profits generated from tobacco should be effectively used to acquire existing small players in FMCG like sunrise Foods.
    Investment on capital intensive hotels can be reduced.

    ITC is probably like in consolidation phase, all I can see is ITC is an attractive package of FMCG, hotel, agribusiness, papers etc.

    ITC should plan similar to Mukesh Ambani and delist the units once they are matured.

    ITC can give 4x or more returns once the consolidation phase gets over.

    ReplyDelete
    Replies
    1. Agree.Right course of action will be useful tobacco cashflows to grow businesses and list those businesses to unlock value for investors..But how much returns stock will give is difficult to give.. it can give 4X returns or may not too..

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    2. I feel ITC pattern may be similar to Reliance. Reliance was trading in the same range for nearly 10 years.

      Reliance effectively used cashflows generated from Oil & Gas to Retail & Jio, once consolidation phase got over, Mukesh has come out with a bang.

      Delete