ITC - A Paradox

Over two decades ago, ITC was put on track for a complete transformation in a quest to diversify its business by its then Chairman Y.C. Deveshwar. As all the earlier efforts to diversify the business had either failed or faltered, the new chairman decided to rationalize ITC’s portfolio – this was done by first exiting the financial services business, followed by edible oils, overseas restaurants, and real estate. Simultaneously, a plan was set up to propel ITC into an FMCG mammoth. Since then the company has seen its revenue grow 10x, while the contribution of its Cigarette business fell below 50% for the first time in a century with its FMCG business becoming the 2nd biggest segment. Nevertheless, ITC is facing a lot of criticism from its shareholders and several questions have been raised on the company’s capital allocation and low profitability of its FMCG segment. The article below will try to touch upon some of these aspects while focusing upon the Cigarette, FMCG, and Hotel businesses as they hold the key to ITC’s future.

Notes: The below analysis is based on the FY2020 and prior results.

The Good

Cash cow of the company

One of the mightiest cash-generating machines in the Indian corporates, ITC has generated a cumulative FCF of over INR 72,000 crore in the past decade. Although the company’s business is diversified among four major segments, the credit for this humongous free cash mainly goes to its Cigarette business. Enjoying a market share of 75%-80%, ITC is a dominant player in the Indian cigarette industry. This dominance, coupled with the addition of a premium range of cigarettes has helped ITC achieve margins that are way above its peers. Also, compared with its FY2011 margins of 29%, the segment now records margins at 67%, resulting in an abnormally high RoE of 386% (yeah, you read it right!), a 3x jump from a decade ago. Even if we consider a higher cost of equity to the tune of 15% due to the sin status of the cigarette industry, we are still left with 3.7x in surplus return.

Having been the growth engine of ITC since its inception, the cigarette business has been facing strong headwinds due to the punitive and discriminatory taxation for the past few decades. This, coupled with a sharp increase in illegal trade in recent years, especially at the premium end, continues to weigh on the volume growth. As a result, the top-line growth for the segment is dwindling – a 10-year CAGR stands at 1.5%, while 7-year and 5-year CAGR stands at -4.1% and -8.7%, respectively.

Creating a new growth engine

ITC has been taking conscious efforts to move away from its cigarette business. This can be clearly seen in the table below – the share of Cigarette in ITC’s overall CAPEX has come down from ~31% in FY2011 to ~13% in FY2020. This decline in CAPEX is being directed towards other segments, namely, Hotel, Paperboard, Agri-business, FMCG, and many more. Among the non-cigarette business, FMCG has emerged as the major focus area in the past two decades. The past 5 years have seen the FMCG segment account for nearly 50% of the entire CAPEX, while in FY2020 alone, it accounted for over 80%.

Started in 2001, the FMCG business has grown to account for nearly 1/4th of the total operating revenue within a short span of time, building over 25 mother brands, with some rising to be market leaders in their respective segments. Now consumers resonate with brands like Sun Feast, Bingo, Aashirvaad, and Savlon, among many others; and not just brands like Gold flake, Classic, and Flake. This vibrant portfolio of brands represents an annual consumer spend of over INR 19,700 crore today, which is near twice the total consumer spending of the whole company in FY2000. The sale is supported by a retail network of ~6.2 million outlets that is third-largest after HUL and Dabur. Revenue for the segment has also grown at a robust pace of ~30% annually since its inception and at 12.3% in the past 10 years. This has led to ITC becoming the second largest FMCG Company in India.

Supporting role

ITC’s Agri-business and Paperboard segments provide strong back-end support to the overall company. The success of the Agri-business can be attributed to a great extent to the company’s “E-Choupal” initiative. A unique social infrastructure set up in the year 2000 for direct procurement from farmers; today the initiative connects 4 million farmers in 35,000 villages through ~6,100 kiosks. Accounting for approximately two-thirds of ITC’s total procurement, “E-Choupal” has helped the Agri-business become the most efficient non - cigarette business of the company. This is evident from the fact that the segment consumes a mere 4.6% of the total CAPEX, as against a contribution of ~12% to revenue.

Playing a vital role in supporting other segments, the Agri-business and Paperboard segments generate 43% and 25%, through internal sales, respectively. Despite these factors, the management does not consider the two segments to be the next growth engine for ITC. This can be seen from the falling share of the segments in total CAPEX – in FY2010 the combined share of the two segments was 28.0%, while this figure fell to 1.3% in FY2020. Further, the top-line growth for the two segments over the past 10 years, stood in low single-digit, while EBIT growth also remained in the mid-single-digit. Assuming that most of the allocation has been done, the management is likely to focus on sweating the assets and improving the return ratio for the two segments.

The Bad

Confused Brand Positioning

ITC has not been able to build an image for itself and create a distinctive place in the minds of consumers, unlike its peers – for example, Dabur is widely known for its natural healthcare products, while Britannia is recognized for its bakery products. On the other hand, ITC is present in several diverse and unrelated businesses ranging from food staples and snacks & confectionaries to stationary and safety matches, to even apparel! This strategy might work if the management is secretly planning to transform into an e-commerce platform because currently it just seems as if the management is using its huge cash pile to expand just for the sake of it.

Numbers can be Misleading

Digging deeper into the company’s claims of brand leadership for some of its products, we see that a lot of these brands are in a constant battle to grow their market share with other well-known brands. Aashirvaad is the only product in the company’s FMCG basket that has clear dominance in its segment. Talking about its other products, Bingo!, which holds the 2nd position in its segment with ~15-16% market share, is in reality very far from the leading player, Pepsico, which has captured >50% market share. Even at its 2nd position, the brand is fighting an expensive battle against Balaji. Let us look into another example of Sunfeast, which holds the 1st position in the Cream Biscuit segment. Delving deeper, we realize that of the broader Biscuit market, the total contribution of the Cream Biscuit segment stands at only ~7-8%. In the overall Biscuit market, Sunfeast is at best the distant 3rd player with a market share of ~15%, while players like Parle and Britannia are leading with nearly 75-80% market share. Talking about Engage, the brand holds a ~10% market share in a segment that is already populated with a large number of brands having a similar share. YiPPee, on the other hand, often considered to be one of the company’s mature brands, holds a market share of only 22%, a distant second to Nestle’s Maggi. In conclusion, we can clearly see that ITC has not been able to create any added advantage over its competitors even in the segments where they do hold leading positions. Apart from the above-mentioned products, the ITC FMCG basket consists of a large number of other products which are yet to capture any significant market share.

Low Profitability

The ITC FMCG business has grown to become the 2nd largest segment with a contribution of 25.2% to total revenue while contributing only 2.3% to the overall profitability of ITC. This low contribution can be directly linked to the low single-digit operating margin of the segment. While it is common for a new FMCG player to operate on low margins for a long period of time due to heavy marketing and depreciation costs, the same is not true for ITC (Refer to the figure below).

Several factors have led to the low profitability of the FMCG business, with the wide range of its product basket being one of the key factors. Vigorously adding new products to its basket, ITC added 60 new products during the entire span of FY2020, while 40 new products were added in the initial 2 months of lockdown itself. Notably, the business currently has very few products that have reached a mature stage, including Aashirvaad Atta, Classmate Notebooks Mangaldeep, and Yippee! Noodles. Although, having a diversified basket is not always a bad thing as it helps lower the cost of expansion into a new segment and provides better operating leverage due to cost-sharing; the flip side of this also results in the dilution of margin and an increase in the gestation period, especially for a younger company.

Cash burn

If I have to point at one segment that has irked the shareholders, then it will be the ITC Hotel segment. Considering it to be close to a black hole of the company, the level of inefficiency observed in the segment is bewildering! Given the fact that this segment was established nearly four decades ago, the revenue contribution today remains close to ~3%, while still accounting for nearly 25% of the total employed CAPEX. Over the past 10 years, the average CAPEX to sales for the Hotel segment was around 50% while for its closest peer, i.e. Indian Hotels Co. Ltd. (IHCL), this figure stands at 5%. To put things into perspective, it simply means that for ITC hotels to earn INR 100 in revenue, they need to invest INR 50 in CAPEX, while IHCL does the same by investing only INR 5.

Comparing the segment’s operating margin with IHCL, ITC earned 7.6% on an average, while IHCL earned 11.4%. This further points at an average OPEX of 92% for ITC, while for IHCL this stands at 88%. Adding the CAPEX and OPEX, together this results in the segment’s total expense at 142%. The surplus of 42% over the revenue is the negative cash flow that is funded by the Cigarette business. Within the company, the hotel business, which accounts for ~20% of the total assets, generates only 5-6% of the total cash flow (I have considered EBITDA as approx. Cash flow); resultant the segment return over assets is just ~2%. After doing all the number crunching I can safely say that the probability of ITC’s hotel business thriving without guzzling cash from the cigarette business is very slim. In such a scenario, management really needs to come clear on how the hotel business fits in the greater scheme of things as it does not have any cross synergy.

Inorganic to Organic

Historically, ITC has mostly depended on organic growth for its expansion. However, the company has recently shown an inclination towards inorganic growth in its FMCG business. So it is worth understanding the current management’s rationale behind their recent acquisitions –Sunrise Foods Pvt. Ltd. (SFPL), a spice making company, and Nimyle, a producer of floor cleaning products.

While the financial details of ITC’s acquisition of Nimyle remain undisclosed, we cannot comment on it from a valuation perspective. But in the case of SFPL, ITC seems to have paid a much higher price when compared to the MTR and Eastern Condiments (a much larger player) deal, which was concluded at 2.2x of sale. Besides the heavy price, the rationale behind this deal also seems unsound. Generally, the spice market is dominated by brands that have captured regional tastes. Considering that ITC is already a market leader in Andhra Pradesh and Telangana, it makes little sense for the company to enter completely new geography. A more effective strategy would be to acquire an established Southern brand and consolidate their position in South India first, where the taste profile is similar to its existing market, thereby creating better synergy.

For both the acquisitions, ITC’s main objective was to scale the respective businesses across India. However, by creating a regional presence before going pan-India, it seems that the management is trying to inorganically enter the segment and then grow it organically. While this can initially seem like a cheaper option, opting for an already established pan-India brand would have instead helped ITC save on incubation and branding costs, and most importantly reduced their risk of failing. This strategy has been already successfully tried and tested by many players, including - HUL in its GSK deal acquired brands like Horlicks and Boost, along with their distribution rights for OTC and oral brands such as Sensodyne, Eno, and Crocin (I bet most of you’ll already know these brands).

The Ugly

Cigarette addiction

Just like its consumers, ITC is also addicted to cigarettes. While the management is quite determined to scale up its FMCG business, there are some key fundamental issues within the company. After running several scenarios it became quite obvious to me that the ITC engine is fuelled by cigarette smoke, a complete contrast to what the management is aiming to achieve. As shown in the table below, in both the scenarios, the FMCG business is set to have a lion’s share in the top line over the next 10 years; however, this does not translate into robust profitability.

Before we delve into reasoning just a small disclaimer – the above projection is just an extrapolation based on several assumptions and filled with my biases. So don’t take the projection too seriously, idea here is to get a sense of how sensitive the P&L is to the cigarette business, and not to project the actual number.

Best case: As you can see in the table above, despite considering the higher end of growth and operating margin for all the segments, the overall 10 year EBIT CAGR is merely 6.5%, as against 11.0% witnessed in the last decade. While this scenario is likely to see the FMCG business transform into a growth engine for ITC with a 7x expansion in its operating margin, the overall growth for the company will remain lackluster. The double-digit growth of 11.0% witnessed by the company over the last decade due to the robust expansion in their Cigarette margin is unlikely to continue as the company is already operating at 2x that of the industry average and ~1.6x of its 10-year average. Furthermore, on estimating PAT for the overall company we get an average annual earnings growth of merely 5.6%, which is way below the last 10 years' average of 14%.

Even on assuming that the PE is set to double in the next 10 years, this gives us a 7% annual growth from the re-rating. Adding this with the earnings growth of 5.6% we get an annual price growth of 12.6%, which is not bad, but remember this is our best-case scenario.

Worst case: If you look at the table, you realize that even the assumption in a worst-case does not look so grim for all the segments except Cigarette. For the Cigarette segment, I have considered an average annual revenue decline of 4.1% as that was the CAGR for the past 7 years (still better than the past 5-year rate of -8.7%), while keeping the margin unchanged. As for the other segments, the assumptions are slightly above their 10-year average. Despite such a balanced view, EBIT is projected to remain stagnant and PAT to decline at an annual rate of 6.0%, you can then imagine the impact on the price growth.

The idea behind all these assumptions and number crunching is just to show the vulnerability of the overall company to the Cigarette business and not to project actual numbers. In the above-mentioned scenarios, it is clear that the overall earnings growth for ITC is majorly dependent on its Cigarette business; no matter how fast the FMCG business grows. Hence, no matter what the management promises, at least in this decade, ITC earnings will continue to be influenced by the Cigarette business and so will the share price.

Finally, the best

Attractive valuation

Simply looking from the historical point of view, the stock is trading at a ~60% discount to its historical P/E of ~28x. If a mean-revision kicks in, it will lead to an upside potential of 65%. Further, on pricing each and every segment separately using SOTP analysis (refer to the table below), we reach a fair price of INR 305, indicating an upside potential of ~63%. Additionally, the new dividend distribution policy will see a pay-out of 80-85%; at the current price, this leads to a dividend yield of ~6.0%. A combination of healthy dividend yield and attractive valuation make ITC a good value bet.

The stock has given zero returns in the past 8 years, but to be fair, the downfall actually began in 2017 after the implementation of GST. Since then the price has corrected by nearly 50%. Much of this correction took place in 2020 - first with the hike in tax, and then the onslaught of COVID. As the stock has been hammered down with negativity, a moderate positive news can help put the stock price back on track for a healthy recovery. This can allow investors to make a good one time return - the keyword here is ‘one-time return’ as I believe ITC is more of a “Ben Graham” style of investing rather than a “Philip Fisher” style of investing (until and unless the management takes drastic steps instead of giving lip service). And obviously, this is not a recommendation as the price can takes days, weeks, months, years, or even a decade to adjust to its fair price, or it may never reach that level.

While there is no doubt that ITC will see its FMCG segment grow into its core business over the next 2-3 decades, this is more likely to happen by coincidence rather than design. This makes it necessary for the management to take some cues from its previous Chairman’s initial restructuring plans and adopt similar transformational decisions to put their plans on a fast-track.

Disclaimer: The views expressed in the reports reflect my (analyst) personal views about the topic covered. Opinions contained in the report represent the analyst’s present opinion only - at the time report is prepared - and may be subject to change without notice. The report is not a recommendation to buy or sell the following securities and no liability whatsoever is accepted for any direct or indirect loss or expense arising from the use of the report. Kindly do your own due diligence before taking any position in security. The report shall not be used for any unlawful or unauthorized purposes.  The report is prepared for information purposes only and not for publication and re-distribution. Any logo used on the blog is for identification purposes only.

Registration status with SEBI: I am not registered with SEBI under the (Research Analyst) regulations 2014 and as per clarifications provided by SEBI: “Any person who makes recommendation or offers an opinion concerning securities or public offers only through public media is not required to obtain registration as research analyst under RA Regulations”