A great company with its share price stuck with a pin; either love it or hate it, there’s no between. Any guesses? Of course, ITC. But, what’s plaguing the giant?
Before we dive into that, here’s an icebreaker…
Formerly known as Indian Tobacco Company, ITC is, undoubtedly, one of India’s bluest Blue Chip stocks. With its century-old legacy, the giant has indeed come a long way to become India’s largest cigarette company. Its professionally-run diversified business, headquartered in Kolkata, turns billions of dollars of profits every year and sits on a huge pile of cash. The dividend-paying company, with its indestructible moat & six-million-outlets-strong distribution network, is unfathomable!
Despite all this, ITC hasn’t exactly been in investors’ good books for the past few years. See for yourself -
As you can clearly notice, two of ITC’s closest peers, VST industries (in Tobacco) & HUL (in FMCG), have clocked a 5-year CAGR in their share prices of more than 15% & the Sensex has registered 10% CAGR in the same period. But ITC?
A miserable -3.1%! Yes, that’s actually true. And trust us, you don’t have to be an investor to know this; just scroll down your social media feed & the umpteen number of memes will tell you everything!
So, why is such a cash-stuffed legacy-rich giant currently a meme material? Why is ITC’s share price pretty much doomed? Why does it garner mixed opinions? Well, read on to understand.
ITC’s addiction to Cigarettes
Tobacco is ITC’s raison d'être. Sure, it makes sense. You see, according to the GATS survey of 2017, one out of every four Indian adults consumes tobacco almost daily! That’s a big market for the taking by the monopoly giant. With more than 80% market share in India’s cigarette industry, ITC’s products like Gold Flake & Classic have become smokers’ favorite.
Consequently: ITC’s cigarette segment, which requires only a tenth of the total capital employed in its business, generates nearly half of the company’s revenues and accounts for a whopping 85% of its profits!
Thus, ITC has all good reasons to ride on this asset-light business. But it isn’t all that rosy!
Tobacco is considered a ‘sin product’. You can’t advertise it openly. You can’t package it the way you like. People will frown on you for making their relatives Cig-addict. Investors who pay a lot of attention to ESG (Environmental, Social and Governance) metrics won’t back you. And above all, there will be uncertainty regarding regulations.
While this is indeed problematic, big players like ITC, with their strong distribution network, happen to sell their products even without much advertisement. Besides, ITC has a stellar ESG rating of ‘AA’ according to MSCI. Its ESG score beats the likes of Dabur, Britannia, RIL & Coal India! Even then, what is the issue, you ask?
“When in need, the smokers have to pay” - a single line that depicts the whole problem. The government can actually ask as much taxes as it can on these ‘sin products’, all in the name of public interest. And this is evident as the annual tax revenues collected from cigarettes have more than doubled in just a decade!
While ITC can pass on the tax burden to sticky customers, pushing them too far will make them switch (considering the fact that India’s legal cigarette market is a mere ~ 20% of the entire tobacco industry). And that can affect ITC’s bottom line!
Besides, legal cigarette consumption in India is on a steady decline -
Thus, it makes sense for ITC to diversify, isn’t it? After six decades as a pure-play cigarette company, ITC decided to do that in the 1970s. Since then, it has been using its cash cow Cigarette segment to fund its diversification plans & shed its ‘bad boy’ image to become a ‘har ghar ka’ product. It seems ITC wants to reduce its addiction to cigarettes.
Some of its diversification plans have worked quite well. The Agri-segment generates a return of 27% on the capital employed. It has the ‘e-Chaupal’ program, the world’s largest rural digital infrastructure, that provides internet access to over four million farmers and is poised to benefit from the new farm laws in place.
ITC is also a market leader in its Paper & Packaging segment, which generates a return of 21% on the capital employed.
However, the company has invited raised eyebrows due to two of its crucial diversification plans - FMCG & Hotels.
A Cig company in FMCG business
In the mid-2000s, ITC made an audacious entry into the FMCG market, challenging incumbents, a few of which existed even when Gandhiji was doing his first legal practice! ITC had pitched itself against the likes of HUL and P&G in personal care products, Britannia and Parle in biscuits, and Nestle in instant noodles.
Fast forward a decade, and ITC has already built 25 vibrant mother brands (plus a few bolt-on acquisitions), each being a category leader. Aashirvaad is the country’s no.1 wheat flour. Sunfeast tops the premium biscuits market. Yippee & Bingo are next only to Nestle’s Maggi & PepsiCo’s Lay’s.
Savlon (an antiseptic liquid soap) is considered the best out of all its good acquisitions. Savlon’s sales of Rs 1000 Crore in 2020 is an incredible 4x times the price ITC paid for it & 16x times the sales during its acquisition! That’s precisely an unbelievable CAGR of 50%!
In a matter of just fifteen years, ITC’s FMCG revenues shot up nearly thirty times to Rs 13,000 Crores in 2020!
However, profitability in its FMCG segment has been a genuine big concern for ITC.
You'd be surprised to know that...
ITC's FMCG segment, which contributes nearly a fourth of its revenues (26%), gives only 2% to its profits!
(Source of data: Ticker)
While its FMCG peers have a profit margin of 15-20%, ITC’s margin is a mere 2% only! Why so, you ask?
The simple reason behind this is that ITC’s FMCG brands are relatively much younger. While the likes of Britannia have been in business since Gandhiji’s times, ITC forayed into FMCG much much later, only in the 2000s.
And you should know this bit about the FMCG industry that it takes a whole lot of time and cash-burning exercise to become a household name. You got to carry out large-scale promotional campaigns, advertise extensively and capture your competitors’ market by enticing customers with aggressive pricing & deep discounts. Thus, being a late entrant, ITC has been incurring huge costs for all of this, which is why its profit margins in the FMCG segment are pretty low.
To some extent, it’s also because of the fact that ITC, unlike its peers, has resorted to organic growth by building most of its brands from scratch with only a few acquisitions, and such a growth strategy requires more capacity to suffer initially. So, there you are.
All in all, ITC is still a Cigarette company trying its hand in the FMCG sector!
ITC’s Luxury Hotels - 'an awful blunder'
ITC Hotels is India’s second-largest chain of hotels, with over 100 outlets spread across the country. However, as the name speaks, luxury hotels cater to only a small group of big pockets and are a very seasonal business. Even when the hotel is vacant, the company has to spend a lot of money on various fixed costs, salaries & other maintenance charges, which are a must for such lavish hotels.
Implied, ITC has to burn a lot of cash to keep its hotels up and running. And if it’s doing so, hotels must be a very lucrative business for it, right? ITC must be generating lots of revenues & profits from hotels, eh? Well, NO.
While ITC invests 24% of the total money put into the business in its hotel segment, that contributes only a meager 1% to its profits!
(Source of data: Ticker)
With ITC burning boatloads of cash for its hotel segment, which is nothing but a losing game, this will be a classic case study of how NOT to allocate capital in a business!
Why is ITC’s share price at a standstill?
By now, you must be having most of the reasons to justify ITC’s stagnant share price. But that’s not all!
With a whopping Rs 25000 Crores of Cash just sitting on its balance sheet, ITC is caught between a rock and a hard place! Even after distributing 85% of its profits as dividends, it has ended up putting money in the wrong places (e.g., Hotel business). So, investors aren’t sure what it is going to do with its huge pile of cash!
Some part of the problem can also be attributed to ITC’s ownership structure. No promoters, conflicts between investors (BAT & GOI) & an abundance of the supply of its shares in the market.
But above all, the business structure of ITC is quite complicated, which makes value discovery difficult. One business generates a lot of cash but has regulatory uncertainty (Cigarette), the other uses cash to generate revenue but fewer profits (FMCG) & another burns a lot of cash for almost nothing good (Hotels). Thus, investors just don’t know on what metrics to judge ITC!
So, don’t you think it makes sense for ITC to split up its business into parts so that investors can value them individually better?
In short, should ITC demerge?
The bottom line
While you could make a perfect case for ITC to demerge, rumor has it that it’s very unlikely. Instead, a revamp for its hotel business could be on the cards. They’re looking for ‘alternative’ ways of running hotels, probably by tie-ups rather than ownership.
If you ask us, we feel it’s totally the management’s call. It must decide whether the business as a whole is indeed better than the sum of its parts. And if not, better to split up.
Anyway, what do you say? Will a demerger pull ITC’s share price out of this doldrum?