Elephant waking up?
ITC is a diversified conglomerate with businesses spanning Fast Moving Consumer Goods, Hotels, Paperboards and Packaging, Agri-Business, and Information Technology. Cigarettes are the biggest segment contributing 46% of revenues but almost 85% of profits, while FMCG and Agribusiness are the growth engines, the company is focused on.
The different businesses are strongly interlinked with one another. In order to grow their cigarettes business, ITC over the years built a strong supply chain starting from the tobacco farmers to the distributors and retailers. This supply chain helped them to tap into the farmers for their agri-business and retailers to distribute their FMCG products. The FMCG business is the main end-user of their packaging and paperboards business. This strong interlinkage helps them in attaining synergies.
Decade of share price underperformance
ITC’s share price has largely remained range-bound for close to a decade now. And hence, it’s currently available at quite an attractive valuation.
When compared historically, the value assigned for future growth is amongst the lowest in the last 20 years and the gap with other consumer staples companies have widened to a level not seen before.
Some of the reasons for the stock price not moving up are
- Cigarettes growth stagnation - driven by high taxation
- Rise of ESG(Environment-Social-Governance) investing
- Inefficient capital allocation
- Concerns on FMCG growth and profitability
Cigarette growth derailed by heavy taxation
ITC’s cigarette growth has been largely derailed by heavy taxation in the last few years. Taxation on cigarettes over the last decade averaged 14% CAGR vs 7% CAGR in 2000-10.
This higher taxation, though, has not resulted in higher overall tax collections for the Centre, as seen by declining cigarette tax collection as % of total indirect tax collection.
Cigarettes contribute to around 85% of the tax collected from tobacco. Hence, the significant increase in taxation and subsequent reduction in taxation
Taxes are the most important factor in determining cigarette pricing and volumes
As taxes contribute to more than 50% of the selling price.
Resulting in an increase in illegal cigarettes & other forms of tobacco. Of total tobacco consumption, cigarettes are less than 10% of consumption today as compared to 20% 30 years ago. Notice the sharp drop from 15% to less than 10% in the last decade, driven by high taxation on cigarettes. A similar trend can be noticed 2 decades prior. Share of legal cigarettes was around 20% in 1991-92, quickly dropped to around 16% in 1998-99 and then remained relatively stable till 2009-10. This was the period when tax increases were less than 10% per year. And the stock market rewarded the company handsomely during this period as the stock went up 7-8x.
The share of illegal cigarettes has gone up as a result of the tax increase in the last few years. Illegal cigarettes don’t have the statutory warnings on the cover, don’t generate any tax income for the government. So, it is against the welfare of both the public and the government to encourage the growth of illegal cigarettes.
We think that this continual tax increase is not something that can be continued forever and at some point, the government will have to resort to a stable tax regime rather than an ever-increasing one. We are starting to see signs of that as there have been no increases in this last Budget and also the quantum of tax increases has been coming down over the last 3 years. Any future tax increases or the lack of it is probably the most important factor to keep tracking over the next few months and years ahead.
Strongest cigarette monopoly in the world
In Spite of the headwinds from taxation, ITC has been able to maintain next to 0% volume decline over the last 5 years pre-COVID
Mainly driven by a superior market position in comparison to other markets. ITC is 6x larger than the no.2 player in India. This is more than twice higher than the other comparable cigarette markets. This strong market position of ITC should help them ride over headwinds and quickly recover in a stable tax regime.
Rise of ESG Theme
The rise of environmental, social, governance (ESG) investing over the last few years to about an AUM of $1tn have ensured that many tobacco companies don’t get enough interest in the market as close to 60% of these funds have tobacco exclusion policies.
This has resulted in foreign investments dropping to their lowest level in 20 years.
The downsides of too much focus on ESG investing are already showing their head. Due to a lack of investments in fossil fuel-based technologies, sharp shortages and price rises of natural gas and coal are being seen across the markets. Any reversal in interest on ESG funds will have an effect on interest in tobacco companies going up.
Capital allocation concerns
A longstanding criticism of ITC has been that they have been using cigarette cash flows, which are highly profitable high ROCE business(>500% ROCE) to fund low-return businesses be it Paperboards(20% ROCE), agribusiness(20% ROCE) or Hotels(usually 5-10% ROCE). To examine this criticism, if we look at the last 20 yrs capital allocation of ITC, we see that 60% of the operating cash flow has been distributed as dividends. Given the lack of capital requirement in their base cigarette business, this could be the best use of capital that the investors can wish for, barring buybacks. ITC’s board doesn’t want to do buybacks, in order to avoid British American Tobacco further increase its share in the business, as that could result in ITC not focusing on these other businesses anymore. 7% of operating cash flow has been used for FMCG CAPEX and 29% on other businesses majorly Hotels and Paperboards.
In spite of significant capital put into these businesses, cigarettes have remained the profit generator.
Capital allocation seems to be improving given that Hotels is to move to an asset-light model where ITC only manages properties; Dividend payout increase over the last couple of years with management committing to 85% payout.
FMCG Growth & Profitability
FMCG- Other is the second most important segment of the group and probably the one with the most management oversight. It is also the segment that can give the best returns on capital employed in the long term.
FMCG growth slowdown
ITC’s FMCG business grew really well in its first 15 years, until 2015. The growth slowdown seen in the last 5 years is what is worrying the markets. But, the point to note is that it is not an ITC specific issue and more of an industry-wide problem led by consumption and GDP slowdown, demonetization, GST impacts, etc.
ITC over the last 2 decades has built really strong brands across categories.
With the strong distribution of the Cigarettes business, ITC can quickly scale up new and coming products.
This inherent brand and distribution strength leaves them with multiple opportunities to grow business profitably.
The main revenue growth drivers are
- Increased adoption of food offerings
- Addressing white spaces(gaps) in the portfolio
- Bolt-on acquisition of regional or national brands
Market expansion to aid growth
Of all FMCG Companies, ITC has the 2nd best expansion of target addressable market.
Their strong brands can be extended successfully to adjacent categories
Improving margin profile
ITC’s FMCG margins have been increasing over the years. It has already reached margins of around 9% and there are still a number of levers to push it up further. For context, Britannia, which is a peer for ITC FMCG, had less than 10% margins for close to a century of operations. So, FMCG is a business, once established can offer sustainable margin increases for many years.
Move to higher gross margin categories
ITC’s biggest brand is Aashirvaad, which operates in the lowest GM category amongst FMCG categories. That is a major reason why current ITC margins are low. As ITC expands into other categories just like the last few years, there is potential to increase gross margins and hence, operating margins.
Operating leverage on media investments
As more and more brands move from incubation to growth and maturity, the need for investments starts going down.
For example, currently, ITC has been spending on media investments more than the market leader Lays. As the brand becomes more mature, the increase in revenue need not be accompanied by subsequent media spend increases.
Operating leverage on manufacturing costs
ITC has invested heavily in state-of-the-art FMCG capacities this decade
These investments have resulted in asset turnover decline which should turnaround once capacity utilization picks up and assets mature
Over the long term, these investments will help in lower contract manufacturing charges and improved margins given in-house manufacturing
Threats to re-rating
High tax regime continuing for cigarettes
ITC has been entering too many categories too soon, which may keep ITC’s advertising spend high and ineffective, which can weigh on margins
Higher adherence to ESG norms by institutional investors may further reduce the shareholder pool.
Continued decline in the valuation of global cigarette majors