Abhinit Kulkarni
Jan 30, 20205 min
ITC is one of India's leading and most respected conglomerates. The company is professionally managed and has a presence across multiple sectors. When one looks at the consolidated results of ITC, everything looks fine and one may feel puzzled as to why the stock price does not move up despite great results. However, by taking a closer look at the individual segments, you may get an answer to the question.
Let us do a detailed analysis of the segments in which ITC Ltd operates. There are broadly the five segments in which the company operates:
FMCG - Tobacco
FMCG - Others
Hotels
Paper & paperboard
Agribusiness
Let us look at the revenue contribution of each segment to the overall revenue of the company:
For the sake of understanding the full-year numbers, we will look at the numbers ending Mar-2019 and not look at the latest quarterly numbers.
As you can see, Cigarette revenue is a substantial portion of the total revenues for the company. We will discuss in the coming section how this affects the share price.
Let us now look at the contribution to the overall profits by individual segments:
As can be easily noted, cigarettes is the segment that contributes a majority of the profits for the company. All other segments are minor contributors to the most important metric- profits.
Let us take a look at the growth rate of each segment for the last 4 years and the pre-tax profit margins:
As can be clearly seen, the company’s cigarette segment enjoys the highest profit margins. However, the cigarette segment also happens to be a slow grower. The segments in which ITC is growing fast (FMCG and Hotels), the company has relatively lower profit margins. If you look at the Hotels and Papers segment, the company makes decent margins. When the margins look good and also the CAGR growth rates are decent, then what is the problem? Why is the share price not moving?
Not analyzing the return on capital employed is a mistake that most new investors commit. In my experience, this metric starts mattering more and more after every passing year. It is like this- Imagine your friend asked you for some money to run a business. You decided to lend him the money. With every passing year, your anxiety will keep increasing if the returns that he generates on the capital are not adequate. Let us now take a look at the capital employed by the company in each of these segments:
It can be clearly seen from the above numbers that the cigarette segment provides high returns on capital employed. Hotels and FMCG-Others are where the company has been pumping capital, but the returns they have generated on these investments are clearly not as per expectations. This is one of the major reasons why investors are not happy with the company and the stock price is being punished. Around 35% of the total capital employed is in the FMCG-Others and Hotels segment. Together these two contribute only 2.8% to the company’s total pre-tax profits.
Cigarette business is a mature business and investors expect returns in the form of a dividend. If you take a look at the dividend yield of ITC, it is not what would entice dividend seeking investors. This leaves the option of enticing the growth-seeking investor. However, as can be seen from the above numbers, since the FMCG and Hotels business is not able to provide adequate returns on the capital employed, growth-seeking investors too are staying away from the stock. If both dividend seekers and growth seeker stay away, then who would invest in this company!
Another aspect of why the company’s stock price is struggling is investor sentiment. Almost all major global cigarette manufacturers are being de-rated by investors. Below is the PE ratio chart of Phillip Morisson which happens to be a leading cigarette company. It can clearly be seen that the valuation that the company enjoys is significantly lower than the peak valuations that the company has enjoyed in the recent past. Something similar is happening with ITC Ltd.
Let us take a look at the PE ratio chart for ITC. As can be seen below, the stock is available at an attractive valuation. Do note that the PE ratio of Nifty 50 is above 28 and you are getting ITC at a ratio of around 20! Does that mean you should get aggressive and put all your money on this stock? In my opinion, not at all! We will shortly come to how you can invest in this company if at all you decide to invest in it.
In a country like India, which has been running a fiscal deficit, investors are always wary of the Government’s policy towards taxing sin products. Any possibility of an increase in taxation on tobacco products will cause the stock price of ITC to react adversely.
Let me summarise this discussion. Broadly these are the points why investors are nervous:
The company has been pumping capital into the Hotels and FMCG businesses by taking money from the cash-cow segment- Cigarettes. This naturally means that the company is not paying enough dividends to the dividend-seeking shareholders. The growth-seeking investor is not very attracted by the value proposition as the return on capital that the company is generating in these segments is not as expected.
Cigarettes is a sin product and in a developing country like India which runs a fiscal deficit, there is a continuous threat of the Government increasing taxation on sin products to meet its revenue shortfall. This dampens investor sentiment and results in lower valuations.
What is the future of this company?
Is there any point in holding the stock for longer terms?
If you look at the fundamentals of this company, it is India’s one of the best companies. The biggest division is a cash-cow and it will keep generating enough cash till such time that the other divisions are able to sustain on their own.
The question then arises is when will these divisions sustain on their own without fresh capital infusion? Well to understand this in detail, we will have to take a look at the individual businesses, which is beyond the scope of this analysis. However, if you look at the management of ITC Ltd, it is a high-quality professionally managed company.
Since the board is professionally driven (against family-driven), the chances of Corporate Governance lapse are lesser.
The businesses that the company is trying to expand are all in the high growth areas. FMCG in India is a segment that has grown leaps and bounds in the last 10–15 years. Hotels and hospitality is another segment which is picking up.
Having said all this, when will the growth in other segments pick up for the company is something that only time will tell. It may take 2 years or 5 years, nobody can predict. Due to the uncertainty of cash flow timings for these segments, it is advisable for investors with a shorter time horizon to stay away from the company. This is a company that is likely to deliver in the long to very long term.
In my opinion, the best way to invest in ITC is after studying every quarterly result. The key metrics to be tracked are growth in hotels and the FMCG-others segment. EBITDA margins for both these segments also need to be carefully tracked. Once growth starts picking up in these areas, the stock price is likely to glitter.
The company has numerous subsidiaries that are in the high growth area. If the management is able to achieve a break-through in any one area, the stock price is likely to zoon.
I hope this post will help you make an informed decision about investing in ITC Ltd.
Disclosure: I am invested in the company and intend to add in a staggered manner
Data sources: Revenues, margins and other financial information from the company annual reports and investor presentations.
PE ratios are calculated on the basis of earnings and share price.