Investors Want ITC To Carve Out Cigarette Business. It Won’t Be Easy.
Interviewer to candidate: What’s your patience level?
Candidate: I’m an investor in ITC.
Interviewer: (Offering the job) How much salary will you take to join?
That’s the gist of a Hinglish meme inspired by Bollywood movie ‘3 Idiots’ cited in a blog called Alpha Ideas. Countless other versions on social media target the cigarettes-to-hotels conglomerate. The reason—ITC Ltd.’s stock has lagged when rest of the market has scaled new records.
ITC has no debt, no litigation and a 77% share of the cigarette market. There are no challengers as e-cigarettes are banned and entry barriers for new players are high because of restrictions on foreign direct investment. Yet, it continues to disappoint.
Cigarettes are the cash-flow engine at ITC, driving its operating income and margins. And cash from the tobacco business is used to reward shareholders. Yet, this business is also suppressing shareholder returns
In the last one year, ITC rose nearly 34.7%, underperforming Nifty 50 and BSE FMCG Index. In the last two years, Nifty rose 27.7% but ITC tumbled 27.8%.
That’s prompted demand from institutions and investors to unlock shareholder value by spinning off the cigarette business. A news report said the company is considering a plan to create three entities through a demerger.
A demerger may also allow BAT, its largest shareholder with 29% ownership, to cash out on non-cigarette business. Other shareholders include Life Insurance Corporation of India Ltd. and SUUTI, through which the government owns sake in the cigarette maker.
ITC, in its filing to exchanges, however called demerger reports “speculative”. The company, in its response to BloombergQuint's emailed queries, said the current structure has benefits of “synergy in the form of access to ITC’s balance sheet to scale up verticals profitably”.
Cigarettes A Problem For Large Investors
Foreign fund flows have started factoring in Environmental, Social, and Corporate Governance or ESG objectives. According to Morgan Stanley, ESG assets have doubled in the last two years to $1.6 trillion as of December. And there are now over 1,700 ESG funds with tobacco-exclusion policies compared with 10 in 2018, it said.
These funds follow the UN Global Compact and UN Sustainable Development Goals as eligibility criteria. In Hong Kong, the regulator assesses whether funds registering with itself are consistent with UNGC or UNSDG guidelines when it approves green or ESG funds.
This transition affected fund flows into ITC. Overseas holding in ITC has fallen from more than 20% as of March 2017 to 13% now, according to stock exchange data.
Not just that, the number of foreign portfolio Investors in ITC has fallen to 866 in December 2020 from 1,151 in March 2017. The largest foreign portfolio investor was the Government of Singapore with 1.28%. It’s no longer among FPIs with more than 1% stake.
Supratim Dutta, chief financial officer at ITC, admitted during the interaction that the FPI holding has come down in recent years largely due to the ESG factors.
“[But] ESG Investing a fast-evolving area and there is an increasing move towards ‘ESG Integration’ as opposed to exclusion investing strategies,” Dutta said. “ITC has top-notch ESG credentials—being carbon positive, water positive and solid waste recycling positive for several years in a row; ITC has been rated AA by MSCI – best among global tobacco companies.”
Dutta said mutual funds’ stake in ITC has doubled to 9.35% in the last four years even though the number of such institutions holding its shares has fallen from 451 to 350 since March 2017.
Retail investors have also increased holding in the company—up from 5.3 lakh investors holding 9.49% to 18.87 lakh owning 12.15%.
ITC trades at a premium to global peers, at around 20 times its earnings compared to 9x for British American Tobacco, which is the largest shareholder in ITC. The Indian company, however, trades at a discount to its domestic consumer goods peers.
The forward premium on ITC that once stood at 30 times has fallen to 20 times, according to Bloomberg data.
Morgan Stanley is building in a 25% discount to the 10-year average earnings growth to factor the ESG headwinds and slowing cigarette EBIT.
The Flip Side
India’s largest cigarette maker has used free cash flow from the tobacco business to incubate the FMCG segment in the last 15 years and also provides growth capital to paperboard, infotech and hotels units.
While cigarettes generated cash flows worth Rs 88,800 crore since FY03, FMCG, hotels and agri business had a cumulative negative free cash flows of Rs 81,300 crore—meaning the three units couldn’t cover expenses from the revenue. The paperboard business saw marginal free cash flow during the period.
In response to BloombergQuint's queries, Dutta said cash flows have been increasing. In the three years to fiscal 2020, the company generated cash flow of over Rs 30,500 crore. In fiscal 2020 alone, it generated Rs 12,000 crore, he said.
Still, shareholders sacrificed dividends to fund these non-tobacco businesses. While the company has the highest dividend yield of 5.3% among consumer goods makers, shareholders have been raising concerns.
Dutta, however, said FMCG business margin has improved by 460 basis points in the last three years. In the nine months ended December, it further widened by 210 basis points.
The agri and paperboards and packaging already generate cash flows; for hotels, the company has moved to an “asset right” model (property management contracts), he said. For the FMCG (others) segment, the company has already invested in expansion and as the business matures, it will generate more cash, Dutta said citing improving operating income and capex requirements.
"We have stepped up the dividend payout ratio considering, inter alia, future needs of growth capital and cash generation from operations," Dutta said.
The company doubled the dividend to Rs 10.15 per share last financial year. And in March 2020, it approved a new dividend distribution policy, promising to pay out 80-85% of the net profit for the medium term compared with 68% in the last 10 years.
Still, the shareholders’ push for spinning off the cigarette business poses its own risk. That of the unviability of the non-cigarette business without support from the tobacco unit’s cash. FMCG, agri and hotels, according to Morgan Stanley, are still weak in terms of cash generation and, therefore, unlikely to support its own growth requirements.
Dutta said the company is committed to creating long-term value for shareholders and the current structure holds merit.
There are many categories within the FMCG business the company is seeding like juices, dairy, coffee, chocolates, he said. “We’re also addressing adjacent opportunities leveraging our 25-mother brands. We also continue to pursue value-accretive M&A opportunities like the recent Sunrise acquisition—this will need support as well.”