ITC has been the famed meme stock of India, mocked for its lack of price movement for years. While the Indian markets shone, ITC lay steady between Rs. 200-300 per share for almost a decade.
But while you laughed at all the memes about ITC, the stock has delivered stellar returns of 75% since the beginning of 2022 till now (February 23, 2023).
While the returns have come in only over the last 15 months, ITC has been executing a strategy slowly and successfully over the last 15 years.
It is this strategy that has now come to a point which makes it necessary to look at ITC from a whole new lens, and perhaps use a different set of memes too!
The Mega Transformation
ITC has ruled the cigarette market in India, with its mammoth 85% market share. While ITC’s massive monopoly in cigarettes gives it healthy cash flows, and the ability to pay high dividends to investors, the business comes with its own set of drawbacks:
Smoking kills, and the government always tries to curb the habit by imposing heavy taxes to elevate prices for consumers
Increasing health-conscious behaviour leads to loyal customers choosing their lives, and quitting, thereby putting more pressure on growth
For these reasons, cigarette companies neither show healthy growth, nor get highly valued by investors, and end up as flat as ITC was.
A well-thought-of strategy which ITC has patiently been executing over the last two decades has finally started to yield material results.
Rule the cigarette market and keep generating a tonne of cash
Invest the tonne of excess cash in other businesses, and reduce dependence on cigarettes
The end result? Become a diversified conglomerate, which is able to exhibit high growth, strong profitability, healthy cash flows, robust dividends, and subsequently (and most importantly) - command higher valuations.
1. Ruling the Cigarette Market
Smoking Isn’t Sexy Any Longer
There was a time when smoking was considered sexy, but that was only till science uncovered its harmful effects. Since then, the world has witnessed a shift in smoking trends - a significant decline in the smoker population.
Take the World Bank data from 2000 to 2020 for example.
Prices have gone up dramatically, driven by tax, which forms 50-70% of the price of a cigarette.
There has been a commensurate decline in the percentage of the adult population smoking.
Despite the decline, India still grapples with a high percentage of the population smoking.
Cigarettes in India constitute less than 20% of the total market, while the rest is dominated by inexpensive bidis.
Nonetheless, government efforts across the globe are pretty obvious towards price hikes, and reduction of smoking, which acts as a natural long-term headwind for the market, and for players like ITC.
But ITC Is Still Killing It
Despite headwinds, ITC has managed to capture and maintain the largest market share by:
Offering a wide range: ITC is present everywhere from Rs. 10/stick price points to premium cigarettes. As people upgrade from bidis or downgrade from expensive cigarettes, healthy volume growth is seen at the Rs. 10 price point. This is expected to see a growth of 20-25% over the next 3-4 years.
Product innovation: ITC has pioneered this from launching flavoured cigarettes to the recent rollout of a 5-cigarette sachet for (Gold Flake Premium and Capstan Special).
From FY10 to FY22, ITC’s cigarette business exhibited a 3% CAGR despite the declining market - a commendable job.
Cash is King
But growth in the cigarette business doesn’t matter. What matters is cash generation! After all, ITC needs the cash to fuel its mega-shift, and steady cash flow is just what it needs, and gets!
The cigarette business operates at an enormous 67% EBIT margin - ITC’s massive scale, distribution prowess, pricing power and brand loyalty give it margins to die for!
It's EBIT/OCF (ability to convert operating profit into operating cash flow) is 100% - healthy by all means
ITC used to invest around 25-30% of its operating cash flow each year into other businesses. With this, it was able to build several other businesses which today contribute to nearly 65% of total revenue (from 40% in FY10)
After investing in other businesses, ITC was paying out the rest in the form of dividends achieving an average payout ratio of 75%
2. Transforming to a Non-cigarette Company
Driving Successful Diversification
Using the steady-and-high-cash-generating cigarette business, ITC has been able to fund its own transformation.
Although it is still commonly recognised as a tobacco firm, its revenue share from the segment has fallen from 57% to 36% over the past 10 years.
Over time, it has built a successful position in several businesses including FMCG, hotels, agriculture, paper and technology services.
Its prowess in the cigarette business has allowed it to invest aggressively in all these businesses, and gain a recognisable name, if not market leadership.
On a cumulative basis, ITC has invested the most in FMCG, paper and hotels.
The capex of nearly Rs. 6,400 crore in FMCG comes second only to HUL which invested a total of Rs. 9,400 crore over FY15-22.
ITC’s investments in this business exceed that of Nestle as well as Godrej.
The aggressive outlay becomes possible for ITC since the cigarette business requires minimal investments.
Profits yet to Get Diversified
While ITC has successfully pulled off revenue diversification, cigarettes still continue to dominate the profit pool - comprising nearly 80% of the total operating profit.
Three prime reasons for this are:
The cigarette business for ITC is a near-70% margin business, which is rather unmatched. Other businesses rarely come to this stature
ITC has been in the investment zone in other businesses, with expansion and market leadership being more important than profitability
Other businesses inherently face higher volatility and are more subject to performance variability compared to the steady cigarette business
While the first is fundamentally unsolvable, the latter two are expected to drive profitability up in the future.
Over FY30, we expect a 12% revenue CAGR and 19% EBIT CAGR in other businesses. Margins are expected to go up from the current 10% to 30% by FY30.
​ | ​FY10 | FY20 | FY30 |
Revenue Composition | ​ | ​ | ​ |
Cigarettes | 60% | 40% | 23% |
Others | 40% | 60% | 77% |
Operating Profit Composition | ​ | ​ | ​ |
Cigarettes | 83% | 84% | 42% |
Others | 17% | 16% | 58% |
Operating Profit Margin | ​ | ​ | ​ |
Cigarettes | 29% | 67% | 70% |
Others | 8% | 9% | 30% |
A New ITC
Better Performance in the Future
While the cigarette business has been steady - thanks to fewer price hikes (lower government tax intervention in the last few years), there are several triggers in other businesses.
​ | Segment | Performance | Prospects |
FMCG | Personal care, health and hygiene, ready-to-eat through brands like Aashirvaad Atta, Bingo, YiPPee, and Sunfeast | Margins have gone from 3-4% in FY17 to 10% now. Competitors operate at >20% | Promising potential in each of the segments since ITC has established a strong brand across the board |
Paper and Packaging | ​Packaging for various product ranges like ice creams, menstrual pads, food packing at fast-food restaurants, trays for eggs, and even cigarette boxes | De-growth of 12% YoY during COVID, but rebounded with a bang at 36% YoY in FY22 and is up almost 13% YoY in 3QFY23 due to the demand revival | Several in-house uses keep demand steady, immense growth in sustainable food packaging, a strong brand of built-in notebooks |
Agribusiness | ​2nd largest exporter of agri-products in the country, the brand caters to products like soya meal, food grains, marine products (shrimp), organic fruits and coffee | Throughout last year the government had imposed strict restrictions on the export of wheat and rice which were lifted in November 2022. Unfortunately, the damage had already been done, with a 37% YoY decline in revenues as of 3QFY23 | Complements the FMCG business, export restrictions coming off, recently won an order worth Rs. 2,000 crore from British American Tobacco, commissioned two new facilities - one for value-added spice processing, and another for export of nicotine products |
Hotels | ​Asset-light operating model in a notoriously capital-intensive industry - has 113 properties at 70 locations | Within the nine months of FY23, ITC has already added 8 properties to its roster with management contracts | With the uptick in post-pandemic travel, conventions, and wedding season, hotels are also reaping the benefits of the favourable winds, with ITC seeing a 50% YoY revenue growth in 3QFY23, and per-room revenues reaching well above pre-pandemic levels |
Valuations
All of ITC’s segments flourished in the past year, except for the unfortunate decline of the agribusiness, influenced by the export bans. Taking the future growth of these segments into consideration; unwavering taxes for cigarettes, rural and urban growth for FMCG products, a rebound of travel and events for the hotels, and a demand boost in packaging needs, we have valued each of its segments using the Sum-Of-The-Parts methodology.
SOTP | Basis | Multiple | Value/Share | Rationale |
Cigarettes | P/E | 20 | 263 | International average added to growth premium based on emerging market |
FMCG-Others | EV/Sales | 5.5 | 108 | Forecasted on the basis of sales as margins are unrealised |
Hotels | EV/EBITDA | 25 | 21 | Industry Standard |
Agribusiness | P/E | 15 | 12 | Industry Standard |
Paper and Packaging | P/E | 12 | 16 | Industry Standard |
Infotech | P/E | 20 | 9 | Industry Standard |
Cash and Investment | - | - | 30 | - |
This brings the value of each share to Rs. 460, giving an estimated upside of around 21% over the current market price - talk about a value buy!
Whether it is considered a meme stock or an investor favourite, it has proven its worth as a value stock for the ages with its recent flurry of returns, as the valuations speak for themselves.
Yet, we’re probably in the middle of a phase where not only is it a value stock (trading at a lower price in relation to its earnings, making it a discount buy), but has also transformed into the likings of a growth stock (where we see massive growth occurring in various business segments that’s either on par or faster than the rest of the market), making this stock a definite quality buy!