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Smoking Kills, but Also Makes Money Sometimes 🚭

ITC has exhibited a rather strong dichotomy over the last many years.

Good company, bad stock

As a company, they have ruled the cigarette market for decades. That’s a tricky market to rule. While it’s true that smoking is addictive, making it a defensive business and a rather lucrative one; it also is injurious to health, which makes it prone to heavy government taxation - so the product always remains expensive, and people get discouraged from smoking.

Adverse actions by the government usually affect the company negatively, and the stock hence has done nothing over the last many years, despite it being a highly successful company.

Well, ITC has been cognisant of this problem, and did actively start diversifying, and successfully so. They’re mighty in hotels, packaged goods, agriculture, paper, IT and packaging.

But, all this might appears diminished in front of the tobacco business. They’re so huge in tobacco, that the other businesses contribute to only 20% of the total profit; thereby belittling the success of the other businesses when it comes to stock price movement.

For the last ten years, the stock has steadily revolved around Rs. 200.

Stock suddenly becomes a favourite

The Indian markets saw an all-time high in October 2021, and since then the markets have been marred by a significant amount of volatility. Also, the two year bull run ended for the markets.

But for ITC, it was the beginning of a bull run! The stock went from Rs. 220 (of course) in the beginning of 2022 to Rs. 300 by July 2022. That’s a 38% return, when the Nifty actually fell by 4%.

ITC also massively outperformed the FMCG index, which was one of the best-performing in the markets. The FMCG index has been up 11% this year so far.

What's driving the stock higher?

1. The movement towards defensives

  • The market fall this year has triggered a flight to safety. Investors look for pockets of relatively safety. Growth stocks get hammered and value stocks do well.

  • ITC is a classic example of a value stock. 80% of its business came from the steady tobacco business. The stock traded at a 30% discount to Nifty 50. The stock had a dividend yield of 6%.

  • In a falling market, investing in a large conglomerate at a discounted valuation and a 6% dividend yield seems like a steal deal!

2. Untouched on taxes (for a change)

  • On February 1, 2022, the Finance Minister left taxes on cigarette and other tobacco products untouched. This rarely happens, and increased taxation has been a popular drag on the stock.

  • With it left untouched this time, investors were pretty encouraged to start hoarding on to the stock.

  • Moreover, the tobacco business has been performing well. ITC’s net revenue from cigarettes reached Rs. 20,000 crore in FY22, from Rs. 17,300 crore in FY21. That’s a growth of 16% year over year.

3. Superior performance in other businesses

  • The other businesses for ITC have been growing faster than tobacco for years now. But since they were in investment mode, they have also been low on profitability, or even loss making.

  • FY22 was another year where revenue growth in these businesses continued to be eye-popping, and margin improvement continued. Hopes of healthy diversification for ITC keep bouncing higher.

  • Revenues for the paper business grew by 36% YoY, and that for the hotels business doubled in FY22. The FMCG business took a bit of a hit, but then standard cost mitigation techniques (price hikes, supply chain optimisation, premiumisation, etc.) helped steady the ship.

Will the stock’s glory continue?

Well, there are issues:

  • There’s still heavy dependence on tobacco, and there’s no other expectation than the government coming down heavily on this category

  • In this context, ITC just isn’t diversified enough to command a better valuation, or even close to what its peers command in the FMCG business

But then, the stock will continue to stay afloat till:

  • Risk aversion in the market continues to be high

  • Preference for value remains higher compared to growth stocks

  • Visibility of revenue and profit remains high for a company like ITC, compared to the rest of the market, which is going through a rough patch on visibility

  • Valuations remain reasonable compared to peers and the broader benchmark

As soon as the market mood changes, ITC is likely to start under-performing, till the company reaches a point where the valuation of other businesses starts to show up materially in stock price appreciation.

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