PremiumMUMBAI : Simba: “Father, what’s an upper circuit?" Mufasa: “I don’t know. We’re ITC investors."
So goes a meme about the ITC stock, featuring characters from the movie The Lion King. It may have been the butt of many such memes in the past, but ITC has smoked them into oblivion this year with its outperformance on the bourses.
ITC shares have risen by about 24% so far in CY2022, significantly beating sectoral index Nifty FMCG, which has gained just 1%. This is at a time when shares of many consumer companies have been hammered by the slowdown in rural demand and the steep rise in costs after the Russia-Ukraine war began.
To put that performance in perspective: ITC’s shares fell 10% from CY2017 to CY2021, while the Nifty FMCG index surged 81%. “During that period, adverse regulatory concerns (tax increases) weighed on the tobacco industry, and ITC, too, felt the heat. The company’s cigarette volume growth remained subdued. Plus, ESG (Environment, Social and Governance) concerns led to a massive de-rating in valuation multiples of global tobacco stocks, including ITC," says Manoj Menon, head of research, ICICI Securities.
What gives?
So, why are ITC’s shares suddenly in demand? With rising interest rates, stocks that command very high multiples but do not generate free cash flow have been punished. This is most visible in technology stocks. As Kunal Vora, head of India equity research, BNP Paribas, says, “Investors have understood the need to be positioned defensively. As such, they are now valuing companies generating a lot of cash flow, that were beaten down. Here, ITC provides good value and also an attractive dividend yield."
Bloomberg data shows ITC shares currently trade at about 18 times their estimated earnings for FY2024. Many analysts reckon the valuations are still undemanding.
A few other things have also fallen in place. For instance, this year, the Union budget was kinder to ITC, with no tax hike on cigarettes. “For a stock like ITC, no news is good news. The absence of a tax increase on cigarettes in Budget 2022 is a big relief," said an equity fund manager at a large fund house.
In its Q4 presentation, ITC said, “Stability in taxes is imperative for the legal industry to combat and progressively claw back volumes from illicit trade." Illicit cigarettes are a concern for ITC though recent launches have alleviated the pain to some extent.
“Our recent interaction with dealers suggests that new products like Classic Connect, Gold Flake Indie Mint, etc. are gaining share against illicit trades," said analysts from Dolat Capital Market Pvt. Ltd in a report on 18 May. They added, “We believe that these products would help the company to accelerate volume growth momentum, which was lost over FY14-21."
Analysts estimate the company’s cigarette volumes grew around 9% in Q4 of 2021-22. Just two years earlier, however, things looked very bleak for ITC. In March 2020, when the covid-induced lockdown was imposed nationwide, people were very worried about their health, as the pandemic took hold. Some thought the terrifying testimonials about the impact of the disease, particularly on the lungs, would push smokers to quit the habit.
Had that scenario played out, it would have been a disaster for ITC’s cigarette business, its flagship. Cigarettes accounted for 81% of the company’s standalone segmental earnings before interest and tax (Ebit) in FY22.
Today, fears of the coronavirus have receded, and much of the population is vaccinated. Restrictions have eased, and people have started smoking freely again. Indeed, with offices reopening, cigarette breaks have made a comeback. Given this, it is perhaps not surprising that the company’s cigarette volumes for the March quarter surpassed pre-pandemic levels.
The icing on the cake is that ITC’s shares have lit up even as broader markets have remained weak.
Handling the ‘S’ of the ESG
But all is not hunky dory. ESG criteria has become a big force driving investments in recent years. Usually, the focus is on the environmental impact and corporate governance of a company, while the social impact is ignored. However, in the case of companies that derive the lion’s share of their revenues from ‘sin goods’ such as cigarettes and alcohol, the impact on the social fabric overshadows anything else they do. For this reason, ITC is not in the Nifty 100 ESG index and S&P BSE 100 ESG.
“All the ESG funds in India are benchmarked against either the Nifty 100 ESG or the BSE’s ESG index. ITC is not in the index and that holds true for all alcohol and tobacco companies, as these are not viewed as a social good," said an ESG fund manager, requesting anonymity as he is not authorized to comment on stocks. For many foreign funds, specifically European funds, cigarettes are in the negative list. Meaning, they cannot invest in ITC even if they want to.
Indeed, ITC’s foreign shareholding dropped from 20.77% in December 2015 to 9.99% in December 2021. This year, however, that decline has reversed; while foreign investors have sold more than ₹1.7 trillion in the broader market over the first five months of this year, they have been buying into ITC. As a result, the foreign shareholding in ITC rose to 12% for the quarter ended March.
“Given the ongoing broader market weakness, some investors now feel it may be better to look at a company’s overall ESG metrics instead of punishing it for one product," said the ESG fund manager quoted above.
Since ITC can do little about its exposure to cigarettes, it has focused on improving its score on the environment. The company has been carbon positive for 16 years, water positive for 19 years and solid waste recycling positive for 14 years, according to the company’s own disclosures. Further, over 41% of the total energy consumed by ITC is from renewable sources.
“The company aims to enhance the share of renewable energy usage to 50% of total energy consumption and meet 100% of its purchased grid electricity requirements from renewable sources. It also aims to achieve a 40% reduction in specific water consumption as compared to a 2018-19 baseline and create rainwater harvesting potential equivalent to over 5 times the net water consumption among others," an ITC spokesperson told Mint.
ITC’s efforts from an ESG ratings perspective are worth noting. The company has had an ‘AA’ rating from MSCI-ESG, an independent ESG data provider, for four years and is part of the Dow Jones Sustainability Emerging Markets Index.
Beyond cigarettes
Diversification from cigarettes is key for ITC as it seeks to burnish its ESG credentials. Over the years it has expanded into ‘FMCG others’ (branded packaged food, personal care products etc), hotels, agri-business and paper products and packaging.
In 2021-22, cigarettes contributed 36.3%, agri business: 25.1%, FMCG (others): 24.8%, paper: 11.8% and hotels: 1.9% of standalone segmental gross revenues. “Current results by ITC management have shown major growth from all the sectors, including tobacco," the ITC spokesperson said.
Indeed, the management, under the chairmanship of Sanjiv Puri, is trying for an image makeover, increasingly asking investors and analysts to look at the topline of segments other than tobacco. But analysts are not convinced. “One can take ITC as a serious FMCG player only when it faintly starts matching the likes of Marico and Dabur," said R Balakrishnan, an independent analyst.
For many analysts, the hotel business is the biggest sore point. The long pandemic has not helped matters. To begin with, even before the covid outbreak, profits in the hotel business, at ₹177.74 crore for FY19 and ₹157.75 crore for FY20, were the lowest compared with profits in other segments. In FY21, the business suffered a loss of ₹534.91 crore due to the pandemic-induced slowdown in hospitality; FY22 saw some recovery, with losses narrowing to ₹183.09 crore.
“You cannot pat your back only on cigarette revenue-led growth. Plus, given that cigarette consumption demand is inelastic, the management does not have to do anything to boost cigarette sales and neither is it right to take credit for it," says Manu Rishi Guptha, an independent analyst. ITC filed a ₹100 crore defamation lawsuit against Guptha in June 2021 for his scathing assessment of the company in a blog post.
In the post, Magic, illusion or just trickery—the story of ITC, Gupta alleges that ITC’s share price “is manipulated weeks before every quarterly result". Further, he said that the vision statement for the growth of the firm’s FMCG vertical would require ‘magical powers’ to be accomplished. ITC, in the suit, called the blog “defamatory and derogatory".
Bets gone wrong
The company’s recent investments and acquisitions include a 10% stake in Blupin Technologies (it focuses on community and content to help young families parent), a 16% stake in Mother Sparsh (an ayurvedic brand for mother and baby care), a 33% stake in Delectable Technologies (it operates vending machines), and the acquisition of Sunrise Foods Pvt Ltd (a spice manufacturer).
“Some of these investments could have been avoided. Since a vendor tie-up would achieve the same output," said the equity fund manager cited earlier.
Indeed, ITC has a history of bets going wrong. For instance, back in 2019, it had to shut down its premium retail brand Wills Lifestyle and sell another retail brand, John Players, to Reliance Retail. Both were loss making. In 2013, ICICI stepped in to rescue ITC’s beleaguered non-bank finance company, ITC Classic Finance Ltd, by way of a merger.
What next?
Despite their recent outperformance, ITC’s shares are still about 20% lower than their all-time high of ₹342.5 per share on 3 July 2017.
Some believe that a demerger of ‘FMCG others’ or the listing of its information technology business may unlock value for shareholders. As Basant Maheshwari, co-founder & partner at Basant Maheshwari Wealth Advisers LLP, puts it: “There are two big triggers for the stock. One, the (potential) stake sale of ITC by Specified Undertaking of the Unit Trust of India (Suuti). Second, the (potential) demerger of the ‘FMCG others’ business. But they are short-term triggers." Suuti holds 7.92% in ITC.
Rumours of value unlocking and a demerger have surfaced in the past, too, but so far, the company has made no substantial announcements in this regard. It goes without saying that for a longer-term re-rating of the stock, ITC’s other businesses need to contribute more to its profits. “In spite of so many diversifications such as hotels, paper, FMCG and rural India forays, ITC doesn’t make enough cash from any of these activities," Maheshwari points out.
For now, ITC’s cigarette business ensures it is relatively protected from sharp inflationary pressures compared to its FMCG peers. That said, it is also likely that investors are factoring in the optimism adequately. “While the company’s paper and agri business did well in Q4 of FY22, growth should moderate over the medium-term. Plus, fears of rise in taxes are a perennial drag for the ITC stock. Against this backdrop, there is no significant scope for a valuation multiple re-rating. As such, if there is a permanent threat on revenue growth, then multiples tend to de-rate," said Varun Singh, an analyst at IDBI Capital Markets and Securities Ltd.
As for dividends, in FY21 and FY22, ITC payouts stood at around 100.5% and 93%, respectively. But Maheshwari is not impressed, noting: “A company that gives so much dividend accepts that it doesn’t have growth opportunities." And that leads him to conclude: “The dividend yield ensures that the stock doesn’t fall and the lack of growth in volume/value puts a ceiling on the upside."
In other words, it’s possible Simba and Mufasa may take time to find out what an upper circuit is.
