So goes a meme about ITC stock, which has characters from the movie The Lion King. It may have been a part of many such memes in the past, but ITC has forgotten them with its stellar performance on the exchanges this year.
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Shares of ITC have gained almost 24% so far in CY2022, outperforming the sectoral index Nifty FMCG, which is up just 1%. This comes at a time when the stocks of many consumer companies have been hit by a slowdown in rural demand and a steep rise in costs after the start of the Russo-Ukraine war.
To put that performance in perspective: ITC shares fell 10% from CY2017 to CY2021, while Nifty FMCG index rose 81%. “During that period, adverse regulatory concerns (tax hike) weighed on the tobacco industry, and ITC also felt the heat. The company’s cigarette volume growth remained sluggish. In addition, ESG (environmental, social and governance) concerns led to massive de-ratings in valuation multiples of global tobacco stocks including ITC,” says Manoj Menon, Head of Research, ICICI Securities.
what gives?
So, why is there a sudden demand for ITC shares? With rising interest rates, stocks that command very high multiples but do not generate free cash flow have been penalized. It is most visible in tech stocks. Kunal Vora, head of India Equity Research at BNP Paribas, says, “Investors have understood the need to be on the defensive. As such, they are now valuing very high cash flow generating companies that were beaten. Here, ITC offers good value and also offers attractive dividend returns.”
Bloomberg data shows ITC shares are currently trading at around 18 times their estimated earnings for FY2024. Many analysts believe the valuation is still under-demanded.
Other things have also happened. For example, this year the Union Budget was favorable for ITC, with no tax hike on cigarettes. “For a stock like ITC, no news is good news. The absence of increase in tax on cigarettes in Budget 2022 is a big relief.
In its fourth quarter presentation, ITC said, “Stability in taxes is imperative for the legal industry and progressively withdraw volumes from trafficking.” Illegal cigarettes are a concern for ITC, although the recent launch has eased the pain to some extent.
“Our recent interactions with dealers suggest that new products like Classic Connect, Gold Flake Indie Mint etc are gaining share against illegal trade,” analysts at Dolat Capital Markets Pvt Ltd said in a report on May 18. “We are confident that these products will help the company accelerate the pace of volume growth, which was lost in FY 2014-21,” he added.
Analysts estimate the company’s cigarette volumes to grow about 9% in the fourth quarter of 2021-22. However, just two years back things were looking very gloomy for ITC. In March 2020, when the nationwide COVID-induced lockdown was imposed, people were very concerned about their health as the pandemic took hold. Some thought that the gruesome testimonials about the effects of the disease, especially on the lungs, would prompt smokers to quit the habit.
Had that scenario unfolded, it would have been a disaster for ITC’s flagship cigarette business. Cigarettes accounted for 81% of the company’s standalone segmental income before interest and tax (EBIT) in FY12.
Today, the fear of the coronavirus has subsided, and most of the population has been vaccinated. Restrictions have been eased, and people have started smoking freely again. Indeed, with the reopening of offices, the cigarette break has 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 special thing is that despite the weak market in the broader market, the shares of ITC have risen.
ESG. handling the ‘s’
But not everything is hunky dory. The ESG benchmark has become a major investment promoting force in recent years. Typically, the focus is on the company’s environmental impact and corporate governance, while the social impact is ignored. However, in the case of companies that derive the bulk of their revenue from ‘goods of sin’ such as cigarettes and alcohol, the impact on the social fabric outweighs anything they do. Hence ITC is not in Nifty 100 ESG Index and S&P BSE 100 ESG.
“All ESG funds in India are benchmarked against Nifty 100 ESG or ESG index of BSE. ITC is not in the index and the same holds true for all alcohol and tobacco companies, as these are not seen as a social good,” said an ESG fund manager requesting anonymity who did not wish to comment on the shares. Cigarettes are on the negative list for many foreign funds, especially European funds, meaning they cannot invest in ITC even if they want to.
In fact, ITC’s foreign stake fell from 20.77% in December 2015 to 9.99% in December 2021. However, this year the decline has reversed; While foreign investors have sold more than 1.7 trillion in the broader market in the first five months of this year, they are buying into ITC. Consequently, foreign holding in ITC rose to 12% for the quarter ended March.
“Given the broader ongoing market weakness, some investors now feel that it may be better to look at the company’s overall ESG metrics rather than penalize one product,” said the ESG fund manager quoted above.
Since there is little ITC can do about its exposure to cigarettes, it has focused on improving its score on the environment. According to the company’s own disclosure, the company has been carbon positive for 16 years, water positive for 19 years and solid waste recycling positive for 14 years. In addition, over 41% of the total energy consumed by ITC is from renewable sources.
“The company aims to increase the share of renewable energy usage to 50% of total energy consumption and meet 100% of grid power requirements procured from renewable sources. It aims to achieve specific water requirement as compared to the 2018-19 baseline. Achieving a 40% reduction in consumption and creating rainwater harvesting capacity equal to more than 5 times the consumption of pure water among others,” an ITC spokesperson told Mint.
ITC’s efforts deserve attention from ESG rating perspective. The company has received 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 important 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%, agribusiness: 25.1%, FMCG (others): 24.8%, paper: 11.8% and hotels: 1.9% of the standalone segment gross revenue. An ITC spokesperson said, “The current ITC management results have shown significant growth in all sectors, including tobacco.
Indeed, the management, headed by Sanjeev Puri, is attempting an image shift, asking investors and analysts to look at toplines from sectors other than tobacco. But analysts are not convinced. R Balakrishnan, an independent analyst, said, “ITC can be taken as a serious FMCG player only if it matches the likes of Marico and Dabur.”
For many analysts, the hotel business is the biggest sore point. The protracted pandemic hasn’t helped matters. To begin with, even before the Covid outbreak, the hotel business profited, at 177.74 crore for FY19 and 157.75 crore for FY20, were the lowest in comparison to profits in other segments. In FY21, business suffered 534.91 crore due to the pandemic-induced slowdown in hospitality; FY22 saw some recovery, with losses narrowing 183.09 crores.
“You can’t just pat your back on cigarette earnings-led growth,” he said. Moreover, given that the demand for consumption of cigarettes is stable, the management does not need to do anything to boost the sales of cigarettes nor take credit for it,” says Manu Rishi Gupta, an independent analyst. ITC filed 100 crore defamation suit against Gupta in June 2021 for his sharp assessment of the company in a blog post.
In the post, Magic, Illusion or Just Tricky- The Story of ITC, Gupta alleged that ITC’s share price is “manipulated weeks before every quarterly result. In addition, he said that the growth of the firm’s FMCG vertical was critical. The vision statement would require ‘magical powers’ to be fulfilled. The ITC, in the suit, called the blog “derogatory and derogatory”.
bets gone wrong
The company’s recent investments and acquisitions include a 10% stake in Bluepin Technologies (it focuses on community and content to help parents of young families), a 16% stake in Mother Sparsh (an Ayurvedic formulation for mother and child care). brand), comprising a 33% stake. in Selectable Technologies (it operates vending machines), and the acquisition of Sunrise Foods Pvt Ltd (a spice maker).
“Some of these investments could have been avoided. Since a vendor tie-up will yield similar output,” the equity fund manager was quoted earlier.
Indeed, ITC’s bets have a history of going wrong. For example, back in 2019, it had to wind up its premium retail brand Wills Lifestyle and sell another retail brand, John Players, to Reliance Retail. Both were running at a loss. In 2013, ICICI stepped in to rescue ITC’s troubled non-bank finance company, ITC Classic Finance Ltd, through a merger.
what next?
Despite its recent outperformance, ITC shares are still down nearly 20% from their all-time highs 342.5 per share as on 3 July 2017.
Some believe that the demerger of ‘FMCG Others’ or the listing of its information technology business could unlock value for shareholders. As Basant Maheshwari, co-founder and partner, Basant Maheshwari Wealth Advisors LLP, puts it: “There are two big triggers for the stock. a, the sale of (potential) stake of ITC by the specified undertaking of the Unit Trust of India (SUTI). Second, the (potential) separation of the ‘FMCG Others’ business. But they are short-term triggers.” Sooty holds 7.92% stake in ITC.
Rumors of value unlocking and demerger have surfaced in the past, but till now the company has not made any major announcement in this regard. Needless to say, for long-term re-rating of the stock, ITC’s other businesses need to contribute more to its profits. “Despite various diversifications in hotels, paper, FMCG and rural India, ITC does not generate enough cash from any of these activities,” explains Maheshwari.
For now, ITC’s cigarette business ensures that it is relatively protected from intense inflationary pressures as compared to its FMCG peers. That said, it’s also likely that investors are factoring in optimism adequately. “The company’s paper and agribusinesses performed well in the fourth quarter of FY12, but growth should moderate over the medium term. Besides, anticipation of hike in taxes is a perennial drag for ITC stock. In this background, there is no significant scope for evaluation multiple-re-rating. As such, if there is a permanent threat to revenue growth, the multipliers de-rate,” said Varun Singh, an analyst at IDBI Capital Markets and Securities Ltd.
As for dividend, in FY 2011 and FY 2012, ITC payout was 100.5% and 93% respectively. But Maheshwari isn’t impressed, noting: “A company that pays so much dividend admits it doesn’t have growth opportunities.” And from this he concludes: “The dividend yield ensures that the stock does not fall and is capped by an increase in volume/value.”
In other words, it’s possible that Simba and Mufasa may take time to figure out what Upper Circuit is all about.