WHY ITC STOCK IS UNDERPERFORMING ITS PEERS?

Twitter :- @saketreddy

FIRST, A BRIEF DESCRIPTION ABOUT THE COMPANY :-

ITC is one of India's foremost private sector companies and a diversified conglomerate with businesses spanning Fast Moving Consumer Goods, Hotels, Paperboards and Packaging, Agri Business and Information Technology. The Company is acknowledged as one of India's most valuable business corporations with a Gross sales value of ₹ 76,097.31 crores and Net Profit of ₹ 15,136.05 crores (as on 31.03.2020). 

ITC is the country's leading FMCG marketer, the clear market leader in the Indian Paperboard and Packaging industry, a globally acknowledged pioneer in farmer empowerment through its wide-reaching Agri Business, a pre-eminent hotel chain in India that is a trailblazer in 'Responsible Luxury'. ITC's wholly-owned subsidiary, ITC Infotech, is a specialized global digital solutions provider.

NOW, COMING STRAIGHT AT THE MAIN TITLE OF THE BLOG - "SHARE PRICE UNDERPERFORMANCE" :-

We can interpret from the above picture that ITC in the last 5 years has been underperforming its peers along with the Sectoral and the Benchmark index.

WHAT ARE THE REASONS FOR SUCH UNDERPERFORMANCE?

I will address one issue at a time, the reason for the stock under performance tends to incline more into its balance sheet and cash flow statement rather than the business of the company.

Lets look at the first aspect :-

CASH FLOW REINVESTMENT

Many people will have a question on 'WHAT DO I MEAN BY REINVESTMENT?'

ONE COULD LOOK AT THE BELOW ILLUSTRATION GIVEN BY MY FAVOURITE FUND MANAGER "CHUCK AKRE" ON REINVESTMENT OF EARNINGS :-

 If a business has an underlying 21% return on capital, but an investor paid a market price of 3x capital to acquire the stock, then a 100% dividend of all earnings would only yield the investor a 7% pre-tax return (the arithmetic: 21%/3 = 7%).  This is very much an average return, even though the underlying business has excellent returns on capital.  While the underlying business model may be outstanding, and while the business may be run by exceptional people, the lack of reinvestment opportunity and a decision to pay out 100% of earnings will cause shareholder returns to be just average.

On the other hand, if it were possible that all earnings could be retained and reinvested at the same 21% rate, the shareholder would receive no dividend, but the capital and earnings of the business would both grow at the rate of 21% per annum.  Over the long term, if the stock is purchased at a reasonable multiple, its market price would grow more or less in parallel with the rate of growth in capital and earnings.  The shareholder, in this example, would build capital gains at a rate in the neighborhood of the underlying 21% growth rate, for so long as the runway of excellent reinvestment opportunities persisted.  To top it off, the shareholder would enjoy tax deferral on the gains.

Source :- Akre Capital Management, https://www.akrecapital.com/what-do-we-mean-by-reinvestment/

Now, Coming onto ITC :-

We all know that ITC is a cash generating machine and its cigarette business along with the other businesses generate huge cash. Now, Cigarette business is a high ROE business, some companies such as BAT, PM & VSTIND generate anywhere between 50-150% ROE, certainly that has decreased significantly now for the whole industry.

With this cash, ITC entered FMCG, HOTELS, PAPERBOARD & the AGRI business and have done extremely well for the company as a whole. FMCG & AGRI revenues grew very well though were affected by low margins at the beginning.

Since last 3-5 years, ITC had continuously slowed down their investments into their non-core businesses where they had a huge runway for growth and also tailwinds through Government Policies on tourism, Packaging, etc.

Everyone knows that recently ITC had made a change to their dividend policy announcing they will distribute 80-85% of profit as dividend to shareholders, this is a big concern to those playing for compounding their money. It is also a caution for those wanting that 6% dividend yield, because of DDT now being imposed on the investor, which brings the net dividend return much lower for an HNI.

I guess everyone read about the REINVESTMENT illustration in the above paragraphs, this huge dividend payout brings down the reinvestment rate of ITC to less than 40%.

A CLSA report on ITC was in news in the previous week, the above pic is an excerpt from that report.

This pic shows how ITC has been allocating its CFO in the last 2 decades. We can clearly see that dividend payout constitutes bulk of the allocation.

This stands true even today.

Now, after dividend comes CAPEX, which is the second largest allocation. Here, they have gone completely wrong. ITC had taken cash from a high ROCE business and has deployed majority of the money into Low ROCE businesses such as Paperboard, Cigarette, Agri, Clothing,etc. The least amount of CAPEX went into the core FMCG business.

Especially, when they were trying to diversify their source of income from cigarette, they failed to create an FMCG behemoth in ITC, hence ended up deploying more and more cash into Low ROCE businesses.

That is the main reason, why ITC on a consolidated basis has reported the LOWEST ROCE in a decade, even when they did a pretty good job turning around their FMCG business.

Source ;- Tijori Finance

Peers like Britannia & Nestle usually used 30-40% of CFO to give dividends unless there was a special dividend. Whereas ITC has been consistently increasing it over 50-70%.

After CAPEX & Dividend payout, majority of the remaining cash goes into their reserves, which are usually kept in FD's or Bonds. that earn interest income which in turn is again distributed as dividend.

Here, one should understand that ITC's FMCG ROE is well above the 6% that a bond gives you, in fact it could be triple of it. So, why not invest the surplus into the FMCG business, they can either do a huge CAPEX or do some big acquisitions in order to achieve inorganic growth.

So, this brings me to an end into ITC's capital allocation plan. Main takeaway is to decrease dividend payout and reinvest 40-60% of CFO back into the FMCG business.

Just like how the population is INDIA's biggest asset, the FMCG business is also ITC's biggest asset, they need to know how to utilise it!

CAPITAL ALLOCATION HAS BEEN MY BIGGEST WORRY IN ITC's JOURNEY IN BECOMING AN FMCG BEHEMOTH!

Now, let us go into various reasons apart from Cash flows on why the share price is subdued. These will be short and crisp!

2. REVENUE GROWTH & BUSINESS DIVERSIFICATION

ITC has grown revenues at a subdued CAGR of 5% in the last 5 years. Now, this sort of dull growth is not limited to ITC, it is visible in HUL, Nestle & Dabur as well.

This is one factor along with poor Cigarette performance that ITC has seen a crush in its valuations and hence share price de-growth!

Now, coming onto business diversification, CIGARETTES still contribute a major part of their EBIT and that is not encouraging the big investors to put their money here, but go elsewhere.

For investors to look at ITC as an FMCG company, they seriously need to turn around all the businesses and decrease their dependency on the Cigarette business.

3. NO SERIOUS PROMOTER

We all know that ITC doesn't have a promoter and is run by the board that was constituted sometime ago. BAT had been a serious problem for the company and GOI couldn't do anything as ITC was a big company in terms of MarketCap!

ITC needs a promoter to own > 50% of the company in order to taek swift actions other than waiting for a couple of institution's approvals and also a serious board that can be trusted and be given ESOP's only when there is good growth in the company!

HOW TO CORRECT THESE?

As I have told the mistakes, let me also tell how to correct them :- 

1. Reduce dividend payout to 30% of PAT against 80% of PAT now.

2. Announce Buybacks at a premium of at least 15% from CMP every year, this is ultimately a tax efficient dividend to the shareholder.

3. Use the Cash to acquire some big single state "Dominant" businesses like SUNRISE FOOD or reinvest the cash in FMCG/AGRI/INFOTECH business.

4. Get some serious talking with GOI and ask them to buy BAT stake and eventually remain as a silent promoter with a private board.

5. Diversify into various businesses and make themselves a leader, they have a habit of doing that.

6. Put a stop to EQUITY DILUTION, be it in the form of ESOPS, Rights, Bonus. Try to reduce outstanding shares through buybacks!

Disclaimer:- I do not hold ITC. This blog is not a recommendation to buy/sell any stock. Please consult your Financial Advisor to take any decision.