Should you place your bets on ITC?

However, for some companies, the rules are not so simple. A case in point is ITC, an FMCG giant with a strong presence in the tobacco, FMCG, hotel and infotech space. The company was renamed ITC from India Tobacco Company in 1974, but carries the burden of the image of a cigarette seller to this day.

Perils of being a tobacconist and a struggling hospitality sector

The decision to invest in ITC is a tricky one because the company seems to be doing well in certain segments, while others are suffering to some degree. Investors shy away from investing in a cigarette business not only because of its image, but also the massive taxes that continue to drive up cigarette prices. Moreover, ITC’s luxury hotel business had borne the consequences of the COVID-19 pandemic and lockdowns.

Cigarette company

Investors perceive a business manufacturing tobacco goods as harmful. Since ITC draws 45% of its sales from cigarettes, this can be a deterrent for many traders. Moreover, the punitive taxes levied on cigarettes - which often increase with each annual budget - can discourage investment because such a rise translates to a rise in the retail price of cigarettes.

A draft of the new Cigarettes and Other Tobacco Products (Prohibition of Advertisement and Regulation of Trade and Commerce, Production, Supply and Distribution) Amendment Act, 2020 that was published in January 2021 has further dealt a blow to the value of the ITC stock. The proposed law seeks to increase the minimum age for smoking from 18 years to 21 years, place a blanket ban on smoking in public and on the sale of loose cigarettes.

 While the impact of this announcement was momentarily felt on the price of the ITC stock, it may not have a significant bearing in the longer run. This, solely because the implementation of such an ambitious law will be extremely difficult.

ESG Norms

Environmental, social and corporate governance (ESG) has in recent years heavily defined the value of tobacco manufacturing stocks worldwide, especially as international financial institutions are increasingly choosing to prioritise investment in firms that highly comply with such governance. Naturally, ESG compliance affects the price of ITC shares as well.

Global investment banker Morgan Stanley has given ITC an AA ESG rating, which the highest among international tobacco companies. In June 2017, the FII holding of ITC was at 20%, and declined to 15% in December 2019. Despite ITC's stellar rating, multiple practices on recycling solid waste, and sustainable policies regarding water and carbon, it has failed to leave a mark on investors.

Long-term underperformance

ITC does not compare with the valuations of its FMCG peers, despite 60% of the company's revenues arising from the sale of non-cigarette products. In fact, these sales make up for only 15% of the company's profits. Other FMCG businesses, despite having been around for more than 20 years, have not been able to do as well as ITC's tobacco business.

Hotels

The hospitality industry has taken a hit because of the COVID-19 pandemic. As a result, ITC Hotels has also borne the brunt of lockdowns and a deadly second wave. Moreover, investors continue to worry that the company diverts a significant cash flow to low return on capital employed (ROCE) businesses like its hotels. However, due to its brand value, management strategy and properties, ITC Hotels does hold great potential.

The management has in the past said that they will simply complete existing projects in the hotel space and not start any new ones or use the capital for ROCE businesses. However, the fact of the matter remains that the company is now driven by its FMCG sector.

Expanding in FMCG and whispers of a demerger

While the pandemic has dealt losses to the hotels segment, it has given a shot in the arm to ITC’s FMCG side of operations. Fuelled by this performance, a demerger, or at least some change in the operational organisation of ITC, seems to be on the cards. Such a decision could give a fillip to investors, boosting ITC’s equity.

FMCG

The FMCG sector as a whole has higher stock valuations. For this reason, ITC's FMCG arm has the scope for incredible growth. Competing against the undisputed ace of FMCG, Hindustan Unilever, ITC also has tremendous resources to truly come to dominate the consumer products market.

In a further boost to its FMCG segment, ITC has launched an e-store. All its FMCG products can be pushed here, without relying on other distribution channels. Moreover, since organised retail stores are giving competition to FMCG companies, ITC has potentially carved a niche with the store. The COVID-19 lockdowns have resulted in increased online shopping. The e-store can also give impetus to the company’s marketing, if not sales, immediately. Incentives and discounts can be given on e-stores instead of third party platforms, thereby slashing costs and earning good margins. Moreover, the data from its website will reveal consumer behaviour and allow ITC to target its consumer base appropriately.

Demerger

Reportedly, ITC has planned a demerger under which its hotel, FMCG and infotech arms will become separate entities, creating sustained value for shareholders. The company, however, has said that reports of such a move are speculative in nature. Despite this, reports have persisted and experts have continued to opine that in the event of a demerger, ITC will be able to focus on its profit-turning segments more keenly.

The production and supply of cigarettes suffered deeply during the coronavirus pandemic. Given the fact that a majority of the company's profit comes from sale of cigarettes, there was a 30% fall in the y-o-y sale of the product between April and June 2020. As such, ITC has introduced 100 fresh FMCG products in the non-tobacco space in order to service the needs that have arisen due to the pandemic.

While FMCG pretax profits rose 66% in the quarter ending in September 2020, the cigarette business continued to drop. It saw a 14.4% y-o-y fall in net revenues. On the other hand, hand sanitiser and personal care products drove consumer spending to over Rs 1,000 crore in December 2020.

Talk of a demerger has taken off in such a situation where FMCG has been bolstered and the cigarette and hotel businesses are weakened. If a demerger does take place, the shareholder can choose to invest in well-performing segments such as FMCG since these will inevitably receive better funding. It will also make ITC a better competitor with its peers, without one segment holding back the entire company.