Even though one in four of all adult Indians uses tobacco, the nation’s addiction runs far deeper, including its government with a toxic dependence. It is called ITC Ltd (1).
ITC Limited had been recently truncated with the name while formerly known as Imperial Tobacco of India and later renamed India Tobacco Company. The 110-year-old conglomerate is owned 29.4% by British American Tobacco Plc., and about 28.5% by several Indian state-run insurance firms and government-controlled banks (2).
But here lies the problem. The huge quasi-state ownership is acting as a value trap (3). It is preventing the enterprise worth 25 billion USD from being carved up into a pure cigarette company with ownership of BAT and Pinduoduo Inc, China’s supply-chain platform, which is about four times bigger in enterprise value. It is a missed opportunity not only for ITC’s minority stakeholders but for India as well.
The firm recently posted its highest-ever Ebitda margins of 9.7% in the September quarter this year. Its brand Savlon is also set to become a 1000 crore INR or 135 million USD brand by the end of 2020 (4). Despite being in the FMCG business for two decades, ITC still lags behind its competitors. FMCG can’t help but play second to its mainstay business; cigarettes.
ITC Limited has some problems for some time now. It might seem to break through the Hindustan Unilever, Nestle India, and Britannia industry in India fast-moving consumer goods or FMCG sector. On the other hand, its tobacco company has seen success as it controlled more than 77% of the cigarette market in 2019. It being India’s second-largest FMCG company is a whole another matter (5).
India gives farmers the freedom to sell their produce outside market yeards designated by states, a corporate buyer such as ITC with distribution capabilities in the even most remote Indian towns, thanks to cigarettes! Has a shot at creating a meaningful digital agri-business with the ability to obtain better producer prices.
The Core Tobacco Business
BAT, based in London, has tried to secure its stake and take over the Indian cigarette maker when it comes to the core tobacco business. However, local managers have seen it off through Indian financial institutes’ voting power. Several investors are now questioning whether the ITC’s management empire-building to protect national interests has gone too far (6).
Since New Delhi is delaying financial support while being cash-strapped, it is more likely that the economy would lose a 10th of its real output in 2020 to COVID-19. The situation has also made it necessary to rethink its stance. What additional harm would come if BAT wins ITC’s successful cigarette division, paying a hefty premium to acquire smokers, a hazy kind in developed markets?
In response, India can wrest a time-bound commitment to steer the revenue toward reduced-risk products like the Swedish snus and heat-not-burn products (7). It would mean a fall in future healthcare costs due to lower tar consumption.
It is worth highlighting that ITC scored 0.62 in Foundation for a Smoke-free World’s 2020 Tobacco Transformation Index. While it is better than China National Tobacco Corp, it is still way behind BAT, Philip Morris International Inc, and Swedish Match AB (8).
According to the new study, companies that offer reduced-risk products mainly focus on selected high and medium nations where overall smoking rates are lower, and cigarette sales are already declining. It seems like India can negotiate better with BAT.
ITC Limited is a holding company that is engaged in the marketing of FMCG. It operates via four segments: FMCG, hotels, paperboards, paper and packaging, and agriculture business. The FMCG segment includes cigarettes and cigars, and other products such as branded packaged food business, including staples, snacks, meals, dairy, beverages, and confections. It also does business in apparel education and stationery product personal care product safety matches and Agarbatti.
Its hotel business includes hoteliers, and its paperboard includes paper and packaging segment, including paperboard, specialty paper, and packaging, including flexibles. Its agriculture business segment includes Agri commodities like Soya, spices, coffee, and leaf tobacco. Its brand includes Aashirwad, Sunfeast dark fantasy, Bingo, Yumitos, YiPPee!, Candyman, GumOn, Classmates, Fiama Di Wills, Vivel. Superia, Engage, Wills Lifestyle, John players, Mangaldeep, and Aim, among others (9).
Suppose we let the 3.3 billion USD cash pile plus the non-tobacco parts such as information technology, hotel, finance, fashion, potato crisps, paper, safety matches, and whatnot, get sequestered under a separate holding company. This way, the Indian managers get to keep what they can and turn into work; digital agribusiness-led supply chain and sell the rest. The government would extract much needed budgetary resources the value trap in the conglomerate will get released.
As the Indian government has given some relaxation, companies gradually resort to operation and adjust to the new normal. The situation is similar to ITC as well. Sanjiv Puri, the Chairman and Managing Director of ITC (10), stated that the whole problem is not going away quickly.
Puri added that we have to carry on a business and continue our economic activities amid the pandemics. Simultaneously, there are challenges in the current situation due to the halt in economic activities; we still see a positive outlook and opportunities.
While the company’s FMCG business, which contributes about 25 to 30% of the overall annual revenue, is gradually coming back to normal. New opportunities are emerging in health and wellness nutrition, and hygiene e space as customers seek trusted brands post covid-19.
There is a reasonable requirement for consumer staples, personal hygiene, food. On the other hand, customer discretionary spending is under stress. Their hotels are not operational, and business is severely impacted; however, their agri-segment is slowly getting back to pre-pandemic level.
ITC is currently deriving 60% of its revenue from the non-tobacco business. It sees growth opportunities in this segment. ITC is continuously investing in the business since it will be fruitful in the future.
However, the back of business is also facing challenges because the illegal imposes taxes on tobacco have jumped two to three times over the past few years. FICCI estimates a revenue loss of more than 13000 crore INR because of illegal cigarettes.
While talking about the lower valuation of ITC shares, Puri said that investors to look at the free cash flow generated by ITC. They have been resilient performers over the years, and their bottom line will improve as they grow. They also believe margins will improve year on year (11).
Eying Agriculture Business
The FMCG major is planning to expand its fresh fruits and vegetable business in a big way as per the agricultural reforms, the central government has recently announced (12). The company would explore the export potential of frozen and fresh vegetables as well.
“We are exploring different locations to develop and engage with for more export-oriented fruit and vegetable, closer to the port cities.”
– Sivakumar, ITC Group Head for Agri-business and Information Technology (13).
Sivakumar further added it was too early to put numbers on the investment plans are directions and guidelines that have to follow as the Ordinances are yet to be out. It provides an alternate route to bypass the existing Mandi system to sell farm produce directly to buyers. The farm produce sales from the clutches of the Essential Commodities Act is exempted under most conditions. It also introduced the provision for a pre-harvest price assurance agreement with the buyer and the farmer.
Even the actual investment figures would be decided after the rules and guidelines evolve; the company has already commenced putting the plans together. Compared to several direct buying activities that they have already been doing, they will see many more activities going forward in grains and horticulture.
Notably, the company has a presence across multiple horticulture areas of fruits for its B Natural fruit juices (14). They are 100% domestic fruit-based, unlike imported concentrates, as in the case of many others. It is also planning to expand its backend infrastructure in different areas because of the Indian government’s reform bills.
The government’s push will also expand its Farmland brand fresh vegetables and fruit retailing business. Due to covid-19 and reforms, there is a lot more consumer awareness and concern about food safety and hygiene.
Today, there is traction for value change that ensures and supports the consumer on a safety and hygiene basis. Hence, ITC is now seeing more interest in Farmland products and the need for better resources and a cluster of direct sources. Notably, tomatoes, onions, etc., are all products that no longer comes under the essential commodities act.
While commenting on the export, Sivakumar stated that globally the trade flow is likely to take some shift due to coronavirus. People are now diversifying their procurement dependence. For example, in the Middle East, people are keen to diversify where they source all their fruits and vegetables, both fresh and processed. Hence, frozen vegetables and fresh vegetables are some of the other areas that ITC is working on to see what needs to be built now concerning the COVID-19 regarding global and local markets.
ITC is also looking to strengthen its traditional grain sourcing infrastructure. They will strengthen the wheat procurement in many of those locations where there are multi-corp as part of their crop development; paddy cycles and pulses and other Nutri cereals cycle, which there in the 365 days cycle. Some of these additional infrastructures will also be used for many of these activities (15).
Making the Shift
For the past several years, reports are coming to light about how ITC wants to shift its focus away from cigarettes (16). The coronavirus pandemic and consequent lockdown managed to achieve some of it as production was halted and supply was stalled in most places.
Still, over 74% of its standalone profit before tax is coming from its cigarette business. It was 87% in the same duration a year before.
While the economic crisis has dried up profit from almost all the market sectors, ITC is unlikely to complain about cigarettes’ resilience. The stake for the April to June 2020 was still low, approximately 30% year on year.
ITC, the Indian conglomerate, had reported about a 26% drop to 2343 crore INR in its standalone profit for the first quarter. Paper and packaging space, which contributed about 10% of its revenue last year, was down by a third and observed a complete washout of revenue from the hotel segment, which clocked a loss of more than 242 crore INR before tax.
However, these numbers are still better than the prediction of analysts. According to several analysts’ reports, ITC would see a profit drop of nearly 35% (17).
The Non-Cigarette Strategy
In September this year, several reports surfaced that ITC has met fund houses to share its non-cigarette strategy. The company’s drawing attention towards its other segments. The company highlighted that its FMCG business had grown four times in the past ten years, to kick the butt away.
The player enjoys a dominant position in various sectors such as hotels, FMCG paperboards, packaging, and Agri exports. At the same time, it has also been exploring and gaining market share in the new business sectors.
There is no denying that it is one of the biggest players in the market for cigarettes in India. However, the stock has been trading at a discounted valuation even when it showing strong fundamentals in the recent month.
While ITC was sharing its non-cigarette strategy with fund houses in September, the company stated that it is now the third-largest FMCG player in India with its rapid growth in the FMCG sector. The firm also believes that it has not been accounted for in recent market performance. It also believes that it is much larger than five years in the space, considering the size of the opportunity of its FMCG business.
The organization sees a potential growth of 4 times in atta and noodle and further growth in spices. The ITC expects healthy growth opportunities in the floor cleaner and the hand wash and body wash space.
Since the previous year, ITC’s share price has slipped 34%, while in the last one month, the fall is greater than 12% (18).
An analyst at Kotak Securities stated that the company currently trades at an inexpensive valuation at 30x and the healthy 6% dividend yield. The data from Refinitiv also show that out of 36 analyses, 18 have a strong buy rating on the stock, 11 have a buy rating, and 6 have a hold rating.
Moreover, market participants also believe that it is focused on the FMCG business. Its growth became more important with Maharashtra, one of India’s largest states, banning loose cigarette sales (19).
Fears of a GST increase already led the current environment given the weakening government finances for only the second time after July 2017. Amid the concern, the news about the apprehension related to separate volumes and cigarette EBIT growth. Both of which have been under pressure since the last two years said Motilal Oswal in a report.
Conclusion: India Needs to Quit Tobacco Nationalism
“Tobacco is toxic. India is finding that tobacco nationalism is an even harder habit of quitting.”
– Bloomberg (20).
The deadlock between two equally large shareholders is hurting minority owners. The stalemate between the two has gone for a long time.
A quarter-century ago, the brawl was over whether the organization should be setting up power plants. Notably, the state-led economy had recently started liberalizing, and there was an acute shortage of electricity. During that time, the Indian cigarette maker was sitting on a cash hoard.
If BAT had wrested control, it wouldn’t have allowed funds to be put into unrelated businesses. But it found its hold weekend after currency control violations saw a change in leadership at the Kolkata based company.
Yogesh Deveshwar, the new chairman in 1996, took the Indian government’s aid to defeat BAT’s plan to separate the cigarette unit to sell international brands like 555, State Express, and Benson and Hedges cigarettes in India.
Since then, the local business has increasingly chartered its course. Now BAT can’t even try to make a bid for all ITC because tobacco has been made off-limits for FDI, foreign direct investment since 2010. That, too, was done to keep ITC in Indian hands.
Though to what end? As much as 84% of it is 2.8 billion USD protect profit came from cigarettes last year; however, four-fifths of the three 25 million USD plus capital expenditure reserve was in snacks paper and hotels. The dividend payout ratio did increase last year to 81%. However, the previous 18 years average is just 50%. It means that almost 20 percentage points lower than BAT distribution.
The UK associate, which has just one representative on the Indian firm’s board, has returned 2.1 billion USD to its stakeholders via buybacks over the past six years. However, it seems like ITC investors have no such luck. They can’t be offered a buyback since it increases BAT shareholdings.
Widows and pensioners get a 6% dividend and five percentage points more than the benchmark Nifty50 index. The scenario is like collecting pennies in front of a value-crunching steam roller. ITC shares have lost 11 % of the dollar value in the past decade, while investment in Nestle India limited has tripled.
The opportunity ahead is crystal clear as the agri-business offers the chance for building a digital platform linking retailers with customers, something that Chinese firms like Pinduoduo have done successfully, says Gaurav Patankar, the head of emerging market equity strategy at Bloomberg intelligence.
As Mukesh Ambani, the richest man of India, and the 152 years old TATA Group mimic platforms for the likes of Tencent Holdings Limited and Alibaba Group Holdings Limited, ITC can also plug another gap granted that New Delhi gives up its addiction.