ITC Limited – An Enigma to Solve

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Currently, the world is divided on ITC. One group of investors is finding it attractive due to its high dividend yield (5% to 6%) and low PE (13 to 15) and another group of investors thinks that ITC Limited is a value trap. Though it is cheap now it will remain cheap for a long period of time.

Who is right on ITC Limited?

Before we answer that question let’s understand a few financial numbers

ITC Limited

As we can see, though ITC’s sales and profit have grown by 9% and 13% respectively, the stock has delivered only a 5% return over the last 9 years. Reduction in PE multiple to 14 times from 28 times has resulted in this low stock return.

To understand this divergence we need to first understand Capital Allocation Skills of Management and the Competitive Moat of the Company

A. Capital (Mis?) Allocation Skills

One qualitative factor which has affected the valuation of ITC Limited is the market’s view of ITC Limited as a Tobacco Company (Cigarette) than FMCG Company (which ITC Limited management is trying to portray).

Management has not been successful in changing markets’ perceptions about it. The same can be seen in the below numbers.

ITC Limited Financials

As can be seen from above, ITC Limited is able to reduce sales mix from the Cigarette business from 59% to 41% in the last 10 years but it is still dependent on profits generated from the Cigarette business (82% to 84%).

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This is despite the fact that ITC has invested Rs. 4,898 Cr and Rs. 4,212 Cr of total incremental capital of Rs. 13,814 Cr in FMCG-Others and Hotels business respectively.

These businesses are not as profitable as the Cigarette business.

Unless and until ITC Limited is able to generate reasonable returns (ROE of around 30% to 50% and profit margin of around 12% to 15%) from its FMCG-others business, the market will view ITC as a Cigarette Company.

B. Competitive Moat

As per Investopedia:

The term “competitive moat” (popularized by Warren Buffett as an “economic moat”), refers to a business’s ability to maintain competitive advantages in order to protect its long-term profits and market share from competing firms.

ITC Limited is very dominant in the Cigarette business as can be seen from high market share and high-profit margin (10-year average EBIT margin of 48% ).

One of the factors which are helping ITC Limited to dominate this business is “Barriers to Entry”. Due to heavy taxes and a ban on cigarette advertisements, no new company is able to sell its product through heavy marketing which is very essential at the early stage of any business.

In addition to that, smokers get addicted to specific brands. They rarely change their brand (Man is a slave of habits).

But most investors missed in the understanding the difference between “Legacy Moat” and “Reinvestment moat”

Connor Leonard has explained it beautifully –

  1. The “Legacy Moat”:

Businesses with a Legacy Moat possess a solid competitive position that results in healthy profits and strong returns on invested capital. In exceptional cases, a company with a Legacy Moat employs no tangible capital and can modestly grow without requiring additional capital.

However, because there are no reinvestment opportunities offering those same high returns, whatever cash the business generates needs to be deployed elsewhere or shipped back to the owners.

In the case of ITC Limited, they have invested only Rs. 268 crores in the Cigarette business over the last 10 years. They have to deploy excess cash on other businesses like FMCG-Others, Hotels, Paper boards, Paper & Packaging, etc.

  1. The “Reinvestment Moat”:
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There is a second group of companies that have all the benefits of a Legacy Moat, but also have opportunities to deploy incremental capital at high rates because they have a Reinvestment Moat. These companies have their current profits protected by a Legacy Moat, so the core earnings power should be maintained. But instead of shipping the earnings back to the owner at the end of each year, the vast majority of the capital will be retained and deployed into opportunities that stand a high likelihood of producing high returns.

ITC Limited is not having a reinvestment moat as can be seen from its low ROCE and low margin from other businesses.

ITC Limited ROCE

Valuation

The company has decided to distribute 80 to 85% of profit as dividends. So its reinvestment rate comes from 15% to 20%. Assuming ROCE of 35%# over a long period, its intrinsic value growth* over a long period will be in the range of 5% to 7%.

Considering a dividend yield of 5 to 6%, the company is expected to give a 10 to 12% return over a long period of time.

Upside potential: – If ITC Limited is able to turnaround it’s FMCG-other and hotels business, the market will rerate the company, and stock may deliver 20% to 25% return over 10 years

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Downside Risk:- If management is not to able to turnaround the other businesses and the company is not able to maintain or grow its cash flow from the cigarettes business due to heavy taxation or change in government regulation, (Recently Govt. has banned selling loose Cigarettes which will affect sales from young population.

Also there is one study which has estimated that 10% increase in Tax reduced 8% of smokers), ITC will continue to trade at cheap valuation and it will be a value trap.

Conclusion:

If the investors think that it will be a Cigarette Company over the long term, then he/she should stay away from investing in ITC Limited (it will give a low return of 8% to 10%).

But if an investor believes ITC will turn around its FMCG-other and hotel business, he/she should buy the stock with expectations of a significant upside. And also downside is limited due to the current cheap valuation

# Though the 10-year average is 42%, the last 5 years average ROCE of 35% is considered for calculation.

*Intrinsic value growth = Reinvestment growth * ROCE

Also Watch: Understanding ITC Limited Businesses

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Vivek Chitale
Life long learner | Passionate about investing in the stock market | Trying to bring differential insights
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