Tuesday, March 18, 2014

ITC Limited - Smörgåsbord of quality, ethics and pricing?

BSE: 500875|NSE: ITC|ISIN: INE154A01025

Contrary to popular belief ITC is still largely a tobacco company with over 75% of the profits coming from the tobacco business. I still dont know who really owns the company. Financial performance is brilliant. The national public health foundation is running cigarrette ads which dont seem to be hurting ITCs financials. Also there is the ethical angle on this company - which is complex due to their cigarette activities being balanced by their hugely successful CSR activities.

1. How good is the moat?

Grade A+ moat.


  • Cigarette business is rock solid. They have over 80% market share and no new entrants into the industry are allowed. FDI is also banned. Nothing better than this moat. Question is can they export the cigarettes?
  • The company has over the years smartly built many businesses around the original tobacco business and brought tobacco revenues to 42% in FY 2013 from 79.4% in FY 2003 or but profit % from tobacco are still is 75% in FY 2013 down from 90% in FY 20013. The quest really remains whether this company can transform itself to become a proper FMCG player outside of tobacco. The company has made a huge effort in this regard.
  • Brand - in the Cigarettes space it has an over 70% market share where the moat is great but in the rest of the areas there might be an issue.
  • Sales & distribution: 100K markets directly serviced & over 20 Lakh retail outlets. Probably one of the biggest FMCG retail networks
  • Vendors - Innovations like e-Choupal enable ITC to procure agri products at very low prices while benefiting the farmers
  • ROE - The Return on equity on the cigarettes business is over 90%, Agri is 26% and the rest are pretty much not so great use of capital
Segment ROE % of revenue % of Capital
Cigaretts 94% 41.6% 27.6%
Other FMCG 0% 21.2% 16.7%
Hotels 1% 3.0% 18.9%
Agri 26% 21.0% 9.5%
Paper&board 9% 13.2% 27.4%


2. Risks

  • The cigarettes business still is growing but is likely to abate at some point due to the health organizations chasing the business. By the time that happens maybe the other businesses would not have picked up.
  • Rapid regulatory changes could hurt the cigarettes business giving ITC not enough time to recoup.
  • I think the hotels, agri, FMCG and other businesses might be a good way to advertise the cigarettes which again brings to fore the ethical question.

3. Financials

  • FX exposure - the business overall is a net exporter of about 5% of revenues. It does repatriate about 1000 Crores of dividends to overseas shareholders making it only a 2% to 2.5% net FX earner - of course the dividend sent overseas does not impact the company performance.
  • CFO and Net income are within 3% of each other.
  • Stock options dilution - This is a bit of an issue with the stock. They do recognize the black Scholes value of the options but whether they market to market the option dilution later is yet to be seen. Volume of options granted in FY2013 will cause dilution to the tune of around 1.1%. Which is high but not a game changer.
  • ROCE is consistently high
  • Debt is zero
  • Working capital is marginally negative - but this contains a provision for dividends which if taken out working capital would be less than 3% of sales. Very efficient!
  • Dividend % of earnings is very high - over 50% in all years - even 100% in some years. Basically the company needs to find good avenues for utilizing the capital. Hotels seems to be not a great way of utilizing the capital - unless they are a real estate play.
  • Not much goodwill on the balance sheet to be worried about.

4. Soft factors

  • Shareholding
    • I have no clue who the promoter is. The largest shareholder is listed on the annual report as Tobacco Manufacturers (India) Limited. This company cannot be found on the MCA website.
    • British american tobacco holds 30% of the company and currently claims to not want to increase its stake as per the news story linked here
  • Some reports suggest that the global tobacco industry is growing at 4.5%.
  • Ethics - is investing in a tobacco company irresponsible? Given the huge activism against the industry its probably seems irresponsible but the question really is that if we stop investing in these companies does that stop people from smoking? I will leave that thought for you to answer and the experts to ponder.
  • Growth - the agri business can grow. Cigarettes growth will have to come through exports. 

5. Pricing


  • Very hard to price as the growth of the cigarettes business is what is going to grow the bottom line and the overhang on that is hard to predict - per capital consumption in India is low but the public health administration in India is trying their best to get people to quit. Even if we assume that the company is able to grow bottom lines by 20% for 10 years (which is a very aggressive assumption) and then 10% after that the valuation would enable us to buy the stock at a 20 times multiple or so. For this to be a value investment I would say it would need to trade at 15 times or so.
  • Price to book is fairly irrelevant with such a high dividend % of earnings, no debt and ROE.