ITC — An Investor’s Dilemma (Part 1 - Cigarette Business)
As of today, May 3 2020, the Indian financial twitter is split between ITC’s believers and naysayers. In a few years, one of the two factions will have won the righteous authority to say ‘I told you so’.
ITC is involved in broadly five businesses -
Fast-moving Consumer Goods
Paperboard & Packaging
Hotels & Hospitality
We’ll look more in-depth into the FMCG & Cigarettes businesses as those are the business I’m interested in betting on. I see the agriculture and paperboard & packaging verticals as quasi-proxies to the FMCG & Cigarettes businesses. Therefore to keep things to the point, their implications on these business will be the extent to which I will cover them. I don’t like the Hotels & Hospitality business & for the sake of keeping this post short, I won’t explore that avenue.
For some context I’ll first point out a few blueprints/strategies that I’ve observed spilling over different businesses that ITC manages. They will help you understand how ITC approaches new segments.
Key Business Strategies
Backward Integration — ITC has nested backward-integration deep into their supply chains as a core business strategy. Backward-integration is lingo for when a company produces parts of it’s supply chain internally. ITC sources raw materials it needs through its e-Choupal network of 4-million-plus farmers to produce Cigarettes & FMCG goods. ITC’s paper plants supply raw material for Classmates & Paperkraft notebooks, and their packaging segment is responsible for packaging Cigarettes & FMCG products. Recently, the company noted that they will use their dairy sourcing capabilities to enter mass-market chocolates segment with Fabelle. Capitalising on these integrations allows ITC to have reasonable control over costs of raw materials procured to produce cigarettes & FMCG products. In the long haul, this gives ITC a significant competitive advantage, or as investing folks like to call it, moat.
Top-down Approach — In their early days, ITC used top-down approach in building their Cigarette brands. To put it simply, ITC entered the premium pricing range in any segment it wanted to tap. After building a succesful mother brand, it moved to enter mass segments by moving down the value chain. It worked for them in the cigarettes segment, so they incorporated it in entering new FMCG segments. Building succesful business models and replicating them benefits companies massively in the long run. They help the company to validate their strategies with the least risk taken consistently by providing a confined framework. It’s a playbook. All they need to do is recognise these models and clone them.
Off-topic: I’ve found it beneficial to clone mental models (similar to business models) laid down by great people. IMost value investors, for example, clone Warren Buffet’s and by extension Ben Graham’s mental models. They’re abstract blueprints to build your thought process around. I’m not necessarily advocating for models built upon investment philosophies specifically, you could for example replicate Steve Jobs’ mental model when it comes to running businesses.
A few instances amongst many where I’ve observed them taking this approach —
ITC entered the stationery business with Paperkraft (premium, expensive range) in 2002 and established a brand in the segment. Then, they went ahead with a massmarket range of stationary products with Classmate in 2003. By 2007, Classmate had become the largest notebook brand in India.
In 2005, ITC entered the personal care segment with premium range brand Essenza Di Wills, followed by sub-premium range Fiama Di Wills within two years, then mid-segment Vivel and eventually the massmarket range under the brand Superia. (They’ve also entered a niche segment of personal care products endorsed & made by dermatologists and biologist since then). With the failure of Superia, they launched another massmarket brand Engage. Fiama has the #2 position in its segment, Vivel has a consumer spend of over 500 crores & Engage holds #2 position in deoderants with a consumer spend of 330 crores.
Recently, the company has entered premium chocolates business under the brand Fabelle. By first looks it appears that they’re looking to take on Mondelez’s (Dairy Milk) & Nestle’s premium chocolates, and then widening its access through lower price points.
Umbrella Branding — ITC has recently incorporated umbrella branding (or brand extension) as a way to expand its portfolio in FMCG. Simply put, it’s a practice of using well established mother brands with loyal customers to sell products that come under the same segment. A good example to showcase is how Nestle uses the motherbrand Maggi to sell ketchup. Brand extension has been fruitful for them. Aashirvaad, one of ITC’s flagship brands now sells staples such as salt, dairy products, spices & instant mix packages. Going forward, scaling up these motherbrands and capitalising on them is the path to profitability for their FMCG business. Managing director Sanjiv Puri agrees. The focus right now is on scaling up some of the categories that we have forayed into in recent times rather than adding newer categories
Product Differentiation — ITC takes on segments where the market leader holds an agressive position, gains significant market share & then attempts to differentiate their product by innovating in the space. How? They try and look for what grinds the consumer’s gears. Few instances that showcase this —
ITC noted that kids preferred longer length noodles that they’re able to slurp, and that in order to cook instant noodles such as Nestle’s Maggi, it had to be broken into pieces to be placed in a round-bottom shaped utensil, which are typical in an Indian household. Therefore, Yippee! launched a round shaped cake that could be cooked in utensils without being broken.
ITC observed that while most Indian dishes were traditionally made in two different curries: yellow (haldi) and orange (tomato based), Nestle sold only one kind of masala with Maggi. ITC started giving consumers a choice between the two variants. (Note that this was early on, now both Yippee and others have a wide variety of flavors.)
ITC’s Master Chefs is taking on frozen food competitors McCain and Venky by offering products that are not available in India — prawns, middle-eastern cuisines like falafel, and pin-specific flavors like chicken galauti (the company relies on its hotel business’s chefs for insights on which flavors would sell best).
Obsession on Quality — ITC aims to deliver products of the highest possible quality. Until a product achieve that bar, it’s not internally approved. Take Fabelle for example, it was on ITC’s launchpad for a decade before it finally got approved in 2016, and by then it had raw materials such as cocoa sourced from highest quality growing regions in the world.
“Our commitment was to craft the finest luxury chocolates in India that rival the best in the world. When we entered foods, there were well entrenched local and global players. But our strategy was clear — to develop superior and differentiated offerings that could win in the marketplace. When we launched Aashirvaad atta, people asked us how you can differentiate — it’s a commodity. The objective was not just to sell atta but ensure that consumers could enjoy soft chapatis on a consistent basis.” — Executive Director B Sumant
There are more bricks such as these ITC builds their business model upon when moving into a new segment, but these are a few which I find inherent to most of their product launches. They will hopefully help you navigate the company’s sometimes controversial entries in a market. For example, I’ve seen many people criticise Fabelle’s entry in a premium range instead of going directly to a low costing massmarket segment, even though the top down approach has worked for them so far.
Profit & Revenue Breakup
Let’s take a look at the breakup of revenues and profits. As I’ve mentioned earlier, I’ll talk about what’s tangible & won’t speculate with surreal projections. That right is only reserved for self-proclaimed superstar analyst and yours-friendly brokerage houses.
A few observations —
FMCG makes up for 25 percent of revenue. But this won’t translate well for profits as we’ll see in a moment.
Cigarettes are responsible for 46 percent of revenue.
Cigarettes contributes to 80.3 percent of the profits.
While FMCG makes up for 25% of revenue, they chip in for just 2.1 percent of the profits. More on this while analysing FMCG business later.
As you’ll rightly observe, the cigarette business is more significant to the bottomline of the company than any other businesses, so let’s start with it first.
ITC is the largest cigarettes seller in India, accounting for roughly 85 percent market share in the legal cigarettes market in the country. It is important to emphasise that I’ve used legal trade as the benchmark — for reasons I’ll talk about in a few moments. Roughly 10% of the world’s tobacco smokers live in India, representing the second largest group of smokers in the world after China.
ITC’s cigarette brands include Wills Navy Cut, Gold Flake, Insignia, India Kings, Classic, 555, Silk Cut, Scissors, Capstan, Berkeley, Bristol, Lucky Strike, Players, Flake and Duke & Royal. The wide portfolio of brands allow ITC to cater to every consumer demographics. That, the nature of brand loyalty fundamental to smokers, & the time in the industry has allowed ITC to permanently engrave its place in the cigarettes industry in India. Heavy regulations & taxations (specially in terms of illegal nature of advertisements related to tobacco products) make it impossible for any of ITC’s peers to setup operations on a similar scale. Therefore, it’s not surprising that ITC has the biggest slice of the pie.
As a consequence of this big a market share, ITC is able to exercise pricing power in the market to push down costs to consumers. This is important, since the government of India has time and again raised taxes in terms of a whopping 64% excise duty, 25% GST & 5% cess! Why? Well here’s the deal — The goverment collects about 35,000 crores from taxing legal cigarettes every year. With a tough fiscal position such as ours, the goverment hopes to pull all the strings it can to manage the deficit. I get it, if some one has to be punitively taxed, getting to smokers & company in the list doesn’t take much time.
The problem is Indians can barely afford to smoke cigarettes anymore. Take a look at the relative money required to pick up a smoking habit in India versus other countries -
Now, if you know smokers, you know they’re not quitters. There are only a couple ways this can go —
Smokers who really can’t afford cigarettes will turn to inferior products such as bidis.
An alternative market is open for cigarettes that are cheaper, sometimes by means of being traded illegally.
Now, either of the consequences hurts the government’s ability to collect high revenues from taxing cigarettes. Bidis are taxed disproportionately lower than cigarettes as the government doesn’t want to hurt the rural employment that comes as a consequence of production of bidis. They can’t afford to hurt tobacco leaf farmers. Cheaper trade of cigerrates can refer to cigarettes that are either duty-free, smuggled, or even worse, counterfeit ones. Infact, ITC made an effort to put a number to the losses in tax revenues due to this -
It is estimated that on account of illegal cigarettes alone, the revenue loss to the Government is more than 13000 crores per year. About 68% of the tobacco consumed in the country remains outside the tax net.
Why does the government push their limits on taxation then? Now, it’s plausible that the government wants to get smokers to quit. It is estimated that one in every six death due to tobacco-related health issues globaly happens in India. However the fault with that argument is simple — Taxation hasn’t been able to hit intended goals anywhere in the world. While the overall consumption of cigarettes is not in a decline in India, the market share of legal cigarettes is. Therefore, it’s evident that not only does taxation fail in it’s purpose, it leads to incentivising illegal participants in the market, and hence hurts the government’s ability to collect significant revenue.
With a fiscal position such as ours, the government will evetually have to ease the burden on legal cigarettes, or really really really clamp down on the illegal trade. Either way, ITC benefits. And they know that, which is why they have interest groups lobbying for them all the time.
Alright, just a few more things that should be noted.
One, being a legal cigarette seller, ITC’s brands have to abide by ‘The Cigarettes & Other Products Act, 2003’, and therefore bear the textual warnings covering 85% of the surface area of the carton. On the other hand, smuggled cigarettes don’t have any warnings or bear much smaller pictorial warnings as per the laws of the countries from where they originate from. ITC says that an independent market research organisation concluded in their study that —
The lack of warnings on packets of smuggled cigarettes create a perception in the consumer’s mind that smuggled cigarettes are ‘safer’ than cigarettes that carry the 85% pictorial warnings.
So, as long as there are cartons with softer or sometimes no warnings, the net effect of legal cigarettes bearing the discriminatory warning is actually negative. ITC and other stakeholders challenged the validity of these warnings & subsequently the Karnataka High Court held in late 2017 that the ‘pictorial warnings with extremely gruesome imagery are factually incorrect and unconstitutional.’ But upon a ‘Special Leave Petition’ filed by the Government, the Supreme Court stayed the order of the High Court. Unfortunate.
And Two, other countries such as the United States have taken into account the economic interests of tobacco farmers while constructing regulatory frameworks for the sale of cigarettes. India is the third biggest tobacco producer in the world, and according to ITC, 46 million lives are impacted when it comes to value chain of tobacco in India. It is estimated that in the four years since 2013–14, Indian tobacco farmers suffered a cumulative drop in earnings of over 4000 crores. A point at which the harsh impact on tobacco farmers outweigh the reasonable consideration of taxation has to exist. As it turns out, the time is ripe for all this. The opportunity to ease taxation and regulation for the sake of farmers aligns with the Prime Minister’s vision of doubling farmers income by 2030. Sorry to put it bluntly, but that’s 46 million units in political capital.
With all that out of the way, let’s make sense of the numbers
Revenues from FY18 & FY19 are not comparable as a result of change in accounting standards. IAS 18 results in subtraction of certain taxes from gross revenues, that were added in FY10–17.
Taking a look at revenues from cigarettes business first —
Right off the bat you’ll notice that the revenue generated by cigarettes business has been declining in the past two years. This is a consequence of being adjusted for GST (earlier numbers (FY10–17) had certain taxes added to it, Indian accounting standard 18 resulted in GST, GST compensation cess, & VAT to be excluded from gross revenues) With a ten year outlook, the growth has been poor for the same reason. In nominal terms—
Over the last 5 years, revenue from cigarettes went through a CAGR of -6.4 percent.
Over the last 10 years, revenue went through a CAGR of just 2.4 percent.
Let’s take a look at segmental profits (EBIT) —
In nominal terms,
Over the last 5 years, profits from cigarettes underwent a CAGR of 5.8 percent.
Over the 10 year period, profits from cigarettes went through a CAGR of 11.7 percent.
Let’s look at operating margins to see what’s going on
Since the revenue have gone down in the past two years as a result of new accounting standards, margins have gone up being adjusted for that. On average, margins have impressively been 47 percent and 39 percent over 5 years and 10 years respectively.
Okay, let’s also take a look at how profitable ITC’s cigarettes business is compared to its peers. For this I’ll use Return on Capital Employed. It is a useful ratio for comparing relative profitability of companies involved in the same business after taking into account the amount of capital used. We’ll also check out how operating margins stack up. For both, I’ve taken 5 year averages under consideration (FY15-FY19).
Clearly, ITC’s cigarettes business can hold it’s own. It maybe worthwhile to look at the business that’s responsible for roughly 45 percent of revenue and 80 percent of profits (EBIT) and see how it stacks up against its competitors in terms of growth.
For Godfrey Philips, instead of 10YCAGR, we’ve taken 9Y CAGR as that’s when Screener.in started reporting segmental numbers for the company.There’s no denying, VST has significantly outperformed ITC’s business in terms of profit growth. Comparison for If organic profit growth for the cigarettes business are the parameters you’re looking for, perhaps you should consider betting on VST instead. Not that past performance is indicative of future performance, but you already know that.
So my closing thoughts are this — Look, although sales growth has been sub-par, profits have been decent. Benchmarking profitability versus other players, I’m convinced that ITC is able to stack up. That’s important to me, because my play here is ease of taxation, regulation (graphic content on the boxes), and scrutiny of illegal cigarette trade by the government to make up for the lost tax revenue. If any of this happen, which I do for the reasons I’ve cited above, growth in the legal cigarettes market will be disproportionate anyway, and you’ll see big value in ITC’s market leadership when it outperforms in terms of profitability.
Disclaimer: This post originally appeared on the Medium account of Divyansh Agnani and has been reproduced here (with certain minor edits) with his kind permission. Do follow Divyansh's medium profile to see the excellent coverage of ITC. This article does not represent Galactic Advisors views and should not be construed as professional advice.