ITC — An Investor’s Dilemma (Part 3 - FMCG Revenue & Profitability)

As we reach part 3 of our 5 part series on ITC - let's look at the FMCG numbers for ITC. If you haven't read Part 1 and Part 2 read those first.

Let’s take a look at sales first —

• Over the first 5 years (FY14–19), growth has been exceptional at a CAGR of 18%!

• Over the next 5 years (FY15–19) however, the growth slows down to a CAGR of 6.7%

• Overall, in the past 10 years (FY10–19), growth went through a CAGR of 13.1%.

To put things in perspective, let’s benchmark these numbers against other FMCG giants —

For Nestle, we’ve taken FY15–18 for CAGR 5 year and FY10–18 for CAGR 10Y as that’s the data available on screener.in

Clearly, ITC’S FMCG business is growing faster than its peers in terms of revenue. Let’s look at profits (EBIT) and margins (EBITM) —

It’s worth noting that while gross margins for the FMCG business are at par with peers at 40–45%, it’s the low EBIT margins that make the business less profitable. This is because ITC has been organically expanding their product portfolio, and to build evergrowing number of new brands, they need fresh capital. As these brands scale and ITC stops expanding their product mix, margins — and therefore profits will eventually shoot up.

In the next 3 years (FY22), assuming revenue grows at a conservative 6% CAGR (in-line with estimates), and EBIT margins heading for mid-single digits — EBIT from FMCG business translates to roughly 800 crores, which is 2x of what it was in FY19. That translate to profit CAGR of about 20 percent. Look, scratch these assumptions and make your own estimates for all I care, but my point is that when the company focuses on net margins, even conservative numbers translate to disproportionate profits growth. And I’m not asking to commend ITC for that, that’s just how FMCG business is at early stages. That was the story with Hindustan Unilever, or any other FMCG giant that you want to pick and study. These companies (HUL, Nestle etc) have been in business for multiple decades! In their early days, they have jumped from low single digit EBIT margins to 12–13% within a span of 8–9 years too.

Now, I emphasised that EBIT margins are suffering because ITC chooses to expand their portfolio organically and build these brands from scratch. That can change. They can choose to go the acquisition route anytime they want. MD Sanjiv Puri has talked about this in 2019.

We are certainly open to inorganic opportunities to grow our FMCG businesses. We will look at the inorganic route only if it is a strategic fit to our plans and brings in value commensurate to our financial commitment. While we will leverage opportunities for potential acquisitions that will enable us to scale up our businesses, we will continue to build new categories organically.

It wouldn’t be the first time they choose to acquire a brand, they have acquired Savlon from Johnson & Johnson and B-natural juices from Balan Natural foods before, and then there are the rumors of ITC acquiring Sunrise Foods. Thanks to COVID-19, valuations of these brands may be stressed, opening up opportunities for ITC.

Thanks to the cigarettes business being a cash cow, they sure as hell have the cash for it. To understand how much purchasing power ITC has, let’s take a look at the cash they have in surplus after meeting their capital expenses. That’s Free Cash Flow (FCF, calculated as Cash flow Operations — Capex).

Yes, you read that right. ITC has free cash worth HUL’s, Nestle’s, Dabur’s and Marico’s free cash combined. They should be using more of this cash to expand their business inorganically, but they don’t. Instead, they give heavy dividends to their shareholders. ITC is a professionaly run company, which means that there are no active promoters, so things get a bit different — By yielding high dividends, the largest shareholder British American Tobacco Plc and others are able to get money. Infact, they have recently stated that their dividend payout policy over the next few years is expected to be 80–85% of net profit — higher than nearly 69% average over last 3 years. But even barring the money reserved for paying out dividends, ITC should be able to make acquisitions. We’ll just have to wait and watch.

Okay, I’ll quickly address one more thing. I don’t think expecting FMCG’s contribution in the bottomline to be at par with the cigarettes business is reasonable even for the next few years as margins expand. The cigarette business just makes wayyyyy too much money & needs relatively lower capital to run it. So set realistic goals for profits breakup down the line. People just expect too much.

Here are my final thoughts then. Clearly the market isn’t sold on ITC’s ambitions to be a FMCG behemoth yet, because they’re not looking at the long run. Once ITC is content with their topline expansion, they’ll push margins, and bottomline will reflect. It’s not a tough job, they just have to decide when to do it. They may do it sooner than later, like MD Sanjiv Puri has hinted. Or, they may take years (inline with their 2030 targets), and I’m okay with that.

Editors Note: This is a very good example of a discounted cash flow model based on fundamentals as detailed in our blog post.

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