ITC — An Investor’s Dilemma (Part 5 - Valuation, Risks and Concluding Remarks)
As we reach the final part of our series on ITC - we look into the Valuation, Risks, Ethical Dilemma of investing in a sin stock and conclusion
Before I discuss valuations, I want to differentiate between two common understanding of what an investor means by ‘value’. Many investors I’ve are of the opinion that ITC is undervalued as a consequence of only its price decline. That is not my perspective here. I want to stress on what Joel Greenblatt had to say about Buffet’s investing philosophy overlapping with Ben Graham’s to illustrate my point —
One of Buffett’s major contributions has been to extend the idea of value beyond the simply “cheap.” Buffett looks for “good” businesses that are available at an attractive price. The concept of growth is incorporated into the calculation of value. This estimate of value includes an estimate for future growth in earnings or cash flow.
Therefore, the best we can do is to correctly estimate the value of a business, and buy it for less than that. Ideally, much less than it. The bigger the mismatch between a company’s market price and it’s intrinsic value, the more margin of safety you get while purchasing it. A company can be ‘cheap’ as per the market price, but don’t make the expensive mistake of presuming it is undervalued too. So is ITC undervalued or cheap? I extend the idea of value to be inclusive of future cash flows, and my investment thesis is built upon 1) topline expansion in cigarettes business & 2) bottomline expansion in FMCG business. Therefore, I’m inclined to believe that ITC is infact priced lower than it should be. Perhaps I’m right, or perhaps I’m wrong. As a value investor, it may take years to comprehend whether I am right or wrong.
Value investing is hard when compared to other professions like law or medicine. A big part of the reason for that is the feedback is delayed. That makes it very hard to separate skill from luck. In value investing, the results of investment operations take a long time, sometimes years. — Professor Sanjay Bakshi
Ben Graham famously said — The market is a “weighing machine” over the long term, even if it is often emotional over the short term. So let’s let the market weigh. It is entirely possible that the market has perhaps discounted ITC’s ‘value’ adjusting for the risk of never being able to expand it’s topline in cigarettes business and bottomline in FMCG business, but my opinion is that perhaps that discount is too harsh, if not unwarranted as a consequence of my conviction that these are eventualities and not possibilities. It is a tangible fact that the quantum of loss of revenue for the government is high due to trade of illegal market place. It is also a tangible fact that ITC has to stop expansion some time and scale up margins. I like to look at EV/EBIT multiples more than other ratios available, and at a multiple of less than 10, I believe ITC is significantly priced lower than the business’s inherent value.
ESG Commitments of Institutional Investors — With 75–85 percent of profits generated from selling cigarettes, there is a lot of capital adhered to sustainable and responsible investing that won’t touch ITC as a consequnce of persuasion from various activist groups and regulations. According to Wikipedia, about 1500 instituitions signed United Nations’ Principles for Responsible Investing with AUM worth $60 trillion as of 2006. For a liquid stock like ITC, flows from institutions may be needed to move the stock.
Capital misallocation — As far as I understand, the hotels business is making very low returns, yet for the last decade roughly 30% of the total capital employed for businesses has been towards the hotel business, for which return on capital employed (ROCE) has been very low (1–3% in last few years). The capital employed (Hotels) stood at 6,665 crores as of FY19. Till FY10, it was 2520 crores. So roughly 4150 crores have been allocated to hotels business in this decade, which has been subject to ROCE of just roughly 4.5% on an average. Apart from Hotels business, ITC has accumulated a lot of cash that’s sitting in investments that are not related to ITC’s core businesses. But with the new dividend policy, that’ll stop for the coming years. As for the cash that’s already accumulated, it can be used to re-invest in businesses or be given to shareholders in the form of dividends.
No Buybacks — As mentioned earlier, the management is cautious about BAT’s stake being increased to a controlling position, therefore I can’t expect buybacks anytime soon. Too bad, perhaps a buyback is warranted to represent how undervalued ITC is.
SUUTI/LIC Stake Overhang — Specified Undertaking of Unit Trust of India, or SUUTI in short, holds 8 percent stake in ITC. It has previously been inclined to not sell it’s stake so as to defend ITC against hostile takeovers. It may eventually sell it’s stake to raise funds for the government’s disvestment targets if they feel ITC can prevent such takeovers. LIC may want to sell their stake as they prepare for their IPOs. These selloffs could be supply overhangs in the market.
Ethical dilemma while investing in a sin stock For all practical purposes, ITC is primarily a cigarettes business for now. While the impact smoking leaves to the society is negative in essence, realise that a majority of money made by the cigarettes business flows to ethically good avenues —
Tax revenue for the government collected as a result of cigarettes sales is used for the welfare of the people. Legal cigarettes only account for 10% of tobacco consumed in India but is still responsible for more than 75% of the taxes paid by the industry.
Profits realised by ITC itself by the cigarettes business gets reinvested in businesses that are non-smoking related.
Apart from that, the e-Choupal network run by ITC is a blessing in disguise for many farmers in the country, specially for the ones engaged in farming of tobacco leaves as there are very limited avenues for them (Indian tobacco leaves don’t get exported as they’re of inferior quality).
ITC is also planning to open a non-profit hospital business for the underprevileged in India. As for the harm caused to the enviornment that is caused by smokable tobacco, it may be worthwhile to know that ITC is the only corporation in the world to be carbon positive for 14 years, water positive for 17 years and solid waste recycling positive for 12 years.
Now I know the argument is going to be whether they do it to attract ESG funds, but I don’t care what causes these actions, as long as they are taken. The realisation of these actions is observable in the real world, and that’s all that matters.
As a consequence of significant loss of revenue for the GOI, I see ease in regulations & taxations of cigarettes in the coming years. More market share for legal cigarettes will drive more tax revenue for the government, therefore there will be curbs to put a stop to the illegal trade market. Besides this, the hit taken by tobacco farmers puts significant political capital of the ruling party at risk. The opportunity to benefit these farmers aligns with the Prime Minister’s ambitions to double farmer’s income. As a result of these circumstances and the quantum of the losses taken by various stakeholders, I see these steps as an eventuality instead of a possibility in the coming years.
Topline growth in FMCG business as well as market leadership in some segments in a short amount of time deserves credit. Opportunities for inorganic growth are open as company holds a lot of cash. Gross margins are standard compared against peers. When the management sees fit, it will stop entering new segments to put a stop to product gestation costs, followed by expansion in net margins. That will boost the bottomline of FMCG business. This may or may not take time.
Combined with belief that ITC’s market price is significantly lower than it’s value, an investment provides high margin of safety, and thus buying ITC appears very attractive to me.
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. Also note that this post should not be construed as investment advice.