What price to pay for ITC

Valuation Summary –

ITC has produced net CAGR Profit growth of 14% over the past decade, mainly led by Cigarette business .

However, As is evident from the below table, In last 10 years-

  • Almost all returns have arrived from the Cigarette biz. which has been the undoubtedly the best. The segment generated significant growth in PAT without any major CAPEX . Hence, was a wonderful business and cash generating machine
  • Hotels business has been a poor cyclic performer. Its returns are very poor and is a capital destroyer.
  • Agri, Paper & packaging grew as Capital invested grew (in same proportion) maintaining decent average ROCE
                      2009
Sales        Profit           Capital
                    2019
Sales          Profit             Capital
Cigarette15,000      3100            360022,915        12,000         4,000
FMCG3,000         -500            220012,515        240               6,224
Hotels1,086         234             22501,746          126               6,700
Agriculture3,845         176             10009,569          560               3,400
Paper & Packaging2,821         350             37003,695          800               5,800
Total26,800      3,350          12,750                   13,926         26,124

Valuation

  • ITC has cash and equivalents of Rs. 30/share
  • The Cigarette biz is a cash –cow (with limited –to-no-growth potential) , generating Annual EPS of Rs 9 commanding a no growth valuation = 100/share. With so much regulatory oversight and heavy tax implications, I would keep the assumption that the PAT wont grow, hence consider no growth in profits for cig. SegmentNote : No growth valuation = Sustainable Earnings per year/Rate of alternate investment. For me, alternative investments (safe) provides returns of 8.5% … any retained capital in ITC that generates less returns than 9% is a value lost to me. Hence cigarette business is worth 90 Rs/share
  • Currently, hotels is a business segment, which is a value destroyer… which means it is negating the overall valuation of the firm.. It will consume OPEX from cig. Biz to grow this segment and will continue to do so for a longer period of time. Additionally, with Covid impact, this may even get worse. Hotels biz. generates FCF of -1 Rs/share, decrementing valuation of ~ Rs 10 per share
  • FMCG business is picking up profitability, and it can still take 5 yrs or so till the segment is self-sufficient, which is to ensure that OPEX from FMCG only is used for FMCG CAPEX. Hence, i expect that by 2025, the segment to be self sufficient but before that, to continue absorb cash .To be on conservative side, it would value this at Zero.
  • Paper & Packaging and Agri biz. with current ROCE generates no growth valuation of Rs. 12/share.

Total Valuation = 30 (Cash) + 90 (Cigarette) -10 (Hotels) + 0 (FMCG) + 12 (Paper) = Rs 132/share

My valuation calculation doesn’t need excels and complicated models. It is based on super conservative estimates that ensures safety of capital .The margin of safety is the growth . Any growth that company does (which is not currently) accounted for, will be additional returns for me beyond 9% that has been assumed as a baseline. Since the future is very uncertain, I don”t place premiums on growth . Any growth in the company that beats my conservative valuation tactics if it happens, will only provide me a positive surprise. As I firmly believe, that money is in the waiting – Waiting for the right opportunity and not acting till you get it. And even after buying a stock/asset, waiting for the sufficient time for it to grow .

I firmly believe that any investment in a stock should fulfil the three criteria-

a) It must be bought at a valuation that protects the downside. The risks that one take in putting one’s hard earned cash should have sufficient margin of safety to get invested in a stock. One must be able to sleep comfortably believing that you own a good business at fair valuation, especially if you are investing a significant capital to it.

b) Valuation must be highly conservative . Even conservative valuation must aim to beat the highest tax-free alternative Provident Fund (which currently pays around 8.5%) as well as the index (Sensex).

c) The price at which stock is bought must have the room for it to provide positive surprises.

Nevertheless, I didn’t buy ITC assuming it wont ever grow as I anticipate a lot of upside potential adding to my returns if ITC is bought around the above valuation (not exceeding Rs. 150). I personally own ITC in my own portfolio with avg price around this number.The likely upsides include-

  1. Favorable Opportunities to continue to grow PAT for cigarette biz , as ITC has been doing in the past
  2. FMCG getting out of gestation and cash burning segment to major cash generating segment. As in our valuation, we have assigned 0 to this segment. As ITC management quoted below on the FMCG Segment-

“Yes, in the short-term, there are costs of having additional capacities but ultimately it will make us  more efficient and we are very confident that we are in the right direction as  far as that is concerned.”

“Besides this, there are gestating costs of newer categories. If you look at our portfolio, we have categories that I would say not even nascent, we are incubating. We are building on the brands and therefore at the right time, we will get to the market. So there are costs associated with that.

But as our older categories,  Aashirvaad is a Rs 4,000 crore plus brand, Sunfeast is Rs 3,000 crore, we have  three brands that have crossed Rs 1,000 crore mark, which is Bingo, Yippee and Classmate. So as our earlier brands have started to get scaled, I think they are now in a position at a profit and loss (P&L) level to more than support the investments that we are going to make in the newer categories. So we will see a much better trajectory but yes, it will be a while before we get to the benchmark level of profitability where we will be”

4. Possibilities to spinoff hotels segment or convert it into asset light business.

Note : the above assessment was done in March 2020. Pls feel free to reach out to me for any questions or comments .

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