ITC – Is 'Capital Misallocation' a narrative fallacy or a reality?

The share of ITC is at seven-eight year low after the current market turmoil and because of several reasons related to its business:

a) The escalating and unprecedented tax burden on legal cigarettes which has trebled between 2012-13 and 2017-18.

b) The legal cigarette industry’s volume growth has declined steadily since 2010-11 at a compound annual rate of over 4% p.a., while illegal industry’s volume growth, in contrast, has grown at nearly 5% p.a. during the same period which forms 1/4th of the Cigarette Industry in India.

c) The company has moved from high RoCE cigarette business to FMCG business which has a longer gestation period to build brands and low RoCE hotel business. Also, the company has accumulated thousands of crores of net cash and non-core investments on the balance sheet.

More on Capital Allocation:

While everyone has their own opinion on capital allocation of ITC and most of them being negative, I will put my two cents on the same by going through some numbers of ITC.

In the past 10 years (2010-19), the company has generated cash flow from operations (CFO) of 86,689 crores and out the total CFO, the company has distributed 53.2% of CFO as dividends (i.e. 46,121 crores)

Of the remaining 40,568 crores, the company has allocated 13,479 crores across different business segments as follows:

So, what about the remaining 27,000 crores?

The company has accumulated approximately 27,000 crores of surplus cash and non-core investments in the past decade. As a result, the unadjusted RoE (RoE unadjusted for cash and none-core investments) has decreased drastically.

Summary of Data Points:

Future ahead:

The company’s cash cow, the Cigarette business is generating approximately 12,000 crores of cash flows each year on the capital of 4,000 crores i.e. 300% post-tax return on capital, probably the highest return on capital generating business globally and in India. But the industry is in a declining stage and cigarette business hardly requires any reinvestment. The company has reinvested just 1% of the last 10 years cumulative cash flows in the cigarette business.

And that’s why the company is building other businesses for the future with the cash flows generated by cigarette business.

The vital point here to understand is that the return of incremental capital will be lower relative to the current return on capital and the number will decline with the decline of the cigarette business.

Cigarette Business still contributes 85% of EBIT (Earnings Before Interest and Tax) and growing at high single-digit:

Segment EBIT in %:

EBIT Growth:

Cigarette business still contributes 85% of EBIT and it is growing at a healthier rate despite negative growth in volumes. The EBIT growth is healthy because of the pricing power of the company, as pricing is covering for the volume growth, tax burden as well as for further growth. However, it will not continue perpetually.

The high growth in profitability of Hotels and FMCG business in the last 3-4 years is because of improvement in margins from a very low base.

I am emphasizing more on hotel and FMCG business and not on Agri and Paper business because those businesses are relatively stable and proved as they have generated relatively better spread in terms of return on capital over the cost of capital. While the company has been making a much higher investment in FMCG and Hotel business as can be seen in the following data:

Trend of reinvestment in different businesses as a % of CFO:

Return on Capital of different Business:

As I already mentioned, Cigarette business generates RoCE in the north of 250-300%, let us see what kind of RoCE other businesses have generated in the past 10 years and what kind of potential there is for improvement.

Agri-Business has consistently generated a return on capital over the cost of capital but in recent times it has subdued because the company has invested close to 1300 crores in this business in the last 5 years, while Indian crop output of Flue-Cured Virginia (FCV) tobacco has dropped over 30% in the last 5 years. However, this business is very important for procurement of raw material for all other businesses.

Paper boards, Paper and Packaging business has consistently generated 16 to 22% return on capital despite the cyclical nature of business. The main reason is the company’s ability to procure raw material at a competitive cost and other cost efficiencies. The company directly purchases wood from farmers and has integrated capacity for pulp leading to reduced dependence on imported pulp and thereby cost savings. In the past few years, the growth is mainly driven by specialty paper business and company continue to invest in the same.

As I already mentioned, FMCG business has a longer gestation period. All developed FMCG businesses which generate a significantly higher return on capital have been built over decades and not years. So, it is impractical for ITC to build the business in a few years. Even though ITC started its FMCG operations in the early 1900s but the main focus and investment are shifted in the past decade or two.

The following list includes companies which have survived through all the business cycles. Given that the ITC has cash cow in the form of Cigarette business, they can build the FMCG business over the next decade or two. Some of the brands are already generating revenue in the north of 1,000-4,000 crores. Another action which we may see from ITC is to cut unprofitable brands.

The question is whether the ITC can generate a return on capital in the north of 20% or so?

Probably, yes.

RoCE is a result of asset turnover and Margins. FMCG business of ITC has churned assets near 2x-2.5x in the last decade and margins have improved from -10% in FY10 to 3.2% in FY19. If the company can churn assets at the same rate and margins improve from 3% to let say 8-10% in the next 5-7 year, the company will generate pre-tax RoCE near 18-20%. All the above-mentioned FMCG companies earn EBIT margins between 15-25%. For example, a company like Britannia had an EBIT margin of 3-4% in FY10 and has increased to 15-16% in FY19.

If ITC can replicate something like this, it will be unprecedented. But even if they can increase margins to 8% in the next 8-10 years and if the revenue grows at 10%, the EBIT which you will see should be near 2,500-2,600 crores, which implies EBIT growth of 21% and 18-20% RoCE. Even if the company achieves this 2,500-2,600 EBIT, it will be 1/5th of the cigarette business’s current EBIT.

And the most gruesome business segment of ITC, hotel business, where the company has invested nearly 4,000 crores in the last decade with a total capital employed of 6,600 crores, highest across all segment, barely generate any profits. It has more to do with the Industry as a whole than ITC in particular.

The average RoCE of hotel industry in the last 18 years is 9% and the last 10 years is 6%, below the cost of debt.

Dividend Payout and Investment:

Over the past decade, ITC has reinvested 16% of its cash flows and distributed 53% of cash flows as a dividend. And the rest of cash flows has been invested in assets yielding 7-9%. But now with the new dividend policy, the company has decided to offer 80-85% of its profit after tax (PAT) as dividend to its shareholders, which will be effective from the current financial year, which implies the company will not accumulate further cash on the balance sheet. Also, the board may consider distributing non-core investment on the Balance sheet in the form of a special dividend.

Conclusion:

Given that the cigarette industry is in the declining stage, reinvesting cash flows generated from cigarette business for building new businesses for the future is marching in the right direction. But investing in a business like hotel, where the industry’s return on capital has not beaten even the cost of debt, was not the right decision in my view. But anyway, the company has invested just 5% of its cash flows in the hotel business.

And the second point that the company has accumulated cash in the north of 25,000 crores on the balance sheet in the business which does not require so much cash was always a bad decision. But the company is trying to rectify it by changing the dividend policy.

In a nutshell, ITC has acceptably allocated capital. The decline of return on capital was on the wall with the decline of the cigarette business.