All triggers played out. Is ITC peaking out?

ITC's defensive characteristics made it an attractive choice for investors.

Tobacco-to-hotels conglomerate ITC briefly tipped HUL, India’s largest consumer company, as the leader in the stock markets on Monday, during intra-day trade. Moments later, the excitement over what was meant to be a shareholder-friendly move – the much anticipated de-merger of the hotels business - turned out to be a dampener. Has ITC peaked out?

ITC has been the subject of much criticism among investors as its stock severely underperformed between 2013 and 2020 while consumer companies flourished. However, since March 2020, the stock defied expectations by rising steadily, drawing attention from investors and analysts alike. As the stock price soared, more analysts turned bullish and more investors joined the bandwagon, propelling the stock even further.

Veteran value investors explain that such languishing periods are inherent in stock markets, and the sentiment often drives short and medium-term performances. However, in the long run, earnings hold the key to stock price movements. In the case of ITC, five factors have contributed to the recent turnaround.

First, the changing perception for cigarettes. For a decade, ITC faced erratic sales volumes in its cigarettes segment, leading to negative perceptions about its potential. Tax hikes too impacted sales. But ITC's volumes have rebounded remarkably in the past two years due to rational taxing that helped it regain the market share and stabilise profits.

Second, ITC's non-cigarettes FMCG business witnessed growing profitability, moving from negligible EBIT margins in FY17 to around 8 percent in FY23. Although lagging behind FMCG peers, this segment's improved profitability is contributing positively to ITC's overall performance now. These two were important fundamental factors that have forced investors to take ITC’s growth seriously.

There are two more market-related factors that too helped the stock. One is the fading away of the anti-ESG (Environment, Social, and Governance) narrative and the comeback of value trades. Companies that showed resilience in earnings, irrespective of what businesses they were operating in, were preferred. Cash piles and cash flows were preferred over growth projections. Be it fossil fuel, or sin businesses, investors are now more focused on economic opportunities rather than strictly adhering to ESG standards.

Additionally, ITC's defensive characteristics made it an attractive choice for investors seeking stability amid uncertainties in the market. The company's predictable revenue and profit growth, bolstered by robust cigarette volumes, add to its appeal as a defensive stock.

Amid all this, the management is also raising the pitch on being shareholder friendly. One of those measures that was talked about was the de-merger of the cash-guzzling hotels business, which was announced finally on July 25. Markets would have liked a vertical split, so the hotels business was completely out of ITC’s books and there would be no ambiguity over future capital allocations, or about lower return on invested capital.

But the management has chosen to retain a 40 percent stake. The only way this can be justified is if the management sells this stake to a strategic investor at a higher price at a later stage, but it complicates the matter anyway. If the remaining stake is sold, the new strategic investor would have to shell out more by making an additional open offer which will make it costlier. That being the case, the sell-out option could have been exercised at any time including now when the hotels business is on a high.

Either way, the most ambitious analyst estimate for the hotel business is not more than Rs 23 per share. The stock closed 4 percent down, losing Rs 21 on July 24. The deal is done, dusted and impact digested in the stock price.

Now what? All the triggers for ITC’s re-rating have played out. The stock still appears undervalued compared to other consumer companies. Its P/E ratio of 31 times trailing earnings versus 60 times for HUL. Nonetheless, ITC's heavy reliance on tobacco, which contributes 75 percent of its overall EBIT, despite representing only 37 percent of revenue, remains a concern.

The perception of cigarettes being a declining business which will always face the wrath of the government will prevent investors from valuing the business highly despite its superb economics. Cigarettes requires absolutely no capital – around 800 percent return on capital - and thus the entire cash flows of cigarettes can be utilised to create new businesses that will have lower profitability but higher longevity.

If the ITC management enhances the return ratios of its consumer businesses – current the FMCG business produces a return on capital of 15 percent - investors can easily justify a higher multiple for ITC from current levels, not equal to what other multinationals command though.

For now, ITC's near and medium-term earnings story looks promising. Besides, the company's strong dividend yield, close to 3 percent, provides some cushion.