Our take on... ITC demerger
Dear readers,
We are now starting a weekly segment called ‘Our take on...’. We will focus this segment to discuss any important event that is on top of our head. It may or may not concern our portfolio or the way we identify potential investment opportunities.
The demerger of Indian Tobacco Company (ITC)
ITC, one of India's largest conglomerates, has announced its plan to demerge its FMCG, hotels, paperboards and packaging businesses into three separate entities. The move is aimed at unlocking value for shareholders and enhancing focus on each segment. The demerger is expected to be completed by the end of the next fiscal year.
According to the company, the demerger will create three new listed entities: ITC Consumer Products Ltd, which will house the FMCG business; ITC Hotels Ltd, which will operate the hospitality business; and ITC Paperboards and Packaging Ltd, which will manage the paperboards and packaging business. The existing ITC Ltd will retain the cigarettes, agri-business and information technology businesses.
The company said that the demerger will enable each business to pursue its own growth strategy, attract dedicated investors, and leverage its own strengths and capabilities. The demerger will also facilitate sharper alignment with the emerging needs and preferences of consumers and customers.
To give you a perspective, the hotel business of ITC has yielded below par results barely in the range of 4-6% ROCE while eating up about 25% of their total CAPEX over the last 10-odd years. This led to a huge drag as its other segments were giving out scintillating results (Cigarettes – 65%; Agri – 8%, FMCG – 8%, Paperboards – 25%).
The history of sideways movement of ITC
The stock price of ITC has swayed only sideways and been rangebound for more than the last 10 years. It has stayed in the range of 180 to 280 between 2013 and 2022 breaking the Rs. 300 mark only thrice in 10 years before coming back to its comfort zone. Everyone believed that if the whole market is reacting in a certain way to the stock, it must be the right decision and a well-thought-out one. Following were among the main reasons for this investors’ reaction:
Investors preferred that the company either reinvest in segments that are more profitable than their then-upcoming businesses like FMCG and hotel or distribute dividends.
On the other hand, there was also contention in the market that since ITC is not an attractive investment avenue as it is heavily dependent on the Cigarette business, one that is heavily regulated and usually is on the receiving end in every year’s budget due to government increasing taxes on ‘sin goods’.
There were doubts about management’s competency since they were going against the expectations of investors and putting money in unrelated businesses.
However, once the businesses reached their critical mass of investments, they slowly started turning profitable and self-reliant to earn, invest and grow.
Why did we get in?
As long-term investors, we did not mind the sideways movements of the stock as long as we were sure that their results were going to be on a consistent growth trajectory. While the stock price remained rangebound, its Return on Equity was consistent at 25% every year. Can you imagine a company earning so well and yet being beaten down by the investors for such a long time?
We found a unique ‘Heads I win, Tails I win’ situation:
The moment we realized the gaping relationship of price and earnings, we were happy to buy the stock and sit tight. It was a clear bargain for us and one that was shouting undervaluation in our faces.
We also realized that once these unrelated, yet allied businesses mature, they have the potential to be hived off to unlock value for investors.
When the company finally came up with its much-awaited decision to demerge the hotel business from the core fast-moving consumer goods (FMCG) business, we could see our picture getting painted with the color of our conviction in our thesis. From our point of entry, the stock price has more than doubled, which is like a cherry, on icing, on top of the cake.
Given the facts, will we stay with all the businesses of ITC now?
We will definitely stick to its core Cigarettes, Agri and Paperboard business as we are very positive on their prospects. However, we are not yet sure for their hotel business. In our opinion, the hotel business is a cash guzzler that requires high investments that are locked in for good and our thoughts in investing don’t align with such businesses. However, the management has been talking for sometime now of being ‘asset lite’ in the hotel business where they will partner with existing hotel properties and assign ITC management and run with their own or joint brand. We would like to wait and watch how this new strategy turns out.
Investors beat the stock, yet again
In the last week, ITC has again been at the receiving end from the investors and stock has lost close to 10% of its market value.
One reason that we heard from our scuttlebutt sources was that ITC hasn’t done a fair demerger. The principal company will hold 40% and rest will be proportionately distributed amongst the current shareholders. In other words, the shareholding is not a mirrored one post demerger. More such reasons will come our way.
When we look at the intention of the structure, it doesn’t seem to be a fraudulent one. They are simply looking to hold the 40% so that it doesn’t become vulnerable to a hostile takeover attempt. We will write an elaborate piece about the concept of hostile takeover next.
For now, just think about hostile takeover in the context of ITC. It’s hotel business will be freshly demerged and there will be a lot of shares available to grab. At such a point, any promoter will look to keep a sizeable portion with themselves so that a potential competitor doesn’t end up buying a meaningful stake. That will defeat the entire purpose of a demerger.
If we look at it this way, it’s a net positive for the shareholders. Nobody wants to invest in businesses which are vulnerable to such acts of hostile takeover.
The behemoth has just started moving. Its a stock of this decade. Much more to come.