Quarterly Magic of ITC
Numbers

The
greatest trick the devil ever pulled was convincing the world he didn’t exist.
And looking at the way ITC is managed, it can be said with reasonable certainty
–

The greatest trick the ITC is pulling is to convince its shareholders that its
board exists and is indeed responsible for the company.

The
alarming regularity with which the stock price is manipulated weeks before
every quarterly result, the rumours about the demerger, stellar results round
the corner, special dividend in the offing and buyback, only to be disappointed
quarter after quarter – is nothing short of a movie plot. The retail
investors also known as the hopeful romantics within the ITC
fraternity, keep buying the stock, while Wealth Managers across the country
have created an entirely new and risk-free business model of selling ATM call
options month after month and making a killing, as they exactly know where the
stock is going – NOWHERE  

Here’s
the secret Y’e stupid shareholders of the ITC

ITC
will never ever demerge its businesses as the present comfort of the high tide
that hides all the executives that are swimming without pants will get exposed.
The cash machine that ITC is, through its cigarette business is good enough to
keep the party going for a very long time.

And
no one likes the party to end isn’t it?

When
I wrote this
piece some 8 months ago asking some pertinent questions to the board,
the least they could have done was to gather some data, do some math and
respond with a sound and logical rebuttal or future strategy, especially when
thousands of shareholders resonated with my thoughts all over the
world, but obviously rebuttals require courage, facts, demonstration of intent
and a clear conscience – all of which seem to be missing in ITC.

Can
we even begin to imagine if ITC was managed / owned by Mr. Ambani or Mr. Adani
how happy we minority shareholders would have been? Or if the representatives
of SUUTI, LIC and a few Mutual Funds along-with BAT could discover their spines
jointly, and make the management answerable – ITC has the potential to be one
of the best companies in India. But alas….

So while the latest investor
presentation used the word robust 31 times and growth 41 (the same is missing
from actual performance), it has no mention of shareholders, reduction in
executive compensation during the pandemic year but they did try and take
credit of reducing “controllable” fixed costs. Fixed costs are uncontrollable
and that’s why it requires serious executive courage to control them.
Controllable Fixed costs? – Are you kidding me?.

At
a time when the entire listed corporate world has left shareholders spellbound
in the last 15 months, with appreciable reduction in costs, stellar EBITDA
margins, efficiency not seen in the last decade, ITC has at best established
itself as a mediocre company with a mediocre P&L, poor decision making and
afraid of taking any meaningful steps that are value accretive for its
shareholders. – 

details later here…..

The
talk of a robust dividend yield is akin to shifting money from one pocket to
the other because the board doesn’t have the courage to declare a buyback for
the fear of losing control and were gleefully diluting the value of minority
shareholders till recently, when BAT put an end to equity dilution
through issuing
stock options in year 2018. Since then, the company has changed its policy
and it gives Stock Appreciation Rights (SARs) which entails more cash-outflow
for the company. We aren’t sure that the principle of ‘High Water Mark’ is being
followed to ensure that SAR isn’t brought lower to adjust to the stock’s
abysmal performance.

Isn’t
it surprising that the top management of ITC, despite generous grants of stock
over the years, owns less stock than perhaps me and my family and are selling
their stock with alarming regularity. So much for the confidence in their own
executive abilities. The issue of ESOPs and quick-sale
data is available here.

Fun
fact : Just top 282 employees of ITC sold shares worth 1024 Cr in the last 3
years. And the top 10 sold shares worth 190 Cr. The real KBC is
being played here at the cost of minority shareholders.

SEBI
came out with a bold skin in the game reform for the mutual fund managers
by   mandating that a minimum of 20% of the compensation of
mutual fund managers and other key personnel in an asset management company
(AMC) should be in the form of units of the mutual fund schemes they manage.. 

I
wrote a recommendation piece about the same some 3 years ago and when I heard of this reform,
I was pleasantly chuffed about it. I am proposing 2 more reforms and will write
to SEBI soon that : 

a. Companies that don’t have a promoter
shouldn’t allow its executives to draw a compensation beyond a pre-defined
threshold and all other compensation should only be in form of dividends generated
through restricted stock options monetizable only upon end of employment.

b.  The other skin in the game reform for
promotor-less companies where the promoter or the KMP has less than 20% stake
should definitely have a representation of minority shareholders on the board
and that too in the proportion of their stake.

That would indeed be another set of
‘skin in the game reforms’ for promoter-less corporations.

If
this would’ve been the norm and discipline, one celebrated CEO of an American
corporation wouldn’t have been allowed to fly fresh salmon from Norway for
lunch in the company’s private jet. The folklore has it that he was terribly
fond of Salmon.

But
lets get back to the recent stellar quarter of ITC and study the ‘FMCG giant
in the making’ narrative:

1.  Companies that make significant growth, report
their numbers in absolute numbers
and        the ones that enjoy growth on the base
effect of extreme underperformance only talk in         percentages.

2.  While Marico (Sales up – 10% y/y, PAT up – 15% y/y), Britannia (Sales up
– 13% y/y, PAT up – 33% y/y), and Dabur (Sales up – 10% y/y, PAT up – 17% y/y )
grew at a remarkable pace, ITC sales de-grew by (2%) and PAT de-grew by (15%).
ITC has almost become like a few other PSU Banks where “the worst is behind us”
and “the future is bright” narrative is being peddled for years, quarter after
quarter while the balance sheet at the cost of tax payers needs to be
recapitalised ever so frequently and here in the case of ITC, the minority
shareholders are underwriting the underperformance.

3.   Further
its pertinent to note that a large part of the FMCG growth came from a very
very expensive acquisition of Sunrise which means that for every Rs 1 of
growth in revenues, the shareholders paid Rs 4.

4. Remove the Sunrise acquisition, and the revenues from Aashirwaad
atta (where the EBIDTA margins are negligible) the real growth would be much
lower.

5.  “Value
Accretive M&A” is a meaningless metric until ITC acquires another company
that’s trading at cheaper valuations than itself. And thereby creating some
shareholder value. M&A at the cost of free-cash that generates lower ROE
than treasury yields is nothing short of financial hara-kiri.

6.  Recently
a new kid on the block – Rossari Biotech trading at 80 PE acquired Unitop
Chemicals trading at 10 PE (just an example). But ITC is the only generous and
philanthropic organisation that itself barely manages to trade at 19 PE but
acquired Sunrise at 38 PE. So much for its negotiation ability and size leverage.

7.  ROCE
of ITC has been dramatically falling. In just last 5-6 years alone the ROCE has
declined from 50% to just 29%.

8.   With
a consistently falling EPS and ROCE the cash generation will likely not keep up
with the abysmally low shareholder expectation of atleast earning dividends
that match treasury yields and ITC will be forced to dip into their cash
reserves thereby weakening the only reasonable moat around their balance sheet.

Hotels

This
division can single handedly bring the entire ITC down. Someone from the
industry recently informed me that ITC keeps building hotels because one
(deceased now) earlier Chairman liked hotels. Wow that’s some real compelling
investment argument to destroy shareholder wealth. ITC hotels hasn’t been able to
develop its own distribution network in so many years and relies on Marriott
and Preferred for its booking engine and loyalty program. And it talks of
creating a world class brand.

Allow
the powers that be in the hotel division to raise funds, deal with financial
institutions, consider capital an expensive and rare resource and then make
investment decisions and only then gloat in the glory of making green hotels
and winning global awards. Every investment and every new hotel would then seem
like a wasteful expenditure. But then the past Chairman liked hotels……..

If
managers don’t have the ability to raise and manage capital and understand the
concept of ROCE, then either the managers need to be replaced or the businesses
sold off.

Rather
than trying to acquire Oberoi hotels (through the present 14% ownership) for
the purpose of empire building, ITC should sell their hotels to some global
hospitality chain that has the edge of a superior global brand recall and a
distribution network. That indeed would be value accretive for shareholders.

All
the We-assure and the marketing campaigns that the hotel division indulged in
couldn’t prevent an outbreak
in the Chennai hotel when the entire hotel had to be shut down.
Marketing is good, but gimmicks are misleading especially in the face of the
ferocity of Covid-19.

If
hospitality was a separate division, the mettle of the managers would have come
to fore and perhaps the expression “house of cards” would be exemplified if
they would have had to raise working capital through ECLGS, deal with financial
institutions, institute meaningful salary cuts and worry about cash to sustain
rather than dip in papa’s pocket whenever money runs out.

Can
we – the minority shareholders know the equity invested and ROE (return on
Equity) only in the Hotel division alone please?

The
segment assets of 6,525 Crores (post an approx. 30 yr opportunity cost)
tantamounts to approx. equity worth more than approx. Rs. 50,000 crore
destroyed in hotel division alone. And we aren’t even talking of
Capital Work in Progress that will further erode the shareholder wealth. This
money over 30 years with any half-wise capital allocation would have added
atleast Rs. 2-3 lac crores (26 – 39 billion USD) in market cap alone

FMCG

Agri
business grew at 23% for the year but the EBIT that should have grown better or
more only grew at 11% resulting in EBIT margin going down from 8% to 7% (Poor
operating leverage). Does that mean that there is a possibility that Agri
margin is being sacrificed to prop up the margins of FMCG business through
transfer pricing tricks thereby misleading shareholders?

Or does this mean that the company has no clue or understanding or internal
controls to increase operating leverage??

FMCG
– Peer Group Comparison

Now
if there was a my-baap in ITC these numbers would have been
treated like murder – but we have no doubt that the powers that be in the FMCG
division would not only have got ample pats on their backs but also huge
increments and ESOPS (needless to say – value destructive for minority
shareholders) 

All Hope isn’t lost

While
much has been debated about ITC’s strategic decisions on business ventures,
capital allocation and performance of the businesses, all hope is not lost as
company can alter its approach and enhance shareholder’s value through a few
short term and long term initiatives which are presented below –

1)  Hotels –
While company has created admirable properties across India, The present
management neither runs these with any sense of ownership (would have been
reflected in the numbers else) nor do they take decisions that are prudent in
the interest of shareholders.

Due to the evolving dynamics of the industry, hotels are not
value accretive as these have very long gestation periods. Further, the
pandemic has grounded even the most ardent believers of face-to-face meetings
and have compelled them to adopt the ‘new normal’ of Zoom and WFH, and this
trend will permanently impair business travel as demand side will dramatically
drop.

The pandemic
provides a great opportunity to sell the hotel division ‘NOW and HERE’ rather
than continuously bleed the consolidated B/S and putting good money after bad.

If the
wishes of the past chairman are so dear, then reimagine the division to make it
profitable and figure out WHY (do we exist), HOW (will we
prosper) and WHAT (needs to be done).

Value Unlocking:

a)
Demerge the business which will bring financial discipline and bring
more accountability as mentioned earlier

Or

b)
REIT – Develop a REIT structure, divest stake in the business to a
global alternate asset manager who is looking to lock capital for a longer
period to time. All the owned assets can be transferred to a separate trust and
properties could be leased back at an attractive yield. Not only would this
make the managers accountable, as they would have to earn to pay the lease, but
also this would unlock the shareholder equity to the tune of approx. Rs. 25,000
crores and thereby become an efficient Operating Company (OpCo)

Or

c)
Sell all the owned assets to strategic players i.e., global hotel chains
to focus on Cigarette and FMCG business.  

Or

d)
Become a Property Company (PropCo) and get some of the best global
operators to manage hotels

2)  FMCG –
Building FMCG companies from scratch can take years. The company has done a
commendable job in building some widely recognized brands by channelizing its
strong distribution network. However, ITC has high volume and low margin
businesses, and products are largely ‘Me too’. If the company were to achieve
Rs. 100,000 crores target by 2030 (Vision
statement) the top-line of FMCG should grow by ~23% in the face of
cigarette sales degrowing by 5% YOY over the decade which is much higher than
the present 13% growth rate. But I am sure ITC is managed by magicians and this
growth wont be hard to achieve. We have faith in the magical powers of the
executives but pls don’t behave like a minister who recently, famously said –
“don’t go into numbers and don’t do math” have faith.

Tatas, Ambani and Damani are all getting into D2C and private
labels to create an edge. Use the power of your network to take advantage of
the large fortune at the bottom of the pyramid rather than wasting time selling
some expensive chocolate that will remain unprofitable. If ITC doesn’t evolve
or acquire (not at Sunrise valuations) some new-age businesses, it faces an
existential crisis in the modern well connected e-world.

Strategy:

a)  Product
Innovation/Creation of category: Stop
being a me-too company through Yipee and Sunfeast biscuit. Create a new game-changing
category.

Tell me the second man on the Moon and the Everest – no one
knows them. And ITC should stop being a distant No.2. Unless ITC gets its mojo
to create and sustain a category, it has no future.

b)  Spotting
trends early: While market share gradually
shifts from unorganized to organized, it is a multi-year process and this
seldom results in high margins. Few of the interesting areas that look
promising are Frozen food market, Adult Health & Nutraceuticals,
Cosmeceuticals etc.

c)   Geographical
Diversification: ITC is ITC – don’t allow
regional players such as  Adani Wilmar to
weed you out. Get your act together or you wont exist.

d)  Contract
Manufacturing:  Demonstrate the power of
the ITC brand to outsource a large %age of products to contract manufacturers
and free up capital. ITCs incessant desire to do all-by-myself is hurting its
shareholders.

3) 
IT Services –
 Demonstrate the ability to become the Larsen and Toubro Infotech or
stop pretending to be an IT company and allow the super-efficient Board to be
distracted. There is no way that ITC Infotech can ever become anything
meaningful or it would have already become.

4) Cigarettes and
general – As the capex requirements are complete, the company should return the
money to the shareholders in form of buybacks. Rs. 60,000 crores buyback can be
planned for next 6 years, utilizing existing bank balances and the rest through
borrowing. Theoretically, if the earnings yield is more than the post-tax
borrowing of the company, the company should do a buyback until such time that
palatable debt is reached. Debt magnifies RoEs and buyback reduces the equity
base, both done today maximizes returns for shareholders.

But
that would mean sacrificing a bit of control to BAT – but Boards that
mean well for the company and its shareholders think beyond the virtues of
selfishness and control freakery.

Overall –

1) Selling Non-core assets –
Small business should be sold or shut down. Stakes held in other hotel chains
should be sold at optimal valuation as of yesterday.

2) Shareholder
Communication – Company of this size
should have analyst concalls, provide definitive guidance on the numbers. (the
way Infosys does)

3) CAPEX Guidance –
Company of this size should declare its capex plans so that it can be built in
pricing of financial models.

And above all –

4) Appoint Minority Shareholder Directors –
The company should onboard an eminent small shareholder director with a
relevant experience so as to amplify the importance of retail shareholders as
well.

A family can never be fatherless. And if it is – the minority shareholder
should become the deemed one.

When someone posts an opinion or an
article on ITC, the emotion and response that it generates is overwhelming. If
the true meaning of Stockholm Syndrome needs
to be understood, delve deep into the mind of an ITC shareholder – That’s the
Enigma of ITC. 

During
my hospital visit to look upon someone some years ago, I learnt that the ECG
monitor of a dead person is just a straight line. ITC stock price graph reminds
me of that line I saw years ago because the price is more stable and straighter
than that line.

Long live ITC…..

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