Magic, Illusion or just Trickery – The story of ITC

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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