The company may be generating cash flows in excess of Rs 1,600 crore, but the market questions the wisdom of some of its diversifications and modest dividend payouts.
Great company. Great brands. Huge profits. That's one view of ITC Ltd, the cigarettes, paper, agri-products and hotels company. Here's another: Just one cash cow. Lots of failed ventures. Poor utiliser of capital. A miserly dividend payer. Which one is the true ITC?
The answer, of course, is both. Neither view is entirely true or false. But as investors start taking a closer look at the companies they invest in, ITC is coming under the microscope of many equity analysts. And not all that they see is pretty.
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Consider this: ITC's tobacco business generated a return on capital employed (ROCE) of 118 per cent in the last fiscal (ended march 2003). Terrific.
The rest of the businesses, including FMCG products, hotels, paper and agri-products, managed a measly 7.34 per cent between them. Not so terrific. And even that hides the negative score in FMCG (-152 per cent), and a princely one per cent in hotels.
The ROCE looks at all respectable only because of higher returns in agri-products and paper, with the former again being largely tobacco oriented.
Quite clearly, ITC's non-tobacco businesses are guzzling the cash being surplussed by tobacco. These businesses are proving a trifle injurious to ITC's bottomline.
Nobody grudges ITC the fact that it must diversify. Not when your main product is cigarettes, which politicians love to tax and social and health activists love to hate.
In the west, tobacco companies are busy paying out billions of dollars in compensation to the weed's health victims. In India, cigarettes cannot be advertised on print and TV and smoking is banned in public places. Tobacco is steadily becoming an uncool business to be in.
Says Samir Arora, head, Asia-Pacific, Alliance Capital Investment Managers: "It is wise not be viewed long-term as a pure cigarette company and having non-tobacco businesses helps perceptions."
Adds Abhay Aima, head of private banking at HDFC Bank: "Even though the tobacco business remains a cash cow, in terms of perception a pure tobacco business will get continuously de-rated on the bourses."
But diversification is one thing, and reaping returns from diversification quite another. ITC's track record in this area has been less than heartening.
Some of its past diversification ended in disaster (ITC Classic, ITC Global and International Travel House, while others have been capital-guzzlers.
What the rest of ITC's businesses have done is reduce the 118 per cent ROCE in the tobacco business to 49 per cent on a capital employed of Rs 4,316 crore.
Questions arise: Is ITC paying too high a price for diversification? Did it choose the wrong industries to invest in? Is is capable of managing those investments well?
If not, would shareholders have been better off with higher rewards payouts and dividends in the short-term instead of being dragged into long-gestation investments, some of doubtful value?
ITC's critics basically constitute people who like the colour of its money, but not the way the company has utilised its cash hoard in unrelated diversifications.
Says Raamdeo Agrawal, joint managing director of Motilal Oswal Securities: "It's sheer misallocation of capital. ITC has lost enormous sums in the past dues to lack of vision and concerted effort. Major ventures like ITC Classic Finance, ITC Global, International Travel House have gone completely awry."
Agrawal believes ITC should be part of any institutional portfolio given its sheer profitability. But he is not sure all the money is going to the right places.
"Diversifying into other businesses may be an essential evil to elongate the life of a corporate. But it's impossible for any company to manage such diversity under one umbrella. Paper, hotels, lifestyle retailing and agri-products are poles apart," says Agrawal.
If none of this has affected ITC's popularity on the bourses, one has to thank the sheer size of the profit it throws up every year. The company generates free cash to the tune of Rs 1,500 crore every year.
With nearly 70 per cent marketshare in the domestic cigarettes market and 30 active cigarette brands, the company has created a substantial entry barrier over the years.
"More than the company, the government is helping it create entry barriers by proposing a ban on advertisements, etc" says Agrawal of Motilal Oswal.
Moreover, despite the official pariah status of the industry, the domestic market potential is enormous.
Cigarettes currently account for only 14 per cent of tobacco consumed in the country compared to 85 per cent in most other regions. There are 10 times as many bidi smokers in India as there are cigarette smokers.
"India is a great market for tobacco purely because of its demographics. More than 50 per cent of the population is below 20 years," says Ramesh Damani, a Mumbai-based broker.
On the flip side, it's clear that being a tobacco company is not a comfortable feeling anymore for companies that are overdependent on it.
Compelled by mounting litigation and flat growth in cigarette sales in the United States, Philip Morris decided a few years back to diversify into food products.
Consequently, it acquired Kraft Foods. For financial year 2002, the foods division recorded sales of $ 29.72 billion, about 37 per cent of Philip Morris' total turnover of $ 80.41 billion.
In January 2003, the company changed its corporate identity and called itself the Altria group. Under the new structure, Altria owns Philip Morris, USA, Philip Morris International, Philip Morris Capital Company and FMCG major Kraft Foods.
Though the company denies any attempt to distance itself from tobacco, analysts refuse to believe that's the case.
Other tobacco companies are trying geographical diversification rather than product diversification. BAT, which owns more than a third of ITC shares, has adopted this strategy and today has a presence in nearly 180 market across the globe.
To some extent, this is what constrains ITC's growth outward. Areas it would like to get into may already have been staked out by its parent. Given this backdrop, ITC's diversifications seem logical.
That, however, is not the same as saying that all of them were sensible. From a shareholder's point of view, ITC's strategic diversification would make sense only if it leads to a growth in price-earnings multiples or higher dividends payouts.
This hasn't quite happened. Over the last four years, in fact, ITC's price-earnings P/E have taken a steady dive. From P/E levels of around 42 in 1999, ITC currently trades at a P/E multiple of 12. And that's not just because the whole market is in decline.
The Sensex's P/E fell from 16.83 to 13.26 during the same period. If the P/E deteriorates to 11 from current levels, it will shave off nearly Rs 100 from the current share price of Rs 700. That means a loss of nearly Rs 2,475 crore from the current market capitalisation of ITC (Rs 17,326 crore).
What worries market observers is not the decision to diversify, but the way it is doing so, and the areas it is getting into.
In particular, they feel that the idea of managing diverse businesses under one roof may not be a great idea. Says a fund manager who declined to be identified.
"Diversification per se is not be bad. But it's all a question of management bandwidth. ITC's past experience does not inspire confidence at all."
Others feel that ITC's sheer ability pour so much good money into new businesses may also be a weakness. Says broker Ramesh Damani: "At ITC, it's a problem of plenty. The best results are not born from establishment-based business but entrepreneurial capabilities."
"As long as the key business (tobacco) is throwing out the cash, managements generally are complacent about smaller businesses," adds Agrawal.
The performance of ITC's business divisions underscores this point. The ROCE of the major non-tobacco ventures compares unfavourably with those of their competitors.
In the hotels business, for instance, where the company has been present for more than a decade now, its returns are weaker than both that of the Taj group and the Oberois.
Even though the division recorded a profit of Rs 10 crore compared to a marginal loss in the last fiscal, the return on capital employed was a meagre 1.05 per cent.
Last fiscal, East Indian Hotels and Indian Hotels, on the other hand, enjoyed superior returns at 6.48 per cent and 4.33 per cent respectively.
Company officials, however, dislike this comparison and say this is bound to happen during an expansionary phase, especially in a capital-intensive area like hotels.
"It is a balance sheet in transition and hence returns are not high," says a company official. Papers and paper products, which is the second largest contributor to revenues, witnessed good growth this year.
Revenues grew 12.79 per cent while EBIT (earnings before interest and tax) grew 39.53 per cent to Rs 226 crore from Rs 162 crore. Consequently, ROCE was 17.94 per cent. In greeting cards, ITC's Expressions cards have not performed as well as leading player Archies Greetings.
Though the company is reported to have fared well in recent ventures like match-boxes and agarbattis, these are relatively smaller segments currently dominated by the unorganised sector. In recent times, ITC has also been talking about focusing on FMCG products as a major growth driver.
ITC's food plate includes gourmet foods under the 'Kitchens of India' and Gharana brands, confectionery, (Mint-O, Candyman), wheat and salt (Aashirvaad) and snack food (I bischip). Given the weak state of the FMCG markets, these businesses are likely to be long-gestation in nature.
ITC's entry into retailing is also something many analysts are concerned about. While some see the Wills Lifestyle apparel stores as surrogate marketing to push cigarettes, others believe that the cost-benefit ratios do not look favourable.
"The most successful segment is retailing is discount stores and not boutiques, which Wills Lifestyle stores will ultimately turn out to be. And the business is extremely capital-intensive," says Nikhil Vora, analyst with ASK Raymond James.
ITC officials explain the logic of diversification as a means to lend stability to the overall portfolio. "Our portfolio is a mix of businesses which will take care of short, medium and long-term needs," says an ITC official.
At one level, it makes sense for ITC to keep all businesses under one roof because there is a tax advantage.
Losses in some businesses can be set off against the profits of other divisions, minimising the total tax outgo. This was the biggest driver for the merger of ITC and ITC Bhadrachalam.
The company can also take advantage of the higher depreciation, especially when some businesses are expanding. But most analysts feel that these are one-time transient advantages and will not reflect in better valuations for long.
Can the management do anything to improve the valuation of its shares? Raamdeo Agrawal has a suggestion: "The best way to handle this is to put a cap on diversification ventures, and keep them as separate entities. Start ventures with the initial seed capital and then let them sustain themselves. If companies cannot be sustained on their own, may be they are not worth pursuing."
The market also has gripes about payouts. Their logic is simple: if your main profit earner is tobacco - a politically sensitive animal - it makes sense to dole out cash to shareholders rather than offer a mouth-watering target to taxmen and finance ministers.
Though the dividend rate has been increasing steadily, the increments have only been marginal. This year, the company's payout ratio was 30.6 per cent, analysts say this is far too low, especially for a tobacco company.
The world over, major tobacco companies trade on a dividend yield basis. At the current price of $42.09 a share, Altria (which owns Philip Morris) trades at a yield of 6.05 per cent.
"Considering the risks related to the tobacco business and the possibility of litigation eating into profits, the best way is to dole out money to shareholders as much as possible," says an analyst.
Even those who do not disagree with ITC's need to diversify feel that it is stingy on dividends. Says Samir Arora: "I philosophically agree with ITC's strategy of controlled diversification rather than returning 100 per cent of money to the shareholders. However, the company has been too stingy in its dividend payout and we are holders of the stock in the belief that this payout ratio will increase over time."
The market clearly expects more from ITC. A cap on cash-guzzling diversification, payouts above 50 per cent of net profits, and dividend yields above 5-6 per cent (currently below two per cent) are among the things they would like to see.