Sunday, June 9, 2019

ITC Analysis 2019-06-11

ITC is a company which is very well know to all of us. Here in this article I will try to see the impact of major changes that happened for ITC in the last 5 years and then look at its business from a long term perspective.

Figure 1 (Standalone financials) (Source: Screener.in)

Lets first look at figure 1. Here I have divided ITC history in 2 phases. One phase is upto 2014 when its profit was growing at the rate of around 20% per year. From 2015 it has entered into another phase when its rate of increase in profit dropped to around 9% (with a drop in profit in year 2016).

So what happen in 2015-16? 
- Increase in VAT and Excise duty 
- Increase in 85% Pictorial warning implemented (this change I have seen myself on the pack of cigarette)
  
Regarding VAT and Excise duty ITC management mentioned in page number 40 of 2016 annual report that the incidence of Excise duty and VAT on cigarette at per unit level has gone up cumulatively by 118% and 142% over the last 4 years. Which means that from 2012 to 2016 the Excise duty has gone up by 118% per cigarette. 

Now lets look at the trend of Excise duty (company don't declare any numbers on VAT)

Figure 2 (Source- Page 296 2017 annual report for Excise duty and March end financial results of each year for Cigarette Gross Revenue Breakup ) 

If we look at figure 2 then we would notice that the Excise duty as % of Cigarette revenue has remained around 47% from 2009 to 2017. It was little surprising for me. I was expecting the % to go up from 2012 to 2016 based on the increase in Excise duty of 118% in that period. I would be happy if any one of the reader can throw up more light on this.

Figure 3 (Source - March end financial results of each year)

In figure 3 you would notice that almost 80% of the total profit for ITC is still coming from Cigarette. 

Now lets again look at Figure 2. Lets go by the management comment of significant increase in VAT and Excise duty in the time period from 2012 to 2016. ITC is a market leader in branded Cigarette business. As long as everything is constant Cigarette has an inelastic demand. On the other hand the major risk for this business is the regulatory challenge of ever increasing tax rate and other forms of opposition (like increasing the Pictorial Warning). We have already seen that due to this ITC  profit growth has already came down from 20% to 10%. If in future government further increases the tax rate or impose any other challenge then ITC will definitely have a significant bottom-line impact.

In summary since 80% of the profit is still coming from Cigarette any changes in its tax rate will have a significant impact on ITC. 

Figure 4 (Source - March end financial results of each year)

Now lets try to understand how the management is managing the profit of ITC. Please refer figure 4. You would notice that almost 55% of the profit is distributed back to shareholders and 45% is kept back. 
Figure 5 (Source - March end financial results of each year)

In Figure 5. The row "Profit-Dividend" is the amount which ITC keeps back with themselves. 
Under "Capital employed" we have how much of the capital ITC has invested in Cigarettes and rest of the business. Under "Incremental Capital employed" we have how much incremental capital is employed by ITC. You would notice that incremental capital employed in Cigarette is very little compared to the annual profit of ITC (ignore the capital movement in 2017, all the movement you see there is mainly because of the change in accounting standard to IAS from GAAP).
You would notice that since Cigarette business does not require much capital ITC has the option to invest its profit in other business. Based on Figure 5 you would notice that almost 50% of the (Profit-Dividend) ITC invest in all the other business. I dont have the table to show but the balance 50% of (Profit-Dividend) ITC invest in mutual funds and bonds. 

Lets take another look at figure 1 where I explained the 2 phases of ITC. 
                                  Figure 6 (Source - March end financial results of each year)

Now lets take a look at figure 6 (please note that in Figure 1 the 2016 numbers as per screener is based on IAS accounting standard whereas in Figure 6 it is based on GAAP).
Please ignore the movement in year 2017 since most of the movement here is because of change in accounting standard. If we ignore 2017 you would notice that the Cigarette profit is slowly inching up from 5% in 2016 to 9% in 2019 because not major tax changes happened after 2016. 
Now lets look at the PBT movement of other business. You would notice that its little volatile but still more than 10% every year. In other words all the profit that ITC is investing in the business other than Cigarettes is helping it to grow by more than 10% every year. 

Now lets take a deep dive into ITC different businesses 
   Figure 7 (gross revenue) (Source - March end financial results of 2003 and 2019)

ITC started its FMCG business other than Cigarettes back in early 2000. Its other major business includes Hotels, Agri and Paper.
Now lets take a look at figure 7. Its shows the movement of ITC gross revenue by business from 2003 to 2019. Its mainstay business of Cigarettes revenue has actually grown by only 5.5% CAGR over the last 16 years which is even less than our GDP growth rate (Please note that ITC is the dominant player in organised cigarette market, in other words  it represents organised cigarette market). The low growth is mainly attributable to the significant increase in tax rates on cigarette. This increase is affecting only the organized market. The unorganized and smuggled cigarette is not affected by this tax rate hence over this period of time ITC is losing its market share to unorganized sector. 
Now lets look at its other business one by one. 
Lets start with FMCG - Others : From 2003 to 2019 it had an impressive CAGR of 34.5%. Now lets take a look at one more figure below.
   Figure 8 (gross revenue) (Source - March end financial results of 2003 and 2019)

You would notice that in figure 8 in last 5 years the FMCG- Others growth rate has come down to 6.8%. 
Hotels, Agri and Paperboard also had impressive CAGR of more than 10%. Lets take a further in-depth analysis of all these business with more data. 

 Figure 10 (Margins are based on PAT) (Source - March end financial results of 2003 and 2019)


Figure 11 (ROA are based on PAT) (Source - March end financial results of 2003 and 2019)

So far we saw the revenue analysis. Now lets take a look at Figure 10 and 11. 
FMCG - Cigarettes : In contrast to the rev the profit has grown at a CAGR of 13.5% mainly because of the significant improvement in its margin from 15% to 49%. The other interesting thing to note is that not much capital was required to be invested in this in the last 16 years since its ROA is significantly high. The ROA of 122.5% in 2019 is something which is very very difficult for any business to achieve. 

FMCG- Others: In contrast to the impressive revenue growth the profit has not grown much. Still from a loss in 2003 now there is a profit. But the margin is still very poor at 1% and ROA is also very low at 2.1%. ITC is still investing a lot in FMCG-Others and this is proving to be a very challenging market with competitors like  HUL, Marico, Britannia etc. Earlier we have seen that ITC FMCG section revenue growth rate has come down a lot in the last 5 year. ITC has entered in this market more than 16 years back and still their margin and ROA are quite poor. Despite these figure we cannot deny the fact that they have launched a lot of successful brands with good share of consumer mind. Now its just a matter of time to see how far ITC can further grow in this segment while improving margin.   

Hotels: The business revenue and profit both as grown impressively in the last 16 years. But still its a insignificant part of ITC total revenue and profit. On the other hand if you notice a good chunk of ITC total capital employed is in Hotels business. The reason is low ROA of hotel business. From 2003 to 2019 its ROA did improve from 0.7% to 2.1% but still its very low. Hotel business by its nature is a very low ROA business. So no matter how much you invest in it you wont get good return. Now is it a good or bad business depends on your perception and the idea that to what extent the assets itself will appreciate. Here in this case the assets are Hotels. If you ask me overall its not a good business. Over a long period of time if your asset value growth is lower than inflation and the ROA is very low then inflation will eat away the worth of this business.

Agri, Paperboard, Paper and Packaging business: All these business ITC created to support its Cigarette and FMCG business as backward integration. They have nicely expanded these business for other clients as well. Unlike any other commodity business they have grown this business at a healthy rate of more than 10% CAGR for last 16 years while maintaining a good ROA of 13-14%. 

Summary

If we take another look at Figure 11 we would notice that despite giving out almost 55% of profit as dividend ITC has close to 36000 cr of unallocated capital. Most of that is invested in mutual fund and bonds as liquid assets. ITC has entered FMCG- others almost around 20 years back but they are yet to generate good profit from it. Still almost 80% of their profit is from FMCG-cigarette business. Any impact in further tax rates would have a significant impact on its profit. The silver lining here is that ITC dont need much capital to increase its cigarette business and to a large extent they have been successful in creating lot of good brands in FMCG. Now time will tell to what extent they will be able to increase the share of FMCG-others profit in future. 

Valuation

Today's Market price of ITC is 280 and its standalone 2019 EPS is 10.1 which means its trading at a PE of 28. Lets take a look at figure 12. You would notice that historically its PE has been around 30 for last 10 years. The 2nd thing to notice is that in the last 5 years it has gone through a very tough phase of high tax rate and the probability is high that it will go even higher. But the silver lining here is that despite the high tax rate its profit is holding up well. ITC is one of the few Indian companies favorable to small shareholder. It has been consistently paying around 55% of its profit as dividend for a long time.
Since ITC profit is not very volatile we can actually look at its historical PE to compare its current valuation. At its current PE of 28 its not very far from its historical PE ratio. On the other hand when compared to any other FMCG company its valuation would look attractive. Primarily because its 80% profit is still from Cigarette and the risk of higher tax rate its PE has not expanded in the past similar to other major FMCG companies like HUL, Marico etc. 

Figure 12 (Source- Screener)

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I would like to thank you if you have read my analysis upto this point :). I would be very happy if you can give me your feedback and point out anything important which I have missed here

Regards
Team Arthavriksh

Video version of this analysis
   


  







2 comments:

  1. Why ITC Cigarette margins are so high compared to its peers like Godfrey, VST ?

    ReplyDelete
  2. Quite well documented analysis, continue with your good work.

    ReplyDelete

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