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Payoff Time for ITC

India's largest FMCG firm's cigarette and hotel businesses continue to weigh on valuations, making investors restless. Can a demerger help it attract investor attention?

Sanjiv Puri, Chairman and MD of ITC -- Photograph by Yasir Iqbal Sanjiv Puri, Chairman and MD of ITC -- Photograph by Yasir Iqbal

When Sanjiv Puri took over as Chairman and MD of ITC from Y.C. Deveshwar, his mandate was clear — carry forward the vision of transforming the cigarette company into a diversified consumer-centric conglomerate. ITC’s dependence on cigarettes had begun to dent its stock market performance even during Deveshwar’s tenure. In his 21-year stint as Chairman and CEO, ITC entered many consumer categories, including staples, snacks, biscuits and personal care. By the time he hung up his boots, the FMCG business was a sizeable Rs 10,500 crore.

Under Puri, the FMCG business is now almost Rs 15,000 crore. FY21 has been one of the best years for the non-cigarette FMCG business with EBITDA margins at 9 per cent, up 180 basis points over FY20. “Our segment EBITDA margins have improved by 640 basis points between FY17 and FY20. In FY21, ITC’s FMCG revenue grew 16 per cent on a comparable basis, which is nearly double the industry peer group average and all of that is led by organic growth. Almost 75 per cent of our FMCG portfolio has grown by as much as 20 per cent,” says Puri.

Despite disruptions caused by the pandemic, ITC’s revenue grew 3.3 per cent to Rs 53,155.12 crore in FY21. Its profit after tax fell 13.3 per cent to Rs 13,389.80 crore but is still 40 per cent higher than rival Hindustan Unilever’s (HUL’s) Rs 7,963 crore.

However, none of this has rubbed off on the company’s stock market performance. ITC’s stock was at Rs 202 on July 2, 2021, down 16 per cent from Rs 245 on June 30, 2016. In contrast, stock prices of HUL and Nestle have sky-rocketed and are at Rs 2,475 (Rs 898 five years ago) and Rs 17,698 (Rs 6,488 five years ago), respectively.

Why isn’t ITC able to win attention of investors? “More than 80-85 per cent EBIT still comes from cigarettes. EBIT margins of cigarettes have gone up. Hence, dependence on cigarettes remains high. Therefore, overall multiples have been coming down. FII shareholding has come down 13-15 per cent in the last three-four years,” says a senior stock market analyst.

Most new businesses are still in the investment phase and haven’t matured enough to impress stock markets. Analysts say even if ITC is able to expand EBIT and EBITDA margins of non-cigarette businesses by 15 per cent in the next five years, they would be one-fifth its cigarette margins. “For transformation, the share of cigarettes in EBIT has to come down from 80 per cent to 60 per cent in the next five years,” says an analyst.

Multiples of cigarette companies have halved globally. Investors are shying away from investing in tobacco companies on fears they may not abide by global environment, social and governance (ESG) norms. ITC has been hit despite having the best ESG scores in the world. “In the last four years, Sanjiv Puri has made positive changes. ITC has huge financial muscle. It is the largest FMCG company in profits. It has all the components to win. ESG is the only reason the stock is not moving,” says Abneesh Roy, Executive Vice-President (Research), Edelweiss Securities.

The other factor going against the diversified conglomerate is its hotel business. The past year has been especially difficult, with hotels not being allowed to operate due to the pandemic. ITC’s hotel business shrunk 65.8 per cent in FY21. “ITC has best-in-class hotels, but since the business is tied to macro factors, investors find it much riskier. That’s the other reason why the stock gets a lower valuation,” says Roy.

Future-Ready

The Puri-Deveshwar strategy is to make ITC future ready. ITC has adopted an aggressive innovation and product launch strategy. Puri has not only taken his mentor’s vision forward but also crafted new growth drivers. He ramped up FMCG investments both organically and through acquisitions — ITC acquired Savlon, Nimyle and Sunrise brands. He also made moves in agri-business by getting into value-added products. It recently launched frozen vegetables, fruits and sea-food under Farmland and Kitchens of India brands. Puri claims ITC is well on its way to achieving the Rs 1 lakh crore sales target by 2030. “We are serving 3.6 times the markets we served earlier, we are covering 1.6 times more outlets, our stockist outlets have been multiplied four times.”

Not only has it strengthened its core portfolio of staples (Aashirvaad Atta), biscuits (Sunfeast) and snacks (Bingo, Yippee! Noodles) and entered into adjacent categories (pulses, cakes and masalas), it has forayed into dairy, chocolates and coffee too. In one year, it has had 121 launches, right from a host of Covid-19 products (surface disinfectant sprays, surface wipes, clothes disinfectant spray and vegetable cleaners) under the Savlon brand to ready-to-eat food and snacks.

Arun Kejriwal, Founder, Kejriwal Research and Investment Services, finds brand extensions in a highly commoditised segment like staples unique. “This is a segment where they are capitalising on their agri-sourcing strength. They have direct control over the price and quality of what they are buying and are able to do the right kind of value-addition for the consumer.”

Over the past three years, Puri has hired a lot of senior people. Ali Harris Shere, former CMO of Britannia, was brought in to give a facelift to the biscuits and cakes business, while Sanjay Singhal was hired from Dabur to head the dairy and beverages business. “They have got good lateral hires from other FMCG companies. It is a large business for ITC and getting the best talent from outside and not fully depending on internal talent is a good strategy,” says Roy of Edelweiss.

In paperboards, it tried to improve efficiencies by investing in pulp made from hard wood. “Across the world, pulp is made with soft wood. India doesn’t have soft wood. So, we invested in innovative technologies to convert hard wood into soft-wood pulp. This has been a significant intervention and given us lot of efficiencies,” says Puri.

Way back in 2000, Deveshwar gave Puri the task of setting up an ecommerce business. Since the idea was way ahead of its time, the project never took off. He says creating tech-based business practices had always been his passion, and the moment he took over as head of ITC, digitisation was among his top priorities. While the ITC e-store launched during the pandemic last year is the most obvious intervention, almost 10 per cent non-cigarette FMCG revenue, says B. Sumant, Executive Director, has been coming from ecommerce. The company has also pivoted towards building direct-to-consumer brands. For instance, its personal care brand, Fiama, which didn’t have too many takers on conventional trade platforms, has been getting 38 per cent revenue through ecommerce.

In agri-business, e-Choupal is on the next phase of digital evolution. “While e-Choupal 1.0 had less than 10 per cent digital adoption, with 90 per cent farmer engagements being done physically, in e-Choupal 4.0, digital intervention is as high 40 per cent,” says S. Sivakumar, Group Head, Agri and IT, ITC. e-Choupal 4.0 aims to bring the benefits of digital revolution to farmers even more effectively. Envisaged as a ‘phygital’ system, it is designed as a crop agnostic integrated solution that will aggregate remote sensing, precision farming, drone-based services, quality assaying and e-marketplace.

Puri has also created a digital council, DigiNext, as part of which his core team meets once every month. He regularly invites digitally savvy entrepreneurs to talk to his team. He also runs the Young Digital Innovators Lab which, he says, has cyber natives, young employees who understand digital better than the senior team and play a dominant role in new initiatives. Puri says he owes most of his digital knowledge to youngsters in the team. “Everything I speak today about AI, ML and big data, is what I have learnt from my younger colleagues.”

Unlocking Value

Analysts, however, believe that the only way the ITC stock can can unlock its potential is through de-mergers. They suggest separate listed entities for cigarettes, paper, hotels, FMCG and agri-business to offer value to stakeholders. “Demerger may improve management focus but will involve significant operational costs. FMCG and cigarettes share a common distribution system. If they separate the two, they will have to create a new distribution system, and that’s not going to be cheap,” says a former COO of a leading FMCG company.

Kejriwal has a different take on this. He says the management should divide the business into two verticals. The cigarette and hotel businesses, according to him, should be under one vertical, while other businesses should be under a different umbrella. “The hotel business is non-remunerative for them, and though cigarettes are extremely profitable, there is a stigma attached to it. By clubbing the two, any losses in the hotel business can be written off by the cigarette business. The hotel business doesn’t lose so much money that it can affect the combined balance sheet of ITC,” says Kejriwal.

Puri, however, is non-committal on any possible demerger. He says the stagnant stock price is a matter of concern for the management but the company will not take hasty decisions. “If there is a better way of organising ourselves to create more sustained value for stakeholders, we are open to it, but it has to be something that will generate sustained value. ITC doesn’t believe in doing things that will create short-term excitement. We want to look at the long term, that’s very clearly our goal,” he says. He says the company’s financial metrics are in place and there is no reason to panic. “In three years up to FY20, our EPS has gone up by 47 per cent. Our ROCE has gone up 24 per cent, we have robust cash flows, sharper capital allocation and much clearer dividend policy.”

The advantage of having all businesses under one umbrella is the synergy they can derive from one another. “The FMCG business, the new baby, has been built leveraging a lot of enterprise strengths. For instance, we are using our agri-business expertise to build our frozen snacks portfolio. Our hotel business’ strength of understanding cuisines enables us to understand consumer palates and what is required in a kitchen. We are, therefore, able to launch relevant products,” says Puri.

He, however, says that nothing is cast in stone. “At one point of time, hotels and paperboard were separate companies, we brought them in with a purpose, and these businesses have acquired scale and market standing over time. We periodically review how to organise ourselves in the context of competitive environment, external challenges as well as business strategy and maturity.”

Though demerger of the hotel business isn’t on the cards anytime soon, Puri admits that the existing model is causing stress on its balance sheet. Soon, it plans to move to an asset-light, management contract model. “At the moment, there is demand destruction in this segment. We will continue to examine alternative structures in line with industry recovery dynamics. An enterprise exists for stakeholders, not just for today, but for tomorrow as well. It must add value to all stakeholders on a sustained basis. We have to recognise that.”

Consumer Bandwagon

ITC sees the next wave of value creation happening in its FMCG business, but industry isn’t particularly gung-ho. Though its consumer business showed promise in initial years, it has not lived up to it. Apart from atta and a few categories in snacks, it doesn’t have market leadership in most other segments. In the Rs 40,000 crore branded biscuits market, while Britannia and Parle have 30 per cent and 27 per cent market shares, respectively, ITC is a distant number three at 11 per cent.

“There is lack of clarity on what they are trying to build. They are doing many things. The turnover is growing but there is no clarity on what winning means in terms of market share and profitability,” says a former CEO of a leading FMCG major. He says operating margins of the non-cigarette FMCG business have been in the region of 6 per cent, as opposed to HUL’s around 22 per cent.

Though FMCG has been a star performer in FY21, with Savlon growing 13.9 times and Nimyle 4.5 times, experts say most recent launches have been Covid-centric and one isn’t sure if the performance will last in the longer term.

Be it food or personal care, ITC has been a late entrant in most categories. “ITC has done better in food than in personal care,” says Roy of Edelweiss. “They should exit soaps and shampoos, as they don’t have a right to win there. It is completely dominated by large MNCs who have been around much longer. They have created strong brands and have access to global R&D, which is a huge advantage. ITC, on the contrary, is a strong No. 2 only in deodorants, and that’s not a segment where margins are high,” he adds.

Roy says FMCG EBITDA margins, despite improvement by 180 basis points, are still way behind the likes of HUL. This raises the question if the company should focus on fewer categories and brands instead of adopting a carpet-bombing strategy? The company, after all, is in 14 food segments. Its FMCG portfolio has 25 brands. It has forayed into chocolates, which is dominated by Mondelez (with over 50 per cent market share) and has, therefore, had no choice but to operate in the luxury segment, which is highly niche. “ITC has invested heavily in attempting to innovate, but product innovation has not made too much of a dent on consumer mind-space,” says Raghu Vishwanath, MD of brand valuation company Vertebrand. Vishawanth believes that stock prices are as much a function of perception as profit. “People need to believe in long-term equity and sustainability of the brands, irrespective of the financial muscle of the organisation.”

A senior stock market analyst says the debate on margins, profitability and scale has put ITC in a chicken-and-egg situation. “Deveshwar’s target was to have Rs 1 lakh crore of sales by 2030. With its existing core, ITC can’t achieve that number. In order to get scale, they have to be much more diversified and that’s going to impact margins. So, they can either focus on scale or profitability.”

FMCG Strategy

The ITC management isn’t concerned that it’s not leading in categories where it operates. Nor does it consider a presence in multiple categories a bad idea. “We are creating a new core for the future with innovative offerings in various stages of development. Some of them are being scaled up, some of them are being piloted or incubated. The idea is not necessarily to scale up every category at the same time. We will progressively scale up as we validate the concept or business model in select markets,” says Puri. One example of ITC exiting a non-performing business is lifestyle retail. Industry believes it was a smart move. “There is absolutely no right to win for any FMCG company in retail. ITC should take similar decisions in businesses such as personal care, which is not working for them. That money and management focus can be put into interesting and scalable opportunities,” says a senior analyst of a Mumbai-based brokerage.

Puri says the larger ambition is to create a business of scale, which will require immense patience. “We believe we have capabilities in the organisation to do well, we have synergies to do well. Our businesses have scaled up, deriving competitive advantage by leveraging internal synergies.”

“We are focused on delivering sustained profitable growth. We will do it by entering certain high-potential categories, which we call the new core, by continuously adding new products and variants in existing formats as well as new products which are adjacent to the current formats,” says B. Sumant, Executive Director ITC.

He claims presence in multiple categories gives ITC economies of scale. “In manufacturing, we have created integrated consumer goods manufacturing and logistics facilities, where we have multiple production lines. So, the overheads of running a factory are amortised over six-seven product categories. We have integrated factories that produce atta, noodles, biscuits, snacks and juices at scale. The idea is to create a distributed manufacturing network and produce close to the market, thereby ensuring freshness while leveraging logistical advantages. Similarly, when my salesman goes to a store, he sells a variety of products and I save costs on distribution, warehousing as well as transportation,” says Sumant.

Since it was a late entrant in almost every category, it was important to ensure its products are superior to what was already available. “Unless our offering is better than the best international products, we don’t launch. Being a challenger brand in most categories, which already have entrenched players, it has been our endeavour to innovate smart products that are differentiated and serve evolving needs of discerning consumers,” says Sumant. He cites the example of the Fiama shower gel where they introduced a technology that keeps fragrance intact for hours.

Most of ITC’s FMCG products, barring staples and biscuits, play at the premium end of the market and have limited scope for volume growth. Sumant, though, doesn’t agree with this assessment. “Most of our categories are strategically laddered across the range from premium to economy. We have products at all price points. In soaps, we have offerings at the mass end, Vivel competes in the mid-popular segment and Fiama in the premium end. We have a strategy of straddling price points and launching lower unit packs. Even in the premium bodywash segment, we have sachets,” he explains.

Won’t a presence in multiple categories lead to confusion? Puri seldom gets tired talking about the entrepreneurial culture he has built in the organisation. He has broken the non-cigarette FMCG business into clusters to ensure agility. “We have reorganised the food business into clusters and each cluster has integrated teams that we have empowered to sharpen customer centricity and steer the business. My role has been to mentor all the teams,” he says.

ITC v/s Competition

While ITC’s dependence on cigarettes is definitely playing against it in the stock market, what have HUL and Nestle done right for a blockbuster performance? According to Kejriwal, what the market likes about the two companies is predictability. “Their results are predictable. One is quite sure that one can’t go too wrong by investing in HUL or Nestle. Because of cigarettes, the ITC stock isn’t as dependable.”

HUL is the gold standard for FMCG in India, explains Roy of Edelweiss. “Their parentage gives them access to latest brands, R&D and scale of sourcing. HUL does so well in soaps because of its sourcing capabilities. They source palm oil globally, giving them better sourcing capabilities then ITC, which is limited to India.”

Moreover, both HUL and Nestle are in high ROCE businesses and far more profitable businesses than ITC. “They are also not saddled with a target of serving one lakh consumers. Such targets create problems for shareholders. You may gain scale but will lose out on margins and ROCE. ITC had to do that as its most profitable business is its most controversial business,” says a senior analyst.

On its part, ITC is trying hard to morph into a diversified consumer products business with a basket of good-for-you as well as indulgence products. But will this strategy reduce its dependence on cigarettes? Or, will it listen to the market’s demand for unlocking value? Stock markets investors are hoping the demerger would be announced soon. Let’s wait and watch.

@ajitashashidhar