Unlocking ITC value
Over the last five years, ITC stock had lost traction in comparison to its peers across industries like FMCG, hotels, agricultural and paper businesses. Although the valuations did catch up recently, is there an investor concern? What are the issues where ITC needs to get its act together?
Corporate Strategy issue
First; the problem with its corporate strategy, i.e., the businesses it has decided to be present in. ITC has been consciously attempting to steer away from its ‘core’ tobacco business over the last forty years; way back in the seventies it decided to diversify into other FMCG, agri-products, papers and hotels businesses.
With its entire top-line from tobacco four decades earlier; it is only 40% today. FMCG other than tobacco, today accounts for around 25%, agri-business around 20%, paper around 10%, hotels 2% and the rest 3%; thereby having achieved significant diversification away from tobacco.
The bigger problem however is that while the 40% tobacco business yields 80% of all its earnings before interest and tax; the 60% diversified businesses account for only 20% of its earnings. In effect the diversified businesses are yet to gain maturity in terms of viability! The diversification over the last forty years has been very slow and the company could have moved much faster, escaping the over-dependence on tobacco! But this has not happened!
Today, the diversified businesses in which ITC is playing has focused competitors with many of them having a strong competitive advantage, given their focus; a concern for ITC, the ‘diversified conglomerate’! Markets are clearly getting impatient, in spite of the what ITC as company is, in terms of superior leadership, capabilities and the social responsibilities it delivers to the society!
On this count, late last year its CEO Sanjiv Puri did lay down a ‘strategy re-set’ that aims for deepening digitalization, enhancing sustainability, deepening its e-commerce capability and divesting non-core businesses. While there were mentions on ITC’s aspirations over the next eight years to aggressively grow its portfolio of non- tobacco brands into mega-brands, introduce newer brands and taking its mega-brands to international markets, the communication from the company fell short in terms of how and when such diversified business can achieve ‘standalone’ viability!
In effect, ITC needs to aggressively grow its earnings, or profits, from its diversified businesses with clear timelines and communicate the same to the market!
ESG implications of tobacco business
Secondly, the most important reason for the value discount is due to the ‘core’ business ITC is in; the tobacco! Given the inherent risk that could arise from regulatory onslaught on cigarettes, tobacco and potential litigations tobacco business is exposed to, which investor could be wary of. The growing importance of ESG over the last few years is likely to strengthen over the years to come, discounting in ITC valuation could becoming inevitable.
ITC has been one of Indian companies that has demonstrated the highest levels of sustainable initiatives in all its businesses for decades; be it Triple bottom line, CSR or be it working at micro level with the villages sustaining more than 6 million livelihoods. Excelling in the areas of climate change, water security, responsible luxury ethos and decarbonization; all of these are not new to the ‘pioneer’ ITC.
In spite of such commendable sustainability efforts for decades, prominent ESG rating agencies like sustanalytics has placed ITC under ‘medium’ ESG risk category, which is a higher risk that ‘negligible’ and ‘low’ ESG risk categories, possibly due to its presence in the tobacco business. MSCI, another ESG rating agency for example has however rated ITC as an ESG leader. In effect there is not much clarity on how precisely ITC’s presence and overdependence in tobacco will impact its ESG rating!
There are a number of views as to how ITC can unlock value; frequently quoted solutions like demerging diversified businesses of tobacco, agri-products, hotels and paper into standalone companies will fire-wall tobacco assets from other assets. Further such demerger can reduce the cost of capital for other diversified businesses, given the higher risks tobacco business is exposed to. Also, demerger can push managers in demerged companies to scale and attain viability on a stand-alone basis, rather than having the luxury of access to corporate funds!
Such arguments are fine and could be effective only when the diversified business have scaled-up into matured businesses with an ability to stand-alone with revenue and profits that can self-sustain. This has not yet happened in ITC; moreover it still seems a long way to go in comparison to its peers!
Hence demerger may not be a solution for ITC to unlock value at this stage! Then what is the second solution to address investor concerns and to unlock value?
The ESG frameworks and rating agencies are themselves still at nascent stages of precisely understanding the ESG risks, placing an ESG ‘risk value’ and eventually rating companies on the ESG risk metric. For example, how does being in tobacco business enhances ESG risk for ITC? Does the risk emanate from potential for higher government taxation of the sector and the impact it creates on company through increased price of tobacco products, leading to reduced consumption and lower profits and cash flows?
Or, does ITC’s ESG risk emanate from potential litigations and class action suits that cigarette companies around the world have faced in the past, that could impair the company, financially? Or does the ESG risk of being in tobacco business arises from negatively impacting the health of the society, or the pollution tobacco and cigarettes create to the environment; precisely where does such ESG risk emanate for ITC? These may get clearer and transparent as ESG framework matures in the future, but not very clear now!
In order to unlock value as we speak, I believe the onus lies with ITC and it possibly needs to understand such issues and communicate more to the market as to how it is targeting to manage its tobacco related ESG risks in the medium to long term. This is not happening now!
For example, the annual report of the board of directors for the year 2022 of ITC does not seem to communicate precisely the magnitude of the ‘tobacco’ dependence problem, i.e., the ‘elephant in the room’. Demonstrating ITC doing humungous sustainability initiatives in other businesses is by no means enough! It needs to assess the drivers of tobacco related ESG risks, how such risk will be managed and thereby communicate the same to the investors, rather than remaining silent on this issue! Knowing well that this is the biggest concerns for the investors, more transparent communication by ITC management on this front, will unlock value!
Corporate Strategy issue
First; the problem with its corporate strategy, i.e., the businesses it has decided to be present in. ITC has been consciously attempting to steer away from its ‘core’ tobacco business over the last forty years; way back in the seventies it decided to diversify into other FMCG, agri-products, papers and hotels businesses.
With its entire top-line from tobacco four decades earlier; it is only 40% today. FMCG other than tobacco, today accounts for around 25%, agri-business around 20%, paper around 10%, hotels 2% and the rest 3%; thereby having achieved significant diversification away from tobacco.
The bigger problem however is that while the 40% tobacco business yields 80% of all its earnings before interest and tax; the 60% diversified businesses account for only 20% of its earnings. In effect the diversified businesses are yet to gain maturity in terms of viability! The diversification over the last forty years has been very slow and the company could have moved much faster, escaping the over-dependence on tobacco! But this has not happened!
Today, the diversified businesses in which ITC is playing has focused competitors with many of them having a strong competitive advantage, given their focus; a concern for ITC, the ‘diversified conglomerate’! Markets are clearly getting impatient, in spite of the what ITC as company is, in terms of superior leadership, capabilities and the social responsibilities it delivers to the society!
On this count, late last year its CEO Sanjiv Puri did lay down a ‘strategy re-set’ that aims for deepening digitalization, enhancing sustainability, deepening its e-commerce capability and divesting non-core businesses. While there were mentions on ITC’s aspirations over the next eight years to aggressively grow its portfolio of non- tobacco brands into mega-brands, introduce newer brands and taking its mega-brands to international markets, the communication from the company fell short in terms of how and when such diversified business can achieve ‘standalone’ viability!
In effect, ITC needs to aggressively grow its earnings, or profits, from its diversified businesses with clear timelines and communicate the same to the market!
ESG implications of tobacco business
Secondly, the most important reason for the value discount is due to the ‘core’ business ITC is in; the tobacco! Given the inherent risk that could arise from regulatory onslaught on cigarettes, tobacco and potential litigations tobacco business is exposed to, which investor could be wary of. The growing importance of ESG over the last few years is likely to strengthen over the years to come, discounting in ITC valuation could becoming inevitable.
ITC has been one of Indian companies that has demonstrated the highest levels of sustainable initiatives in all its businesses for decades; be it Triple bottom line, CSR or be it working at micro level with the villages sustaining more than 6 million livelihoods. Excelling in the areas of climate change, water security, responsible luxury ethos and decarbonization; all of these are not new to the ‘pioneer’ ITC.
In spite of such commendable sustainability efforts for decades, prominent ESG rating agencies like sustanalytics has placed ITC under ‘medium’ ESG risk category, which is a higher risk that ‘negligible’ and ‘low’ ESG risk categories, possibly due to its presence in the tobacco business. MSCI, another ESG rating agency for example has however rated ITC as an ESG leader. In effect there is not much clarity on how precisely ITC’s presence and overdependence in tobacco will impact its ESG rating!
There are a number of views as to how ITC can unlock value; frequently quoted solutions like demerging diversified businesses of tobacco, agri-products, hotels and paper into standalone companies will fire-wall tobacco assets from other assets. Further such demerger can reduce the cost of capital for other diversified businesses, given the higher risks tobacco business is exposed to. Also, demerger can push managers in demerged companies to scale and attain viability on a stand-alone basis, rather than having the luxury of access to corporate funds!
Such arguments are fine and could be effective only when the diversified business have scaled-up into matured businesses with an ability to stand-alone with revenue and profits that can self-sustain. This has not yet happened in ITC; moreover it still seems a long way to go in comparison to its peers!
Hence demerger may not be a solution for ITC to unlock value at this stage! Then what is the second solution to address investor concerns and to unlock value?
The ESG frameworks and rating agencies are themselves still at nascent stages of precisely understanding the ESG risks, placing an ESG ‘risk value’ and eventually rating companies on the ESG risk metric. For example, how does being in tobacco business enhances ESG risk for ITC? Does the risk emanate from potential for higher government taxation of the sector and the impact it creates on company through increased price of tobacco products, leading to reduced consumption and lower profits and cash flows?
Or, does ITC’s ESG risk emanate from potential litigations and class action suits that cigarette companies around the world have faced in the past, that could impair the company, financially? Or does the ESG risk of being in tobacco business arises from negatively impacting the health of the society, or the pollution tobacco and cigarettes create to the environment; precisely where does such ESG risk emanate for ITC? These may get clearer and transparent as ESG framework matures in the future, but not very clear now!
In order to unlock value as we speak, I believe the onus lies with ITC and it possibly needs to understand such issues and communicate more to the market as to how it is targeting to manage its tobacco related ESG risks in the medium to long term. This is not happening now!
For example, the annual report of the board of directors for the year 2022 of ITC does not seem to communicate precisely the magnitude of the ‘tobacco’ dependence problem, i.e., the ‘elephant in the room’. Demonstrating ITC doing humungous sustainability initiatives in other businesses is by no means enough! It needs to assess the drivers of tobacco related ESG risks, how such risk will be managed and thereby communicate the same to the investors, rather than remaining silent on this issue! Knowing well that this is the biggest concerns for the investors, more transparent communication by ITC management on this front, will unlock value!
