Daybreak - ITC's sin good is now fuelling the reversal in its fortunes

Episode Date: March 10, 2023

ITC's stock had been lagging for years. Many institutional investors stayed away from ITC because the company's shares are considered sin stocks. The company, meanwhile, has avoided acknowledging the importance of cigarettes, its mainstay business, in its communications.But over the last year, the ITC stock has made a dramatic comeback. Suddenly, investors can't get enough of the company.What changed?Tune in to find out.

Hi, this is Rohan Dharma Kumar. If you've heard any of the Ken's podcasts, you've probably heard me, my interruptions, my analogies, and my contrarian takes on most topics. And you might rightly be wondering why am I interrupting this episode too. It's for a special announcement. For the last few months, I and Sita Raman Ganesh, my colleague and the Ken's deputy editor, have been working on an ambitious new podcast. It's called Intermission.

We want to tell the secret sauce stories of India's greatest companies. Stories of how they were born, how they fought to survive, how they build their organizations and culture, how they manage to innovate and thrive over decades, and most importantly, how they're poised today. To do that, Sita and I have been reading books, poring over reports, going through financial statements, digging up archives, and talking to dozens of people. And if that wasn't enough, we also decided to throw in video into the mix. Yes, you heard that right. Intermission has also had to find its footing in the world of multi-camera shoots in professional studios, laborious editing, and extensive post-production.

Sita and I are still reeling from the intensity of our first studio recording. Intermission launches on March 23rd. To get an alert as soon as we release our first episode, please follow Intermission on Spotify and Apple Podcasts or subscribe to the Ken's YouTube channel. You can find all of the links at the ken.com slash I am. With that, back to your episode. If you look up ITC Limited on Wikipedia,

you will notice something conspicuously missing from the company's introduction. If you look at the right at the box where Wikipedia puts together basic information about a company, there is a list of ITC's products. Again, cigarettes are right at the end of this list. But we're talking about ITC here. The Indian Tobacco Company, one of the oldest companies in the country. In fact, the company has even changed its name to just ITC Limited. ITC is no longer an acronym for Indian Tobacco Company.

But nothing can hide the fact that ITC is the leader of the legal cigarette market in India. It controls about 80% of it and cigarettes contribute 80% to ITC's operating profit. So why then does ITC shy away from talking about its main product? You see, for investors, the shares of a company that sells cigarettes are sin stocks. They are considered unethical. So for a long time, ITC has been downplaying the importance of its cigarettes business in its communications. One is of course because of the public health concern, but it is also because of the regulatory pressure. So for years, the company's stocks have been lagging until last year.

It was quite a turnaround. Suddenly, investors just can't seem to get enough of the company. The stock is up by 80%. Just this Monday, in fact, the stock hit an all-time high of $388. So what is it that has brought up? about this reversal in ITC's fortunes? The answer may surprise you. Turns out, it is the cigarettes business that is tempting potential investors towards the company.

Anand Kalyan Aramann, a writer at the Ken, wrote about it in a recent report. From being the bane, cigarettes have become a boon for ITC. But how? Welcome to Daybreak, a business podcast from the Ken. I'm your host, Nekda Sharma, and I don't chase the news cycle. Instead, thrice a week on Mondays, Wednesdays and Fridays, I will come to you with one business story that is worth understanding and worth your time. Today is Friday the 10th of March.

Despite being one of India's most valuable companies, many institutional investors have stayed away from ITC because of its cigarettes business. But it is not just cigarettes that ITC sells. It is the country's second largest FMCG company. The company has been churning out large amounts of cash and dividends. But with the advent of ESG, as more and more investors started looking for sustainability bragging rights, ITC started suffering. ESG is essentially a framework that helps stakeholders understand how a company is managing risks and opportunities related to E, environment, S for social and G for governance criteria. So this demand for socially responsible investing contributed to a decline in the ITC stocks value.

It fell over 10% between January 2017 and February 22, while the benchmark index BSE Sensex doubled. The company became the subject of many memes online. ITC of course has been aware of the stigma, which is why it has made lot of effort to diversify its portfolio beyond tobacco to include FMCG goods like food, personal care, clothes, stationary, incense, safety matches and a lot more. And not to forget the hotel business, of course. The company has actually become a top player in most of the segments in which it operates. In terms of revenue, it is only second to Hindustan Uni liver in the highly competitive

FMCG sector. But most of the company's fortunes still come from the century-old. cigarette business. My colleague Anand spoke to Satchin Bobaday, who is a VP research at Daulet Capital, a Mumbai-based investment management firm. He told him that for a big part of the last 10 years, ITC stocks could not attract investors. Bobaday said, and I'm quoting, earlier we had a sell rating on the ITC stock primarily because the government was continuously increasing duties on cigarettes. End quote. He explained that during this period, The illegal cigarette market was growing rapidly.

But ITC's volumes were stagnant and the government sought tax leakage. According to the Tobacco Institute of India, which is an industry lobby, nearly one in every four cigarettes sold in India is illegal. So if you look at the growth rate of ITC's cigarette volume before the pandemic, it was negative to single digits. But in the last three quarters, it has been in the range of 15 to 26%. The operating profit of this segment has also increased significantly. The December 2020 results, which were announced last month, saw ITC clock its highest quarterly

profit. It crossed the 5,000-crow-rupy mark. So what brought about the striking turnaround in the company's fortunes? Stay tuned to find out. ITC posted solid profit growth across its sprawling empire, including the cigarette business, FMCG, agri-products, paper and packaging, hotels and even its software arm ITC Infotech. Operating margins have also shot up and true to its reputation, the company declared a healthy dividend. But like I told you earlier, it is mainly the cigarette segment that is driving this success.

The government's policy shifts like the stable taxation on legal cigarettes and a crackdown on illegal cigarettes are turning out to work in ITC's favour. For example, analysts have noted that cigarette duties have not seen much of a rise since the introduction of GST in 2017. Modest increases in duties such as those in the recent budget have not really affected sales volumes. Like Bobaday told Anand, whenever the prices remain. stable, cigarette consumption tends to go up. Plus, the government is taking serious steps against the illegal cigarette trade. And that is because the sale of illegal cigarettes is actually rising. To give you a better picture, the value of seized illegal cigarettes in the financial year

2020 was 188 crore rupees. By the next year itself in 2021, it went up by nine times to 1,770 crores. The government has vowed to take strict action against it, and that obviously works in ITC's favour. Investors, of course, noticed these developments, especially with the shift over the last year in investor preference from growth stocks to value stocks. ITC was a value buy, at least until last year. And not just that, there is a growing skepticism around ESG investing. Like I told you earlier, it was mainly ESG that had done.

deterred investors away from ITC stocks. But now it has made ITC more acceptable to a wider range of investors. All these factors together have created the perfect environment for ITC's turnaround. So what's next for ITC? I will tell you in the next segment. Like Anand said in his report, the lion's share, which is close to 60% of the company's operating profit growth in the recent quarters has come from the cigarettes business. The company is near zero debt status over the years and the expansion into multiple capital intensive segments also owes to the massive cash generated by this very business. But Manoj Manoge Menin, the head of research and consumer analyst at ICICI Securities, which is a financial services firm, warned against a very real threat

for ITC. He said, and I'm quoting, the Damocles sword of high taxation always hangs over the cigarettes business. End quote. So if the government decides to impose taxes on cigarettes higher than inflation, there could be a significant impact on ITC. And this is a very real possibility because India is a signatory to the WHO's protocols. These protocols actually mandate such tax hikes. So over time, cigarettes become unaffordable for more and more people. ITC knows this and for this reason it is not keeping all its eggs in one basket. Daybreak is produced from the newsroom of the Ken, India's first subscriber-focused business news platform. What you're listening to is just a small sample of our subscriber-only offerings.

A full subscription unlocks daily long-form feature stories, newsletters, subscriber-only apps and podcast extras. Head to the Ken.com. and click on the red subscribe button on the top of the website. I am Snigda Sharma, your host, and today's episode was edited by my colleague Rajiv Sien.