- National Coronavirus response: a roadmap to reopening (here)
- 3 months of no EMI but why you should pay if you can (here)
- Outrage in Germany as Adidas and H&M stop rent payments (here)
- Planes will fly with new owners: NT urges UK to let Virgin Airlines go bust (here)
- The road back to normal (here)
- How Kotak Mahindra has averted all the crisis so far (here)
- The man who predicted the Indian banking crisis warns of a new danger (here)
- ITC – is capital misallocation a narrative fallacy or reality (here)
- My first decade as a full time investor (here)
- What clark street has been buying – Coronavirus edition (here)
ITC’s Use of Cash
ITC has this great cash engine called Tobacco. I dug a little bit into the published 2015 results to see how ITC was using its cash.
There is good news and bad news. Bad news — Cash from Cigarettes which generated ~180%+ ROC is being used to fund FMCG and Hotels business where if the ROC is ~1% in 2015. 90% of the additional capital in ITC went into FMCG or the Hotels business. While one might argue that FMCG will make money in the long run, the hotels choice is a bizarre one as it is cyclical and a low return business. Also, they paid 500 Crores for a property in Goa that is being challenged in the courts right now. Was 2015 an anomaly on how much capital went to hotels or will this be a trend? While one might hope a more prudent allocation in the future, it is something one definitely must be concerned about. Also, a clear road to profitability on FMCG will help as well. Good News — 700 Crores out of the 1,500 Crores that were invested came from other parts of the balance sheet like deferred taxes, better TWC etc. Essentially only 900 Crores or 10% of net profit went into capital for in all FMCG and Hotels. Glass half full or half empty?
| All Numbers in Crores INR | |||
| ITC Last 12 Month Net Profit | 9765 | ||
| Depreciation | 1027 | ||
| Owners Earnings Before Capex | 10792 | ||
| Dividends | 5621 | ||
| Net of Dividends | 5171 | ||
| Additional Capital Employed | % of Capital Employed | 2014-2015 ROC of Segments | |
| Capital Employed in Cigarettes | 121 | 8% | 183% |
| Capital Employed in FMCG | 632 | 40% | 0.8% |
| Capital Employed in Hotels | 769 | 48% | 1.1% |
| Capital Employed in Agri | -79 | -5% | 44.1% |
| Capital Employed in Papers | 110 | 7% | 17.0% |
| Capital Employed in Others | 41 | 3% | 32.6% |
| Total Capital Into Business | 1594 | 31% | |
| Net Capital Left After Investing in Business | 3577 | ||
| Additional Cash in Balance Sheet Compared to 2014 | 4299 | Additional cash coming in from better Deferred Taxes, TWC, Cash Management etc; | |
Nestle and ITC
Nestle
Maharastra government joined forces with a few other states banning Nestle’s Maggi creating a classic case of the government attacking a well entrenched moat Here
While it will take a while to sort this out, there is an air of uncertainty around Nestle’s flagship product in India. The biggest asset that Nestle carries on its balance sheet is its brand and this controversy puts Nestle’s most precious asset into the cross hairs. While the company has definitely the in-depth resources and financial wherewithal to survive the crisis, it still remains to be unknown as to the extent to which the moat will be breached. As warren says, ‘You only know who is swimming naked when the tide goes out’, this episode will really test the endurance and reputation of Nestle in India. Even with the recent dip of 18%, the stock continues to enjoy a PE of 47, which takes the earnings yield just north of 2% making it a very expensive proposition even today.
While one might look at companies like Coca Cola which have faced such issues globally before and have emerged our relatively robust earnings power for the future here Nestle still does not have the margin of safety required to evaluate Nestle fully. It must also be noted, there is a new breed of investors (the Buffett clones) who are watching quality companies with one-time resolvable issues to take advantage of the discrepancies that occur with these companies including Sanjay Bakshi in India (latest update on Nestle here)
Disclosure: No Position
ITC
We had written previously about ITC here.
In the recent market volatility that we have been seeing and with Maharastra (after Chandigarh) banning loose cigarettes, another stalwart in the FMCG space is fighting for the relevance of its business model and its flagship products (here). The company is trading at 25 times earnings or 4% earnings yield. With the excise duty hikes and the resilience that we have seen in the past with respect to the business model, it might be worth another look to see whether this stalwart is worthy at the current prices.
Disclosure: Long ITC
ITC
“I’ll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It’s addictive. And there’s fantastic brand loyalty.”
— Warren Buffett, ‘Barbarians at the Gate’ on RJR Nabisco
Cigarette company discussions often start and end on moral stands that investors take about tobacco usage. While we will leave the individual preferences to the respective investors to evaluate and act upon, we will discuss a bit about ITC which commands over 75% share in the legal Indian cigarette industry.
Cigarette businesses comes with investment characteristics that are highly desirable (leaving aside the moral question of public good or increasing the value of the ecosystem they operate in)
- Cost a penny and can be sold for a dollar
- Great brand loyalty
- Government restrictions on ads and regulations means it is legally very tough to take market share away from incumbent players
- India still does not suffer from the punitive legal hurdles present in the western world
ITC however has been going through a different challenge. Over 85% of Indian tobacco consumption is not legal or not subject to regulation. This has meant that companies like ITC bear the burnt of the high excise taxes which are increasing every year and VAT as well. Smaller companies that operate outside the legal boundaries have a huge cost advantage over the ITC’s of the world. If the government does get serious about tobacco usage and curbs the usage of illegal tobacco, it might actually strengthen ITC’s business model. Though, the chances are slim and might take a few years at least.
Currently, ITC is suffering a huge volume decline on the back of the big tax hike in the last few years. The volume decline has accelerated in the last two quarters. There is a possibility that the demand is not as inelastic as we believe it to be.
| 2014 | 2015 | ||||||
| Q1 | Q2 | Q3 | Q4 | Q1 | Q2 | Q3 | Q4 |
| -2% | -4% | -2% | -3% | -3% | -4% | -13% | -13% |
In the backdrop of this, the already weak shares of ITC might see further weakness of the next few quarters. While we are not predicting the short term stock movements, as long term holders, we are hoping for a sale in ITC stock.
There are two catalysts that we see in the long run
- The sustainability of the cigarette over the longer period of time and its robustness. You cannot kill this business model except by banning cigarettes in India.
- The cash engine ten years from now will be from FMCG along with Cigarettes that will ensure that the sustainability of the model will continue for the future. This change while tough to evaluate from a cash flow perspective is rather easy to evaluate from a predictability perspective.
You have a good cash cow, a new growth engine (yet to see cash flows though), a terrific management and a solid business model with a fair amount of predictability. For a long term investor, who does not care about short term weakness, price declines and can be contrarian, some pain might be in order but definitely commands a look.
Disclosure: Long ITC
Beowulf Capital 