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Not game-changing but signals sharper capital-allocation focus

ITC’s proposal to demerge its Hotels business (c.3% of segment EBITDA, >20% of segment capital employed) is not exactly a game-changer, in our view, but definitely points towards a sharper capital allocation strategy. The principle, we believe, is that the Hotels business should not be starved of capital simply because ITC’s shareholders at large are unhappy with the cash and ROCE drag from its presence in the sector. To be honest, we see no harm in ITC’s form remaining exactly as it currently is, but the new structure does no harm whatsoever either, we believe. ITC would continue to own c.40% of the demerged entity and the balance c.60% would be directly owned by ITC’s shareholders. The demerged business would then be able to (raise and) deploy its own capital to fund growth of the hotels business and ensure it remains on top amongst peers. Synergies between Hotels and other ITC businesses (e.g. Foods) should largely remain unaffected given that the new entity would remain an associate of ITC. The proposal would up ITC’s post-tax ROIC by c.5-6ppt (our workings) and could drive valuation-multiple further up for ITC as a whole, in our view

* What could be the issues here? 1) ITC’s residual shareholding in the Hotels business could get subjected to a ‘holdco’ discount. This is not exactly a big issue, in our view, given that the Hotels business’ valuation comprises sub-5% of ITC’s overall value. A potential rerating in the ITC stock overall, given a sharper capital-allocation strategy and higher return-ratios and cash-retention, can more than offset such discount, if any. 2) ITC could still land up needing to infuse funds into the new entity, when required. We believe this is possible but having decided to right-size its capital investments into the Hotels business, we expect the management to remain prudent in its future capital allocation decisions as well. 3) BAT would end up with a c.17% holding in the new entity and may have little interest in a hospitality stock. This could create a supply-overhang on the new stock. Or maybe it could be an opportunity to induct a new strategic partner into the Hotels entity?

* ITC valuation could re-rate on the back of this action – better return-rations and higher cash-retention overall: Management has for long referred to an ‘alternate structure’ being worked upon for the Hotels business, and the present proposal signifies that the company is indeed walking its talk. Ceteris paribus, we believe the proposal could drive a 5-6ppt increase in its ROIC-profile (Exhibit 3 - our workings) and also help conserve future cashflow to be utilised in the core businesses or be paid out as dividend to shareholders (payout ratio already >90%). Part of the Street argues that ITC’s 12M forward multiple is already back at 26-27x which is close to the peak that the stock traded at ten years back. One difference here, in our view, is that consumer staples ex-ITC used to then trade at 35x forward PE then but is currently at 52-53x. Further, ITC’s ROIC has improved 10ppt since (plus another 5ppt more once the Hotels business is demerged) with a very significant enhancement in payout ratios. See Exhibit 6. Equally important are that 1) the policy environment in the cigarettes business is now much more supportive, and 2) the FMCG business has reached double-digit margin and now earns sufficient profit to fund its own plans (barring maybe for large acquisitions). For the upcoming Jun-Q result, we forecast ITC’s cigarette volume growth to be c.15% which is higher than what we expect consumer staples businesses to deliver during the quarter.

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