ITC demerger with a twist: Deep dive

ITC demerger with a twist: Deep dive

ITC Limited, one of India's leading conglomerates recently announced a demerger of their hotel business, and it comes with a twist that has caught the attention of the street. So, let's dive right into it!

Let us begin with -

1. Background on ITC business segments and trends in hotels business:

ITC's business operations are diversified across multiple segments with the Fast-Moving Consumer Goods (FMCG) segment, encompassing cigarettes and other FMCG products, being the company's primary revenue contributor.?

In FY 2023, FMCG segment accounted for a combined share of 66.4%. Cigarettes alone held the largest share of both revenue (41.2%) and profits (75.4%) for the company, indicating its significant role in ITC's financial performance.

The Agri-business and Paper board, paper, and packaging segments also played substantial roles in ITC's operations, contributing 16.3% and 9.5% to the revenue, respectively. Their presence in the asset allocation (10.8% and 20.4%, respectively) indicates their significance in the overall business portfolio.

On the other hand, ITC's hotel revenue has seen a 12% CAGR growth from FY19 to FY23, while EBITDA has increased nearly eight times in FY23 compared to the previous year, with a CAGR of 23% from FY18 to FY23 (Source: Jefferies).

Moreover, ITC Hotels' quarterly revenue has steadily increased from 555 crore in Q1 FY23 to 782 crores in Q4 FY23, reflecting positive performance in the hospitality sector.

Furthermore, it remained an essential part of ITC's asset allocation, holding 17.6% of the total assets. This highlights the company's commitment to its hotel ventures despite not being the primary revenue driver.

As the company explores the possibility of demerging its hotel business, it will be interesting to observe how this move impacts the financial dynamics and strategic focus within each segment in the coming years.

2. Explanation of Demerger and Spin-off:

In a move to create more value for shareholders, ITC has decided to separate its hotels business from the rest of its operations. This is known as a demerger, where the parent company carves out a business unit and establishes it as an independent entity. Now, in a typical spin-off, the parent company would distribute all the shares of the new entity to its existing shareholders. But in this case, ITC has chosen a different approach.

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3. Description of ITC's Chosen Structure:

Unlike a conventional demerger, where shareholders of the parent company would receive shares in the new entity based on their existing shareholding, ITC has opted to retain a 40 percent of total market capitalisation of the hotel company. The remaining 60 percent will be allotted to ITC's shareholders. This means that the hotel company's capital will increase as it issues shares to ITC in lieu of consideration for the hotels business. Additionally, shares will be allotted to ITC's shareholders representing the remaining 60 percent.?

It is worth noting that ITC does not have any identifiable promoters as such except for the largest shareholder, British American Tobacco (BAT), that holds around 23.96% (FY 2023) but is not classified as promoter.?

The idea is to form a subsidiary, ITC Hotels Ltd, that will have ITC Ltd as its promoter/parent company. This is similar to standard corporate structures followed by various hotel companies in India, where East India hotel has Oberoi and Reliance as its promoters, and Indian hotels has Tatas' as its promoters.

4. How many shares would you get? An Illustrative calculation:

Now, let's take a closer look at what the demerger means for individual shareholders, using an example.

Imagine you hold 1000 shares of ITC Limited. With the total number of outstanding shares being 12.4 billion, let's see how this demerger might affect your investment.

So, as an individual shareholder, you hold 1000 shares of ITC. After the demerger, ITC has decided to retain 40 percent of total market capitalisation of the hotel business and distribute the remaining 60 percent to its shareholders. This means that ITC will hold 40 percent of the newly formed hotel company, ITC Hotels Ltd, and the rest will be allocated to you and other shareholders proportionate to your stake in ITC.

Now, to calculate your allocation in the hotel business, we will first find out the total number of shares to be allotted for this business. To keep it simple and easy to understand let’s say, with 12.4 billion shares currently outstanding for ITC Ltd, 60 percent of these many shares will be allotted to shareholders in this scheme of demerger. So, we get;

Total number of shares to be allotted for hotels business = 12.4 billion x 0.60 = 7.44 billion shares (illustrative only).

Next, let's calculate ITC's stake in the hotel business, which represents 40 percent. From the total number of shares allotted to the hotels business, we can find ITC's portion:

ITC's stake in the ITC Hotels Ltd = 7.44 billion shares x 0.40 = 2.976 billion shares (i.e., ITC Ltd to continue holding 40% stake in the hotel business).

Now, to find out how many shares you'll receive in the new hotel entity, we need to calculate your proportionate allocation based on your existing 1000 shares. Here's the calculation:

Your allocation in the hotel business = (1000 shares / 12.4 billion shares) x 7.44 billion shares ≈ 600 shares.

So, after the demerger, you will receive approximately 600 shares in the ITC Hotels Ltd in consideration for your 1000 shared, which is effectively 6 shares in ITC Hotels Ltd for every 10 shares held in ITC Ltd.

We hope the above illustration helped you understand the implications of ITC's demerger better. Keep in mind that this is just an illustrative example, and the actual numbers may vary based on the final details of the demerger.?

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5. Future Prospects:

As a shareholder, you will now have ownership in two separate entities: ITC and the new hotel company. The impact on the valuation of both companies will depend on their performance and market conditions going forward.

It's essential to closely monitor the developments and financial performance of both companies to make informed decisions about holding, buying, or selling shares in the future.

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6. Market reaction:

The demerger is expected to positively impact ITC's return ratios and valuations, but it might not have been as well-received by investors as a clean demerger would have been.

As we can see from the share price reaction, ITC's shares were down nearly 3.6 percent on Monday, July 25, 2023, after the announcement, indicating some disappointment among investors.

This arrangement has probably raised some concerns amongst the shareholders for various reasons like;

• Hotel’s business may be dependent on the parent company for its future capital requirements
• With ITC retaining a significant stake in the hotel company, minority shareholders of the hotels business won't be entitled to all of its earnings.
• ITC will still consolidate the hotels business but as a minority shareholder, which may impact its overall business.?

Shareholders might find it challenging to value the business with this unique arrangement, but the short-term reaction of ITC's shares was only a temporary reaction and the long-term impact of the demerger on the valuation of the business is still uncertain.?

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7. Key Triggers for ITC's Growth:

Despite the concerns surrounding the demerger, several factors indicate potential growth for ITC. Its core cigarette business is expected to grow by 10-12 percent, and the non-cigarette FMCG business is set to outperform peers with mid-to-high teens' growth in the coming quarters. Additionally, the demerger of the asset-heavy hotel business is expected to improve ITC's return profile significantly.

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8. Analyst Projections:

Analysts project ITC's hotels' share price to range between Rs 15 to Rs 23. Jefferies, a data provider, ascribes an EV/EBITDA multiple of 18x to ITC Hotels, which is lower than its target for Indian Hotels, a leader in the segment. However, other domestic broking firms give both ITC Hotels and Indian Hotels equal valuations.

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9. Potential Upside:

Despite the mixed reactions, there are potential upsides for ITC. The hotel business rebounded post-pandemic, and the future outlook remains positive with upcoming events like the cricket world cup and G20 expected to boost demand in the Indian hotel industry. Furthermore, the hotel business is also expected to benefit from the growth of the Indian economy and the rising demand for tourism.

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10. Closing thoughts:

So, there you have it, the demerger of ITC's hotel business with a twist. While it might not have been the cleanest separation from a minority shareholder's perspective, it does open up opportunities for ITC's growth and improvement in its return profile. Investors will be eagerly awaiting more details about this transaction and how it will unfold in the coming months as the scheme of arrangement is expected to be placed before the board for approval on August 14, 2023.

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If you found this article informative, don't forget to share it with your friends and as always, do your research and consult with financial experts before making any investment decisions.

Thank you for reading. Take care, and have a great day!

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