ITC - Meme Stock or Outperformer? ??

Greetings!

When we meant that the markets aren’t moving, we didn’t want to manifest a decline! Yet, markets fell this week, and apparently so did Joe Biden, again! Hopefully, the market doesn't fall as many times as he does from the Air Force One stairs!

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NIFTY 50: 17,466 (-3%)

NIFTY 10Y Benchmark G-Sec Index: 2,078 (0%)

Founder’s Recap

It’s about Ukraine, but Not about Ukraine ??

Friday marked one year of the conflict in Ukraine. The conflict strained economies, reshaped international trade, and revamped supply chains.

The conflict triggered higher inflation when the world was already grappling with higher inflation. Prices across commodities - energy, industrial and agricultural saw increases, sometimes running in multiples.

Prices have gone back to pre-war levels

One year on, prices for energy, industrial and agricultural commodities have reversed.

• Oil, which was up 25% within three months of the invasion, has fallen by more than 40% after
• Nickel prices had doubled within a month, but are now back to where they originally were. Prices are down by more than 10% for copper, iron ore, and zinc amongst others
• The war sent prices for several items like wheat, corn, soybean and sunflower oil soaring high. However, prices have gone to pre-war levels

For energy and industrial commodities, most of the normalisation can be attributed to reordered trade relations (India buying cheaper Russian oil), substitutes (Europe reducing dependence on Russian natural gas but firing up coal), and slower economic growth (first in China, and then in the West).

For agricultural commodities, prices eased thanks to continued Russian exports, other countries making up for the deficit, and the implementation of the Black Sea Grain Initiative.

But food inflation is a problem

A lot of the cooling off in prices can be seen in inflation rates going off their peak, across the globe. However, one thing that remained sticky was food inflation, and rightly concerning in the case of India. The latest CPI numbers were a ‘shocker’ for many on the street.

Wheat inflation was 25%, rice was at 10%, and Eggs and milk reported inflation at 9%. If international prices have gone back to pre-war levels, and if it’s not about Russia-Ukraine any longer, what is it that’s driving food inflation in India?

1. Poor domestic wheat crop after last year’s heat wave
2. Poor rice production because of rainfall deficits and irregularities
3. Rising fodder prices
4. A global egg shortage caused by a nasty bird flu

What next?

We reckon there is a case for stability on prices of energy and industrial commodities hereon as the Western economies have shown more resilience and now that China intends to come back with all its might.

On food inflation, there is little that central bank policies can do when the problem isn’t demand-led, but rather supply-driven.

Both these factors make a case for prices to remain steady to higher in the coming months.

?? Our View:?Sticky inflation may push the RBI to hike rates once more in April. This pushes the probability of a reversal in monetary policy towards the end of the year. Higher rates and higher yields are expected to stay for at least a couple of months, after which, it would be a good idea to start shifting maturities on debt portfolios. A policy standby if not reversal would offer a window for locking yields.

Market Stories

ITC - Meme Stock or Outperformer? ??

The 110-year-old cigarette giant has been making the rounds in newsrooms and investor portfolios alike, as the stock that was infamous for being stuck around the Rs. 200-300 range has finally broken the curse and given investors a 75% return since the beginning of 2022 (February 23, 2023)!

But are these returns here to stay? Yes!

ITC is slowly moving away from killing its customers to building an empire over the span of the last 15 years, which has now reached a pivotal point, and a fresh perspective on this supposed meme stock.

The strategy has been simple:

1. Keep making copious amounts of cash from its cigarette business, and
2. Funnel that cash into building other segments under the ITC brand, thereby reducing dependence on the cigarette business

Why does it need to shift?

• Smoking has declined as a global trend, not just as consumer sentiment, but due to the rising prices, driven by the hiking of taxes by the government. Specifically in India, we’ve seen smoking rates (% of the population that smokes) go from 55% to 27% in 2 decades as prices have gone up 5.5x in the same period!
• Furthermore, being a part of this category inhibits getting valued highly by investors, resulting in a flatlining of share price, as seen with ITC for a decade. After all, it is a declining market, with several headwinds and poor growth.

Cigarettes may not grow, but make a lot of money

• In the declining market, ITC holds a massive 85% market share. However, owing to its dominance in all sub-categories, and constant product innovation, it has managed to maintain its leadership
• Its revenue in the cigarette business has grown at a 3% CAGR from FY10 to FY20. Growth did pick up over the last couple of years as the government paused on tax hikes - but that seems unsustainable looking at larger trends

?? The beauty of the cigarette business however is in the high amount of profit and cash it generates: The business fetches operating margins of nearly 70%, Cash generation is high, with an OCF/EBIT of 100% and Capex requirements in the cigarette business are minimal

Excess cash for diversification

• The healthy cash generation allows ITC to diversify into segments that are more sustainable and have higher growth potential - FMCG, Hotels, Paper and Packaging, and Agricultural products
• Over the last two decades, it has heavily invested in these businesses, pumping in, on average 25% of its operating cash flow into diversification - aiding market leadership in all new businesses
• Now, those businesses make up 65% of revenue, from 40% in FY10
• While the revenue mix has morphed with time, the profit mix is yet to change, with cigarettes still making up 80% of the operating profits
• All other businesses combined still make just about 10% operating margins, as the focus has been on garnering a higher market share. However, now that the leadership position has been established, ITCs focus has been moving towards higher profitability
• From now to FY30, we expect ITC to clock revenue CAGR of 12% in other businesses (much faster than 3% in cigarettes), and for operating margins in other businesses to go from 10% now to 30%, which would lead to a 19% CAGR in operating profits

?? This would take the contribution of other businesses to 77% of revenue and 58% of operating profit by FY30

Several tailwinds and trigger

While the long term seems set for ITC to be classified as a conglomerate, and not a cigarette company, there seem to be several triggers in the other businesses, which could provide an immediate upside:

Valuations

By undertaking a Sum-Of-The-Parts valuation methodology, here is what we’ve come up with:

• Cigarettes are being valued at a 20x P/E multiple on FY25E
• FMCG is being valued at 5.5x EV/Sales multiple (forecasted based on sales as margins are yet to be realised)
• Hotel business is being valued at a 25x EV/EBITDA multiple
• Agriculture is valued at 15x P/E multiple, Paper and Packaging at 12x P/E and Infotech at 20x P/E

All of this amounts to a price of Rs. 460 cumulatively, providing a 21% upside (February 23, 2023)

?? Our View: We’re probably in the middle of a phase where not only is it a value stock, but has also transformed into the liking of a growth stock, making this stock a definite quality buy

We sat down this week to decode this and more about the ITC story on our podcast Common Cents by Rupeeting, so do check out the episode attached below!

We’re Betting on The Budge with Kotak Cherry ??

Rupeeting built and launched a portfolio which is exclusively available to the users of Kotak Cherry. Introducing Budget Bets - a bet on the beneficiaries from the Budget.

A straightforward concept, this portfolio is a bet on key sectors and themes of the Union Budget, riding that government growth wave!

Betting on the budget is a logical way to display a pro-growth stance on the markets, and certain sectors are usually distinct winners in this case. Take the Union Budget of 2022 for example - if you had placed bets on the defence sector (13% of capex budget) and railways (11% allocation of budget), you could’ve made outstanding returns with stocks like Bharat Dynamics (146% in 2022) and RVNL (109% in 2022)!

This year’s budget is an interesting one as well, with a much larger capex outlay of Rs. 10 lakh crore, which is 33.4% higher than the previous year, and 3x that of what was denoted in 2019!

The 2023 budget is especially important as it is the last one before the much-awaited General Elections of 2024, making this possibly the final chance for the ruling party to make a tangible mark on the country and in the minds of the voters.

In short?- you might just be making the most strategic move of the year by betting on stocks affiliated with the budget, which takes time and effort, or you could just invest in our portfolio! Give it a look at the link below!

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