There has been a lot of conversation on why a demerger of ITC Ltd will unlock value. FMCG is a large basket but remains under the portfolio of a diversified conglomerate. So does the hotel business. Then there is the tobacco business, which has ESG implications.
As asset managers and investors get extremely conscious of ESG-compliant issues, the ITC stock bears the brunt. ESG is an acronym for Environmental, Social and Governance issues, which are parameters on which a business is analysed.
Sustainalytics, a leading independent global provider of ESG research, gives ITC a “Low Risk” rating when it comes to Resource Use and Supply Chain parameters (human rights, land use, biodiversity, resource use).
“Resource Use” looks at how efficiently and effectively a company uses its raw material inputs (excluding energy and petroleum-based products) in production and how it manages related risks.
When it comes to “Supply Chain”, the focus is on the management of water scarcity and raw material inputs risks (excluding energy and petroleum based products) within its supply chain, how companies manage the impact of their suppliers' operations on land, ecosystems and wildlife, and a company’s management of fundamental human rights issues occurring in its supply chain.
Though ITC’s efforts on the overall ESG front are truly commendable, it’s Achilles’ heel is the business in which it operates it. No doubt, it is a conglomerate, but is still extremely dependent on cigarette sales. Earnings before interest and tax (Ebit) of the cigarette division contribute over 85% to total Ebit.
Which brings us to the question: How will a demerger unlock value for ITC Ltd?
Professor Sanjay Bakshi answers. Before proceeding, he would like to make a few things clear:
- He is not recommending the stock
- His answer is purely from an academic perspective
- He has no position in the stock
Technically speaking, it is possible.
In a tobacco litigation scenario, if the courts decide against the company and award huge damages, litigants can go after all the assets.
In the U.S. something analogous happened when tobacco companies massively increased dividend payout ratios, thereby protecting payouts to shareholders from litigation awards. That’s because you can sue a company for alleged harm but not its stockholders as the company is not the same as its stockholders. If the company has disgorged its assets (cash) to the shareholders, then the litigants have no claim on them anymore.
The rise in the P/E multiple in those situations was warranted because, in valuation terminology, those earnings that were paid out were no longer retained in the company and were therefore immune from litigation awards.
A demerger means that the taint of tobacco is removed from the non-tobacco assets, if they are separated with ITC Tobacco having no stake in them. Then non-tobacco assets would have no recourse to funding from tobacco. Some of those assets may have to be sold off and their asset value may be more than earning power value.
A third scenario is to do with cost of capital. With ESG becoming a dominant force, a large number of global institutional investors and others won’t touch the ITC stock. A low P/E (caused by apathy in this case) increases cost of equity capital. That’s because lower the P/E, higher the cost of capital and higher the discount rate used to bring back future cash flows to present value, and vice versa. But when non-tobacco assets are separated and lose the stigma of tobacco, they may be more appropriately valued at a lower cost of capital (discount rate), resulting in value creation.