Hindustan Unilever (HUL)

Stock Opportunities
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FMCG margin has been consistently getting better. I have attached a snapshot from HDFC Q2 report below.

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HDFC also said in a side note that ITC’s gross margin is at par with peers ( 40-45 % ) but low margin is due to Higher upfront brand investments and Losses in retail business. FMCG EBIT margin expansion was driven by enhanced scale, product mix enrichment and cost management initiatives notwithstanding higher investments in brand building and gestation costs of new categories.

Everyone is comparing HUL margin with ITC now… But I think best would be to look at HUL margin in their early days in 1990-2000s. Actually HUL ( in their older version ) exists in India from 1933. From 1956 inwards its called Hindustan Lever. And from the beginning they are into FMCG products. I could not find earlier Annual reports in their website. So I read the AR of 2002 and attached a snapshot of their margin from 1992-2001.

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Clearly margins have been low during the product gestation period. Margins did pick at a rapid pace. But thats mainly due to liberalisation in 1991 and lots of funds in flow. ITC is trying to build our own Indian brands competing with worlds biggest FMCG giants like Unilever, Nestle, Coke and Pepsi. It’s a matter of time that FMCG margins will gain.

They are already number 1 brand in Aashirvaad, sunfast cream biscuit, Bingo, matches (Aim/Ship) and number 2 in Yippe, Fiama, Savlon and Classmate. Plenty of other brands are emerging. These are no way easy goals to achieve competing with established players. Next decade will be a good one for ITC.

Of course our economy is not doing well and consumption is growth is slowest in 11 years ( after the severe financial crisis ) and the problem does look structural. But I hope that consumption revives in next months.

Discl: I hold ITC and hence my views could be heavily biased

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Biggest risk with ITC is not FMCG. That part of biz is doing well and margins will expand sooner or later.

Biggest risk is tobacco which investors should focus on. Global movement against tobacco, ESG investing, highly punitive taxes to discourage consumption. These are risks whose probability only increases with every passing year.

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Disagree. From an investors perspective who will hold this stock for say 20 years, others not buying the stock because of non commercial reasons is good opportunity to accumulate. If price is low, dividend yield will become higher as profits grow… in short term, might be bad but over longer term, it will be great to accumulate … cigarettes are not dying… I think this is a the safest largecap now with good margin of safety

[Biased view. Please make your own POV]

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135

If governments can ban alcohol what stops them from banning tobacco/cigarettes.

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IMHO banning won’t stop consumption. Only illegal cigarette production will increase. Illegal cigarettes don’t have quality control and can be harmful. So, why would Govt. risk that? They would rather increase taxes and somewhat ‘pray’ that people stay away from it.

Further, Govt’s most dependable child LIC is the second highest stakeholder of ITC. Why would they let Govt. stop their source of dividend (ITC’s high yield mostly results from the Tobacco business)?

Still, Govt, especially some state govt can put ban on tobacco sale, but logically thinking that will be a temporary action (read, populist measures) at best.

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There was lots of question about 25000 Cr investments… It was a ongoing process and not in a single year or so… Also in the recent interview Mr. Puri said that they are not stopping infrastructure capex as it takes long time to get the process done. But they are calibrating the capacity addition depending on the demand. Almost 9 ICMLs started the production and 2 more is in advanced stage. 9 more are in different stages of development.

ITC has been doing a capex of 2500 Cr per year across different business verticals. I have also given other metric for last 10 years below…

ITC
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On ITC, this report from HDFC securities - (https://www.marketsmojo.com/recommendation/view-report-26192) has good info on the different FMCG brands and the potential (basically says headroom in revenue growth is ~13x)… Not pasting the report content here as I am not sure of copyright etc.

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ITC:

The argument on other FMCG:

The argument is usually that ITC’s other FMCG & other businesses make no contribution to the bottom line and takes up bulk of the capital deployed by the firm. It is however contributing to the top-line as the years go by and now I believe it accounts for more than 50% of the top line.

Cigarettes do contribute more than 80% to the current earnings of the company (this should include tobacco business as well, will have to verify). That means out of some 18,000cr (check the exact numbers, all approximates from me) around 14,500cr would be from the cigarette business.

The conclusion is pretty simple, the other businesses would have to make around 10,000cr in earnings to meaningfully skew the %. Assuming the cigarette business grows its earnings slowly too.

So ITC really has to scale up its other businesses aggressively as there is no point in focusing on the bottom line at this stage. An Other FMCG business of 12k cr at industry standard margins simply will not hit the earnings profile at this juncture.

ITC’s problem is the cigarette business just makes too much money! Even if the contribution to top line decreases the margin profile of the cigarette business is much much higher.

Therefore, scaling the other FMCG business by constantly investing in growth and branding makes sense at this point, considering the objective is to decrease the cigarette business contribution.

As per the HDFC Report (shared here) ITC’s gross margins of their FMCG other business is in line with industry standards at 40-45%. This shows that it is not unit level issues with the business, but investment in creating brands & new product launches. HUL also had a period like this as per the data on this thread.

This business went from some 2kcr to 12kcr in around 12 or 13 years for ITC. In the process they have built huge back-end infrastructure as well.

At 21x TTM, ITC is clearly being valued as only a cigarette business with some premium attached to it since its a nifty heavyweight, clean governance, dividend yield etc:. Globally 15-18x is what peers trade at. So basically you are buying a cigarette business which is what it is today. But you get this whole other business with very strong brands, infrastructure and supply chains for essentially nothing. All this along with a 2.5% dividend yield.

Question obviously is what about the govt. risk on the cigarette business?

  • Govt. Cannot increase taxes and destroy the industry, it is a cash cow for the govt.

  • If the govt. bans cigarettes or makes it exceedingly difficult to use them, citizens may not like this as it feels like they do not have a choice etc etc:

  • Vapourisers would be a big positive for ITC as they can brand effectively on the boxes and build an afforable indian vape. They can also innovate on the cartridges side with various indian flavours etc: ITC actually has/had its own vape called eon but they don’, it can be found on some ecommerce websites still.

  • There is a big reason Governments don’t openly allow e-cigarettes or impose bans/heavy restrictions, it is because it harms tax revenues.

  • Inspite of the heavy tax hikes over the past few years, ITC still managed to grow its earnings at a respectable pace. This shows the pricing power of the company and unfortunately the strength of the cigarette as a sin product.

  • The opportunity size of cigarettes in India can be researched online, data is readily available even on ITC’s presentations. In short, unfortunately there is head

With the above in mind does it make sense to buy ITC as a cigarette business today and treat the rest of its initiatives as optionalities? And can one hope for 8-10% earnings growth with 2.5% yield resulting in 10-12% cagr with lower risk? Can it be long term 12% compounder with growing dividends just as a cigarette business?

One would have to question their views on the long term future of the cigarette industry. Can ITC over the next decade significantly decrease cigarette dependence as a company, that is an endless debtate. It would be more productive in my view to take a call based on the cigarette business, because that is the valuation that you are getting today.

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This could well be the reason for price coming down.

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Any factual basis for this?
Why would govt open the option for BAT to gain further stake in ITC and possibly become its parent co!?
Or could this be Motabhai’s foray into FMCG!

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I have created a semi-automated peer comparison sheet for most of the companies in the industry.

FMCG Industry Data.xlsx (560.0 KB)

You can find comparisons of more industries here:

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Excellent results from ITC beating estimates on both topline & bottomline fronts. FMCG margins also showed decent improvement sequentially from 2.8% in Q2’FY20 (2.5% in Q3’19) to 3.3% in current quarter.

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Excluding the Lifestyle retailing business, segment revenue for FMCG-Others grew by 6.1%. Segment EBITDA grew by 48% to ₹256 crores, with margins expanding by 230 basis points, despite stepped up marketing investments, gestation and start-up costs of new categories and new facilities and uptick in input costs, the company said in its statement.

“The FMCG-Others Segment delivered a resilient performance during the quarter which witnessed a slowdown in overall growth rates both in urban and rural markets. Categories with relatively higher rural salience remain the most impacted,” the company said.

The only FMCG which seems to be relatively resilient to this slowdown.

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ITC does operating profits of close to 18,000cr. Around 14,500 would be cigarette contribution.

I think all other businesses contribute around 50% of ITC’s 50,000cr top line i.e 25,000cr comes from all the other businesses I think.

Even if the other businesses show an operating margin of 25% put together on this 25k cr top line, it still would not change the companies dependence on the cigarette business. Out of 18,000cr around 6,000cr would be due to other businesses in such a case, still around 65% would be contributed by the cigarette business.

ITC’s core focus should be top-line growth of its other businesses. Only a 70,000cr plus top line from other businesses with a reasonable 15% Opm would mark a shift from the dependence on cigarettes.

A long way to go. Cigarettes do around 70% opm if I’m not wrong for ITC.

These are all back of the envelope figures, but I feel like I have to reiterate this because for the foreseeable future ITC will not derive enough from its other businesses simply because cigarette makes too much for no investment.

ITC is not wrong in spraying capital to garner market share and grow top-line. We are talking about replacing 15,000cr in operating profits meaningfully through other businesses. To put that into context, lever does only around 10,000cr in operating profits on a 40,000cr top line and lever is the gold standard for FMCG companies in India.

ITC should perhaps be viewed as a business that will protect investor’s downside due to the cash cow, but has a mega optionality should it have a few big hits through its new initiatives. The cigarette business will always be there to support the company and keeps growing marginally without absorbing any capital pretty much.

Whatever said and done I think investors should drop this hope story on ITC meaningfully decreasing dependence on cigarettes. At best its other businesses could provide comfort to investors in someway leading to the company holding onto its multiple or valuation metric.

What I think investors should be more interested about is the outlook and slow growth prospects of the cigarette business. If this business can show slow growth of 5-8% in earnings and 2-3% in volumes for the next decade, that itself would make ITC a valuable proposition as a 10-12% cagr low risk, low cyclical business including dividends and some operating leverage from its other businesses giving a marginal kicker to earnings growth.

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Budget-2020: Tax on cigarettes and other tobacco products to be increased.

Ref: https://www.cnbctv18.com/personal-finance/budget-2020-smokers-have-to-pay-more-on-cigarettes-5182091.htm

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It’s around 10 percent avg on over all tobacco and cigarettes business put together

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I think at company level they will managed to save DDT too now as amount which used to get paid as DDT it will move from tax to PAT

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Folks, could someone please help me understand would a 10% increase in tax reduce people smoking Cigarette ? If No, why is market so worried about it. Even before the budget itself this was expected to increase though extent of increase was unknown factor.

Majority of Smokers (who smoke Cigarette and not Beedi) may hardly care 7–9 Rs increase per box. Even if it pinches initially, with a couple of weeks one gets adjusted with reality and increased price may not bother.

Or is the market concerned that company may not be able to pass on this hike (due to competition) to customers and take a hit on P&L ?

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True increase will be from 1.5-5 rupee per pack.

No how much impact it can make? Most people will not care. But some people switch to smuggled version which are equally premium brand but way cheaper.

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https://marcellus.in/video/dissecting-new-sebi-rules-q2-corporate-results-valuing-consistent-compounders/

From minute 38 onwards ITC’s thesis is reviewed.

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