How ITC's new capital allocation plan could revive investor sentiment

Higher dividend payout addresses key concern of lower return on capital employed

The stock of ITC surged 7.5 per cent to close at Rs 161.95 on Tuesday, even as bears continued to dominate the markets, with the BSE Sensex slipping 2 per cent. The company’s new capital allocation policy was the key reason for the improvement in investor sentiment. Since almost a year now, the stock has been off investors’ radar because of concerns over cigarette volume growth and profitability of other businesses.

According to ITC’s new dividend distribution policy, announced on Wednesday and to remain in force over the medium-term, the company would pay 80-85 per cent of its profit after tax (dividend payout) to its shareholder, starting FY20. This is higher as compared to 68-69 per cent dividend payout in the last three years. Such a move will have multiple implications for the shareholders.

First, this would result in a dividend yield of close to 7 per cent at the current market price (after Thursday’s surge), which makes it even higher as compared to other FMCG players (below 2.5 per cent). ITC’s cash rich-position provides good comfort on this front. Additionally, higher payout also addresses one of the key investors’ concerns of lower returns earned on the substantial capital allocated over a long term to some businesses like hotels.

According to Shirish Pardeshi, analyst at Centrum Broking: “Higher investments in businesses such as hotels and other-FMCG have not yielded industry benchmark returns to ITC and this has raised investors’ concern. Therefore, returning cash to shareholders should be taken positively.”

In the last three years, return on capital employed for ITC’s hotel and other FMCG businesses has remained at mere 2-5 per cent, which is very low even as compared to players, such as Indian Hotels (8.5 per cent in FY19) and Britannia (43-44 per cent in FY19). However, going ahead, the ratio is likely to improve with lower capital expenditure requirement. This also perhaps is an indication that most businesses (other than cigarette) are now better-placed to grow independently, aided by the investments made so far by ITC. In a way, it could also review investor sentiment. Other non-cigarette segments (agriculture and paperboards, paper and packaging) have given relatively better returns.

The stock of ITC is currently trading at around 12 times its FY21 estimated earnings, a 50 per cent discount to its long-term mean average. In fact, implied valuation of its cigarette business (85 per cent of operating profit) of around 7 times FY21 earnings is also lower than major global tobacco players (8-13 times), according to JM Financial’s report.

However, investors need to cognisant of near-term volume pressure in cigarette business because of competitive intensity in the lower-end category, where ITC’s prices are relatively higher. Some analysts foresee around 4 per cent cigarette volume fall for ITC in FY21. Yet, a higher share of the premium segment should support volumes and margins.