Demerger to boost ITC's cash flows, create India's 2nd biggest hotel group

The demerger will however have only a marginal negative impact on ITC overall earnings and share price given the hotel division miniscule contribution to its consolidated finances

The planned demerger of ITC’s hotel division into an independent listed company marks the end of an era for the tobacco and fast-moving consumer goods (FMCG) giant. The company had merged the erstwhile listed ITC Hotels with itself in April 2005 to create a diversified and vertically integrated conglomerate with leading presence in tobacco, personal care, ready to eat foods, paper & packaging, food & agri products and hotels. Prior to it, the company had merged ITC Bhadrachalam Paperboards with itself in April 2002.

The demerger signals a reversal in ITC’s historical growth strategy of using the cash flows generated by highly profitable but slow-growing tobacco business to invest in other business such as FMCG, hotels and paper, paperboard & packaging.

For example, in the 2022-23 financial year (FY23), the FMCG -cigarettes division generated 75 per cent of ITC’s consolidated PBIT (profit before interest and tax) worth Rs 18,883 crore, but the division only accounted for 6 per cent of all capital expenditure (capex) incurred by the company. Nearly a fifth of capex worth Rs 589 crore went to hotels division while paper, paper boards and packaging division absorbed another 25 per cent of the capex worth Rs 745 crore. In all, in the last ten years, ITC has cumulatively spent Rs 24,095 crore on capex; out of which 30 per cent (worth Rs 7436 core) went to non-cigarette FMCG, 25 per cent (worth Rs 6348 crore) went to hotels and 22 per cent (or Rs 5560 crore) were invested in paper and paperboards side.

Analysts expect an improvement in ITC free cash flows after the demerger that absorbed a significant portion of its cash flows but contributed very little to its overall revenues and earnings. In FY23, the hotel division’s contribution to ITC’s consolidated revenues and PBIT were just 3.5 per cent and 2.2 per cent, respectively, even though the division accounted for 17.6 per cent of all its assets.

The rise in free cash due to the demerger is likely to result in a step-up in dividend pay-outs by the company which is positive for its shareholders. The demerger may also lead to an improvement in ITC’s return on equity (RoE) and return on capital employed (RoCE) which was pulled down by the hotel division — a cash guzzler with poor profitability and return ratios. This is another positive for ITC’s valuation, which continues to trade at a discount to FMCG peers such as Hindustan Unilever and Nestle.

“The high capex (in the hotel division) has always been a bone of contention for investors. For example, over the last 5/10/15/20-years, average annual free cash flows (FCF) has been negative in the range between Rs 150 and Rs 300 crore.

RoCE has also been in single-digits for most years, well below cost of capital,” wrote analysts at Jefferies in their note on demerger.

The demerger will however create India's second biggest hospitality group in terms of revenues and asset base right behind industry leader Indian Hotels Company. ITC's hotel division reported revenues of Rs 2,689 crore in FY23 against Indian Hotel Co (IHCL) consolidated net sales of Rs 5,810 crore last fiscal.

Similarly, ITC Hotel division reported profit before interest and taxes (PBIT) was Rs 557 crore last fiscal against IHCL's PBIT of Rs 1,531 crore. ITC Hotels will also start its new innings with an estimated net worth of Rs 6,976 crore in FY23, against IHCL consolidated net worth of Rs 7,982 crore last fiscal.

Based on the current valuation of industry peers, ITC Hotels is expected to start with a market capitalisation of at least Rs 15,000 crore and as high as Rs 42,000 crore. For example, IHCL is currently trading at 36.4 times its trailing PBIT and 7 times its book value; the corresponding ratio for EIH is 27.8X and 4X respectively. In comparison, ITC ended Monday with a market capitalisation of Rs 5.87 trillion, 31 times its earnings in FY23.