Key Takeaways:
- ITC's board has approved in principle the demerger of its hotel business into a separate listed entity. ITC will retain a 40% stake, while existing shareholders will directly own the remaining 60%. This structure, while providing greater transparency and potentially unlocking value, differs from a complete vertical split, which some investors might have preferred.
- The hotel business, while accounting for less than 5% of ITC's revenue and EBIT, represents over 20% of its capital employed and historical capex. This disparity highlights the historically capital-intensive nature of the hotel business and its impact on ITC's overall financial performance.
- ITC's hotel business has undergone a strategic shift towards an "asset-right" model, emphasizing management contracts over owned properties. This strategy is reflected in the limited pipeline of under-construction projects and aims to improve the business's return on capital employed (ROCE) and free cash flow (FCF).
- The recent demerger announcement is facilitated by the hotel business's improved profitability and positive FCF generation. This turnaround is driven by a cyclical upturn in the industry, leading to higher average room rates (ARR) and occupancy levels.
- Jefferies maintains a 'BUY' rating on ITC with a price target of INR 530. The valuation is based on a sum-of-the-parts (SOTP) methodology, with the hotel business valued at 18x EV/Ebitda.
Important Facts and Ideas:
1. Historical Performance:
- "The hotel business contributed <5% of ITC revenues & Ebit over the last decade. However, it accounted for >20% of ITC's capex in the past."
- "High capex has always been a bone of contention for investors. For example, over the last 5/10/15/20-years, average annual FCF has been negative in the range of Rs1.5-3bn. RoCE has also been in single-digits for most years, well below cost of capital."
2. Asset-Right Strategy:
- "ITC has been increasingly focusing on an asset-light strategy and today, slightly over half of the room inventory is through management contracts, while rest comes from owned hotels."
- "Focus on management contracts is also evident in the pipeline of under-construction projects, which has thinned out significantly in the last few years."
3. Improved Profitability:
- "Recent trends however are much stronger, as the industry is seeing an up-turn post-Covid. FY18-23 revenue Cagr is at 12% with FY23 Ebit margin a decade-high of 21% (~19%, incl. unallocated)."
- "Put together, after seeing negative cash flows, the business generated a positive FCF for the first time in nearly 15 years."
4. Demerger Structure and Implications:
- "Board has in principle approved hotel de-merger in a step down sub (final call on 14-Aug). ITC will own a 40% stake while shareholders will directly own 60% - we believe some investors may have preferred a vertical split (100% direct)."
- "This move will not likely have a big implication for ITC's share price and in our view is not a precursor to other businesses going the same way."
5. Valuation and Outlook:
- "With improving profitability, we shifted to EV/ Ebitda valuation for the hotel business vs. EV/ Invested capital earlier. We applied 18x EV/Ebitda multiple, pegging ITC hotels at a 20% discount to our fair value multiple for the leader, Indian Hotels (IHCL) at 23x."
- "Outlook is positive for the industry too, with further increase in ARR looking likely in FY24"
Potential Risks and Considerations:
- Supply Pressure: The report highlights the risk of potential supply pressure from existing shareholders, particularly BAT, once ITC Hotels is listed. This selling pressure could negatively impact the share price of the newly listed entity.
- Holding Company Discount: Analysts currently do not apply a holding company discount to ITC. However, the report notes that this might change once ITC Hotels is listed separately, potentially impacting ITC's overall valuation.
- Brand Royalty: The potential for ITC to levy a brand royalty on the hotel business.
