Does ITC’s hotel business demerger truly unlock value?

In the past few weeks, India’s stock markets are witnessing a huge surge in the number of companies announcing mergers, demergers, and buybacks. A demerger involves a company splitting one or more of its commercial ventures into another company.

To put it in another way, a demerger is said to take place when a business separates its current business operations into several parts to establish a new business that runs independently.

Past demergers

When multiple business segments or subsidiaries exist under the same company, the market tends to value the holding company at a lower valuation than the sum of their parts. This is called a holding company discount. Demergers help in getting rid of this discounted valuation, and unlocking value by allowing each entity to focus on its core strengths and strategic priorities. It could also lead to improved operational efficiency and better capital allocation.

In the past, we have seen plenty of examples where a demerger has resulted in long-term wealth creation for their shareholders. In 2007, Bajaj Auto Limited announced a demerger of its finance operations and listed Bajaj Finance on the bourses, which was only a two-wheeler finance company at that point. Today, Bajaj Finance is one of the biggest NBFCs (Non-Banking Finance Companies) in India and boasts an AUM (Assets Under Management) of over Rs 2.5 lakh-crore and a market capitalisation of over Rs 4 lakh-crore. Another example is Ultratech Cement which demerged out of Larsen & Toubro, and was later acquired by the Aditya Birla Group to become the biggest cement company in India in terms of capacity.

ITC segments

ITC Limited, formerly known as Imperial Tobacco Company of India Limited, is a conglomerate with a diverse business portfolio wherein the major chunk of revenues and profits of the company are earned through the company’s cigarette segment. In FY23, the cigarette division contributed to 41 per cent of the company’s total revenues, and 75 per cent of its total operating profits.

For many years, capital allocation has been the talking point with ITC. The management has been asked questions regarding plans to demerge the segments of the company numerous times since it was always believed by analysts and shareholders that the company could be better off using the cash generated in the cigarette business somewhere other than spending it in a capital-intensive segment like hotels. The drag due to this segment on the balance sheet quality of the company has been immense.

Source: Ace Equity

ITC's hotel segment contributed a mere 3.5 per cent to the total consolidated revenues of the company, while needing to employ 17 per cent of the total assets. Even the operating margins of the hotel business have remained below 12 per cent for every financial year in the last decade, except in FY23 when it reached 21 per cent of revenues.

The high capital expenditure required in this segment dilutes ITC’s return on assets and return on capital. Hence, any move to demerge the hotel business can be called a prudent move for the shareholders of ITC, and should have resulted in increasing the attractiveness of the company. However, going by the reaction of the bourses to the stock price of the company, this does not seem to be the case.

Is demerger good enough?

As per the structure of the demerger decided by the company’s management, 40 per cent of the shareholding in ITC’s hotel business will be retained by ITC Limited, while the remaining 60 per cent will be owned by the shareholders of ITC Limited. Hence, the ‘value unlocking’ will be limited to only 60 per cent of the valuation of the segment. The reason why the company could have chosen to keep 40 per cent of the shareholding with itself might have to do with the fact that ITC is not a promoter-driven company.

Ordinarily, when a company undergoes a complete demerger, the equity in the demerged entity gets distributed in the same ratio as the holding in the consolidated entity. This helps the promoters mirror their shareholding percentage in the demerged entity. However, being a professionally managed company, the company does not have any promoter and there is no promoter shareholding. Hence, had the company decided upon a complete demerger, ITC Limited would have lost all control of its hotel business. By keeping 40 per cent, ITC Limited might still want access to the hotel brand it has created.

Hence, apart from moderately improving the balance sheet structure and improving some of its ratios, ITC Limited ceding 60 per cent control through the demerger does not change much for its shareholders as of now. What would be interesting to watch in the upcoming months is the amount of royalty that ITC Limited would get from ITC Hotels, and whether there would be a new management in place to run the show at ITC Hotels. It will be also interesting to see if the management has any plans for the demerger of other segments in the future since the demerger of a larger segment like the FMCG might provide a higher value unlocking trigger.

(Parimal Ade (Twitter: @AdeParimal) is Founder, and Gaurav Jain (Twitter: @gaurav28jain) is Co-Founder, Investyadnya.in.)

Disclaimer: The views expressed above are the author's own. They do not necessarily reflect the views of DH.