ITC's Hotels Demerger: Has the air cleared after the analyst call?

Investors have been disappointed by the structure of ITC's hotel demerger

ITC’s management held a publicly-viewable analyst call, where they fielded questions posed by fund managers and sell-side analysts. Investors learnt more about why they chose the structure they did for the demerger of its hotels business, but the main question is whether this will send their discomfort.

A bit about the structure, first. ITC’s demerger proposal for the hotels business will see it continue to hold a 40 percent stake in the demerged entity, with 60 percent shareholding being distributed to all public shareholders. This is unlike a 100 percent vertical demerger where the shareholding pattern of the demerged company mirrors that of the listed company. This structure will introduce a holding company discount for ITC, it can potentially lead to a bloat in the equity capital of the demerged entity as shares are issued to ITC and its shareholders, and it opens up the door for ITC making future capital contributions to the hotels business. More importantly, it’s not a clean separation from the hotel business. Its shares fell after the demerger was announced.

Here are some of the management responses to the questions, that throw light on the structure and other issues.

Some new data that came out in the course of the analyst meet 

The new entity will be debt-free and have net assets of about Rs 6,000 crore.

Related stories

Ravi Ananthanarayanan

Deputy Executive Editor|Moneycontrol

• 
  Can Colgate sustain the shine?
• 
  Asian Paints: Keeping its powder dry
• 
  ITC’s hotels demerger fulfils key investor demand, but comes with a twist

ITC’s segment ROCE (return on capital employed) should improve by about 18-20 percentage points and its overall ROIC (return on invested capital) should expand by 10 percentage points.

It’s a tax-neutral transaction and the 60:40 structure does not confer any tax benefit or disadvantage, either on income tax or stamp duty fronts.

Why the equity stake in the hotels business? 

‘The whole ecosystem is comforted by the structure’ is how the management described this aspect. The ITC name, goodwill and institutional support appear to have been deemed crucial in convincing employees to shift to the hotel entity from ITC, a much larger and profitable entity compared to the hotels business. And, this same logic could be extended to suppliers too. The structure gives access to synergies and even mobility to employees within the iTC group.

The structure is designed to benefit existing rather than new shareholders, they said. This implies that even if shareholders decide to sell shares in the hotels business, whether institutional or retail, ITC will retain control with its 40 percent stake. Again, this provides stability to the ‘ecosystem’ but is not necessarily beneficial for minority shareholders, as they may benefit in a situation where a takeover is contemplated, for instance.

But, why 40 percent and not lower? 

The hotels company plans to issue ESOPs to its employees, similar to how ITC issues ESOPs to employees above a certain grade. This will dilute ITC’s stake as the equity capital will expand. Then, if strategic investors are inducted in the hotels business, as is contemplated at some time, more dilution will occur. The 40 percent level allows them headroom to undertake these steps without giving away control.

Capital-raising plans 

The hotels business will stay firmly on the asset-right path of managing properties constructed and owned by others and not embark on self-constructed properties that could need capital. Thus, its cash flows are meant to be enough to fund its capital requirements. But even if it does need capital, they believe the new entity can raise capital on its own balance-sheet, whether debt or equity.

Royalty 

Some sort of royalty arrangement will be worked out, to use the ITC name and goodwill. The management does not expect this to be a large number.

The bottom line 

ITC’s clarifications clear the air on why it has put together this demerger proposal. In ITC's current structure, there is no promoter. BAT owns 29.1 percent, and between the government-owned insurance companies and SUUTI they own 28.2 percent. If ITC had a defined promoter, then this group would have controlled the hotel company as well and it would have been business as usual for all stakeholders. The new entity cements the existing management's control over the hotel business.

More details on aspects such as the capital structure, the swap ratio and board composition later, when the scheme of arrangement becomes public.

While the logic may have become clearer, the fact remains that ITC will retain a big chunk in the hotels business, which investors will have to value when they determine the fair value of ITC’s shares. The holding company discount is likely to reflect in ITC's valuation. Investors in the hotel company are unlikely to see a takeover attempt and enjoy the resulting windfall, unless ITC is also on the same page.

But investors will hope that over a period of time, as new investors come into the hotels business, ITC’s stake will fall, such that it becomes insignificant in the scheme of things. And, they may stretch their hopes to also believe that as the hotels business comes into its own, employees and other stakeholders may feel comfortable enough about the prospect of severing the umbilical cord completely with ITC. And, of course, ITC itself should have no problem in letting go at that point.

Till then, investor discomfort over the structure is likely to remain. But the size and growth of its cigarettes and FMCG businesses will probably overshadow this concern. There’s also the question of what ITC will do with its cash flows that were being invested earlier in hotels and the loss of an operating business. It could enter a new business, for example. The excitement created by such a development may see investors relegate this episode to a footnote.