One of the basic facets of investing is to recognize growth. If two companies with equal management skills are available at similar PE’s then it would make sense to buy the one which has a clearer growth path set for itself. In HLL and ITC’s case the answers are not that easy to find. I have tried to initiate a discussion as to why ITC has always been cheaper to HLL on value terms. Is the market missing something or are the investors overlooking?

PEG = Price Earning to growth

RoE = Return on Equity

Excise duty at Rs 6438 crores constitutes almost 40% to ITC’s total revenues of 16,224 crores. This means that the newer businesses that the tobacco leader is getting into will start making a significant impact to the bottom-line sooner then one could expect These businesses have started gaining traction and the company has diversified into foods, hotels, paper etc.The biggest kicker in growth for ITC might come in Fy 09 when its retail venture choupal sagar starts throwing back cash. By that time the non tobacco business might contribute to about 50% of the net revenues of the company. The salient features of the choupal sagar project are:

 Largest web based initiative for Information

• dissemination and effective sourcing
• Reaches 2k-5k population villages

Existing scale

• �� 5,200 choupals & kiosks, across 31,000 villages
• �� Reaching 3m farmers in UP, MP, Maharashtra and

Rajasthan

• Investment by ITC, less than Rs300,000 per e-choupal

Information dissemination

•  Knowledge, information and transaction through a single medium.
•  Help improve productivity and hence returns
• Intermediary services are imperative, not intermediaries
•  De-link them from information chain
•  Utilize their physical transmission & logistics services
• Cost Arbitrage
•  Higher Realization for farmers
•  6% savings for ITC on procurement
• Managed by Sanchalak (lead farmer) –
•  Acts as an interface between farmer and computer
•  Overcomes literacy barriers and is a low cost resource

Target: 1 e-choupal for every 5 villages

"The idea was to first increase the size of the rural wallet, then garner a larger share of it, Basic innovation in our business model is being able to do that in a commercially viable manner" S. Sivakumar, CEO, ITC International Business Division

Therefore even ITC appears to be on a far stronger wicket then HLL but if we look at the PE ratios of the two companies HLL lags behind. Then why is the market is willing to give HLL a much higher PE compared to ITC? This is so because HLL’s RoE is at 64% compares extremely favorably  to ITC’s 26.5%. RoE is one of the important indicators of how efficiently a company is using its capital. More over that ITC's past history of quite a large number of project failures does not impress the market either. These failures did not close down the company because the tobacco division was throwing up cash which was used to wash away the sins from other diversifications. Some misses from ITC over the decade have been:

·         Paper business

·         Finance

·         Aquaculture

·         Excise related problems

More importantly then the real fear in ITC is its business model. Yes, while cigarettes are one of the best known businesses to be in smoking is also injurious to health. Each year the Govt. has screwed the nuts and bolts out for the tobacco industry, railway stations, public parks, movie halls, smoking is being banned everywhere and excise duty increased.. In the US once companies like Philip Morris faced huge damages on account of death caused by smoking, investors’ world over have developed very cold feet towards tobacco stocks.

Sooner or later and it is certain the Indian legal system will have to change and once that happens ITC will also be one of the sufferers. This is also a major reason for a low PEG compared to HLL. While we can be sure that the Govt, will never ban things like having a bath and brushing the teeth and drinking tea on the breakfast table with bread and kissan jam we could not be that sure about whether the govt. would not go ahead a few steps more to ban smoking.

I am not suggesting that smoking will be banned but just that this subjective fear makes ITC available at a cheaper value to HLL. As they say there are no free lunches in the world. Large cap stocks rarely have pricing anomalies and what ever is available is sold for a reason. So while I favor ITC there is nothing to suggest that it is mis-priced. The stock carries a risk premium which might not work out to your disadvantage before you sell it out.