United Spirits - Idfc Sski - 21 04 09

21 April 2009 BSE Sensex: 10980

INDIA RESEARCH

Rs730 NEUTRAL

United Spirits Company update Analyst:

Mkt Cap: Rs73bn; US$1.5bn

Nikhil Vora (91-22-6638 3308; [email protected]) Bhushan Gajaria (91-22-6638 3367; [email protected])

Tracking the market momentum, recovering from the knee jerk reaction post the poor financial performance in Q3FY09 and triggered by the ongoing talks with Diageo for stake sale in United Spirits (USL), USL’s stock is up by ~70% from the bottom. However, at the CMP of Rs730 and trading at a valuation of 16x (net of treasury stock), we see a strong trading ‘short’ opportunity given the pressure on near term profitability (rising prices of molasses) and continued uncertainty over the ‘stake sale’ transaction. While USL’s growth momentum remains robust (sold 90m cases - 88.5m cases in USL and 1.5m cases of W&M in FY09 – 20% growth), we see increasing pressure on the near term profitability as molasses prices are set to stay over Rs5200/ ton (25% higher yoy), less likelihood of material price hikes (given the election period) and limited scope for portfolio uptrade (first line brands account for 93% of the business now). We see continued gross margin erosion in USL’s domestic business in FY10 (expect 200bp). Globally too prices of Scotch whisky could see correction as economic recession hits consumption, thereby limiting the upside gains for W&M as and when the contracts come for renegotiation. Besides operationally, there could be likely GBP5-10m risk on numbers on account of pension scheme provisioning in FY09. All these factors pose a risk to our earnings estimates in FY10. Also, while USL is in talks with Diageo and various private equity players for stake sale, there could be likely delay in the completion of the transaction. Citing all these risks, maintain our Neutral stance on the stock with a near term trading ‘short’ opportunity. Global liquor majors – Diageo and Pernod Ricard have seen 20-25% correction in their stock price since December 2008 (while broader markets have moved up) and are trading at PER of 11x. Key valuation metrics Year (Rs m)

Net Sales

yoy chg (%)

Net profit

EPS (Rs)

yoy chg (%)

EV / E (x)

PER (x)

FY07

29,249

39.5

2973

35.9

607.5

14.7

20.4

FY08

46,275

58.2

2831

32.0

(10.9)

11.3

22.8

FY09E

54,391

17.5

3328

33.2

4.0

11.5

22.0

FY10E

66,462

22.2

4,285

38.2

15.1

11.1

19.1

‰ USL – 70% up from the bottom After the dismal performance in Q3FY09 (860bp of margin contraction), USL’s stock had corrected to Rs425 in January 2009. However the stock has since then seen 70% uptick to current market price of Rs730. This was driven on three counts – the fall, we believe, was sharper than expected and was a knee jerk reaction to the dismal performance (margins below 12% after a span of 7 quarters) and hence the recovery, secondly on account of strong market momentum (25% from the bottom) as indeed the ongoing talks of stake sale to Diageo and deleveraged the company balance sheet (net debt of Rs61bn).

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IDFC - SSKI INDIA

United Spirits – recovers from the bottom United Spirits

110

Sensex

95

40% price correction on dismal performance in Q3FY09

80

65 ~70% recovery from the bottom

Apr-09

Apr-09

Apr-09

Mar-09

Mar-09

Mar-09

Mar-09

Feb-09

Feb-09

Feb-09

Feb-09

Jan-09

Jan-09

Jan-09

Jan-09

Jan-09

50

Source: IDFC-SSKI Research

‰ While Q4FY09 numbers expected to be better than Q3FY09… In Q3FY09, United Spirits saw the sharpest of the margin contraction for the past many years – EBITDA margin contraction of 860bp and gross margin contraction of 940bp. This was primarily on account of sharp increase in molasses and ENA prices (accounting for 40% of material cost) and glass prices. Effective molasses prices had increased from Rs290/quintal in Q3FY08 and Rs460/quintal in Q2FY09 to Rs525/quintal in Q4FY09 (80% higher yoy and 14% higher qoq). ENA prices too were higher by 50% yoy at Rs31/ltr. With cut down in sugarcane cultivation, molasses and ENA prices have remained higher. However, the scenario improved in Q4FY09 (effective molasses prices were down to Rs480/quintal and ENA prices were at Rs28/ltr in Jan-Feb 2009), with slow down in economy resulting in slow down in ENA and molasses consumption for industrial purpose. This, we believe would help improve upon the margins in Q4FY09 over Q3FY09. While the sales growth remains robust (expect 17% growth yoy), EBITDA margins are expected at 14.4% (310bp higher qoq, but 340bp lower yoy). Molasses and ENA prices – peaked in Q3FY09 (Rs/Lt)

(Rs/quintal)

ENA price

Molasses prices

600

35.0 475

30.0

350

Source: Industry, IDFC-SSKI Research

2

Feb-09

Dec-08

Oct-08

Aug-08

Jun-08

Apr-08

Feb-08

Dec-07

Oct-07

Aug-07

Apr-07

Q4FY09

Q3FY09

Q2FY09

Q1FY09

Q4FY08

15.0 Q3FY08

100 Q2FY08

20.0

Q1FY08

225

Jun-07

25.0

IDFC - SSKI INDIA

‰ …but molasses price outlook unfavourable While the molasses and ENA prices saw some correction in January and February 2009, the prices have started moving upward since March 2009. While ENA prices have moved back to Rs30/ltr, molasses prices are near Rs500/quintal. We expect the molasses prices to remain higher for the remaining part of the year, as sugarcane produce has been lower by 40% in the current season at 150-180MT. Part of the reduction in the production would be negated by slow down in the consumption of ethanol for industrial use and alternative to fuel. From our interaction with the sugar industry as well as alcoholic beverages players, we gather that average molasses prices would be higher by atleast 25% in FY10 at ~Rs525/quintal. Further, in case of economic revival and uptick in the demand for industrial use of ethanol, the prices could move up further. USL will not be in position to negate the impact of this sharp increase in the raw material as we do not expect any material price hikes in the near term (till June) on account of ongoing elections and also limited scope for further up trading of the portfolio (first line brands account for 93% of the portfolio). Citing these reasons, we see gross margin contraction of 200bp in FY10 for USL. We have downgraded our PAT estimates for FY10 by 8% for FY10. ‰ W&M – realization gains may not be too soon As expected, Whyte & Mackay may close the year with GBP59m of EBITDA and not add at the net level. While 70% of W&M’s sales is on contracts, 20% is through private labels and rest through own brands. In FY10, W&M was expected to see some gains as older contracts get replaced by newer contract at the newer prices (current scotch prices are at 30-35% higher to the prices when the earlier contracts were entered into). However, significant contracts would come in for renegotiation only in FY11 and hence the gains in FY10 would be limited. Also what could pose a risk to the quantum of upside in scotch prices is the slowing down of scotch consumption globally. Pernod Ricard’s organic sales were down by 12% in the quarter that went by, while Diageo too is witnessing dip in volumes. Korea, one of the largest liquor markets in the world, has seen 7-8% drop in Scotch whisky sales in recent months. As the Scotch whisky demand dries up, there could be correction in the prices. Scotch prices are currently higher by over 45% from the time USL acquired W&M. Any correction in prices could cap the potential upside on W&M’s margins and pose a risk to our GBP66m of EBITDA estimates for FY10. Recession hits liquor consumption globally

Source: IDFC-SSKI Research

3

IDFC - SSKI INDIA

‰ Pension liability – a further downside On account of increase interest cost scenario in FY08, USL has accounted for Rs975m of actuarial gain on pension scheme in W&M. However, with interest rates falling during the year, there would be reprising of the pension liability and expect losses on the same. While the quantum of loss is no ascertained, it could be in the range of GBP5-10m. This could be further risk to our current year profit estimates of Rs3.3bn. ‰ Stake sale – a reality, but timing uncertain With a view to de-leveraged the balance sheet, USL is in talks with Diageo to sell 18.6m treasury shares on a fully diluted equity (worth Rs13.5bn at the current prices). There is also likelihood of Diageo taking up 37% stake in USL (equivalent to the promoter’s holding) and/ or buy stake in Whyte & Mackay. We believe that stake sale is critical for USL to de-leverage its existing balance sheet – net debt of Rs61bn. USL is also supposedly in talks with private equity investors to buy out the treasury stock. While we are optimistic over the occurrence of the stake sales (to either strategic or financial investor), timing uncertainty remains. While with Diageo there are lot many issues pertaining to pricing, Diageo’s role as a strategic partners, distribution of Diageo’s brands into India and where would the economic benefit of the same would like, with regards to the private equity investors, we believe that the transaction is in a very preliminary stage. Uncertainty over the timing of the transaction remains, which was to be the key trigger for the stock run up. ‰ Near term trade opportunity – On the Downside Besides market momentum, two key reasons for the recovery in United Spirits’ stock were relatively better expectation for Q4FY09 financials and talks of stake sale with Diageo. However, we anticipate pressure on operational numbers in the near term with molasses prices moving upward (and expected to remain at least for H1FY10), besides the risk of scotch price and losses on pension scheme provisions (GBP5-10m). This coupled with uncertainty of the timing of stake sale, we see no positive trigger points in the near term and thereby see a trading ‘short’ in the near term. At the current market price of Rs730, the stock is trading at 16x FY10E earnings (net of treasury stock) and 19.1x (including treasury shares). This is at 50%+ premium to its global peers – Diageo and Pernod Ricard. With economic recession adversely impacting liquor consumption globally and risk of profitability, the sector has seen substantial de-rating – trading at PER of 11x (from 15-18x+ in the past). Citing all these issues, we see near term downside risk in United Spirits and would recommend a near term trading opportunity - retracement of 15-20% from the current levels. Global liquor giants – see a sharp price correction, even after market recovery

Source: IDFC-SSKI Research

4

Apr-09

Mar-09

Feb-09

Jan-09

Dec-08

Nov-08

Oct-08

Aug-08

Jul-08

Jun-08

May-08

Apr-08

Mar-08

Feb-08

Jan-08

Apr-09

Mar-09

Feb-09

Jan-09

Dec-08

Nov-08

Oct-08

Sep-08

20

Jul-08

600

Aug-08

35

Jun-08

750

May-08

50

Apr-08

900

Feb-08

65

Mar-08

1,050

Jan-08

RI FP

80

Sep-08

DIAGEO PLC

1,200

IDFC - SSKI INDIA Analyst

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Pathik Gandotra Shirish Rane Nikhil Vora Ramnath S Nitin Agarwal Chirag Shah Bhoomika Nair Hitesh Shah, CFA Bhushan Gajaria Ashish Shah Salil Desai Ritesh Shah Neha Agrawal Swati Nangalia Sameer Bhise Shweta Dewan Nikhil Salvi Rajeev Desai Chinmaya Garg Aniket Mhatre Probal Sen Rupesh Sonawale Dharmesh Bhatt

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Explanation of Ratings: 1. Outperformer: More than 10% to Index 2. Neutral: Within 0-10% to Index 3. Underperformer: Less than 10% to Index

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