United Spirits (UNSP.BO) Whisky Wars … :: Citi Research

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United Spirits (UNSP.BO)
 Whisky Wars …
 
 What’s new? — Per press reports (Source: Moneycontrol), UNSP has cut the price of
Royal Challenge, by ~15% in Delhi to Rs550 / 1L bottle from Rs650 / bottle earlier.
Quick thoughts / implications below.
 UNSP has indeed cut prices — of its brand Royal Challenge in a tactical pricing
action, in select markets like Delhi (and also other states like Punjab, Haryana and
Chandigarh) as part of a concerted strategy (along with McDowell Platinum) to combat
Pernod Ricard’s Blenders Pride and Royal Stag brands. That said, elasticity of demand
is significant – the price cuts of ~5-15% in markets like Punjab, Haryana, etc have
resulted in volume growth >20% in these markets.
 Our take — Short term, we see limited financial impact from these measures. Per our
estimates, Royal Challenge is ~1.5m cases. McDowell Platinum crossed 1m cases last
year. Both brands are ~2.5m cases – in contrast, UNSP volumes are forecast to cross
120m cases this fiscal. With revenue contribution of Royal Challenge <2% to UNSP’s
revenues, we don’t view this price action as a material impact on our short-term (FY12)
estimates, even assuming prices are cut nationwide.
 Long-term implications — a) competitive intensity is gradually escalating in the
alcoholic beverages industry. We estimate (based on various press reports and
sporadic disclosures from Pernod) that its key brands – Blenders Pride and Royal Stag
are ~11m cases and ~2.5-3m in annual sales respectively – meaningful when
juxtaposed against UNSP’s Bagpiper, which is around 16-17m cases (the no.1 whiskey
brand in volumes). b) UNSP’s investment thesis is predicated around two key factors: i)
its dominant competitive positioning, ii) the stickiness of alcohol prices (typically with an
upward bias). Such a thesis might need to be revised, if the magnitude and frequency
of such pricing actions increases.
 Maintain Buy — UNSP is one of our preferred picks in the consumption space, along
with ITC (ITC.BO; Rs206.50; 1L).
United Spirits
Company description
United Spirits is the largest player in India's branded spirits market with more than a
55% market share. It pursues an inorganic growth strategy, acquiring secondlargest Indian liquor manufacturer Shaw Wallace and scotch manufacturer Whyte &
Mackay. While the Shaw Wallace acquisition enhanced its competitive position,
raising its market share in branded spirits market, Whyte & Mackay gave it access
to scotch inventory to drive the next leg of its India growth strategy. UNSP also
acquired French winemaker Bouvet Ladubay - the wine arm of champagne major
Taittinger and plans to introduce its products to the Indian market. UNSP also owns
the Bangalore IPL cricket team ‘Royal Challengers' in a 100%-owned subsidiary.
Investment strategy
We rate United Spirits shares Buy/Medium Risk (1M). The company is well
positioned to benefit from India's organized liquor market that is growing at a rate of
~10-15% (driven by rising disposable incomes, favorable demographics and a shift
in consumption patterns). Pricing environment remains fairly healthy; which coupled
with management’s cost control initiatives - bodes well for profitability. We expect
commodity cost pressures to abate from 2HFY12, as UNSP achieves greater self
sufficiency in ENA production. Whyte & Mackay’s shift to branded products is a
long-term positive in our view. There have been concerns on account of high
leverage - we think the worst is behind us – UNSP's debt levels are likely to remain
stable at current levels, despite its aggressive capex plans.
Valuation
Our target price of Rs1,277 is based on a two-part EV/EBITDA methodology. We
value the domestic operations at 13.5x Sept12E EV/EBITDA. The multiple is at a
25% premium to international peers. We think this is merited, given that: a) volume
growth in India continues at mid teen levels vs. nominal growth in developed
markets, b) With >55% market share, UNSP's market positioning in a high growth
market is attractive, and c) India's demographic story is also attractive from a longer
term alcohol consumption story. We value the W&M EBITDA stream at 9x (which is
a ~20% discount to the global majors). We think this discount is merited, because of
W&M's status as a bulk scotch manufacturer. While over the longer term, we think
that W&M could re-rate, given management focus on building the branded
business; but it is still early days - thus we maintain the discount given the execution
risks. We also ascribe Rs40/share to value the Bangalore IPL cricket team franchise
at investment.
Risks
We rate United Spirits shares Medium Risk, instead of Low Risk as suggested by
our quantitative risk-rating system, which tracks 260-day historical share-price
volatility. We believe this is warranted as the capital structure of the company
remains a challenge vis-à-vis other peers in the India consumer space. The key
downside risks to our rating and target price include: 1) the liquor industry is highly
regulated and thus any change in policy (like increase in taxes, further control on
distribution or an outright ban on liquor sales in some states) could adversely impact
growth and profitability; 2) high interest expenses may impact earnings growth, if
United Spirits is unable to deleverage its balance sheet over the medium term; 3)
Concerns on group-related issues – promoter's pledged stake in UNSP and airline

business losses. Key upside risks to our target price stem from a) lower ENA costs
than our current estimates forecast and b) mgmt ability to pare discretionary costs
that may buttress operating margins.
ITC
(ITC.BO; Rs206.50; 1L)
Valuation
Our target price of Rs207 is based on 25x Sept12E earnings. ITC's stock has
experienced a gradual re-rating, as concerns pertaining to cigarette volume decline
(post the excise/VAT imposition) have been largely unfounded, with overall cigarette
volumes growing c.4% over FY09-11E, thus underscoring the resilience and
defensive attributes of the core cigarette business. Moreover, while PAT and
earnings have been somewhat volatile over the past few years, this has been on
account of the different growth trajectories and life cycles of ITC's other businesses,
some of which (i.e. personal care and foods) are at nascent stages of operations
and have yet to attain sustainable cash generation. In FY11 too, the company took
aggressive price increases that offset the excise increases, and augmented the
operating margins. Our target P/E multiple of 25x is above the last three-year
historical trading average (~21x). We note that from an absolute P/E perspective,
ITC is ~15% below peak valuations (around 27-28x). From a relative P/E
perspective, however, ITC appears relatively cheap - trading at around 1.5x - vs. a
peak of around 1.75x.
ITC has a relatively stable earnings stream, so P/E is our primary valuation
methodology.
Risks
We rate ITC shares as Low Risk because the company operates in branded
businesses and its earnings volatility is low. Downside risks that could prevent the
stock from reaching our target price include: 1) With most of its earnings coming
from the tobacco segment, ITC is most at risk from controls and the government's
tax policy. 2) Perceived as being a "sin" industry, the stock is prone to negative
share price reactions. 3) Other significant risks for the company are dilution in
capital efficiency from investments in non-tobacco businesses and the possible
acquisitions of capital intensive businesses that fail to enhance value.