United Spirits: Significant savings possible on RMs; upgrading margin estimates :: Kotak Securities

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Significant savings possible on RMs; upgrading margin estimates. Our analysis of
UNSP’s RM costs reveals significant ‘inefficiencies’. As per our estimates, gains of
`70-80 per case are possible on the margins front as Diageo goes about rationalizing
the cost structure. Margins would take time to recover as (1) some of the RMs could be
tied through long-term contracts and (2) execution of rationalization measures could
take time. We bake in full efficiency gains in our FY2017E numbers. We have raised our
earning estimates led by higher (`170 versus `135 earlier) margins in FY2017E. Retain
BUY with a revised TP of `4,000.

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UNSP’s RM costs are very high: significant scope for improvement exists
UNSP’s RM cost in FY2014 at `596 per case is very high and indicates a lot of inefficiencies in
the RM procurement process. As per our estimates, UNSP’s RM cost per case should not have
been more than ~`490 per case in FY2014, had the procurement process been efficient. Hence,
ideally UNSP should have made gross margins to the tune of ~50% in FY2014 versus reported
gross margins of 40%. Even tier-2 liquor companies like Radico Khaitan and Tilaknagar make
gross margins in the vicinity of 40% in their IMFL business (actual basis grossing up for tie-up
sales) at realizations in the range of `640-680 per case. UNSP’s gross margins should be
materially higher given higher realizations (net sales per case in FY2014) to the tune of `810 per
case. UNSP reporting similar gross margins as tier-2 liquor companies points towards
‘inefficiencies’ in RM procurement.
EBITDA margin should ideally have been closer to `150 versus `70 reported in FY2014
In our view, in case the RM procurement process would have been efficient in FY2014, savings
in the range of `70-80 per case (assuming 5% error in our costing data) could have been
achieved. Hence, reported EBITDA margins in FY2014 would have been `140-150 versus
reported margins of `70 per case.
We bake in full realization of RM cost efficiencies in our FY2017E numbers
We expect that the impact of cost rationalization being undertaken by Diageo should gradually
start reflecting in better margins in the coming quarters and bake in full efficiencies in our
FY2017E numbers. Time would be required (1) for due diligence of cost structure and
implementation of efficiencies and (2) as previous procurement contracts expire and new
contracts are signed. We are now modelling `170 per case margins in FY2017E versus `135
earlier. We have also reduced our volume estimates to reflect the premiumization strategy being
followed by the company. We are modelling volume growth of 5% CAGR in FY2016-17E. Our
new estimate of FY2017E EBITDA is higher by 11% versus earlier. Retain BUY with a revised target
price of `4,000 (`3,200 earlier) at 25X Dec 2016E EBITDA (multiples are unchanged from before).

LINK
http://www.kotaksecurities.com/pdf/indiadaily/indiadaily21012015mo.pdf