Indian liquor industry Regulatory hangover to continue The Indian liquor industry is a high-risk industry, primarily on account of the

e high taxes and innumerable regulations governing it. As a result, liquor companies suffer from low pricing flexibility and have inefficient capacities, which, in turn, have led to low margins and weak financial profiles. Moreover, even though the two large liquor groups in the country enjoy a majority market share, the price-sensitive nature of the industry has ensured a high degree of competition, which is exacerbated by the low export potential. Hence, while several strong brands have come up and the industry has exhibited healthy volume growth over the last few years (for instance, the Indian-made foreign liquor (IMFL) segment has registered a 8-10% compounded annual aggregate growth rate (CAGR) over the last three-four years), its high-risk profile continues to dog the industry. Like the international liquor industry, the Indian one too has seen players with strong brands, diversified portfolios and large operations achieve market leadership positions. Given the regulatory constrictions, however, an added key success factor for Indian players is the need to have operations across various states. Both because of the inherent nature of liquor and because of the politically-sensitive issue of molasses, a key raw material for spirits1, the Indian liquor industry has been subjected to a high degree of governmental interference. To boot, it is a major revenue contributor to the state governments, most of which are cashstrapped today. Hence, it is unlikely that the level of taxes or control exerted by the various governments would reduce in the medium term. So the regulatory risk is expected to remain high. Nor is the industrys risk profile expected to change significantly with the entry of multinational players or the implementation of commitments made to the World Trade Organisation (WTO). In fact, courtesy the high duty levels, the Indian market has not been flooded with cheap imports or consequently, witnessed greater competitive pressures, belying industry fears. Yet, the market continues to be attractive to the multinationals, especially in the scotch whisky and beer segments. While most of the multinational scotch whisky manufacturers have already established a presence in the country over the last seven to eight years, the beer segment has witnessed greater interest in recent years in anticipation of higher growth here. As a result, the pace of acquisitions and joint-ventures has picked up even as established domestic players try to consolidate their market position. Hence, the industry is expected to witness a shake-out with large players and those with strong parent support likely to survive in the medium to long term. Structure of the Indian liquor industry The Indian liquor industry comprises the IMFL, foreign liquor bottled in India (BII), foreign liquor bottled in origin (BIO), country liquor, beer and wine segments. The estimated 80 million case2 per annum IMFL segment primarily includes molasses-based whisky, rum, brandy, gin and vodka. This segment is dominated by whisky, which accounts for about 60% of its volumes, followed by rum at about 25%. The BII and BIO segments are very small in comparison. Put together, they are estimated to be less than one million cases per annum. The country liquor segment, estimated to be one-and-a-half to two times the size of the IMFL segment, is, however, characterised by fragmented capacities with a number of small players focused on the highconsumption rural areas. The beer market is estimated to be about 70-75 million cases per annum while the wine segment, estimated at less than three million cases a year, is, again, small.

Liquors that are produced using the distillation process and have a high alcoholic content (generally above 40% by volume) are referred to as spirits. Spirits include whisky, rum, vodka, brandy and the like. Beer, on the other hand, is produced using the brewing process in a brewery, and generally has alcoholic content of 5% to 15%. 2 Case is defined as 12 bottles of 750 ml for distilled spirits (IMFL, BII & BIO) and 12 bottles of 650 ml for beer.

The Indian liquor market is concentrated in the southern part of the country, with this region accounting for about 60% of total IMFL sales and 45% of beer sales. Andhra Pradesh is the largest consumer of both while Karnataka and Maharashtra are the second-largest consumers of IMFL and beer respectively.
Flavour wise segmentation of IMFL
Gin 2% Rum 24% Vodka 0.5%

Key IMFL Consuming States

CSD 4% R ajasthan 4% Uttar Pradesh 3%

Others 12 % Karnataka 18 %

Kerala P unjab 8% 3% Haryana 3% Delhi 3% M aharashtra 5% Bombay 3% Tamil Nadu 16 % A nd h r a P r a d e s h 18 %

Brandy 14%

Whisky 60%

Source: Information from industry players

The domestic industry is dominated by two large groups, the Vijay Mallya-controlled UB group and the Shaw Wallace group, which is controlled by the late Manu Chhabrias family. The two enjoy a combined market share of about 55% in IMFL and about 70% in beer. The UB group is larger with about 37% share in IMFL (through McDowell & Company and Herbertsons) and about 45% share in the beer segment (with BrewCo, the recently hived brewing arm of United Breweries Limited). High level of risk on account of regulatory environment Government regulations at every level have affected the Indian liquor industry, introducing structural rigidities. Apart from the high level of taxes and levies (that account for up to 65% of the consumer price), regulations pertaining to licensing, creation or expansion of brewing/distilling and bottling capacities, manufacturing processes (grain-based or molasses-based), distribution and advertising impinge on the industry. Further, liquor being a state subject, every state has different regulations (including those on distribution) and tax rates for the industry apart from restrictions as well as levies on the inter-state movement of liquor. These regulations have impacted the industry on all fronts. The high level of taxes and levies and the fact that companies have little control over distribution systems mean limited pricing flexibility. Consequently, players have low margin levels. Then, as a result of the restrictions on capacity expansions and inter-state movement of liquor, large players have either acquired or entered into contract manufacturing and bottling agreements with local players in various states. This means fragmented capacities with high overheads and poor economies of scale, which has further impacted margins. Restrictions on advertising have seen the industry resort to surrogate advertising besides earmarking high budgets for promotional activities and point of purchase campaigns and offering discounts and commissions to retailers. Besides, in the past, when some states imposed prohibition, these markets virtually dried up overnight. The state governments face a dilemma when it comes to liquor policies. The Indian Constitution says that the state shall endeavor to bring about prohibition of the consumption of intoxicating drinks. But the liquor

industry is one of the large contributors to state revenues, the loss of which can severely affect their cash flows. Also, it is difficult to enforce prohibition given the nature of the demand for liquor. In fact, this encourages consumption of often fatal illicit liquor. Moreover, since huge power subsidies and the impact of the Fifth Pay Commission have weakened state finances, it is unlikely that any state government could afford to lose this revenue contributor. So it is unlikely that these governments would lower controls on manufacturing and selling liquor in the short to medium term. Weak financial profile Typically, Indian liquor companies have a weak financial profile with low margins, large working capital requirements, high gearing and low interest coverage indicators. As mentioned before, low margins are a manifestation of limited pricing flexibility, and high overheads and advertising/promotion expenses. Working capital requirements are large because of the high level of work-in-progress due to the long processing period for fermentation and distillation. At times, this is reflected as loans and advances since most companies fund the working capital requirement of their contract manufacturers. Both large working capital requirements and the capital expenditure required to modernise old facilities or set up new ones has resulted in a high level of debt and gearing. Further, breweries are highly capital-intensive. In fact, the two main beer companies have gone in for debt-funded acquisitions to increase capacities, which has resulted in a further increase in gearing levels. With low margins and high gearing, interest coverage indicators too have been low. In addition, domestic liquor companies are known for their poor accounting policies with auditors qualifying the accounts. So it is often difficult to make any meaningful interpretations from their reported numbers. This is changing, however, as most players are scouting for foreign partners and so have initiated the process of cleaning up their balance sheets. This will improve transparency in the sector and may also result in better access to funds from the capital markets. Key financials of major liquor players Company United Breweries McDowell & Company Shaw Wallace Year ended 31/03/01 30/03/00 31/03/01 30/03/00 31/03/01 30/06/00
Operating Income Operating Profit Margin Net Profit Margin Rs. Mn. % % 3380.8 -2.6% 0.9% 2655.3 -16.9% 4.1% 8547.5 7.0% 2.6% 8250.3 8.2% 3.0% 5053.5 1.1% 0.4% 7106.2 6.4% 0.7% 2.6 1.09

Gearing Times 1.8 0.9 0.6 0.5 2.1 PBDIT Interest Coverage Times 1.4 1.7 2.4 2.9 1.17 Note: Figures derived from annual reports Figures for Shaw Wallace for the period ended 31/03/2001 are for a nine-month period

Healthy growth in overall volumes despite high price elasticity of demand The IMFL as well as the beer segments of the Indian liquor industry have demonstrated a healthy CAGR of about 8-10% over the last three to four years. But the growth has not been uniform across different price segments as the liquor market is highly price-sensitive. In the liquor industry, price sensitivity does not necessarily entail declining volumes; rather, it results in downtrading, that is consumers tend to switch to cheaper brands in face of price increase or recessionary conditions. For instance, since 1999, while there has been a marginal de-growth in the regular whisky segment, the cheap-to-medium-priced whisky segment has witnessed high growth. In the beer segment too, this phenomenon is evident in the higher growth rate achieved by strong beers, which provide a higher amount of alcohol per rupee. The price elasticity of demand also results in intense competition as players drop prices in a bid to retain or increase their market shares.

Characteristics of the Indian liquor market Molasses base Internationally, whisky and gin are made from grain spirit, brandy from fruit spirit (primarily grapes), rum from sugarcane spirit (through the molasses route) and vodka from grain/potatoes/sugarcane spirit or a mix of these. Indian liquors are predominantly molasses-based, however, with a portion of the appropriate grain/fruit spirit being added to them. Thats also the reason why they have not yet been accepted in the international market where spirits are defined in terms of their raw material content and ageing norms, which Indian liquors do not satisfy. Thus, Indian liquor exports are limited. The dependence on molasses also adds to the regulatory risks as there are restrictions on the inter-state movement of molasses. Spirits vs. beer and wine, and dark vs. white spirits Globally, especially in the western markets, the consumption of drinks with lower alcoholic content (beer and wine) not only exceeds that of spirits but is also showing higher growth. Further, within the spirits segment, there is a shift in global demand from dark spirits (such as whisky, dark rum and brandy) towards white spirits (such as vodka, white rum and gin). In India, on the other hand, consumption of spirits exceeds that of beer and wine due to their lower cost per unit of alcohol. The ratio in favour of spirits would be even higher if country liquor were included. Also, in India and in other Asian countries, there is growing demand for dark spirits, especially whiskies. Low margin levels Globally, large liquor multinationals enjoy high margins. For instance, the average net margins for the last three years for three of the largest global liquor players were above 10%. Although these companies have other businesses (primarily food-related) as well, these margins can be taken to be representative of the alcoholic beverage business as this is the largest contributor to these companies revenues and profits. The high margins are driven by the profits generated by the strong brands that these companies have either developed or acquired over a period of time. This is in stark contrast with the low margins of Indian liquor companies. Key revenue financials of the three leading players in the world Allied Domecq Company Diageo Pernod Ricard Year ended 30/06/01 30/06/00 31/08/01 31/08/00 31/12/01 31/12/00
Total Revenue Mn. UK 12821 Net Profit (post tax) before exceptional items Mn. UK 1445 Revenue from liquor business Operating Profit from liquor business Mn. UK Mn. UK 7580 1432 11870 1265 7117 1286 2879 347 2571 505 2602 312 2297 414 2782 84 1171 210 2765 157 1111 190

Net Profit Margin for company % 11% 11% 12% 12% 3% 6% Operating Profit Margin for liquor business % 19% 18% 20% 18% 18% 17% Note: Pernod Ricards net profit margin is low on account of its low-margin soft drinks and transportation businesses that have operating margins of less than 5%, and that together account for about 60% of the companys revenues.

Key success factors in the Indian liquor industry Brands hold the key Liquor is a consumer good. Hence, brand salience is extremely important for building a strong and sustainable market position. Strong brands not only lead to customer loyalty but also allow the owner to charge a premium. Established brands also act as a significant entry barrier for new players/ brands in this industry due to the restrictions on advertising. A companys brand strength is measured in terms of the number of

millionaire brands (brands with sales of more than a million cases a year) that it owns, and the actual volumes (number of million cases) sold. Geographical diversity of production as well as sales Given the restrictions and high duties applicable on inter-state movement of liquor, players whose production facilities and sales are spread over a greater number of states enjoy a competitive advantage. This diversity also helps them to withstand any changes in state policies. Sales to the canteen stores depot (CSD) of the defence services, which accounts for a major portion of institutional liquor sales in the country, also add to this diversity. Presence across spirits and price bands Apart from geographical diversification, a diversified presence across different spirits and price segments is another competitive advantage as such a company is in a better position to withstand the impact of changes in consumer preferences or of a downturn in any particular segment. Along with a diversified portfolio, having a significant presence in the whisky segment, the largest liquor segment in the country, is also essential for building an overall strong market position. Size of operations Size not only helps to reduce distribution overheads but also increases a players bargaining power with distributors. This is especially important in states where distributors, by virtue of their monopolistic position, are very strong and can control not only pricing but also the brands that will be sold in their regions. Raw material linkages The key raw material for IMFL players is molasses, which is a by-product of sugar. Molasses is processed and distilled to produce rectified spirit (ethanol). Players with primary distillation facilities directly consume molasses while others purchase ethanol. Supply of molasses primarily depends on sugarcane production levels, which show cyclicality since sugarcane itself is a cash crop with its production showing cyclicality. This cyclicality also imparts a commodity nature to molasses. As molasses demand arises only from ethanol demand, the demand-supply scenario for ethanol determines the raw material price for IMFL players. Ethanol is consumed by the liquor industry and to produce industrial alcohol, each segment accounting for roughly half the ethanol consumption. Ethanol demand is expected to rise in future when the commercial blending of ethanol with petrol (for producing gasohol) takes off. In the long term, however, the supply is also expected to increase as more sugar manufacturers are expected to set up primary distilling facilities and as new sugar mills are expected to come up in the form of integrated plants with cogeneration and distilling facilities. Thus, while molasses/spirit prices are likely to increase after the commercial production of gasohol starts, they are likely to come down from the increased levels in the long term. For beer and grain-based spirits, the base raw material is barley, which is a foodgrain. Its production is thus linked to climatic conditions. Indian market attractive for multinational suitors Whisky demand has been declining in the western markets in recent years. Simultaneously, demand is rising in India and in other Asian countries. This, coupled with rising disposable incomes in the region, has made Asian countries attractive markets for MNCs with strong whisky brands. Further, beer volumes in India are expected to register high growth in the coming years both because of the latent demand potential per capita beer consumption is extremely low in India compared to the west and even China and liberalisation of beer sales by de-linking it with IMFL. Some state governments like Uttar Pradesh, Himachal Pradesh and Maharashtra have already liberalized beer sales. The wine industry too is hoping to tap the potential and has accordingly

been fighting to be de-linked from the IMFL industry. It has already achieved success in Maharashtra, where wine sales are expected to rise. Multinational players still in infancy Most of the large MNCs such as Diageo and Allied Domecq already have a presence in India through jointventures, and they have introduced some of their global scotch whisky brands through the BII route, by importing the scotch concentrate. Their leading brands are only available through the BIO route, however, and these sales are expected to increase only after a significant decline in basic customs duties and countervailing duties. Players with multinational parents enjoy support in the form of access to established brands, blending technology for developing domestic brands, global marketing campaigns and managerial expertise. On the financial side too, they have access to both fund-based and non-fund-based support (guarantee or letter of comfort/awareness covering the Indian companys borrowings). Despite this support, foreign players have not been able to make a dent in the domestic players market share, and the latter continue to dominate the domestic liquor industry. Thats because most foreign players are either focused on niche, high-value segments that have low volumes currently or they have a small presence, if any, in the high-volume, low-margin regularto-low end of the IMFL segment. Their relatively recent entry in the Indian market (last five to six years for most players) is another reason for their small market share. The credit profile of the Indian subsidiaries factors in the demonstrated support and willingness as well as ability of the parent to financially support its Indian venture in times of distress. But the applicability and extent of this credit enhancement critically depends on the parents business as well as financial risk profile. Life continues as usual after WTO According to Indias WTO commitments, quantitative restrictions (QRs) on BIO liquor had to be removed by April 2001 and the basic import duty on liquor has to be brought down to 150% by April 2004 in a phased manner. The QRs on BIO have been removed with effect from April 1, 2001 and the basic duty on beer and wines (at 100%) is already below the bound rate. Also, the basic duty rate on distilled spirits has been reduced from 210% earlier to 182% in the 2002-03 budget. There were fears that the Indian market would be flooded with cheap BIO liquor after the QRs were removed, resulting in increased competition and lower realizations and margins at the higher end of the market. In order to provide a level playing field to domestic manufacturers, who are subject to excise and other levies, however, the government imposed countervailing duties (CVDs) on imported BIO liquor. Three slabs of CVDs have been applied with the highest duty on lower-priced imports to prevent dumping. As a result, the removal of QRs has not significantly impacted the domestic players high-end sales since the high landed cost of BIO liquor has made it prohibitively expensive for most domestic consumers. Further, it is unlikely that even with lowered tariffs, imported liquor would be able to provide competition to domestic players in the regular or cheap segments, which account for a major portion of the market. Consolidation in the Indian industry While the international spirits industry has witnessed a number of brand acquisitions and consolidation over the past few years, the Indian industry has not gone through any similar churning albeit the MNCs have increased their equity stake in their Indian joint-ventures in recent years following an increase on the limit on the foreign partners shareholding. The beer segment, on the other hand, has witnessed both the entry of MNC players and a lot of consolidation in the recent past. In the capital-intensive brewery business, ownership of brewing capacity is a big entry barrier. Existing players have been trying to consolidate their position in the industry, primarily by acquiring

brewing capacity. The MNCs also view the Indian market as a potentially large and high-growth market, and players like Fosters, Strohs, SAB and Scottish & Newcastle have entered over the last few years. Some of these players have acquired or set up brewing facilities (Fosters & SAB) while others have entered into jointventures with domestic players. Other major international players like Anheuser Busch (makers of Budweiser), Heineken, Interbrew and Carlsberg have also expressed an interest in entering the Indian market. This is likely to result in further acquisitions and joint-venture activity in future. In the long term, the liquor industry is expected to witness a shakeout and further consolidation, with weaker players exiting the industry. Large players and those with strong parent support are likely to survive. But given the politically-sensitive nature of the industry, the plethora of regulations governing it would continue and thereby, restrict such activity to some extent.