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21 April 2009

BSE Sensex: 10980

INDIA RESEARCH
Rs730
United Spirits NEUTRAL

Company update Mkt Cap: Rs73bn; US$1.5bn

Analyst: Nikhil Vora (91-22-6638 3308; nikhilvora@idfcsski.com)


Bhushan Gajaria (91-22-6638 3367; bhushangajaria@idfcsski.com)

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).

IDFC - SSKI Securities Ltd.


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IDFC - SSKI INDIA

United Spirits – recovers from the bottom


United Spirits Sensex
110

95

40% price correction on dismal


performance in Q3FY09
80

65

~70% recovery from


the bottom

50
Jan-09

Jan-09

Jan-09

Jan-09

Jan-09

Mar-09

Mar-09

Mar-09

Mar-09

Apr-09

Apr-09

Apr-09
Feb-09

Feb-09

Feb-09

Source: IDFC-SSKI Research Feb-09

‰ 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/quintal) (Rs/Lt)
Molasses prices ENA price
600
35.0

475
30.0

350
25.0

225 20.0

100 15.0
Q1FY08

Q2FY08

Q3FY08

Q4FY08

Q1FY09

Q2FY09

Q3FY09

Q4FY09

Dec-07

Dec-08
Apr-07

Apr-08
Jun-07

Aug-07

Aug-08
Feb-08

Oct-08
Jun-08

Feb-09
Oct-07

Source: Industry, IDFC-SSKI Research

2
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
DIAGEO PLC RI FP
1,200 80

1,050 65

900 50

750 35

600 20
Oct-08
Jun-08

Dec-08
May-08

Jul-08

Aug-08
Jan-08

Feb-08

Mar-08

Apr-08

Sep-08

Jan-09

Feb-09

Mar-09

Apr-09
Nov-08
Oct-08
Jun-08

Dec-08
Jul-08
Apr-08

May-08

Aug-08

Apr-09
Jan-08

Feb-08

Mar-08

Sep-08

Jan-09

Feb-09

Mar-09
Nov-08

Source: IDFC-SSKI Research

4
IDFC - SSKI INDIA

Analyst Sector/Industry/Coverage E-mail Tel. +91-22-6638 3300


Pathik Gandotra Head of Research; Financials, Strategy pathik@idfcsski.com 91-22-6638 3304
Shirish Rane Construction, Power, Cement shirish@idfcsski.com 91-22-6638 3313
Nikhil Vora FMCG, Media, Retailing, Mid Caps, Education nikhilvora@idfcsski.com 91-22-6638 3308
Ramnath S Automobiles, Auto ancillaries, Real Estate ramnaths@idfcsski.com 91-22-6638 3380
Nitin Agarwal Pharmaceuticals nitinagarwal@idfcsski.com 91-22-6638 3395
Chirag Shah Metals & Mining, Pipes, Textiles chirag@idfcsski.com 91-22-6638 3306
Bhoomika Nair Logistics, Engineering, Power bhoomika@idfcsski.com 91-22-6638 3337
Hitesh Shah, CFA IT Services hitesh.shah@idfcsski.com 91-22-6638 3358
Bhushan Gajaria FMCG, Retailing, Media, Mid Caps bhushangajaria@idfcsski.com 91-22-6638 3367
Ashish Shah Construction, Power, Cement ashishshah@idfcsski.com 91-22-6638 3371
Salil Desai Construction, Power, Cement salil@idfcsski.com 91-22-6638 3373
Ritesh Shah Metals & Mining, Pipes, Textiles riteshshah@idfcsski.com 91-22-6638 3376
Neha Agrawal Financials neha@idfcsski.com 91-22-6638 3237
Swati Nangalia Mid Caps, Media swati@idfcsski.com 91-22-6638 3260
Sameer Bhise Strategy, Pharmaceuticals sameer@idfcsski.com 91-22-6638 3390
Shweta Dewan Mid Caps, Education, FMCG shweta.dewan@idfcsski.com 91-22-6638 3290
Nikhil Salvi Cement, Construction nikhil.salvi@idfcsski.com 91-22-6638 3239
Rajeev Desai Real Estate rajeev@idfcsski.com 91-22-6638 3231
Chinmaya Garg Financials chinmaya@idfcsski.com 91-22-6638 3325
Aniket Mhatre Automobiles, Auto ancillaries aniket@idfcsski.com 91-22-6638 3311
Probal Sen Oil & Gas probal@idfcsski.com 91-22-6638 3238
Rupesh Sonawale Database Analyst rupesh@idfcsski.com 91-22-6638 3382
Dharmesh Bhatt Technical Analyst dharmesh@idfcsski.com 91-22-6638 3392

Equity Sales/Dealing Designation E-mail Tel. +91-22-6638 3300


Naishadh Paleja MD, CEO naishadh@idfcsski.com 91-22-6638 3211
Paresh Shah MD, Dealing paresh@idfcsski.com 91-22-6638 3341
Vishal Purohit MD, Sales vishal@idfcsski.com 91-22-6638 3212
Nikhil Gholani MD, Sales nikhil@idfcsski.com 91-22-6638 3363
Sanjay Panicker Director, Sales sanjay@idfcsski.com 91-22-6638 3368
V Navin Roy Director, Sales navin@idfcsski.com 91-22-6638 3370
Suchit Sehgal AVP, Sales suchit@idfcsski.com 91-22-6638 3247
Pawan Sharma MD, Derivatives pawan.sharma@idfcsski.com 91-22-6638 3213
Dipesh Shah Director, Derivatives dipeshshah@idfcsski.com 91-22-6638 3245
Jignesh Shah AVP, Derivatives jignesh@idfcsski.com 91 22 6638 3321
Sunil Pandit Director, Sales trading suniil@idfcsski.com 91-22-6638 3299
Mukesh Chaturvedi SVP, Sales trading mukesh@idfcsski.com 91-22-6638 3298
Viren Sompura VP, Sales trading viren@idfcsski.com 91-22-6638 3277
Rajashekhar Hiremath VP, Sales trading rajashekhar@idfcsski.com 91-22-6638 3243

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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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