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United Spirits transformation may be a long-drawn-out one

A turnaround could take long, given Diageo’s patient approach with acquisitions and the uncertainty over government regulations
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First Published: Tue, Jul 23 2013. 09 59 PM IST
With state governments keen to increase revenue, duty on branded liquor has continued to rise, which will further dent consumer demand and strain margins. Photo: Ramesh Pathania/Mint
With state governments keen to increase revenue, duty on branded liquor has continued to rise, which will further dent consumer demand and strain margins. Photo: Ramesh Pathania/Mint
Updated: Wed, Jul 24 2013. 09 34 AM IST
Bangalore/Mumbai: Diageo Plc.’s takeover of United Spirits Ltd (USL) in a Rs.5,236 crore deal has sent the Indian company’s share price soaring almost fivefold to about Rs.2,800 from Rs.600 in just 15 months, on the back of investor relief over getting out of Vijay Mallya’s debt-wracked United Breweries Group.
It was one of the best performing stocks in a global index in 2012, according to a Bloomberg study, marking a stunning reverse, as reported by Mint on 31 December. Although the deal was only announced in November, speculation about the deal had begun earlier.
When the rally began in March 2012, it had lost nearly two-thirds of its value over 18 months. The stock has been one of the highest gainers this year as well, adding over 45% so far, making it one of the most expensive on the basis of the forward earnings method of valuation. An investment of Rs.100,000 in India’s largest distiller in March 2012 would be worth nearly Rs.467,000 now.
Analysts and investors seem to be betting that Diageo will beef up United Spirits’ slim profit margins by pushing sales of higher-priced brands such as Antiquity whiskey and Black Dog, increasing prices and reducing its debt. Diageo is now the largest shareholder in United Spirits with a 25.02% stake, lower than the 53.4% it originally sought, which still makes it the biggest shareholder. That lower stake is on account of Diageo’s public offer price being pegged at below the market rate.
Investors are also buoyant because they perceive the takeover as bringing about a break in ties between United Spirits and the UB Group, especially grounded Kingfisher Airlines Ltd.
The market also expects Diageo to put its own management in place to drive change. It has the right to appoint the chief executive officer (CEO) and the chief financial officer (CFO) at United Spirits as part of the deal announced on 9 November.
But is the optimism justified? Things haven’t changed too much on the ground.
Margins at distillers, with the exception of Pernod Ricard, which sells only higher-priced alcohol, have been hammered due to the soaring costs of extra neutral alcohol, a key ingredient. United Spirits’ Ebitda (earning before interest, taxes, depreciation and amortization) margin, a measure of profitability, narrowed to 11-12% last year from 17-18% in 2010.
Indians also seem to be drinking less alcohol, especially the cheaper variety, due to rising prices amid inconsistent regulatory policies. Volume growth dropped below 8% in 2011-2012 and 2012-2013, after advancing over 10% for most of the decade before that.
So far this year, volume has grown just 3%, according to data collected from executives. With state governments keen to increase revenue, duty on branded liquor has continued to rise, which will further dent consumer appetite and strain margins. Liquor is a state subject in India, so taxes and policies differ across the country.
Competitors such as Pernod Ricard, which earns more money than United Spirits despite selling less than one-fourth of its rival’s volume, and Allied Blenders and Distillers Pvt. Ltd are increasing market share.
These factors, along with Diageo’s historically patient approach with acquisitions and uncertainty over government regulations, mean that the operational, strategic and financial turnaround at United Spirits could take longer than expected, according to analysts, industry experts, and current and former UB Group and Diageo executives.
“Can Diageo deliver? Yes. But is there a willingness to do it immediately? That’s a totally different thing,” said Santosh Kanekar, a former marketing head at Diageo’s Indian unit. He now advises funds on investing in India, including the liquor industry. “Diageo is buying an industry leader, not some weak player whom they can easily dictate terms to. I think it’s going to take much longer for Diageo to transform USL’s performance than investors are hoping for.”

Portfolio matters

For instance, Diageo needs to reduce the size of United Spirits’ portfolio by selling low-margin products and increasing focus on higher-priced brands such as McDowell’s, Royal Challenge and Black Dog, Kanekar said.
Diageo, however, has publicly said it will retain all of United Spirits’ products.
It will take at least two-three years for the London-based distiller to successfully implement significant changes in United Spirits’ strategy and business model, said Pradeep Gidwani, an industry veteran who owns The Pint Room, a beer chain with outlets in four cities.
“Diageo is still to get a good understanding of what are the drivers of the Indian drinks market. So if they want to run United Spirits they need to build a significantly better understanding, otherwise they will end up mismanaging the acquisition and losing out to Pernod Ricard,” said Gidwani, a former UB executive who later ran Carlsberg India and Foster’s India, now owned by SABMiller.
Stocks of consumer goods companies, in general, are overpriced and United Spirits is the most expensive within that category on most valuation metrics, said V. Srinivasan, analyst at Angel Broking.
“There’s definitely an exuberance in the market about the company. This year, there’s not going to be that much of a change in their financial performance. It’s only from next year that we will start seeing an improvement and yet the stock has risen so much. The fundamentals just don’t support the valuation,” Srinivasan said.
United Spirits trades at nearly 54-55 times its estimated earnings for the current year, according to Bloomberg data. In comparison, ITC Ltd, another company which sells a product (cigarettes) with somewhat inelastic demand, trades at 32-33 times estimated earnings. The average price to equity multiple of 16 listed liquor companies in the world, including United Spirits and Diageo, is 24 times estimated earnings, Bloomberg data show.

Consumption will rise

Despite the recent slowdown in growth in India’s liquor trade, with hundreds of millions of teenagers about to attain legal drinking age over the next few years, consumption is only going to increase, said analysts who are bullish on the stock.
Some said United Spirits is best placed to take advantage of this with its leadership position and unrivalled distribution strength, which will now be aided by Diageo’s marketing and operational expertise. They also pointed to the expected reduction in the company’s debt from over Rs.8,000 crore to Rs.5,000-5,500 crore by next year.
“As Diageo transitions into United Spirits, we believe the business model will see a significant shift towards premiumization, rendering strong visibility to the long-term profitability of the business. We see United Spirits becoming one of the biggest names in the Indian consumer space in the long run on the lines of an ITC or Hindustan Unilever,” IDFC analyst Nikhil Vora wrote in a report earlier this month.
Since Diageo is its largest shareholder, United Spirits is essentially a multinational firm, and these usually get a higher rating from the markets compared with Indian companies, said Abneesh Roy, analyst at Edelweiss Securities, pointing to the relatively higher valuations of Nestle India Ltd, GlaxoSmithKline Consumer Healthcare Ltd and Hindustan Unilever Ltd.
“United Spirits was a poorly run company in the last two-three years because the promoters were spending most of their time on Kingfisher, so they didn’t invest much in USL brands and even in terms of financial management, there were issues. Now, we’ll see margin improving on a medium- to long-term perspective because of premiumization and better financial control,” he said. Roy expects the stock to rise even further in the next year or two. “Whenever Diageo appoints its own CEO and CFO, the stock will re-rate further. Investors are hoping for Diageo to get new management, on its own timeline of course,” he said.

Management changes

Handling management changes well is going to be crucial for Diageo, which has been a fringe player and a laggard in India despite being present in the country for more than two decades.
It cannot afford to alienate United Spirits executives, who run a larger and more successful liquor business than Diageo’s Indian unit, by making changes too soon. But analysts said it also needs to bring in fresh thinking not bound by the old mindset at United Spirits, which emphasized, among other things, volume growth over anything else, though the company has increased its focus on higher margin products over the past two-three years.
Diageo has retained Ashok Capoor as chief executive and P.A. Murali as chief finance officer.
However, a new chief executive is likely to be appointed by April 2014, two people familiar with the matter said.
Anand Kripalu, managing director at confectionery maker Mondelez India, is likely to join Diageo and may be groomed to take over the top job at United Spirits next year when Capoor leaves, said the people, who spoke on the condition of anonymity.
Diageo declined to comment on any possible management changes.
A spokesperson said by email: “USL has strengths of scale, leading local spirits brands across key categories, great understanding of the emerging market consumer, route to market across individual states and production/supply, as well as talented employees who drive the business with passion and pride. Diageo’s expertise in marketing, innovation and Reserve Brands complement USL’s strengths.”
Neither Capoor nor Kripalu could be reached for comment. Mondelez declined to comment.
Senior Diageo executives are to address United Spirits employees in a town hall meeting at the company’s headquarters in Bangalore on 24 July, they said, following the official completion of the takeover earlier this month.
UB Group chairman Mallya, through a spokesman, said in an email, “We will not comment on incorrect speculation. USL’s business does not need any ‘turning around’. The business is performing well and growing strongly in its areas of focus.”
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First Published: Tue, Jul 23 2013. 09 59 PM IST