Mark to Market | United Spirits-Diageo: deal structure holds the key

Investors should refrain from jumping the gun before contours of the transaction are announced
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First Published: Tue, Sep 25 2012. 01 47 PM IST
The Vijay Mallya-controlled United Spirits provides Diageo with the perfect platform to roll out its India strategy. Photo: Reuters
The Vijay Mallya-controlled United Spirits provides Diageo with the perfect platform to roll out its India strategy. Photo: Reuters
Updated: Wed, Sep 26 2012. 08 11 AM IST
United Spirits Ltd has confirmed through a stock exchange announcement that Diageo Plc is in talks to acquire an interest in the company. This confirms speculation that the global liquor company may invest in United Spirits, lightening the debt-related problems of the Vijay Mallya-owned UB group. The statement from United Spirits refers to “possible transactions” being considered. This may be just an innocuous phrase in the statement, but should also caution investors from jumping the gun, before the contours of the transaction are announced.
Diageo’s motivation is to increase its presence in emerging markets, where a large population with growing disposable incomes and changing lifestyle present an attractive opportunity. It is already investing in India, and in a conference call held in May, the Diageo management said that its success in Tier I cities has emboldened it to go into Tier II markets now, and that it has 83% direct coverage of the outlets that sell liquor in India. It has launched its own IMFL (Indian-made foreign liquor) brand—Rowson’s Reserve.
The company’s current strategy is to participate in price points of $10 and above (Rs.530 at current exchange rates), and its experience in the market has given it the confidence to participate in the premium end of the IMFL market. After Rowson’s Reserve, the company is planning two more launches in the fiscal year ending June 2013. Critically, while answering a question on China, the management stated that it believes that its business in India will reach an inflection point in 2012-13; in China, this point will be reached three-four years later.
United Spirits provides Diageo with the perfect platform to roll out its India strategy, as it has a strong position in the domestic market and experience in navigating complex state-wise regulations imposed on the liquor industry. It also adds significant size to Diageo’s business, as United Spirits’s India business had sales of Rs.7,879 crore, or about 8.5% of Diageo’s revenues of £10.8 billion (Rs.93,000 crore at current rates) in 2011-12. The impact is higher at the regional level. Diageo’s Asia-Pacific revenue will increase by 60%, and spur the company’s emerging market growth to higher levels.
How does United Spirits benefit? Diageo’s entry can help it lower the debt burden, which is crucial as interest ate away half its earnings before interest, taxes depreciation and amortization (Ebitda), a measure of operating profit, in the June quarter, with a debt-to-equity burden of 1.6 times. It will be far easier to fund capital expenditure plans, with Diageo as an investor. If the two companies operate as one in the market, the benefits will be substantial.
How do the promoters benefit? The UB group is financially stretched due to debt in many of its operating companies, especially on the books of Kingfisher Airlines Ltd. A stake sale will help them raise funds, which they can use to recapitalize holdings and get more breathing space for the ventures and satisfy lenders.
What’s in it for United Spirits’s minority shareholders? The best scenario for United Spirits’s shareholders is if Diageo picks up an equity stake in the company, and then makes an open offer to its minority shareholders. The gains will be less if Diageo takes a lower stake, though they could still benefit if the foreign company merges its operations with United Spirits, making it the main investment vehicle for its India plans.
But the real risk is if Diageo does not want to be a part of an India-listed entity. It may work out a structure where the Indian business is carved out into a separate entity, or is acquired by it through a slump sale. This structure would be similar to what happened when Abbott Laboratories acquired Piramal Healthcare Ltd’s domestic pharmaceutical business. That will release significant cash into the listed entity, and solve the promoters’ cash worries, and hold out the promise of a special dividend to shareholders. But it severely limits the benefits to minority shareholders, who get cut off from the growth potential of the business after being acquired by a blue-chip multinational with deep pockets and a hunger for growth. Investors, of course, are hoping for a plain vanilla stake sale, as can be seen from the 8.89% increase in the United Spirits stock.
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First Published: Tue, Sep 25 2012. 01 47 PM IST
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