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Focus on efficiencies to drive margins; await growth pick-up
* Despite the strong margin performance in H1, UNSP has underperformed recently on account of weak volume growth trends, rising competitive pressures and adverse state regulations. Q3 volume trends may see a marginal improvement vs. Q2, led by improvement in scotch portfolio.
* Margin improvement in H1 exceeded expectations on cost savings, while the reduction in A&P may see an increase in H2. Price increases in key markets are yet to come in and the impact of tax increase in Telangana and price cuts by competitors in Maharashtra are yet to play out.
* Reduction in non-core businesses to simplify corporate structure has been positive. Proposed merger of PDL should further simplify structure and drive efficiencies. The share swap, valuing PDL at Rs1.7bn, appears fair and gives its shareholders a strong franchise and better growth.
* Valuations after the recent underperformance at (40x FY21E EPS) are at a discount to peers. However, downside risks exist from slow volume trends and adverse state policies which keep us neutral on the stock. We maintain Hold/UW in EAP with a TP of Rs655.
Volume trends largely stable excl. Andhra Pradesh; Telangana tax increase and competitors’ price cuts in Maharashtra to be watched out for: Q3 demand trends across four key states indicate further slowdown in volumes, largely impacted by AP. Excluding AP, volumes (including the popular segment) in Karnataka, Maharashtra and Telangana have grown by 2-5%, similar to that of Q2. We estimate UNSP to see a marginal improvement vs. Q2 on better performance of its premium/scotch portfolio, also driving higher realizations. While AP (3.5% salience) continues to post a sharp decline due to the trade disruption, the impact of the recent tax increase in Telangana (15-20% MRP increase on prestige and popular brands) and price cuts by competition in Maharashtra will be key watchables. Sequentially, cost pressures are likely to ease marginally, given the softening in ENA prices by 5-10% from the peak. However, we do not see any upsides to forecasts given the likely increase in ad spends (vs. 16% decline in H1FY20) and slower volume growth.
Subsidiary rationalization has been positive, can continue to drive efficiencies: UNSP has simplified its corporate structure by rationalizing several non-core assets/businesses (see Exhibit 6) and driving efficiencies. The proposed merger of Pioneer Distilleries, PDL, (75% owned), although not material, should result in further efficiencies, optimum use of resources for UNSP, and better funding and capital raising ability for PDL, which may also drive a turnaround in its sub-scale and loss-making business (FY19 loss of Rs671mn). PDL has been making cash losses and has a negative net worth. Despite PDL’s weak financial position, the share exchange ratio of 1 share of UNSP for 4.7 of PDL, valuing it at Rs1.7bn, appears fair and attractive for PDL shareholders given UNSP’s stronger business and growth prospects.
Valuations at a discount to peers; await better growth visibility: Valuations at 40x FY21E EPS are now at a discount to peers. H1 performance has been steady and the worst of cost pressures are likely behind; however, adverse state regulations limit near-term growth visibility and keep us neutral on the stock. Maintain Hold/UW in EAP with a TP of Rs655.
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