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Gross margin pressure to ease in coming quarters

Tea price inflation has impacted TCP’s performance since the last four quarters. However, we expect gross margin to improve from 2QFY22 onwards as tea prices have declined (down 32% from their peak in Aug’20 to INR175/kg in Aug’21). In this note, we have analyzed the impact of the fall in tea prices on TCP in the near term. Here are the key insights:

Tea production in Jun-Jul’21 has grown v/s CY19…

* All India tea production (from Mar-Aug’20) declined by 19% YoY due to: a) first flush of the crop being lost as plucking activity came to a standstill due to the COVID-induced lockdown, and b) unfavorable weather conditions in Assam and West Bengal.

* Indian Assam tea is usually harvested in three flushes:

* The first flush is from mid-March to late-June (forms 32% of the whole tea cycle volumes and is of the best quality),

* The second flush is from July to September (forms 38% of volumes and is the second best in terms of quality), and

* The third flush is from October to December (forms 28% of volumes and are of inferior quality v/s the first and second flush) (as per 2019 production data).

* In CY20, tea production in India declined by 10% (to 1,258m kg), which created a supply crunch, leading to an increase in prices.

* Production volumes have started to normalize, but has increased when compared to CY20 and CY19 levels. Volumes have increased by 22%/11% YoY in Jun’21/Jul’21. They have increased by 12%/2% when compared to Jun’19/July’19 levels. All of which led to a decline in tea prices from its peak in Aug’20.

…but prices are above pre-COVID levels…

* According to the Tea Board of India, supply-side shortages led to an increase in India tea prices by 182% YoY to INR258/kg over Mar-Aug’20.

* With the normalization and increase in tea production, prices fell 32% from its peak in Aug’20 to INR175/kg in Aug’21. However, prices were still higher by 17% when compared to Aug’19 levels.

* As per our channel checks, TCP has not yet reduced tea prices as it usually follows a 2-3 months lag while passing on any increase or decrease. This would have a positive impact on profitability in coming quarters.

…which bodes well for gross margin in coming quarters

* Standalone gross margin fell 610bp YoY to 34.7% in 1QFY22 due to tea price inflation, which led to a 640bp contraction in EBITDA margin to 13.9%.

* Standalone gross margin has been contracting on a YoY basis since the last four quarters beginning 2QFY21 and is likely to reverse from 2QFY22.

* Standalone gross margin has been improving since 3QFY21.

* We expect gross margin pressure to ease out further from 2QFY22, which would aid operating performance. We expect standalone gross margin to expand by 700bp in 2HFY22 to 37.5%.

Valuation and view

* In FY21, TCP’s consolidated revenue grew 20% YoY, driven by volume growth of 12%/11% in India Beverages/Foods and tea price inflation. Operating leverage and lower ad spends aided EBITDA growth of 19% YoY in FY21. This despite gross margin contracting by 330bp to 40.5%. The underlying numbers were better given the double-digit volume growth in the base business, despite COVID-related disruptions. Overall performance was impacted by tea price inflation. The same is likely to taper down in the near term and bodes well for TCP.

* The unlocking of sales and distribution synergies from the merger of group companies has started to yield results. This is evident from the market share increase in tea (+190bp YoY) and salt (+160bp) in FY21 (and 1QFY22) on the back of an increase in numeric distribution. Direct coverage rose 30% in FY21, and the management aims to reach 1m by Sep’21. The company is establishing a strong S&D channel, which would act as a key growth driver.

* TCP is targeting lower double-digit growth in the India business – Tata Tea and Tata Salt – driven by: a) cross-selling between the Foods business and TCP’s tea distribution channel, and b) expansion into newer geographies.

* TCP is building Tata Sampann, which deals in pulses and spices. This should grow in high double-digits. The market size for pulses/spices in India currently stands at INR1,500b/INR600b, with unorganized players constituting 99%/70% of the market. Growth is expected through the capture of market share from unorganized players via an increasing distribution reach and new product launches.

* We expect a sales/EBITDA/PAT CAGR of 10%/18%/23% over FY21-24E.

* We arrive at an FY24E SoTP-based TP of INR1,000/share. We maintain our Buy rating.

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